Tableof Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****     ****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF1934**

** **

**For the quarterly period ended March 31, 2010**

 

**Or**

 

**o****        ****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition period from                   to                   **

 

**Commission File Number: 001-32966**

 

**OSIRISTHERAPEUTICS, INC.**

(Exactname of registrant as 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’stelephone number, including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes x  No o

 

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

 

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

 

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

 

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

 

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

 

| **Class**                                 | ** ** | **Outstanding at May 6, 2010** |
|-------------------------------------------|------------|----------------------------------------------------|
| Common  Stock, par value $0.001 per share |       | 32,775,331                                         |

 

 

 

----

Tableof Contents

 

**OSIRIS THERAPEUTICS, INC.**

 

**INDEX**

 
| ** **                                   | ** **                                                                                     | **Page** |
|----------------------------------------------|------------------------------------------------------------------------------------------------|----------|
| **PART I — FINANCIAL INFORMATION** | 3                                                                                              |
|                                         |                                                                                           |     |
| Item 1.                                      | Financial Statements —  Unaudited                                                         | 3        |
|                                         | Condensed Balance Sheets —  March 31, 2010 and December 31, 2009                | 3        |
|                                         | Condensed  Statements of Operations — three months ended March 31, 2010 and 2009     | 4        |
|                                         | Condensed  Statement of Stockholders’ Equity— three months ended March 31, 2010 | 5        |
|                                         | Condensed  Statements of Cash Flows — three months ended March 31, 2010 and 2009     | 6        |
|                                         | Notes to Condensed Financial Statements                                                        | 7        |
|                                         |                                                                                           |     |
| Item 2.                                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations    | 18       |
|                                         |                                                                                           |     |
| Item 3.                                      | Quantitative  and Qualitative Disclosures About Market Risk                                    | 26       |
|                                         |                                                                                           |     |
| Item 4.                                      | Controls and  Procedures                                                                       | 26       |
|                                         |                                                                                           |     |
| **PART II — OTHER INFORMATION**    | 27                                                                                             |
|                                         |                                                                                           |     |
| Item 1.                                      | Legal Proceedings                                                                              | 27       |
| Item 1A.                                | Risk Factors                                                                                   | 27       |
| Item 2.                                      | Unregistered  Sales of Equity Securities and Use of Proceeds                                   | 27       |
| Item 3.                                      | Defaults Upon Senior Securities                                                                | 27       |
| Item 4.                                      | (Removed and Reserved)                                                                         | 27       |
| Item 5.                                      | Other Information                                                                              | 27       |
| Item 6.                                      | Exhibits                                                                                       | 27       |
|                                         |                                                                                           |     |
| Signatures                                   |                                                                                           | 28       |
|                                         |                                                                                           |     |
| Exhibit Index                           |                                                                                           |     |
|                                              |                                                                                                |          |  |

 

2

----

Tableof Contents

 

**PART I— FINANCIAL INFORMATION**

 

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

 

**OSIRIS THERAPEUTICS, INC.**

**CONDENSED BALANCE SHEETS**

**(amounts in thousands)**

 
| ** **                                                                                                             | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                             | ** ** | **(unaudited)**              | ** ** | ** **                      | ** ** |
| **Assets**                                                                                                             |       |                         |       |                            |       |
| Current  assets:                                                                                                       |       |                         |       |                            |       |
| Cash                                                                                                                   |       | $                            | 1,215      |                            | $          | 1,306 |   |
| Short-term  investments                                                                                                |       | 88,588                       |       | 99,409                          |       |
| Accounts  receivable                                                                                                   |       | 1,389                        |       | 1,138                           |       |
| Inventory                                                                                                              |       | 117                          |       | —                          |       |
| Prepaid  expenses and other current assets                                                                             |       | 715                          |       | 948                             |       |
| Total  current assets                                                                                                  |       | 92,024                       |       | 102,801                         |       |
|                                                                                                                   |       |                         |       |                            |       |
| Property  and equipment, net                                                                                           |       | 3,582                        |       | 3,734                           |       |
| Restricted  cash                                                                                                       |       | 666                          |       | 666                             |       |
| Other  assets                                                                                                          |       | 340                          |       | 395                             |       |
| Total  assets                                                                                                          |       | $                            | 96,612     |                            | $          | 107,596 |   |
|                                                                                                                   |       |                         |       |                            |       |
| **Liabilities and Stockholders’ Equity**                                                                          |       |                         |       |                            |       |
|                                                                                                                   |       |                         |       |                            |       |
| Current  liabilities:                                                                                                  |       |                         |       |                            |       |
| Accounts  payable and accrued expenses                                                                                 |       | $                            | 5,794      |                            | $          | 9,013 |   |
| Deferred  revenue, current portion                                                                                     |       | 40,925                       |       | 41,011                          |       |
| Capital  lease obligations, current portion                                                                            |       | 1                            |       | 3                               |       |
| Current  liabilities of discontinued operations                                                                        |       | —                       |       | 412                             |       |
| Total  current liabilities                                                                                             |       | 46,720                       |       | 50,439                          |       |
|                                                                                                                   |       |                         |       |                            |       |
| Deferred  revenue, net of current portion                                                                              |       | 33,963                       |       | 44,173                          |       |
| Other  long-term liabilities                                                                                           |       | 475                          |       | 424                             |       |
| Total  liabilities                                                                                                     |       | 81,158                       |       | 95,036                          |       |
|                                                                                                                   |       |                         |       |                            |       |
| Stockholders’  equity                                                                                             |       |                         |       |                            |       |
| Common  stock, $.001 par value, 90,000 shares authorized, 32,775 shares outstanding -  2010, 32,773 outstanding - 2009 |       | 33                           |       | 33                              |       |
| Additional  paid-in-capital                                                                                            |       | 273,334                      |       | 272,959                         |       |
| Accumulated  other comprehensive income (loss)                                                                         |       | 15                           |       | (88                             | )          |
| Accumulated  deficit                                                                                                   |       | (257,928                     | )          | (260,344                        | )          |
| Total  stockholders’ equity                                                                                       |       | 15,454                       |       | 12,560                          |       |
| Total  liabilities and stockholders’ equity                                                                       |       | $                            | 96,612     |                            | $          | 107,596 |   |

 

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

 

 

3

----

Tableof Contents

 

**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

**Unaudited**

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

 
| ** **                                                                               | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                               | ** ** | **March 31,**     | ** ** |
| ** **                                                                               | ** ** | **2010**               | ** ** | **2009** | ** ** |
|                                                                                     |       |                   |       |   |   |
| **Revenue from collaborative research agreements, government  contract and royalties**   |       | $                      | 11,377     |   | $ | 12,726 |   |
|                                                                                     |       |                   |       |   |   |
| Operating  expenses:                                                                     |       |                   |       |   |   |
| Research  and development                                                                |       | 6,560                  |       | 18,567 |   |
| General  and administrative                                                              |       | 1,807                  |       | 2,913 |   |
|                                                                                     |       | 8,367                  |       | 21,480 |   |
|                                                                                     |       |                   |       |   |   |
| Income  (loss) from operations                                                           |       | 3,010                  |       | (8,754 | ) |
|                                                                                     |       |                   |       |   |   |
| Other  income, net                                                                       |       | 88                     |       | 98 |   |
|                                                                                     |       |                   |       |   |   |
| Income  (loss) from continuing operations, before income taxes                           |       | 3,098                  |       | (8,656 | ) |
|                                                                                     |       |                   |       |   |   |
| Income  tax (expense) benefit                                                            |       | (682                   | )          | 748 |   |
| **Income (loss) from continuing operations**                                             |       | 2,416                  |       | (7,908 | ) |
|                                                                                     |       |                   |       |   |   |
| **Discontinued operations:**                                                             |       |                   |       |   |   |
| Income  from operations of discontinued operations, net of income taxes of $117 in  2009 |       | —                 |       | 1,239 |   |
| Gain  from sale of discontinued operations, net of income taxes of $2,026 in 2009        |       | —                 |       | 21,428 |   |
| **Income from discontinued operations**                                                  |       | —                 |       | 22,667 |   |
|                                                                                     |       |                   |       |   |   |
| **Net income**                                                                           |       | $                      | 2,416      |   | $ | 14,759 |   |
|                                                                                     |       |                   |       |   |   |
| **Basic income per share**                                                               |       |                   |       |   |   |
| Income  (loss) from continuing operations                                                |       | $                      | 0.07       |   | $ | (0.24 | ) |
| Income  from discontinued operations                                                     |       | —                 |       | 0.69 |   |
| Basic  earnings per share                                                                |       | $                      | 0.07       |   | $ | 0.45 |   |
|                                                                                     |       |                   |       |   |   |
| **Diluted income per share**                                                             |       |                   |       |   |   |
| Income  (loss) from continuing operations                                                |       | $                      | 0.07       |   | $ | (0.24 | ) |
| Income  from discontinued operations                                                     |       | —                 |       | 0.69 |   |
| Diluted  earnings per share                                                              |       | $                      | 0.07       |   | $ | 0.45 |   |
|                                                                                     |       |                   |       |   |   |
| Weighted  Average Common Shares (basic)                                                  |       | 32,774                 |       | 32,692 |   |
|                                                                                     |       |                   |       |   |   |
| Weighted  Average Common Shares (diluted)                                                |       | 33,088                 |       | 32,692 |   |

 

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

 

4

----

Tableof Contents

 

