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** **

 

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x**      **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THESECURITIES EXCHANGE ACT OF 1934**

 

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

 

**Or**

 

**o**         **TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                   to                   **

 

**Commission File Number: 001-32966**

 

**OSIRIS THERAPEUTICS, INC.**

(Exactname of registrant as specified in its charter)

 

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

 

**443-545-1800**

(Registrant’stelephone number, including area code)

 

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

 

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

 

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

 

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

 

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

 

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

 

| **Class**                                 | ** ** | **Outstanding at August 6, 2010** |
|-------------------------------------------|------------|-------------------------------------------------------|
| Common  Stock, par value $0.001 per share |       | 32,788,894                                            |

 

 

 

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**OSIRIS THERAPEUTICS, INC.**

 

**INDEX**

 
| ** **                                   | ** **                                                                                   | **Page** |
|----------------------------------------------|----------------------------------------------------------------------------------------------|----------|
| **PART I — FINANCIAL INFORMATION** | 3                                                                                            |
|                                         |                                                                                         |     |
| Item 1.                                      | Financial  Statements — Unaudited                                                       | 3        |
|                                         | Balance  Sheets — June 30, 2010 and December 31, 2009                              | 3        |
|                                         | Condensed Statements of Operations — three and six  months ended June 30, 2010 and 2009 | 4        |
|                                         | Condensed Statement of Stockholders’ Equity— six  months ended June 30, 2010       | 5        |
|                                         | Condensed Statements of Cash Flows — six months ended  June 30, 2010 and 2009           | 6        |
|                                         | Notes to Condensed Financial Statements                                                      | 7        |
|                                         |                                                                                         |     |
| Item 2.                                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations  | 16       |
|                                         |                                                                                         |     |
| Item 3.                                      | Quantitative  and Qualitative Disclosures About Market Risk                                  | 25       |
|                                         |                                                                                         |     |
| Item 4.                                      | Controls and  Procedures                                                                     | 25       |
|                                         |                                                                                         |     |
| **PART II — OTHER INFORMATION**    | 26                                                                                           |
|                                         |                                                                                         |     |
| Item 1.                                      | Legal Proceedings                                                                            | 26       |
| Item 1A.                                | Risk Factors                                                                                 | 26       |
| 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                                                                                     | 28       |
|                                         |                                                                                         |     |
| Signatures                                   |                                                                                         | 28       |
|                                         |                                                                                         |     |
| Exhibit Index                                |                                                                                         |     |

 

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** **

**PART I— FINANCIAL INFORMATION**

 

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

 

**OSIRIS THERAPEUTICS, INC.**

**BALANCE SHEETS**

**(amounts in thousands)**

 
| ** **                                                                                                            | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                                                                                            | ** ** | **(unaudited)**        | ** ** | ** **                 | ** ** |
| **Assets**                                                                                                            |       |                   |       |                       |       |
| Current assets:                                                                                                       |       |                   |       |                       |       |
| Cash                                                                                                                  |       | $                      | 1,484      |                       | $          | 1,306 |   |
| Investments available for sale                                                                                        |       | 82,589                 |       | 99,409                     |       |
| Accounts receivable                                                                                                   |       | 323                    |       | 1,138                      |       |
| Inventory                                                                                                             |       | 126                    |       | —                     |       |
| Prepaid expenses and other current assets                                                                             |       | 786                    |       | 948                        |       |
| Total current assets                                                                                                  |       | 85,308                 |       | 102,801                    |       |
|                                                                                                                  |       |                   |       |                       |       |
| Property and equipment, net                                                                                           |       | 3,445                  |       | 3,734                      |       |
| Restricted cash                                                                                                       |       | 666                    |       | 666                        |       |
| Other assets                                                                                                          |       | 284                    |       | 395                        |       |
| Total assets                                                                                                          |       | $                      | 89,703     |                       | $          | 107,596 |   |
|                                                                                                                  |       |                   |       |                       |       |
| **Liabilities and Stockholders’ Equity**                                                                         |       |                   |       |                       |       |
|                                                                                                                  |       |                   |       |                       |       |
| Current liabilities:                                                                                                  |       |                   |       |                       |       |
| Accounts payable and accrued expenses                                                                                 |       | $                      | 6,894      |                       | $          | 9,013 |   |
| Deferred revenue, current portion                                                                                     |       | 40,898                 |       | 41,011                     |       |
| Capital lease obligations, current portion                                                                            |       | —                 |       | 3                          |       |
| Current liabilities of discontinued operations                                                                        |       | —                 |       | 412                        |       |
| Total current liabilities                                                                                             |       | 47,792                 |       | 50,439                     |       |
|                                                                                                                  |       |                   |       |                       |       |
| Deferred revenue, net of current portion                                                                              |       | 23,753                 |       | 44,173                     |       |
| Other long-term liabilities                                                                                           |       | 474                    |       | 424                        |       |
| Total liabilities                                                                                                     |       | 72,019                 |       | 95,036                     |       |
|                                                                                                                  |       |                   |       |                       |       |
| Stockholders’ equity                                                                                             |       |                   |       |                       |       |
| Common stock, $.001 par value, 90,000 shares authorized,  32,789 shares outstanding - 2010, 32,773 outstanding - 2009 |       | 33                     |       | 33                         |       |
| Additional paid-in-capital                                                                                            |       | 273,816                |       | 272,959                    |       |
| Accumulated other comprehensive income (loss)                                                                         |       | 16                     |       | (88                        | )          |
| Accumulated deficit                                                                                                   |       | (256,181               | )          | (260,344                   | )          |
| Total stockholders’ equity                                                                                       |       | 17,684                 |       | 12,560                     |       |
| Total liabilities and stockholders’ equity                                                                       |       | $                      | 89,703     |                       | $          | 107,596 |   |

 

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

 

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** **

**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

**Unaudited**

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

** **
| ** **                                                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                               | ** ** | **2010**                         | ** ** | **2009**                       | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| **Revenue from collaborative research agreements,****government contract and royalties** |       | $                                | 10,304     |                           | $          | 10,469 |   | $ | 21,681 |   | $ | 23,195 |   |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                                                                     |       |                             |       |                           |       |   |   |   |   |
| Research  and development                                                                |       | 6,456                            |       | 18,540                         |       | 13,016 |   | 37,107 |   |
| General  and administrative                                                              |       | 1,602                            |       | 2,321                          |       | 3,409 |   | 5,234 |   |
|                                                                                     |       | 8,058                            |       | 20,861                         |       | 16,425 |   | 42,341 |   |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Income  (loss) from operations                                                           |       | 2,246                            |       | (10,392                        | )          | 5,256 |   | (19,146 | ) |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Other  income, net                                                                       |       | 36                               |       | 155                            |       | 124 |   | 253 |   |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Income  (loss) from continuing operations, before income taxes                           |       | 2,282                            |       | (10,237                        | )          | 5,380 |   | (18,893 | ) |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Income  tax (expense) benefit                                                            |       | (535                             | )          | 1,650                          |       | (1,217 | ) | 2,398 |   |
| **Income (loss) from continuing operations**                                             |       | 1,747                            |       | (8,587                         | )          | 4,163 |   | (16,495 | ) |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| **Discontinued operations:**                                                             |       |                             |       |                           |       |   |   |   |   |
| Income  (loss) from operations of discontinued operations, net of income taxes           |       | —                           |       | (142                           | )          | — |   | 1,097 |   |
| Gain  (loss) from sale of discontinued operations, net of income taxes                   |       | —                           |       | (952                           | )          | — |   | 20,476 |   |
| **Income (loss) from discontinued operations**                                           |       | —                           |       | (1,094                         | )          | — |   | 21,573 |   |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| **Net income (loss)**                                                                    |       | $                                | 1,747      |                           | $          | (9,681 | ) | $ | 4,163 |   | $ | 5,078 |   |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| **Basic income (loss) per share**                                                        |       |                             |       |                           |       |   |   |   |   |
| Income  (loss) from continuing operations                                                |       | $                                | 0.05       |                           | $          | (0.26 | ) | $ | 0.13 |   | $ | (0.50 | ) |
| Income  (loss) from discontinued operations                                              |       | —                           |       | (0.03                          | )          | — |   | 0.66 |   |
| Basic  earnings (loss) per share                                                         |       | $                                | 0.05       |                           | $          | (0.30 | ) | $ | 0.13 |   | $ | 0.16 |   |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| **Diluted income (loss) per share**                                                      |       |                             |       |                           |       |   |   |   |   |
| Income  (loss) from continuing operations                                                |       | $                                | 0.05       |                           | $          | (0.26 | ) | $ | 0.13 |   | $ | (0.50 | ) |
| Income  (loss) from discontinued operations                                              |       | —                           |       | (0.03                          | )          | — |   | 0.66 |   |
| Diluted  earnings (loss) per share                                                       |       | $                                | 0.05       |                           | $          | (0.30 | ) | $ | 0.13 |   | $ | 0.16 |   |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Weighted  Average Common Shares (basic)                                                  |       | 32,780                           |       | 32,737                         |       | 32,777 |   | 32,715 |   |
|                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Weighted  Average Common Shares (diluted)                                                |       | 33,084                           |       | 32,737                         |       | 33,086 |   | 32,715 |   |