**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY**

**Unaudited**

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

 
| ** **                                                           | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated**    | ** ** | ** **             | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|--------------------|------------|------------------------|------------|------------|------------|
| ** **                                                           | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**          | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                           | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**    | ** ** | **Stockholders’** | ** ** |
| ** **                                                           | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income  (Loss)** | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
| **Balance at January 1, 2010**                                  |       | 32,773,331            |       | $           | 33         |              | $          | 272,959            |       | $                      | (88        | )          | $          | (260,344 | ) | $ | 12,560 |   |
|                                                                 |       |                  |       |        |       |              |       |               |       |                   |       |       |       |
| Exercise  of options to purchase common stock ($0.40 per share) |       | 2,000                 |       | —      |       | 1                 |       | —             |       | —                 |       | 1          |       |
|                                                                 |       |                  |       |        |       |              |       |               |       |                   |       |       |       |
| Share-based  payment — employee compensation                    |       | —                |       | —      |       | 374               |       | —             |       | —                 |       | 374        |       |
|                                                                 |       |                  |       |        |       |              |       |               |       |                   |       |       |       |
| **Comprehensive Income:**                                            |       |                  |       |        |       |              |       |               |       |                   |       |       |       |
|                                                                 |       |                  |       |        |       |              |       |               |       |                   |       |       |       |
| Net  income for the period                                           |       | —                |       | —      |       | —            |       | —             |       | 2,416                  |       | 2,416      |       |
|                                                                 |       |                  |       |        |       |              |       |               |       |                   |       |       |       |
| Unrealized  gain on investments available for sale                   |       | —                |       | —      |       | —            |       | 103                |       | —                 |       | 103        |       |
| **Total Comprehensive Income**                                       |       |                  |       |        |       |              |       |               |       |                   |       | 2,519      |       |
|                                                                 |       |                  |       |        |       |              |       |               |       |                   |       |       |       |
| **Balance at March 31, 2010**                                   |       | 32,775,331            |       | $           | 33         |              | $          | 273,334            |       | $                      | 15         |       | $          | (257,928 | ) | $ | 15,454 |   |

 

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

 

5

----

Table of Contents

 

**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENTS OF CASH FLOWS**

**Unaudited**

**(amounts in thousands)**

 
| ** **                                                                                                     | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                     | ** ** | **March 31,**     | ** ** |
| ** **                                                                                                     | ** ** | **2010**               | ** ** | **2009** | ** ** |
| **Cash flows from operating activities:**                                                                      |       |                   |       |   |   |
| **Continuing operations**                                                                                      |       |                   |       |   |   |
| Income  (loss) from continuing operations                                                                      |       | $                      | 2,416      |   | $ | (7,908 | ) |
| **Adjustments to reconcile income (loss) from continuing operations  to net cash used in operations:**         | ** ** | ** **             | ** ** | ** ** | ** ** |
| Depreciation  and amortization                                                                                 |       | 190                    |       | 127 |   |
| Non  cash share-based payments                                                                                 |       | 374                    |       | 1,018 |   |
| **Changes in operating assets and liabilities:**                                                               |       |                   |       |   |   |
| Accounts  receivable                                                                                           |       | (251                   | )          | 246 |   |
| Prepaid  expenses and other current assets                                                                     |       | 116                    |       | 254 |   |
| Other  assets                                                                                                  |       | 55                     |       | 156 |   |
| Accounts  payable and accrued expenses                                                                         |       | (3,168                 | )          | 1,796 |   |
| Deferred  revenue                                                                                              |       | (10,296                | )          | (10,092 | ) |
| Net  cash used in continuing operations                                                                        |       | (10,564                | )          | (14,403 | ) |
| **Discontinued operations**                                                                                    |       |                   |       |   |   |
| Income  from discontinued operations                                                                           |       | —                 |       | 22,667 |   |
| **Adjustments to reconcile income from discontinued operations  to net cash used in discontinued operations:** |       |                   |       |   |   |
| Non  cash impact of the sale of discontinued operations                                                        |       | —                 |       | (14,121 | ) |
| Depreciation  and amortization                                                                                 |       | —                 |       | 210 |   |
| Non  cash share-based payments                                                                                 |       | —                 |       | 125 |   |
| **Changes in operating assets and liabilities:**                                                               |       |                   |       |   |   |
| Accounts  receivable                                                                                           |       | —                 |       | (17,214 | ) |
| Inventory  and other current assets                                                                            |       | —                 |       | 1,707 |   |
| Accounts  payable and accrued expenses                                                                         |       | (412                   | )          | 4,261 |   |
| Net  cash used in discontinued operations                                                                      |       | (412                   | )          | (2,365 | ) |
| Net  cash used in operating activities                                                                         |       | (10,976                | )          | (16,768 | ) |
|                                                                                                           |       |                   |       |   |   |
| **Cash flows from investing activities:**                                                                      |       |                   |       |   |   |
| Purchases  of property and equipment                                                                           |       | (38                    | )          | (35 | ) |
| Proceeds  from the sale of property and equipment                                                              |       | —                 |       | 17 |   |
| Proceeds  from sale of discontinued operations, net                                                            |       | —                 |       | 9,870 |   |
| Proceeds  from sale of investments available for sale                                                          |       | 11,097                 |       | 11,806 |   |
| Purchases  of investments available for sale                                                                   |       | (173                   | )          | — |   |
| Net  cash provided by investing activities                                                                     |       | 10,886                 |       | 21,658 |   |
|                                                                                                           |       |                   |       |   |   |
| **Cash flows from financing activities:**                                                                      |       |                   |       |   |   |
| Principal  payments on capital lease obligations and notes payable                                             |       | (2                     | )          | (2 | ) |
| Restricted  cash                                                                                               |       | —                 |       | (536 | ) |
| Proceeds  from the exercise of stock options                                                                   |       | 1                      |       | 134 |   |
| Net  cash used in financing activities                                                                         |       | (1                     | )          | (404 | ) |
|                                                                                                           |       |                   |       |   |   |
| Net  (decrease) increase in cash                                                                               |       | (91                    | )          | 4,486 |   |
| Cash  at beginning of period                                                                                   |       | 1,306                  |       | 940 |   |
|                                                                                                           |       |                   |       |   |   |
| Cash  at end of period                                                                                         |       | $                      | 1,215      |   | $ | 5,426 |   |

 

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

 

6

----

 

 

Tableof Contents

** **

**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

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

 

Osiris Therapeutics, Inc.(“we,” “us,” “our,” or the “Company”) is a Delaware corporation headquarteredin Columbia, Maryland. We began operations on December 23, 1992. We are aleading stem cell therapeutic company focused on developing and marketingproducts to treat serious medical conditions in the inflammatory, autoimmune,orthopedic, and cardiovascular areas.. Our biologic drug candidates utilizeadult human mesenchymal stem cells, or MSCs, which can selectivelydifferentiate, based on the tissue environment, into various tissue lineages,such as muscle, bone, cartilage, marrow stroma, tendon or fat. In addition,MSCs have anti-inflammatory properties and can prevent fibrosis or scarring,which gives MSCs the potential to treat a wide variety of medical conditions.Our operations consist primarily of research, development and clinicalactivities to bring our biologic drug candidates to the marketplace. We haveseveral research collaboration agreements and a government contract foradditional product development.

 

**2.**                       **Significant AccountingPolicies**

 

***Unaudited Interim Financial Statements***

 

The accompanying unauditedcondensed financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“US GAAP”) forinterim financial information and with the instructions to Form 10-Q 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 31,2009.

 

***Use of Estimates***

 

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

 

***Revenue Recognition***

 

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

 

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

 

In October 2008, weentered into a Collaboration Agreement with Genzyme Corporation (“Genzyme”) forthe development and commercialization of our biologic drug candidates,Prochymal® and Chondrogen®. Under the agreement,Genzyme has paid to us non-contingent, non-refundable cash payments totaling$130.0 million, with $75.0 million paid during November 2008 and$55.0 million paid on July 1, 2009. The agreement provides Genzymewith certain rights to intellectual property developed by us, and requires thatwe continue to perform certain development work related to the subject biologicdrug candidates. We have evaluated the deliverables related to these payments,and concluded that the various deliverables represent a single unit ofaccounting. For this reason, we have deferred the recognition of revenuerelated to the upfront payments, and are amortizing these amounts to revenue ona straight-line basis over the estimated delivery period of the requireddevelopment services, which extend through the first quarter of 2012.Accordingly, we recognized $10.0 million of revenue in the first fiscalquarters of both 2010 and 2009 related to the amortization of the upfront payments.The balance of these payments has been recorded as $40.0 million ofcurrent deferred revenue and $33.3 million of long-term deferred revenueas of March 31, 2010. The agreement 

 

7

----

Tableof Contents

 

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

also provides for contingentmilestone payments of up to $1.25 billion in the aggregate, as well asroyalties to be paid to us on any sales by Genzyme. Consistent with our revenuerecognition policies, we will recognize revenue from these contingent milestonepayments 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 performance obligations.

 

In 2007, we partnered withGenzyme to develop Prochymal as a medical countermeasure to nuclear terrorismand other radiological emergencies. In January 2008, we were awarded acontract from the United States Department of Defense (“DoD”) pursuant to whichwe are seeking, in partnership with Genzyme, to develop and stockpile Prochymalfor the repair of gastrointestinal injury resulting from acute radiationexposure. We began recognizing revenue under this contract during the firstquarter of 2008, and we will complete our work under the contract during 2010.Contract revenue is recognized as the related costs are incurred, in accordancewith the terms of the contract. We recognized $86,000 in revenue from the DoDcontract during the three months ended March 31, 2010 and $2.6 million inrevenue during the comparable period of 2009.

 

In October 2007, weentered into a collaborative agreement with the Juvenile Diabetes ResearchFoundation (“JDRF”) to conduct a Phase II clinical trial evaluating Prochymalas a treatment for type 1 diabetes mellitus. This collaborative agreementprovides for JDRF to provide up to $4.0 million of contingent milestonefunding to support the development of Prochymal for the preservation of insulinproduction in patients with newly diagnosed type 1 diabetes mellitus. Thecontingent milestone payments under the agreement are amortized to revenue on astraight line basis over the duration of our obligations under thecollaborative agreement as they are received and earned. We have received$3.5 million of the contingent milestones to date, and expect to receivethe remaining $500,000 during 2010. We are amortizing the funding received,resulting in $210,000 of revenue to date in 2010 under the agreement withJDRF. The remaining deferred revenue under this agreement has been recorded as$840,000 of current deferred revenue and $630,000 of long-term deferred revenueas of March 31, 2010.

 

We have also entered intoseveral strategic agreements with other pharmaceutical companies focusing onthe development and commercialization of our stem cell drug products. Forexample, in 2003, we entered into an agreement with JCRPharmaceuticals Co., Ltd. (“JCR”) pertaining to hematologicmalignancies (GvHD) drugs for distribution in Japan.  Under such agreements, we receive fees forlicensing the use of our technology. We recognized $1.0 million of revenue in2010 from JCR upon the achievement of a milestone event specified in theagreement.

 

We also earn royalties onthe sale of human mesenchymal stem cells sold for research purposes andrecognize the revenue as the sales are made. Our overall revenues include$81,000 and $66,000 of such royalty revenue during the three months ended March 31,2010 and 2009, respectively.