 

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

 

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**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY**

**Unaudited**

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

 
| ** **                                                                     | ** ** | ** **            | ** ** | ** **              | ** ** | ** **               | ** ** | **Accumulated**   | ** ** | ** **                    | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------------------|------------|-------------------|------------|-------------------------------|------------|------------|------------|
| ** **                                                                     | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Other  Comprehensive** | ** ** | **Accumulated**   | ** ** | **Total  Stockholders’** | ** ** |
| ** **                                                                     | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**              | ** ** | **Income (Loss)** | ** ** | **Deficit**                   | ** ** | **Equity** | ** ** |
| **Balance at January 1, 2010**                                            |       | 32,773,331            |       | $                       | 33         |                     | $          | 272,959           |       | $                             | (88        | )          | $          | (260,344 | ) | $ | 12,560 |   |
|                                                                           |       |                  |       |                    |       |                     |       |              |       |                          |       |       |       |
| Exercise  of options to purchase common stock ($0.40 per share)           |       | 3,750                 |       | —                  |       | 1                        |       | —            |       | —                        |       | 1          |       |
|                                                                           |       |                  |       |                    |       |                     |       |              |       |                          |       |       |       |
| Issuance  of common stock for services rendered by Directors ($6.46 per share) |       | 11,500                |       | —                  |       | 74                       |       | —            |       | —                        |       | 74         |       |
|                                                                           |       |                  |       |                    |       |                     |       |              |       |                          |       |       |       |
| Share-based  payment — employee compensation                              |       | —                |       | —                  |       | 782                      |       | —            |       | —                        |       | 782        |       |
|                                                                           |       |                  |       |                    |       |                     |       |              |       |                          |       |       |       |
| **Comprehensive Income:**                                                      |       |                  |       |                    |       |                     |       |              |       |                          |       |       |       |
|                                                                           |       |                  |       |                    |       |                     |       |              |       |                          |       |       |       |
| Net  income for the period                                                     |       | —                |       | —                  |       | —                   |       | —            |       | 4,163                         |       | 4,163      |       |
|                                                                           |       |                  |       |                    |       |                     |       |              |       |                          |       |       |       |
| Unrealized  gain on investments available for sale                             |       | —                |       | —                  |       | —                   |       | 104               |       | —                        |       | 104        |       |
| **Total Comprehensive Income**                                                 |       |                  |       |                    |       |                     |       |              |       |                          |       | 4,267      |       |
|                                                                           |       |                  |       |                    |       |                     |       |              |       |                          |       |       |       |
| **Balance at June 30, 2010**                                                   |       | 32,788,581            |       | $                       | 33         |                     | $          | 273,816           |       | $                             | 16         |       | $          | (256,181 | ) | $ | 17,684 |   |

 

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

 

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**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENTS OF CASH FLOWS**

**Unaudited**

**(amounts in thousands)**

 
| ** **                                                                                                     | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                     | ** ** | **June 30,**         | ** ** |
| ** **                                                                                                     | ** ** | **2010**             | ** ** | **2009** | ** ** |
| **Cash flows from operating activities:**                                                                      |       |                 |       |   |   |
| **Continuing operations**                                                                                      |       |                 |       |   |   |
| Income  (loss) from continuing operations                                                                      |       | $                    | 4,163      |   | $ | (16,495 | ) |
| **Adjustments to reconcile income (loss) from continuing operations  to net cash used in operations:**         | ** ** | ** **           | ** ** | ** ** | ** ** |
| Depreciation  and amortization                                                                                 |       | 378                  |       | 305 |   |
| Non  cash share-based payments                                                                                 |       | 856                  |       | 1,771 |   |
| **Changes in operating assets and liabilities:**                                                               |       |                 |       |   |   |
| Accounts  receivable                                                                                           |       | 815                  |       | 892 |   |
| Prepaid  expenses and other current assets                                                                     |       | 36                   |       | (2,083 | ) |
| Other  assets                                                                                                  |       | 111                  |       | 278 |   |
| Accounts  payable and accrued expenses                                                                         |       | (2,034               | )          | 4,220 |   |
| Deferred  revenue                                                                                              |       | (20,533              | )          | (20,213 | ) |
| Net  cash used in continuing operations                                                                        |       | (16,208              | )          | (31,325 | ) |
| **Discontinued operations**                                                                                    |       |                 |       |   |   |
| Income  from discontinued operations                                                                           |       | —               |       | 21,573 |   |
| **Adjustments to reconcile income from discontinued operations  to net cash used in discontinued operations:** | ** ** | ** **           | ** ** | ** ** | ** ** |
| Non  cash impact of the sale of discontinued operations                                                        |       | —               |       | (26,623 | ) |
| Depreciation  and amortization                                                                                 |       | —               |       | 210 |   |
| Provision  for bad debts                                                                                       |       | —               |       | 45 |   |
| **Non cash share-based payments**                                                                              |       | —               |       | 98 |   |
| **Changes in operating assets and liabilities:**                                                               |       |                 |       |   |   |
| Accounts  receivable                                                                                           |       | —               |       | 519 |   |
| Inventory  and other current assets                                                                            |       | —               |       | 1,707 |   |
| Accounts  payable and accrued expenses                                                                         |       | (412                 | )          | 669 |   |
| Net  cash used in discontinued operations                                                                      |       | (412                 | )          | (1,802 | ) |
|                                                                                                           |       |                 |       |   |   |
| Net  cash used in operating activities                                                                         |       | (16,620              | )          | (33,127 | ) |
|                                                                                                           |       |                 |       |   |   |
| **Cash flows from investing activities:**                                                                      |       |                 |       |   |   |
| Purchases  of property and equipment                                                                           |       | (89                  | )          | (181 | ) |
| Proceeds  from the sale of property and equipment                                                              |       | —               |       | 17 |   |
| Proceeds  from sale of discontinued operations, net                                                            |       | —               |       | 9,853 |   |
| Proceeds  from sale of investments available for sale                                                          |       | 17,098               |       | 23,770 |   |
| Purchases  of investments available for sale                                                                   |       | (209                 | )          | — |   |
|                                                                                                           |       |                 |       |   |   |
| Net  cash provided by investing activities                                                                     |       | 16,800               |       | 33,459 |   |
|                                                                                                           |       |                 |       |   |   |
| **Cash flows from financing activities:**                                                                      |       |                 |       |   |   |
| Principal  payments on capital lease obligations and notes payable                                             |       | (3                   | )          | (4 | ) |
| Restricted  cash                                                                                               |       | —               |       | (536 | ) |
| Proceeds  from the exercise of stock options                                                                   |       | 1                    |       | 430 |   |
|                                                                                                           |       |                 |       |   |   |
| Net  cash used in financing activities                                                                         |       | (2                   | )          | (110 | ) |
|                                                                                                           |       |                 |       |   |   |
| Net  increase in cash                                                                                          |       | 178                  |       | 222 |   |
| Cash  at beginning of period                                                                                   |       | 1,306                |       | 940 |   |
|                                                                                                           |       |                 |       |   |   |
| Cash  at end of period                                                                                         |       | $                    | 1,484      |   | $ | 1,162 |   |