 

As discussed in Note 5-*Segment Reporting* below, at the end of the third quarter of2009, we created a new Biosurgery Division, focused on developing high-endbiologic products for use in surgical procedures.  Revenues on any such products will berecognized when legal title to the product has passed to the customer.

 

***Research and Development Costs***

 

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

 

***Income per Common Share***

 

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

 

Potentially dilutive effectsof common share equivalents are calculated based upon the income (loss) fromcontinuing operations.  Accordingly, the1,000,000 shares issuable upon the assumed exercise of our outstanding warrantand all 1,273,043 of our outstanding options as of March 31, 2009 wereexcluded from the calculation of diluted earnings per share, as their impact onour loss from continuing operations is anti-dilutive.  As a result basic and diluted income pershare are identical for that period.

 

8

----

Tableof Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

Diluted income per commonshare for the three months ended March 31, 2010 excludes 630,625 “out-ofthe money” stock options and the 1,000,000 shares issuable upon the assumedexercise of our outstanding warrant, as their effect is anti-dilutive.

 

Areconciliation of basic to diluted weighted average common shares outstandingis as follows:

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|
| ** **                                         | ** ** | **March 31,**     | ** ** |
| ** **                                         | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                                         | ** ** | **(000s)**             | ** ** | **(000s)** | ** ** |
| Basic weighted average common shares outstanding   |       | 32,774                 |       | 32,692 |   |
| Dilutive weighted average options outstanding      |       | 314                    |       | — |   |
| Dilutive weighted average warrants outstanding     |       | —                 |       | — |   |
|                                               |       |                   |       |   |   |
| Diluted weighted average common shares outstanding |       | 33,088                 |       | 32,692 |   |

 

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

 

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

 

Investments available for saleare evaluated periodically to determine whether a decline in their value is “otherthan temporary.” 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-Based Compensation***

 

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

 

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

 

A summary of the combinedactivity under both of our stock-based compensation plans as of March 31,2010 and changes during the three 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, 2010 |       | 1,000,762                  |       | $                                                                                           | 10.78      |                                                            | 8.11       |                                | $          | 2,187 |   |
| Granted  at market value             |       | 290,000                    |       | 7.74                                                                                        |       |                                                            |       |                                |       |
| Exercised                            |       | (2,000                     | )          | 0.40                                                                                        |       |                                                            |       | 14                                  |       |
| Forfeited                            |       | (8,125                     | )          | 16.56                                                                                       |       |                                                            |       | —                              |       |
| Outstanding  at March 31, 2010  |       | 1,280,637                  |       | 10.07                                                                                       |       | 7.56                                                            |       | 2,350                               |       |
|                                 |       |                       |       |                                                                                        |       |                                                            |       |                                |       |
| Exercisable  at March 31, 2010  |       | 618,761                    |       | 8.07                                                                                        |       | 6.13                                                            |       | 2,334                               |       |
|                                      |            |                            |            |                                                                                             |            |                                                                 |            |                                     |            |  |  |

 

The weighted average grantdate fair value of options granted during the three months ended March 31,2010 was $3.96 per share.  We received a total of $1,000 in cash fromthe exercise of options during the three months ended March 31, 2010.

 

9

----

Tableof Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

As of March 31, 2010,378,000 shares of common stock remain available for future share awards underour Amended and Restated 2006 Omnibus Plan.

 

Share-based compensationexpense (including director compensation in 2009) included in our statements ofoperations for the three months ended March 31, 2010 and 2009 is allocableto our research and development activities, discontinued operations and generaland administrative activities, as follows:

 
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|
| ** **                  | ** ** | **2010**                                             | ** ** | **2009** | ** ** |
| ** **                  | ** ** | **($000)**                                           | ** ** | **($000)** | ** ** |
| Research  and development   |       | $                                                    | 190        |   | $ | 244 |   |
| Discontinued  operations    |       | —                                               |       | 125 |   |
| General  and administrative |       | 184                                                  |       | 774 |   |
| Total                       |       | $                                                    | 374        |   | $ | 1,143 |   |

 

As of March 31, 2010,there was approximately $2.5 million of total unrecognized share-basedcompensation cost related to options granted under our plans, which will berecognized over a weighted-average period of approximately 1.5 years, as theoptions vest.

 

***Supplemental Cash Flow Information***

 
| ** **                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                             | ** ** | **2010**                                         | ** ** | **2009** | ** ** |
| ** **                                             | ** ** | **($000)**                                       | ** ** | **($000)** | ** ** |
| **Supplemental disclosure of cash flows information:** |       |                                             |       |   |   |
| Cash  paid for interest                                |       | $                                                | —     |   | $ | 4 |   |
| Cash  paid for income taxes                            |       | 450                                              |       | — |   |
|                                                        |            |                                                  |            |  |  |  |  |

 

***Recent Accounting Guidance Not Yet Adopted at March 31, 2010***

 

In September 2009, ASU2009-13, *Revenue Recognition*(Topic 605)— *Multiple-Deliverable Revenue Arrangements*(“ASU 2009-13”) was issued and will change the accounting formultiple-deliverable arrangements to enable vendors to account for products orservices (deliverables) separately rather than as a combined unit.Specifically, this guidance amends the criteria in Subtopic 605-25, *Revenue Recognition* — *Multiple-Element Arrangements,* forseparating consideration in multiple-deliverable arrangements. This guidanceestablishes a selling price hierarchy for determining the selling price of adeliverable, which is based on: (a) vendor-specific objective evidence; (b) third-partyevidence; or (c) estimates. This guidance also eliminates the residualmethod of allocation and requires that arrangement consideration be allocatedat the inception of the arrangement to all deliverables using the relativeselling price method. In addition, this guidance significantly expands requireddisclosures related to a vendor’s multiple-deliverable revenue arrangements.ASU 2009-13 is effective prospectively for revenue arrangements entered into ormaterially modified in fiscal years beginning on or after June 15, 2010with early adoption permitted. The impact of ASU 2009-13 on our financialstatements will depend on the nature and terms of revenue arrangements that weenter into or materially modify after the adoption date. However, based on ourcurrent customer arrangements, we do not believe the adoption of this ASU willhave a material impact on our financial statements.

 

In March 2010, ASU2010-11, *Derivatives and Hedging* (Topic 815)— *Scope Exception Related to Embedded Credit Derivatives* (“ASU2010-11”) was issued and will change the accounting for the transfer of creditrisk that is only in the form of subordination of one financial instrument toanother.  This guidance establishes aconsistency in how such instruments are treated by clarifying that suchinstruments are embedded derivatives that should not be subject to potentialbifurcation and separate accounting under paragraph 815-10-15-11 and Section 815-15-25.ASU 2010-11 is effective for an entity’s first fiscal quarter beginning on orafter June 15, 2010 with early adoption permitted. Based on our currentcontracts and arrangements, we do not believe the adoption of this ASU willhave a material impact on our financial statements.

 

In March 2010,ASU 2010-17, *Revenue Recognition—Milestone Method*(Topic605)*: Milestone Method of Revenue Recognition—aconsensus of the FASB Emerging Issues Task Force* (“ASU 2010-17”) wasissued and will amend the accounting for revenue arrangements under which avendor satisfies its performance obligations to a customer over a period oftime, when the deliverable or unit of accounting is not within the scope ofother authoritative literature, and when the arrangement consideration is contingentupon the achievement of a milestone. The amendment defines a milestone andclarifies whether an entity may recognize consideration earned from theachievement of a milestone in the period in which the milestone is achieved.This amendment is effective for fiscal years beginning on or after June 15,2010, with early adoption permitted. The amendment may be appliedretrospectively to all arrangements or prospectively for milestones achievedafter the effective date. We do not believe the adoption of this ASU will havea material impact on our financial statements.

 

10

----

Tableof Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

**3.****               ****Collaboration Agreements and Government Contract**

 

Below is a discussion ofeach of our material collaborative agreements and other contracts. Thisdiscussion is qualified in its entirety by the actual terms and provisions ofthe respective agreements and contracts. The accounting policies related toeach of these contracts, including material impact on our financial statements,is included above under the “Revenue Recognition” section of Note 2,Significant Accounting Policies.

 

***Collaboration Agreement with Genzyme Corporation***   On October 31, 2008, weentered into a 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 other countries(the “Genzyme Territory”), except with respect to Prochymal for Graft vs. HostDisease (“GvHD”) in Japan, which has previously been licensed to anotherpharmaceutical company. Genzyme has the right to “opt-out” of any furtherChondrogen 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 forthe grant of these rights, the Collaboration Agreement provides for anon-contingent, non-refundable cash payment to us of $130.0 million fromGenzyme, with $75.0 million paid in November 2008 and$55.0 million paid on July 1, 2009. The Collaboration Agreement alsoprovides for contingent milestone payments of up to $1.25 billion in theaggregate, in addition to royalties on any sales by Genzyme, to be paid byGenzyme to us, as follows:

 

*Prochymal:*  As respects Prochymal, we are eligibleto receive up to $500.0 million in development and regulatory milestonepayments and up to $250.0 million in sales based milestone payments, asfollows:

 

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

 

·                  Totaldevelopment milestones of up to $180.0 million related to Crohn’s diseaseand Ulcerative Colitis, with $50.0 million payable upon achievingstatistically significant endpoint(s) in a Phase III clinical trialfor Crohn’s disease, $100.0 million payable upon marketing approval by theEMEA for Crohn’s disease, $10.0 million payable upon achievingstatistically significant endpoint(s) in a Phase II or Phase IIIclinical trial for Ulcerative Colitis, and $20.0 million payable uponachieving marketing approval for Ulcerative Colitis by the EMEA.

 

·                  Totaldevelopment milestones of up to $270.0 million related to the developmentof follow-on indications for Prochymal, with $20.0 million payable uponeach success in a Phase II clinical trial for acute myocardial infarction,type 1 diabetes mellitus or other follow-on indications, as agreed to bythe Company and Genzyme, and $40.0 million payable upon receipt of eachmarketing approval by the EMEA for Prochymal for chronic obstructive pulmonarydisease (“COPD”), acute myocardial infarction, type 1 diabetes mellitus orother follow-on indications, as agreed to by the Company and Genzyme.

 

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

 

*Chondrogen:*  Upon receipt of the results of theplanned Phase II/III clinical trial of Chondrogen, Genzyme may elect toopt-out of any further Chondrogen development, at which point all rights toChondrogen will revert to us with no further obligations between the companieswith regard to Chondrogen. If Genzyme does not opt-out, we are eligible toreceive up to $500.0 million in development, regulatory and sales basedmilestone payments for Chondrogen, as follows:

 

·                  Totaldevelopment and regulatory milestones of up to $100.0 million, with$10.0 million payable if Genzyme does not opt-out, $10.0 millionpayable upon demonstration of disease modification in the current clinicaltrial program, $40.0 million payable upon marketing approval by either theFDA or EMEA for a pain reduction indication, and $40.0 million payableupon marketing approval by either the FDA or EMEA for a disease modificationindication.

 

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

 

We will be solelyresponsible for ongoing clinical trial costs and future clinical trial costswith respect to both Prochymal and Chondrogen through Phase II clinicaltrials. We will share with Genzyme all costs of future Phase III andPhase IV clinical trials for agreed-upon indications 

 

11

----

Table of Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

(assuming in the case ofChondrogen that Genzyme does not opt-out), with us being responsible for 60% ofsuch costs and Genzyme responsible for 40% of such costs.

 

Assuming successfuldevelopment and marketing approval (and assuming in the case of Chondrogen thatGenzyme does not opt-out) , we will be entitled to receive escalating royaltieson sales of Prochymal and Chondrogen within the Genzyme Territory.

 

***Genzyme Partnership and the United States Department of DefenseContract.***  In2007, we partnered with Genzyme to develop Prochymal as a medicalcountermeasure to nuclear terrorism and other radiological emergencies. In January 2008,we were awarded a contract from the DoD pursuant to which we, in partnershipwith Genzyme, are seeking to develop and stockpile Prochymal for the repair ofgastrointestinal injury resulting from acute radiation exposure. Under theterms of the contract, the DoD will provide funding to us for the developmentof Prochymal for acute radiation syndrome (“ARS”). If we are successful inobtaining FDA approval for ARS, the contract provides for the purchase by theDoD, at its option, of up to 20,000 doses of Prochymal, at $10,000 per dose, infour 5,000 dose increments. Under the terms of our partnership with Genzyme, wecontribute Prochymal and corresponding safety and efficacy data to the effortand Genzyme lends its vast product development and large-scalecommercialization expertise. The agreement provides for Genzyme to receive aroyalty of 15% on sales of Prochymal, limited to those sales made undercontract to U.S. or allied governmental agencies for emergency preparedness.

 

***Juvenile Diabetes Research Foundation Agreement.***  In 2007, we entered into acollaborative agreement with the JDRF which provides funding to support thedevelopment of Prochymal as a treatment for the preservation of insulinproduction in patients with newly diagnosed type 1 diabetes mellitus. Thiscollaborative agreement provides for JDRF to provide up to $4.0 million ofcontingent milestone funding. We initiated a Phase II clinical trialevaluating Prochymal as a treatment for type 1 diabetes mellitus in thefourth quarter of 2007, and have received $3.5 million of the contingentmilestones to date.  We expect to receivethe remaining $500,000 of contingent milestones during 2010. Consistent withour revenue recognition policies for such contingent milestones, we beganamortizing each milestone payment as it was received and will continue toamortize the payments over the remaining term of our obligations under theagreement. Future milestone payments received will be similarly amortized overthe term of our obligations beginning upon their receipt.

 

***JCR Pharmaceuticals Agreement.***  In 2003, we entered into astrategic alliance with JCR. Under the JCR agreement, we have granted JCR theexclusive right in Japan to use our technology in conjunction with thetreatment of hematologic malignancies using hematopoietic stem celltransplants. The JCR agreement entitles us to a licensing fee and to royaltieson any resulting revenue. We have earned a total of $5.0 million in feesunder the agreement, $1.0 million of which was earned in the first quarter of2010, The JCR agreement also provides for additional contingent payments up to$8.5 million, which will be recorded as revenue if and when earned.

 

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

 

In April 2008, wecommitted to a plan to sell our entire product line relating to the processing,manufacturing, marketing and selling of Osteocel® and Osteocel® XO, anallograft material containing cancellous bone, used in spinal fusion and othersurgical procedures. We refer to these assets as our Osteocel asset disposalgroup, and on May 2, 2008, we entered into an Asset Purchase Agreement tosell these assets to NuVasive, Inc., a Delaware corporation. Not includedamong the Osteocel asset disposal group is Osteocel® XC, our second generationproduct candidate under development for bone repair, utilizing culture expandedmesenchymal stem cells to create a synthetic version of Osteocel.

 

The Asset Purchase Agreementto sell the Osteocel asset group to NuVasive provides for two closings—atechnology assets closing, at which technology and certain other businessassets were transferred, and a manufacturing assets closing, at whichmanufacturing assets and facilities were transferred. On July 24, 2008, weheld a Special Meeting of Stockholders at which our stockholders overwhelminglyapproved the sale of the Osteocel business. The technology assets closing alsooccurred on that date, at which time we received an initial payment of$35.0 million. Concurrent with the technology assets closing, we enteredinto a Manufacturing Agreement with NuVasive, under which we continued tomanufacture Osteocel and sold 100% of the product to NuVasive at specifiedprices.

 

In March 2009, weentered into further amendments to the Asset Purchase Agreement and the relatedManufacturing Agreement, as a result of which the manufacturing assets closingwas accelerated and all performance conditions to receipt, by us, of$30.0 million of contingent milestone payments were removed. As a result,those payments became payable at specified dates, without regard to otherconditions, either in cash or in shares of NuVasive stock, at the option ofNuVasive.

 

The Asset PurchaseAgreement, as amended, provided for up to $85.0 million of total purchaseprice, all of which we ultimately earned.

 

As stipulated under the March 2009amendments, we ceased manufacturing Osteocel on March 28, 2009. As aresult of this cessation of manufacturing, we committed to a workforcereduction of the approximately 80 employees involved in the 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 received severancebenefits, comprised principally of severance, benefits continuation costs andoutplacement services. Total one-time termination benefits for the reduction inforce totaled approximately $1.4 million, which was recorded as acomponent 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 our cessation ofOsteocel manufacturing and retaining the lease obligations for the 

 

12

----

Table of Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

Columbia, Maryland facility,we conducted an analysis of our future minimum lease payments for the facility,related to unutilized space, and recorded an impairment charge of approximately$3.2 million related to our future minimum lease payments. Additionally,we recorded an impairment of the leasehold improvements specifically related toOsteocel production of approximately $3.0 million.

 

At the end of the thirdquarter of 2009, we created a new Biosurgery Division, focused on developinghigh-end biologic products for use in surgical procedures. This new BiosurgeryDivision will utilize the facilities previously used to manufacture Osteocel.As a result, we updated our analysis of the lease impairment charge andreversed the $2.8 million impairment that remained unamortized at thattime. Both of these impairments charges were recorded as components of the gainon the sale of discontinued operations in 2009.

 

We recognized a pre-tax gainof approximately $23.5 million on the sale of discontinued operations duringthe first quarter of 2009.  Net of taxes, the gain on the sale wasapproximately $21.4 million during the quarterly period ending March 31,2009.

 

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

 

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

 

Summarized operating resultsof the Osteocel asset disposal group for the three months ended March 31,2009 are as follows:

 
| ** **                                                              | ** ** | **2009**   | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|
| ** **                                                              | ** ** | **($000)** | ** ** |
| Product  sales                                                          |       | $          | 6,267      |   |
| Cost  of goods sold                                                     |       | 4,787      |       |
| Gross  profit                                                           |       | 1,480      |       |
|                                                                    |       |       |       |
| Selling,  general & administrative expenses                    |       | 124        |       |
| Income  from operations of discontinued operations, before income taxes |       | 1,356      |       |
| Income  taxes                                                           |       | 117        |       |
| Income  from operations of discontinued operations, net of tax          |       | $          | 1,239      |   |

 

Revenues on Osteocel saleswere recognized when legal title to the product passed to the customer. Costsof goods sold related to the Osteocel product consist primarily of the costs toobtain the tissue and other chemicals and supplies, quality and sterilitytesting, plus labor and allocated overhead costs and the costs of operating theclean-room facilities.

 

**5.**             **Segment Reporting**

 

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

 

In 2010, we began to manageour business in two reportable operating segments: the Biologic Drug Candidatessegment and the Biosurgery segment. Our Biologic Drug Candidates segmentfocuses on developing and marketing products to treat medical conditions in theinflammatory, autoimmune, orthopedic and cardiovascular areas. Its operationshave focused on clinical trials and discovery efforts to identify additionalmedical indications. Our Biologic Drug Candidates segment does not presentlyhave any products approved for sale and its revenues consist of collaborativeresearch agreements and royalties as described in Note 2-*SignificantAccounting Policies*.

 

Our Biosurgery segmentincludes the manufacture and sale of biologic products designed to promote thebody’s natural healing process and improve surgical outcomes.  During the first quarter of 2010, wecommenced the manufacturing of our first product from this new segment, aregenerative wound care product.

 

Although we commencedmanufacturing operations during the first quarter of 2010, we have not yetlaunched the product commercially. Accordingly, we have incurred research, development, manufacturing,general, and administrative costs related to the Biosurgery segment, but haveyet to recognize any revenue from sales. We expect to initiate sales of our first Biosurgery product duringfiscal 2010.

 

Therefore, at this time, wemanage our business based on the costs specifically attributable to each of oursegments.  We expect to begin managingour business based on more traditional measures of segment income once we havecommenced sales of our Biosurgery products.

 

13

----

Tableof Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

The costs specificallyattributable to each of our segments for the three months ended March 31,2010 are as follows:

 
| ** **                   | ** ** | **Three  Months Ended March 31, 2010** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **($000s)**                                 | ** ** |
| ** **                   | ** ** | **Biologic  Drug  Candidates  segment**     | ** ** | **Biosurgery  segment** | ** ** | **Total** | ** ** |
| **Operating expenses:**      |       |                                        |       |   |   |   |   |
| Research  and development    |       | $                                           | 5,431      |   | $ | 1,129 |   | $ | 6,560 |   |
| General  and administrative  |       | 1,662                                       |       | 145 |   | 1,807 |   |
| **Total operating expenses** | ** ** | **$**                                       | **7,093**  | ** ** | **$** | **1,274** | ** ** | **$** | **8,367** | ** ** |

 

In general, our total assets, includinglong-lived assets such as property and equipment, and our capital expendituresare not specifically allocated to any particular operating segment.Accordingly, capital expenditures and total asset information by reportablesegment is not presented. The only assets that are specifically allocated tothe individual segments are inventory and accounts receivable.