 

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

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREE AND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

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

 

Osiris Therapeutics, Inc.(“we,” “us,” “our,” or the “Company”) is a Maryland corporation headquarteredin Columbia, Maryland. We began operations on December 23, 1992 and were aDelaware corporation until, with approval of our stockholders; wereincorporated as a Maryland corporation on May 31, 2010. We are a leadingstem cell company focused on developing and marketing products to treat seriousmedical conditions in the inflammatory, autoimmune, orthopedic, andcardiovascular areas. Our biologic drug candidates utilize adult humanmesenchymal stem cells, or MSCs, which can selectively differentiate, based onthe tissue environment, into various tissue lineages, such as muscle, bone,cartilage, marrow stroma, tendon or fat. In addition, MSCs have anti-inflammatoryproperties and can prevent fibrosis or scarring, which gives MSCs the potentialto treat a wide variety of medical conditions. Historically, our operationshave consisted primarily of research, development and clinical activities tobring our biologic drug candidates to the marketplace. We have several researchcollaboration agreements and a government contract for additional productdevelopment.  During 2009, we created aBiosurgery Division, focused on harnessing the ability of cells and novelconstructs to promote the body’s natural healing.

 

**2.**      **Significant Accounting Policies**

 

***Unaudited Interim Financial Statements***

 

The accompanying unauditedcondensed financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“US GAAP”) forinterim financial information and with the instructions to Form 10-Q andRule 10-01 of Regulation S-X. Accordingly, they do not include all of theinformation and footnotes required by US GAAP for complete financialstatements. In the opinion of management, these statements include alladjustments (consisting of normal recurring adjustments) considered necessaryto present a fair statement of our results of operations, financial positionand cash flows. Operating results for any interim period are not necessarilyindicative of the results that may be expected for the full year. ThisQuarterly Report on Form 10-Q should be read in conjunction with ourfinancial statements and footnotes included in our Annual Report onForm 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 whether multipleelements of a collaboration agreement meet the criteria for separate units ofaccounting 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 madenon-contingent, non-refundable cash payments to us, totaling$130.0 million, with $75.0 million paid during November 2008 and$55.0 million paid on July 1, 2009. The agreement provides Genzyme withcertain rights to intellectual property developed by us, and requires that wecontinue to perform certain development work related to the subject biologicdrug candidates. We have evaluated the deliverables related to these payments,and concluded that the various deliverables represent a single unit ofaccounting. For this reason, we have deferred the recognition of revenuerelated to the upfront payments, and are amortizing these amounts to revenue ona straight-line basis over the estimated delivery period of the 