 

The assets specificallyattributable to each of our segments as of March 31, 2010 are as follows:

 
| ** **               | ** ** | **March 31, 2010  ($000)**         | ** ** |
|--------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **Biologic  Drug  Candidates  segment** | ** ** | **Biosurgery  segment** | ** ** |
| **Segment assets:**      |       |                                    |       |   |   |
| Accounts  receivable     |       | $                                       | 1,389      |   | $ | — |   |
| Inventory                |       | —                                  |       | 117 |   |
| **Total segment assets** | ** ** | **$**                                   | **1,389**  | ** ** | **$** | **117** | ** ** |

 

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

 

Wecalculate our interim tax provision in accordance with the guidance foraccounting for income taxes in interim periods. At the end of each interimperiod, we estimate the annual effective tax rate and apply that tax rate toour ordinary quarterly pre-tax income. The tax expense or benefit related tosignificant, unusual or extraordinary discrete events during the interim periodis recognized in the interim period in which those events occurred. Inaddition, the effect of changes in enacted tax laws or rates or tax status isrecognized in the interim period in which the change occurs.

 

Thetax expense of $682,000 and tax benefit of $748,000 reflect effective tax ratesof 22% and 8.6% for the three months ended March 31, 2010 and 2009,respectively, and reflects our expectation that a portion of our income will besubject to the Federal alternative minimum tax.

 

As of March 31,2010, the balance of our net operating loss and credit carryforwards is $63.6million, a decrease of $1.7 million from December 31, 2009.  Our deferred tax assets have been fullyreserved in both 2010 and 2009 since their ultimate future realization cannotbe assured.

 

14

----

Tableof Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

**7.**                     **Investments Available forSale**

 

Investments available forsale consisted of the following as of March 31, 2010 and December 31,2009:

 
| ** **                                             | ** ** | **March 31, 2010********($000)** | ** ** | **December 31, 2009  ($000)** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                             | ** ** | **Cost**                              | ** ** | **Fair Value**                     | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| **Cash equivalents:**                                  |       |                                  |       |                               |       |   |   |   |   |
| Money  market funds & certificates of deposit |       | $                                     | 10,395     |                               | $          | 10,395 |   | $ | 23,706 |   | $ | 23,707 |   |
| Commercial  paper                                      |       | 22,993                                |       | 22,993                             |       | 19,393 |   | 19,393 |   |
|                                                   |       | 33,388                                |       | 33,388                             |       | 43,099 |   | 43,100 |   |
| **Short term investments:**                            |       |                                  |       |                               |       |   |   |   |   |
| Common  stock                                          |       | —                                |       | —                             |       | 573 |   | 489 |   |
| Corporate  notes and bonds                             |       | 41,749                                |       | 41,754                             |       | 42,586 |   | 42,578 |   |
| US  government agencies                                |       | 13,437                                |       | 13,446                             |       | 13,239 |   | 13,242 |   |
|                                                   |       | 55,186                                |       | 55,200                             |       | 56,398 |   | 56,309 |   |
|                                                   |       |                                  |       |                               |       |   |   |   |   |
| **Total investments available for sale**               | ** ** | **$**                                 | **88,574** | ** **                         | **$**      | **88,588** | ** ** | **$** | **99,497** | ** ** | **$** | **99,409** | ** ** |

 

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

 
| ** **                               | ** ** | **March 31, 2010  ($000)** | ** ** | **December 31, 2009  ($000)** | ** ** |
|------------------------------------------|------------|---------------------------------|------------|------------------------------------|------------|
| ** **                               | ** ** | **Cost**                        | ** ** | **Fair Value**                | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| **Maturities:**                          |       |                            |       |                               |       |   |   |   |   |
| Within  3-months                         |       | $                               | 18,844     |                               | $          | 18,840 |   | $ | 28,330 |   | $ | 28,240 |   |
| Between  3—12 months           |       | 64,411                          |       | 64,417                             |       | 65,824 |   | 65,819 |   |
| Between  1—2 years             |       | 5,319                           |       | 5,331                              |       | 5,343 |   | 5,350 |   |
| **Total investments available for sale** | ** ** | **$**                           | **88,574** | ** **                         | **$**      | **88,588** | ** ** | **$** | **99,497** | ** ** | **$** | **99,409** | ** ** |

 

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

 

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

 

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

 
| *Level 1* |   | Inputs are unadjusted,  quoted prices in active markets for identical assets 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.                                                                                                                                                                                                                                                                                                                                                                          |

 

15

----

Table of Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

 

Whenquoted prices in active markets for identical assets are available, we usethese quoted market prices to determine the fair value of financial assets andclassifies these assets as Level 1. In other cases where a quoted market pricefor identical assets in an active market is either not available or notobservable, we obtain the fair value from a third party vendor that usespricing models, such as matrix pricing, to determine fair value. Thesefinancial assets would then be classified as Level 2. In the event quotedmarket prices were not available, we would determine fair value using brokerquotes or an internal analysis of each investment’s financial statements andcash flow projections. In these instances, financial assets would be classifiedbased upon the lowest level of input that is significant to the valuation.Thus, financial assets might be classified in Level 3 even though there couldbe some significant inputs that may be readily available.   To date, we have never had any assets thatwere required to be classified as Level 3.

 

EffectiveJanuary 1, 2010, we adopted the FASB’s updated guidance related to fairvalue measurements and disclosures, which requires a reporting entity todisclose separately the amounts of significant transfers in and out of Level 1and Level 2 fair value measurements and to describe the reasons for thetransfers. In addition, in the reconciliation for fair value measurements usingsignificant unobservable inputs, or Level 3, a reporting entity should discloseseparately information about purchases, sales, issuances and settlements. Theupdated guidance also requires that an entity should provide fair valuemeasurement disclosures for each class of assets and liabilities anddisclosures about the valuation techniques and inputs used to measure fairvalue for both recurring and non-recurring fair value measurements for Level 2and Level 3 fair value measurements. The guidance is effective for interim orannual financial reporting periods beginning after December 15, 2009,except for the disclosures about purchases, sales, issuances and settlements inthe roll forward activity in Level 3 fair value measurements, which areeffective for fiscal years beginning after December 15, 2010 and forinterim periods within those fiscal years. Therefore, the Company has not yetadopted the guidance with respect to the roll forward activity in Level 3 fairvalue measurements. The adoption of the updated guidance for Levels 1 and 2fair value measurements did not have an impact on the Company’s consolidatedresults of operations or financial condition, as there were no transfers to orfrom Levels 1 and 2 during the quarter ended March 31, 2010.

 

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

 
| ** **                                             | ** ** | **March 31,  2010** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|
| ** **                                             | ** ** | **($000s)**              | ** ** |
| ** **                                             | ** ** | **Level I**              | ** ** | **Level  II** | ** ** | **Level  III** | ** ** | **Total** | ** ** |
| **Assets**                                             |       |                     |       |   |   |   |   |   |   |
| Cash  Equivalents                                      |       | $                        | 7,894      |   | $ | — |   | $ | — |   | $ | 7,894 |   |
| Government  Obligations                                |       | 11,313                   |       |   |   |   |   | 11,313 |   |
| Certificates  of Deposit                               |       |                     |       | 2,500 |   |   |   | 2,500 |   |
| Agency  Obligations                                    |       |                     |       | 39,896 |   |   |   | 39,896 |   |
| Corporate  Debt Securities & Commercial Paper |       |                     |       | 25,596 |   |   |   | 25,596 |   |
| Municipal  Securities                                  |       |                     |       | 100 |   |   |   | 100 |   |
| Foreign  Bonds                                         |       |                     |       | 1,288 |   |   |   | 1,288 |   |
| Common  Stock                                          |       |                     |       |   |   |   |   |   |   |
|                                                   |       |                     |       |   |   |   |   |   |   |
| **Short Term Investments Available for Sale**          | ** ** | **$**                    | **19,207** | ** ** | **$** | **69,381** | ** ** | **$** | **—** | ** ** | **$** | **88,588** | ** ** |

 

16

----

Table of Contents

** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE MONTHS ENDED MARCH 31, 2010 AND 2009**

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

 

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

 

We evaluated our March 31,2010 financial statements for subsequent events through the date the financialstatements were available for issuance. We are not aware of any subsequentevents which would require recognition or disclosure in the financialstatements.

 

17

----

Tableof Contents

 

**Item 2.**                                   **Management’s Discussion andAnalysis of Financial Condition and Results of Operations.**

 

**Cautionary Statements About Forward-Looking Information**

 

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

 

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

 

Readers arecautioned that all forward-looking statements attributable to us or personsacting on our behalf apply only as of the date of this Quarterly Report and areexpressly qualified in their entirety by the cautionary statements includedherein. We undertake no obligation to publicly update or revise anyforward-looking statements to reflect subsequent events or circumstances and donot intend to do so.

 

You should read thefollowing management’s discussion and analysis of our financial condition andresults of operations in conjunction with our audited Financial Statements andrelated notes thereto and other disclosures included as part of our AnnualReport on Form 10-K for the year ended December 31, 2009, and ourunaudited Condensed Financial Statements for the three months ended March 31,2010 and 2009 and other 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 risksand uncertainties that could cause our actual results to differ materially fromthe forward-looking statements contained in this report. Some of the importantfactors that could cause our actual results to differ materially from theforward-looking statements we make in this report are set forth in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2009 underPart I — Item 1A “Risk Factors.” There may be other factors that may causeour actual results to differ materially from the forward-looking statements.

 

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

 

**Introduction and Overview**

 

The following is adiscussion and analysis of our financial condition and results of operationsfor the three month periods ended March 31, 2010 and 2009.  Youshould read this discussion together with the accompanying unaudited condensedfinancial statements and notes and with our Annual Report on Form 10-K forthe year ended December 31, 2009.  Historical results and anydiscussion of prospective results may not indicate our futureperformance.  See “Cautionary Statements About Forward-LookingInformation.”

 

Weare a leading stem cell therapeutic company headquartered in Columbia, Marylandand focused on developing and marketing products to treat serious medicalconditions in the inflammatory, autoimmune, orthopedic, and cardiovascularareas. We were incorporated in Delaware in April 2002. Our predecessorcompany was organized in 1992. Our lead biologic drug candidate, Prochymal, isbeing evaluated in Phase III clinical trials for four indications,including acute and steroid refractory graft versus host disease (“GvHD”),Crohn’s disease and for the repair of gastrointestinal injury resulting fromradiation exposure (animal rule), and is the only stem cell therapeuticcurrently granted both Orphan Drug and Fast Track status by the United StatesFood and Drug Administration (“FDA”). Prochymal is also being developed for therepair of heart tissue following a heart attack, and for protection ofpancreatic islet cells in patients with type 1 diabetes. Our pipeline ofinternally developed biologic drug candidates under evaluation also includes Chondrogenfor osteoarthritis in the knee.

 

18

----

Tableof Contents

 

Inthe fourth quarter of 2008, we entered into a collaboration agreement withGenzyme Corporation for the development and commercialization of Prochymal andChondrogen. Under the terms of the agreement, we retained the rights tocommercialize Prochymal and Chondrogen in the United States and Canada andGenzyme has been granted exclusive rights to commercialize Prochymal andChondrogen in all other countries, except with respect to GvHD in Japan, whereProchymal has previously been licensed to another pharmaceutical company. Underthe agreement, we were paid $130 million for these rights. The agreementalso provides for contingent milestone payments of up to $1.25 billion inthe aggregate in addition to royalties on any sales by Genzyme to be paid byGenzyme to us.

 

Wehave also partnered with Genzyme Corporation to develop Prochymal as a medicalcountermeasure to nuclear terrorism and other radiological emergencies. In January 2008we were awarded a contract from the U.S. Department of Defense, pursuant towhich we, in partnership with Genzyme, are seeking to develop and stockpileProchymal for the repair of gastrointestinal injury resulting from acuteradiation exposure. Additionally, we have partnered with the Juvenile DiabetesResearch Foundation (“JDRF”) for the development of Prochymal as a treatmentfor the preservation of insulin production in patients with newly diagnosedtype 1 diabetes mellitus.

 

InApril 2008, we committed to a plan to sell our assets related toOsteocel®, a product that we had produced and marketed since July 2005,for regenerating bone in orthopedic indications. On May 8, 2008, weentered into an Asset Purchase Agreement to sell our entire product linerelating to the processing, manufacturing, marketing and selling of Osteocel toNuVasive, Inc. The total proceeds from the sale of Osteocel were $85.0 million,all of which has been received by us. The assets and operations related toOsteocel are reported as discontinued operations in the condensed financialstatements included in this Quarterly Report on Form 10-Q for all periods.

 

InAugust 2009, we announced the creation of a new Biosurgery Divisionfocused on developing and marketing high-end biological products for use insurgical procedures. We intend to build on the success of our first generationimplantable product, Osteocel which generated over $40 million of revenuefor us before being sold for $85.0 million in 2008. We introduced ourfirst biologic product from the Biosurgery Division during March 2010 formarketing trials.  Grafix Prime® is awound care product manufactured from human placenta.

 

Weare a fully integrated company, having developed capabilities in research,development, manufacturing, marketing and distribution of stem cell products.We have developed an extensive intellectual property portfolio to protect ourtechnology including 49 U.S. and 280 foreign patents owned or licensed. We have22 U.S. patent applications pending and 74 foreign patent applications pending.

 

Ourtwo biologic drug candidates utilize human mesenchymal stem cells, or MSCs.MSCs can selectively differentiate, based on the tissue environment, intovarious tissue lineages, such as bone, muscle, fat, tendon, ligament, cartilageand bone marrow stroma. In addition, MSCs have anti-inflammatory properties andcan prevent fibrosis or scarring. These characteristics give MSCs the potentialto treat a wide variety of medical conditions. We believe that our biologicdrug candidates have advantages over other stem cell therapeutics indevelopment for the following reasons:

 

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

 

·                                          **Ability to Mass Produce.**  Through our proprietarymanufacturing methods, we can grow MSCs in a controlled fashion to produce upto 10,000 treatments of our biologic drug candidates from a single bone marrowdonation. Our ability to produce a large quantity of treatments from onedonation provides us with manufacturing efficiencies and product consistencythat are essential to commercialization.

 

·                                          **Universal Compatibility.**  Many stem cell therapies underdevelopment can elicit a rejection response in the recipient and thereforerequire donor-to-recipient matching or potentially harmful immunosuppression.This greatly reduces manufacturing efficiencies and creates a risk of mismatchwhich can result in an acute inflammatory response leading to serious medicalcomplications and can even be fatal. Based on our clinical experience, webelieve that our biologic drug candidates are not rejected by the patient’simmune system and so, like type O negative blood, do not require matching.This universal compatibility allows us to produce a standardized productavailable to all patients in almost any medical setting.

 

·                                          **Treatment on Demand.**  Our biologic drug candidates canbe 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.

 

19

----

Table of Contents

 

Thefollowing table summarizes key information about our biologic drug candidates.

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

 

***Prochymal,***our lead biologic drug candidate, is beingevaluated in Phase III clinical trials for four indications including thefirst line treatment of acute graft versus host disease (“GvHD”), steroidrefractory acute GvHD, biologics refractory Crohn’s disease and for the repairof gastrointestinal injury resulting from radiation exposure (animal rule).Prochymal is the only stem cell therapeutic currently designated by the FDA asboth an Orphan Drug and Fast Track product.

 

*Prochymal for Treatment-Resistant GvHD*

 

GvHDis a life threatening immune system reaction that commonly affects one or moreof the skin, gastrointestinal tract, and liver in patients who have received abone marrow transplant. Although in the U.S. there are no drugs approved for treatingGvHD, the disease is commonly treated off-label with steroids. GvHD that doesnot respond to this treatment is known as steroid refractory GvHD. A largemajority of steroid refractory GvHD patients die within six months. In aPhase II trial for treatment refractory GvHD, we enrolled patients thatdid not respond to treatment with steroids and at least one second linetherapy. Of these patients, all responded to treatment with Prochymal, and 59%achieved complete resolution of their disease. Prochymal has been granted FastTrack status by FDA as well as Orphan Drug status by FDA and the EuropeanMedicines Agency for GvHD.

 

InMay 2008, we received clearance from the FDA to initiate an expandedaccess treatment program making Prochymal available to children with lifethreatening GvHD. Under the program, children, 2 months to 17 yearsof age, with Grades B-D acute GvHD that hasn’t responded to steroids areeligible for treatment. Upon completion of enrollment of the Phase IIItrials evaluating Prochymal in adults with GvHD, the expanded access programwas broadened to include patients 18 to 70 years of age. The expandedaccess programs for Prochymal in treating adult and pediatric patients withrefractory GvHD are ongoing.

 

InFebruary 2010, we reported the results of a study evaluating Prochymal asa rescue therapy in 59 pediatric patients with severe, treatment-resistantacute GvHD. The trial enrolled patients with Grades B-D acute GvHD who hadfailed steroids and other immunosuppressive agents. Patients in the studyreceived two intravenous infusions of Prochymal per week for a total of fourweeks. Patients who experienced a partial response by day 28 were eligible forcontinued treatment. GvHD assessments were used in the study to detectimprovements in patients treated with Prochymal. At study entry, 90% ofchildren had Grade C/D GvHD, the most severe forms of GvHD and wereunresponsive to an average of three lines of therapy. Overall response totreatment with Prochymal at 28 days was 63%. Response to Prochymal at day28 significantly improved survival over those patients who progressed (78% vs.9%, p<0.05). Patients in the trial were treated at 33 pediatric transplantcenters across the U.S., Canada, Europe and Australia.

 

InSeptember 2009, we announced the preliminary results for the two ProchymalPhase III GvHD trials described below. While the trials did not reachsignificance in their primary endpoints, the studies did reveal severalimportant findings:

 

·                  Theprimary endpoint for the steroid-refractory GvHD trial (durable completeresponse) for the per protocol population approached statistical significance(40% Prochymal vs. 28%, standard of care, p=0.08, n=179);

 

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

 

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

 

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

 

20

----

Tableof Contents

 

·                  Inchildren with steroid-refractory GvHD, Prochymal more than doubled completeresponse rates (64% vs. 29%) and reduced disease progression by half (21% vs.43%).

 

*Phase III Clinical Trial—Steroid Refractory Acute GvHD*

 

OurPhase III trial evaluated the safety and efficacy of Prochymal inconjunction with standard of care for the treatment of patients who had failedto respond to corticosteroid treatment for acute GvHD. This clinical trial wasa double-blind, placebo-controlled study. Patients six months to 70 yearsof age were randomized to receive Prochymal or placebo at a 2:1 ratio inaddition to standard of care. The trial enrolled 260 patients and treated 244patients from 72 leading bone marrow transplant centers in the United States,Canada, Europe and Australia.

 

Theprimary endpoint, durable complete response, for the per-protocol population inthe Phase III trial evaluating Prochymal in steroid-refractory GvHDapproached but did not reach statistical significance, with 40% of patientsreceiving Prochymal, as compared to 28% of placebo patients, achieving adurable complete response. The per-protocol patient population refers to thegroup of patients that met all of the study protocol requirements, such asinclusion and exclusion criteria. The addition of Prochymal to standard of caresignificantly improved response in steroid-refractory liver (76% vs. 47%,p=0.03) and gastrointestinal (82% vs. 68%, p=0.03) GvHD. In the sickestpatients—those with GvHD affecting all three organs—skin, liver andgastrointestinal tract—treatment with Prochymal resulted in a 63% overallresponse rate, while none of the placebo-treated patients responded(p<0.05). Prochymal also demonstrated a positive safety profile relative toplacebo.

 

*Phase III Clinical Trial—First Line Treatment of AcuteGvHD.*

 

Ourprevious Phase II trial for treatment of newly diagnosed acute GvHDindicated that patients were twice as likely to have total clinical resolutionof their disease when Prochymal was added to steroid therapy, compared toreported results for treatment with steroids alone. Twenty-nine of 31 patients,or 94%, responded in the Phase II trial, after receiving two infusions ofProchymal, with 24 patients, or 77% achieving a complete response, meaning thepatients had experienced total clinical resolution of the disease. At sixmonths, 61% of all patients treated with Prochymal still had a durable responserequiring no additional immunosuppressive therapy, clinical intervention, orincreased steroid use. Of these, 95% were alive at six months.