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS (Continued)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

required developmentservices, which extend through the first quarter of 2012. Accordingly, werecognized $10.0 million of revenue in each of the first two fiscalquarters of both 2010 and 2009 related to the amortization of the upfrontpayments. The balance of these payments has been recorded as $40.0 millionof current deferred revenue and $23.3 million of long-term deferred revenueas of June 30, 2010. The agreement also provides for contingent milestonepayments of up to $1.25 billion in the aggregate, as well as royalties tobe paid to us on any sales by Genzyme. Consistent with our revenue recognitionpolicies, we will recognize revenue from these contingent milestone paymentsfor which we have no continuing performance obligations upon achievement of therelated milestone. For any milestone payments for which we have a continuingperformance obligation, the milestone payments will be deferred and recognizedas 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 $27,000 and $113,000 in revenuefrom the DoD contract during the three and six months ended June 30, 2010,respectively, and $200,000 and $2.8 million, respectively, in revenue duringthe comparable periods of 2009.

 

In October 2007, weentered into a collaborative agreement with the Juvenile Diabetes ResearchFoundation (“JDRF”) to conduct a Phase 2 clinical trial evaluatingProchymal as a treatment for type 1 diabetes mellitus. This collaborativeagreement provides for JDRF to provide up to $4.0 million of contingentmilestone funding to support the development of Prochymal for the preservationof insulin production in patients with newly diagnosed type 1 diabetesmellitus. The contingent milestone payments under the agreement are amortized torevenue on a straight 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 in each of the two fiscal quarters todate in 2010 under the agreement with JDRF. The remaining deferred revenueunder this agreement has been recorded as $840,000 of current deferred revenueand $420,000 of long-term deferred revenue as of June 30, 2010.

 

We have also entered intoseveral strategic agreements with other pharmaceutical companies focusing onthe development and commercialization of our stem cell drug products. For example,in 2003, we entered into an agreement with JCRPharmaceuticals Co., Ltd. (“JCR”) pertaining to hematologicmalignancies (GvHD) drugs for distribution in Japan.  Under such agreements, we receive fees forlicensing the use of our technology. We recognized $1.0 million of revenueduring the first fiscal quarter of 2010 from JCR upon the achievement of amilestone event specified in the agreement.

 

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$68,000 and $148,000 of such royalty revenue during the three and six monthsended June 30, 2010, respectively, and $87,000 and $153,000 of such revenueduring the comparable periods of 2009.

 

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 be recognizedwhen 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 of stockoptions 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 1,221,292 of our outstanding options as of June 30, 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 those periods.

 

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** **

**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS (Continued)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

Diluted income per commonshare for the three months ended June 30, 2010 excludes 939,125 “out-ofthe money” stock options and the 1,000,000 shares issuable upon the assumedexercise of our outstanding warrant, as their effect is anti-dilutive.  Similarly, diluted income per common sharefor the six months ended June 30, 2010 excludes 791,041 “out-of the money”stock options and the 1,000,000 shares issuable upon the assumed exercise ofour outstanding warrant.

 

Areconciliation of basic to diluted weighted average common shares outstandingfor the applicable periods is as follows:

 
| ** **                                         | ** ** | **Three months  ended********June 30, 2010** | ** ** | **Six months ended  June 30, 2010** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                         | ** ** | **(000s)**                                        | ** ** | **(000s)**                               | ** ** |
| Basic weighted average common shares outstanding   |       | 32,780                                            |       | 32,777                                   |       |
| Dilutive weighted average options outstanding      |       | 304                                               |       | 309                                      |       |
| Dilutive weighted average warrants outstanding     |       | —                                            |       | —                                   |       |
|                                               |       |                                              |       |                                     |       |
| Diluted weighted average common shares outstanding |       | 33,084                                            |       | 33,086                                   |       |

 

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

 

***Share-Based Compensation***

 

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

 