 

ThePhase III trial to evaluate Prochymal as a first line treatment for GvHDis a randomized, double blind, placebo controlled study that completedenrollment with 192 patients from 52 leading transplant centers across theUnited States, Canada and Australia. Patients received a total of six infusionsduring the first four weeks of the study. The majority of patients enrolled inthis trial were suffering from skin GvHD, which was well-controlled withsteroids, particularly when given at a uniform controlled dose as prescribed inthe protocol. The high response rates diminished the potential for Prochymal todemonstrate an effect.

 

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

 

Basedon our clinical observations of the effects of Prochymal on thegastrointestinal symptoms of patients with GvHD, we are developing Prochymalfor the treatment of Crohn’s disease. Crohn’s disease is a chronic conditionthat results in inflammation of the gastrointestinal tract. We completedpatient enrollment in a Phase II trial for Crohn’s disease.  We received Fast Track designation from theFDA for the development of Prochymal for patients with moderate to severeBiologics Refractory Crohn’s Disease.

 

Patientswere enrolled in a Phase III trial evaluating Prochymal for the treatmentof moderate to severe Crohn’s disease that is refractory to biological therapy.The placebo-controlled, double-blind study was designed to enroll 270 patients,18 to 70 years of age, with a Crohn’s Disease Activity Index (“CDAI”)greater than 250. Patients were enrolled at approximately 60 leading centers inthe United States and Canada. The trial is evaluating patients with severeCrohn’s disease that is not responsive to treatment with steroids,immunomodulators (azathioprine, 6-mercaptopurine, and methotrexate), andbiologic agents (Remicade®, Hurmira®, and Cimzia®).  The majority of patients enrolled thus farhave failed at least two immunomodulators and two biological agents.  Patients are required to complete a “washout”period prior to study entry to ensure that residual benefit from prior therapydoes not influence their response.  Therewere no differences in average Crohn’s Disease Activity Index (CDAI) scores atentry, which exceeded 350 in all arms prior to treatment, indicating thepatients had very debilitating disease.

 

Theprimary endpoint for Protocol 603 is the proportion of patients experiencingdisease remission within 28 days of initiation of therapy with Prochymal,compared to those patients receiving placebo. For a patient to reach the primary end-point of disease remission, theirCDAI score must fall to below 150.

 

InApril 2010 we announced that we are resuming enrollment in this clinicaltrial evaluating Prochymal for patients with treatment resistant Crohn’sdisease.  The findings of an interimanalysis showed that for the primary endpoint of disease remission, Prochymalis approaching statistical significance in the intent to treat (ITT)population, and has reached significance in the per protocol population.  Additionally, the analysis showed thatProchymal continued to demonstrate a benign safety profile with no significantdifferences in any of the pre-defined safety outcomes compared to placebo.

 

TheCrohn’s program consisted of two linked trials — one aimed at inducingremission (Protocol 603) and the other at maintaining response (Protocol 610)in patients who had failed other available treatments for the disease.  Enrollment was suspended in 2009 overconcerns the trial design would make it difficult to detect a treatmenteffect.  The trial remained blinded,however, to permit an interim analysis of all 207 patients enrolled in thestudy.  The results showed that despitethe initial concerns, the effect size, or difference between the Prochymal andplacebo response rates, of one dose arm of Prochymal is consistent with theoriginal statistical assumptions of the protocol and is significantly outperformingplacebo.

 

Thedecision to resume enrollment was made following discussions with the Food andDrug Administration (FDA) about the results of the interim analysis.   Enrollment will now continue with thebest-performing Prochymal dose arm and the placebo arm, according to thepre-specified adaptive trial design.  Thetrial has been repowered to compensate for the statistical penalty incurred bythe interim analysis in the ITT population. The follow-on maintenance trial (Protocol 610) has been discontinued toremove the potential for bias.

 

21

----

Tableof Contents

 

*Phase II Clinical Trial—Acute Myocardial Infarction.*

 

Prochymalis also being evaluated as a therapy to improve heart function in patients whohave suffered a heart attack. Based on statistics published in 2005 by theAmerican Stroke Association and the American Heart Association, approximately700,000 individuals in the United States each year experience their first heartattack. According to these same statistics, approximately 20% of these patientssuffer extensive damage to their heart muscle leading to heart failure withinsix years. In preclinical studies in animal models, Prochymal targeted thedamaged area of the heart following a single intravenous infusion. Thesestudies also indicate that Prochymal prevents scar formation that typicallyoccurs after a heart attack and improves cardiac function eight to ten weeksafter its administration.

 

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

 

APhase II double-blind, placebo-controlled trial to evaluate the safety andefficacy of Prochymal in conjunction with standard of care to improve heartfunction in patients who experience a first heart attack is currently enrollingpatients. The trial is being conducted at leading institutions and academicresearch centers in the United States and Canada. Target enrollment is 220patients and those participating will be randomized to Prochymal or placebo ata 1:1 ratio.

 

*Phase II Clinical Trial—Early Onset Type 1Diabetes Mellitus.*

 

Inearly 2010, enrollment was completed for 63 patients in our Phase II,double-blind, placebo-controlled study evaluating Prochymal for the treatmentof early onset type 1 diabetes in individuals 12 to 35 yearsold. We believe that based upon their mechanism of action, MSCs may home to thepancreas and inhibit the local immune and inflammatory responses, preventingthe destruction of pancreatic islets and promoting the repair of pancreatictissue damage. Patients were enrolled within 2 to 16 weeks of beingdiagnosed with type 1 diabetes and received three infusions of Prochymalover the course of 60 days. The primary efficacy endpoint, the measurementof C-peptide produced after glucose stimulation, will be measured at one year.We have entered into a collaborative agreement with the Juvenile DiabetesResearch Foundation (“JDRF”) for this study. This agreement provides for JDRFto fund $4.0 million of clinical study costs. To date, we received$3.5 million from JDRF to fund clinical costs, and expect to receive theremaining $500,000 during 2010.

 

*Phase II Clinical Trial—Chronic Obstructive PulmonaryDisease*

 

Enrollmentin the 62-patient Phase II clinical trial evaluating the safety andefficacy of Prochymal in conjunction with standard of care for improvingpulmonary function in patients with moderate to severe Chronic ObstructivePulmonary Disease (“COPD”) was completed in the second half of 2008. Patientsin the double-blind, placebo-controlled study were randomized to eitherProchymal or placebo at a 1:1 ratio and received 4 infusions over the course of90 days. Measurements used in the trial to detect potential improvementsin subjects treated with Prochymal include pulmonary function tests, exercisecapability, systemic inflammation and quality of life assessments. In addition,exacerbations and hospitalizations due to COPD will be monitored for bothsafety and efficacy. Patients will be evaluated over the course of two yearsfollowing initial Prochymal or placebo infusion.

 

Atthe six-month interim analysis, the trial met its primary goal of demonstratingthe safety of Prochymal in patients with compromised pulmonary function.Prochymal significantly decreased systemic inflammation in patients whencompared to those receiving placebo, as determined by C-reactive protein (CRP).Despite this reduction in inflammation, however, pulmonary function in patientsreceiving Prochymal was not significantly improved compared to those receivingplacebo.

 

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

 

In2007, we partnered with Genzyme Corporation to develop Prochymal as a medicalcountermeasure to nuclear terrorism and other radiological emergencies. In January 2008,we were awarded a contract from the United States Department of Defense (“DoD”)for the development and stockpiling of Prochymal for the treatment of acuteradiation syndrome (“ARS”). Assuming FDA approval of Prochymal for ARS, the DoDmay exercise purchase options for up to 20,000 doses of Prochymal at a price of$10,000 per dose.

 

***Chondrogen***is our biologic drug candidate for thetreatment of osteoarthritis and the reduction of pain in the knee. In 2006, wecompleted enrollment of a randomized double-blind, placebo controlledPhase I/II clinical trial evaluating Chondrogen for safety and preliminaryefficacy based upon regeneration of meniscus at six-months. In November 2007,we reported one-year data for the Phase I/II Chondrogen trial. The datacontinued to show improvements in joint condition that correlated with aclinically and statistically significant improvement in pain in patients withosteoarthritis (OA) who received Chondrogen as compared to those treated withthe control, hyaluronic acid (HA). Patients receiving the control were 3.5times more likely to experience degenerative bone changes associated with OA ascompared

 

22

----

Tableof Contents

 

tothose receiving Chondrogen. The effects were dose dependent and pain scoresimproved from six months to one year following treatment, suggesting thatChondrogen caused a biological modification of patients’ OA.

 

**Financial Operations Overview**

 

*Revenue*

 

In 2008, we entered into aCollaboration Agreement with Genzyme for the development and commercializationof Prochymal and Chondrogen, and providing for non-contingent, non-refundableupfront payments of $130.0 million and contingent milestone payments. ThisCollaboration Agreement has multiple deliverables, and consistent with ouraccounting policy for such transactions, we are amortizing the up frontpayments into revenue on a straight-line basis over the estimated completionperiod of the deliverables, which extend through the first quarter of 2012. Werecognized $10.0 million of revenue in each of the first quarters of 2010and 2009, related to this agreement.

 

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

 

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

 

Under the DoD contractawarded to us in January 2008, we are seeking, in partnership withGenzyme, to develop Prochymal for the repair of gastrointestinal injuryresulting from acute radiation exposure. Under the terms of the contract, theDoD provides funding to us for development. We recognized $86,000 in revenueunder the terms of this contract in the first quarter of 2010, on a costreimbursement basis.

 

In prior years, we haveentered into strategic agreements with others for the development andcommercialization of select stem cell biologic drug candidates for specificindications and geographic markets. In 2007, we entered into a collaborativeagreement with the JDRF to conduct a Phase II clinical trial evaluatingProchymal as a treatment for type 1 diabetes mellitus. Under this collaborativeagreement,  JDRF will provide up to $4.0 million of contingentmilestone funding to support the development of Prochymal for the preservationof insulin production in patients with newly diagnosed type 1 diabetesmellitus. The contingent milestone payments under the agreement are amortizedinto revenue on a straight line basis over the duration of our obligationsunder the collaborative agreement as they are received and earned. Werecognized $210,000 in revenue during the first three months of 2010 under thisagreement.

 

*Researchand Development Costs*

 

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

 

Consistent with our focus onthe development of biologic drug candidates with potential uses in multipleindications, many of our costs are not attributable to a specificallyidentified product. We use our employee and infrastructure resources acrossseveral projects. Accordingly, we do not account for internal research anddevelopment costs on a project-by-project basis. From inception in December 1992through March 31, 2010, we incurred aggregate research and developmentcosts of approximately $374 million.