We recognize all share-basedpayments to employees and non-employee directors in our financial statementsbased on their grant date fair values, calculated using the Black-Scholesoption pricing model. Compensation expense related to share-based awards 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 June 30,2010 and changes during the six 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      |                                                            | 7.11       |                                | $          | 2,187 |   |
| Granted  at market value             |       | 404,500                    |       | 7.38                                                                                        |       |                                                            |       |                                |       |
| Exercised                            |       | (3,750                     | )          | 0.40                                                                                        |       |                                                            |       | 24                                  |       |
| Forfeited                            |       | (27,875                    | )          | 12.38                                                                                       |       |                                                            |       | —                              |       |
| Outstanding  at June 30, 2010   |       | 1,373,637                  |       | 9.77                                                                                        |       | 7.31                                                            |       | 1,726                               |       |
|                                 |       |                       |       |                                                                                        |       |                                                            |       |                                |       |
| Exercisable  at June 30, 2010   |       | 638,886                    |       | 8.26                                                                                        |       | 5.79                                                            |       | 1,726                               |       |
|                                      |            |                            |            |                                                                                             |            |                                                                 |            |                                     |            |  |  |

 

The weighted average grantdate fair value of options granted during the six months ended June 30,2010 was $3.78 per share.  Wereceived a total of $1,000 in cash from the exercise of options during the sixmonths ended June 30, 2010.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS (Continued)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

As of June 30, 2010,732,000 shares of common stock remain available for future share awards underour Amended and Restated 2006 Omnibus Plan.

 

Share-based compensationexpense (including director compensation) included in our statements ofoperations for the three and six months ended June 30, 2010 and 2009 isallocable to our research and development activities, discontinued operationsand general and administrative activities, as follows:

 
| ** **                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                 | ** ** | **2010**                                            | ** ** | **2009**                                          | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                 | ** ** | **($000)**                                          | ** ** | **($000)**                                        | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Research and development   |       | $                                                   | 229        |                                              | $          | 242 |   | $ | 420 |   | $ | 486 |   |
| Discontinued operations    |       | —                                              |       | (27                                               | )          | — |   | 98 |   |
| General and administrative |       | 253                                                 |       | 511                                               |       | 436 |   | 1,285 |   |
| Total                      |       | $                                                   | 482        |                                              | $          | 726 |   | $ | 856 |   | $ | 1,869 |   |

 

As of June 30, 2010,there was approximately $2.3 million of total unrecognized share-based compensationcost related to options granted under our plans, which will be recognized overa weighted-average period of approximately 2.0 years, as the options vest.

 

***Supplemental Cash Flow Information***

 
| ** **                                             | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                             | ** ** | **2010**                                      | ** ** | **2009** | ** ** |
| ** **                                             | ** ** | **($000)**                                    | ** ** | **($000)** | ** ** |
| **Supplemental disclosure of cash flows information:** |       |                                          |       |   |   |
| Cash  paid for interest                                |       | $                                             | —     |   | $ | 4 |   |
| Cash  paid for income taxes                            |       | 935                                           |       | — |   |
|                                                        |            |                                               |            |  |  |  |  |

 

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

 

In September 2009, ASU2009-13, *Revenue Recognition*(Topic 605)— *Multiple-Deliverable RevenueArrangements* (“ASU 2009-13”) was issued and will change theaccounting for multiple-deliverable arrangements to enable vendors to accountfor products or services (deliverables) separately rather than as a combinedunit. 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-party evidence; or (c) estimates. This guidance alsoeliminates the residual method of allocation and requires that arrangementconsideration be allocated at the inception of the arrangement to alldeliverables using the relative selling price method. In addition, thisguidance significantly expands required disclosures related to a vendor’smultiple-deliverable revenue arrangements. ASU 2009-13 is effectiveprospectively for revenue arrangements entered into or materially modified infiscal years beginning on or after June 15, 2010 with early adoptionpermitted. The impact of ASU 2009-13 on our financial statements will depend onthe nature and terms of revenue arrangements that we enter into or materiallymodify after the adoption date. However, based on our current customerarrangements, we do not believe the adoption of this ASU will have a materialimpact on our financial statements.