 

We expect our research anddevelopment expenses to continue to be substantial in the future, as wecontinue our clinical trial activity for our existing biologic drug candidatesas they advance through the development cycle and as we invest in additionalproduct opportunities and research programs. Clinical trials and preclinicalstudies are time-consuming and expensive. Our expenditures on current andfuture preclinical and clinical development programs are subject to manyuncertainties. We test our products in several preclinical studies, and we thenconduct clinical trials for those biologic drug candidates that we determine tobe the most promising. As we obtain results from clinical trials, we may electto discontinue or delay trials for some biologic drug candidates in order tofocus our resources on more promising biologic drug candidates. Completion ofclinical trials may take several years or more, but the length of time generallyvaries substantially according to the type, size of trial and intended use of abiologic drug candidate. The cost of clinical trials may vary significantlyover the life of a project as a result of a variety of factors, including:

 

·                  the number of patients who participate in thetrials;

 

·                  the number of sites included in the trials;

 

·                  the length of time required to enroll trialparticipants;

 

23

----

Table of Contents

 

·                  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 ability tosecure, regulatory approvals.

 

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

 

*Generaland Administrative Expenses*

 

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

 

*OtherIncome (Expense), Net*

 

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

 

*IncomeTaxes*

 

We have not recognized anydeferred tax assets or liabilities in our financial statements since we cannotassure their future 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 loss andresearch and development carry-forwards. In the event that we become profitablewithin the next several years, we have net deferred tax assets (before a 100%valuation allowance) of approximately $65.3 million that may be utilizedprior to us having to recognize any income tax expense or make payments to thetaxing authorities other than the alternative minimum tax. In fiscal 2009, werecorded a provision for income taxes to recognize the U.S. Federal alternativeminimum tax on our taxable income.

 

The tax provision for thethree months ended March 31, 2010, reflects an effective tax rate forcontinuing operations of 22% compared to a U.S. statutory tax rate of35%.  The effective tax rate reflects our estimated annual effectivetax rate, which reflects our expectation that a portion of our income will besubject to the Federal alternative minimum tax in 2010.

 

**CriticalAccounting Policies**

 

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

 

**Results of Operations**

 

***Comparison of Three Months Ended March 31,2010 and 2009***

 

*Revenues from Continuing Operations*

 

Revenues from continuingoperations were $11.4 million for the three months ended March 31, 2010compared to $12.7 million for the first quarter of fiscal 2009.  Duringthe three months ended March 31, 2010, we recognized $10.0 million inrevenue from our collaborative agreement with Genzyme, $1.0 million from ourcollaboration with JCR and $210,000 from our collaborative agreement with JDRF.Our revenues for the three month period also include $83,000 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 March 31, 2009consisted of $10.0 million from the Genzyme agreement, $92,000 from the JDRFcollaboration and $2.6 million from the DoD contract.

 

24

----

Tableof Contents

 

*Researchand Development Expenses*

 

Research and developmentexpenses for the three months ended March 31, 2010 were $6.6 million ascompared to research and development expenses of $18.6 million for the sameperiod of 2009.  The first quarter 2010 expenses include $1.2 million ofdevelopment and initial manufacturing costs associated with our BiosurgeryDivision. The reduction in research and development expenses during thefirst quarter of 2010 when compared to the comparable period of the prior yearreflects the completion of enrollment in our Phase III clinical trials and theassociated reduction in site and patient costs, and reductions in our contractmanufacturing activities as a result of the need for fewer clinical batches ofProchymal.  We also incur research and development expenses in connectionwith the preparation of our  applicationsfor marketing approval as we work towards the commercialization of Prochymalfor an initial indication.

 

*Generaland Administrative Expenses*

 

General and administrativeexpenses were $1.8 million for the three months ended March 31, 2010compared to $2.9 million for the comparable period in fiscal 2009.  Thedecrease in general and administrative expenses is primarily attributable toreductions in our non cash share-based compensation expense related to thedeferral of issuance of stock for Board compensation until the second quarterof 2010. The non cash charge for share-based compensation allocated to generaland administrative expenses during the fiscal quarter ended March 31, 2010was $184,000 as compared to $774,000 for the same period last year.

 

*OtherIncome (Expense), Net*

 

Interest income, net was$88,000 for the three months ended March 31, 2010, compared to $98,000 inthe corresponding period in fiscal 2009.  Our investments available forsale consist of relatively short-term, investment grade securities with a focuson avoiding market risk. Interest expense was immaterial in both periods.

 

***Income from Discontinued Operations***

 

Our Osteocel operations weresold during fiscal 2009 for $85.0 million, all of which was received during2009.  During the first quarter of fiscal2009, we recognized $22.7 million of income from discontinued operations, whichprimarily reflected the initial gain on sale, upon our receipt of the initialsales proceeds of $35.0 million.

 

**Liquidityand Capital Resources**

 

***Liquidity***

 

At March 31, 2010, wehad $91.2 million in cash, receivables and investments available forsale.  We did not have any outstanding debt at any time during fiscal 2010to date, or during all of fiscal 2009. Although there can be no assurance, webelieve that we have sufficient liquidity on hand as of March 31, 2010 tofund our operations through the commercialization of our first biological drugcandidate.

 

***Cash Flows***

 

***Comparison of Three Months Ended March 31, 2010 and 2009***

 

Cashused in operating activities of continuing operations for the three monthsended March 31, 2010 was $10.6 million compared to $14.4 million in thesame quarter of the prior year.  The 2010 income from continuingoperations of $2.4 million was offset by decreases in working capital,primarily accounts payable, accrued expenses, and deferred revenue.  Cashused by operating activities of continuing operations during the first quarterof 2009 reflect our loss from continuing operations of $7.9 million, which was increasedprimarily by a reduction in deferred revenue.

 

Cashused by operating activities of discontinued operations for the first quarterof fiscal 2010 was $0.4 million, compared to cash used in operating activitiesof discontinued operations of $2.4 million in the same period of the prioryear.  The 2010 amount represents the final settlement of the currentliabilities of discontinued operations that had been outstanding as of December 31,2009.  The 2009 amount reflects the cashportion of the income from discontinued operations generated in 2009, offset bya decrease in receivables.

 

Cashprovided by investing activities during the first quarter of 2010 was $10.9million compared to $21.7 million in the same period of the prior year. Both amounts represent approximately $11 million in proceeds from the sale ofinvestments, while the difference between the two years was due to the cashreceived from the sale of our Osteocel business in 2009.

 

Cashused in financing activities during the first quarter of 2009 was $0.4 million,which reflects an increase in restricted cash used to collateralize a letter ofcredit for our lease.  Cash used in financing activities during the firstquarter of 2010 was not material.

 

25

----

Tableof Contents

 

***Capital Resources***

 

Our future capitalrequirements will depend on many factors, including:

 

·                  the scope and results of our research andpreclinical development 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 inobtaining regulatory approvals for our biologic drug candidates, which could bemore lengthy or complex than obtaining approval for a new conventional drug,given the FDA’s limited experience with late-stage clinical trials andmarketing approval 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 andprotecting our intellectual property portfolio, including possible litigationcosts and liabilities; and

 

·                  the costs of expanding our work forceconsistent with expanding our business and operations and status as a publiccompany.

 

**Off-Balance Sheet Arrangements.**

 

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

 

**Item 3.**                                                           **Quantitative and QualitativeDisclosures About Market Risk**..

 

*Interest Rate Risk*

 

Dueto the short duration of our investment portfolio and the high quality of ourinvestments, an immediate 10% change in interest rates would not have amaterial effect on the value of our portfolio. Therefore, we would not expectour operating results or cash flows to be affected to any material degree bythe effect of a sudden change in market interest rates on our securitiesportfolio.

 

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

 

*Foreign Current Exchange Rate Risk*

 

Weconduct clinical trial activities in areas that operate in a functionalcurrency other than the United States dollar (USD). As a result, when the USDrises and falls against the functional currencies of these other nations, ourcosts will either increase or decrease by the relative change in the exchangerate. Foreign currency gains and losses were not significant during the threemonths ended March 31, 2010 or 2009, and at the present time, we haveelected not to hedge our exposure to foreign currency fluctuations.

 

*Derivative Instruments*

 

Wedo not enter into hedging or derivative instrument arrangements.

 

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

 

***Evaluation of Disclosure Controls and Procedures.*** An evaluation of the effectiveness of thedesign and operation of our “disclosure controls and procedures” (as defined inRule 13a-15(e) under the Securities Exchange Act of 1934, asamended), as of the end of the period covered by this Quarterly Report on Form 10-Qwas made under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer.  A controlsystem, no matter how well designed and operated, can provide only reasonable,not absolute, 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 

 

26

----

Table of Contents

 

reports filed or submittedunder the Securities Exchange Act of 1934 is accumulated and communicated toour management, including our Chief Executive Officer and Chief FinancialOfficer, as appropriate to allow timely decisions regarding requireddisclosure.

 

***Changes in Internal Control over Financial Reporting.*** There have not been any changes in ourinternal control over financial reporting that occurred during the quarterended March 31, 2010 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II- OTHER INFORMATION**

 

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

 

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

 

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

 

Therehave not been any material changes in the risk factors previously disclosedunder the heading “Risk Factors” in Part I — Item 1A of our AnnualReport on Form 10-K for the fiscal year ended December 31, 2009,filed with the Securities and Exchange Commission on March 12, 2010.

 

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

 

None.

 

**Item 3.****                                                          ****Defaults Upon SeniorSecurities**.

 

None.

 

**Item 4.****                                                          **(**Removedand Reserved**).

 

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

 

None.

 

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

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

 

27

----

Tableof Contents

 

**SIGNATURES**

 

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

 
|                   | **Osiris  Therapeutics, Inc.**                    |
|------------------------|--------------------------------------------------------|
|                   |                                                   |
| Date: May 7, 2010 | /s/ PHILIP R. JACOBY, JR.                              |
|                   | Philip R. Jacoby, Jr.                             |
|                   | Chief Financial Officer  (Principal Financial Officer) |
|                   |                                                   |
| Date: May 7, 2010 | /s/ MATTHEW NEUMAYER                                   |
|                   | Matthew Neumayer                                       |
|                   | Corporate Controller  (Principal Accounting Officer)   |

 

28

----