 

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

 

**3.    Collaboration Agreements and Government Contract**

 

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

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS (Continued)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

that requiredisclosure.  The accounting policiesrelated to each of these contracts, including material impact on our financialstatements, is included above under the “Revenue Recognition” section ofNote 2, Significant Accounting Policies.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 
| ** **                                                                     | ** ** | **Three Months********Ended********June 30, 2009** | ** ** | **Six Months********Ended********June 30, 2009** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **($000)**                                                   | ** ** | **($000)**                                                 | ** ** |
| Product  sales                                                                 |       | $                                                            | 29         |                                                       | $          | 6,296 |   |
| Cost  of goods sold                                                            |       | 128                                                          |       | 4,915                                                      |       |
| Gross  profit (loss)                                                           |       | (99                                                          | )          | 1,381                                                      |       |
|                                                                           |       |                                                         |       |                                                       |       |
| Selling,  general & administrative expenses                           |       | —                                                       |       | 124                                                        |       |
| Income  (loss) from operations of discontinued operations, before income taxes |       | (99                                                          | )          | 1,257                                                      |       |
| Income  taxes                                                                  |       | 43                                                           |       | 160                                                        |       |
| Income  (loss) from operations of discontinued operations                      |       | $                                                            | (142       | )                                                          | $          | 1,097 |   |

 

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

 

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

 

In 2010, we began to manageour business in two reportable operating segments: the 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 segment isfocused on the development, manufacture and sale of biologic products designedto promote the body’s natural healing process and improve surgicaloutcomes.  During the first quarter of2010, we commenced the manufacturing of our first potential product from thisnew segment, a regenerative wound care product.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS (Continued)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

We commenced manufacturingoperations during 2010, and are currently distributing the product only forinitial clinical evaluation. We have not yet launched the product forcommercial sale.  Accordingly, we haveincurred research, development, manufacturing, general, and administrativecosts related to the Biosurgery segment, but have yet to recognize any revenuefrom sales.  We expect to initiate salesof our first Biosurgery product during fiscal 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.

 

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

 
| ** **                  | ** ** | **Three Months Ended**             | ** ** | **Six Months Ended**   | ** ** |
|-----------------------------|------------|------------------------------------|------------|------------------------|------------|
| ** **                  | ** ** | **June 30, 2010**             | ** ** | **June 30, 2010** | ** ** |
| ** **                  | ** ** | **($000)**                         | ** ** | **($000)**             | ** ** |
| ** **                  | ** ** | **Biologic Drug  Candidates** | ** ** | **Biosurgery**         | ** ** | **Total** | ** ** | **Biologic Drug  Candidates** | ** ** | **Biosurgery** | ** ** | **Total** | ** ** |
|                        |       |                               |       |                   |       |   |   |   |   |   |   |   |   |
| Operating  expenses:        |       |                               |       |                   |       |   |   |   |   |   |   |   |   |
| Research  and development   |       | $                                  | 5,161      |                   | $          | 1,295 |   | $ | 6,456 |   | $ | 10,592 |   | $ | 2,424 |   | $ | 13,016 |   |
| General  and administrative |       | 1,439                              |       | 163                    |       | 1,602 |   | 3,101 |   | 308 |   | 3,409 |   |
| Total  operating expenses:  |       | $                                  | 6,600      |                   | $          | 1,458 |   | $ | 8,058 |   | $ | 13,693 |   | $ | 2,732 |   | $ | 16,425 |   |

 

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

 

The assets specificallyattributable to each of our segments as of June 30, 2010 are as follows:

 
| ** **               | ** ** | **June 30, 2010  ($000)** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **Biologic Drug  Candidates**  | ** ** | **Biosurgery** | ** ** |
| **Segment assets:**      |       |                           |       |   |   |
| Accounts  receivable     |       | $                              | 323        |   | $ | — |   |
| Inventory                |       | —                         |       | 126 |   |
| **Total segment assets** | ** ** | **$**                          | **323**    | ** ** | **$** | **126** | ** ** |

 

**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 is recognizedin the interim period in which the change occurs.

 

Thetax expense for the six months ended June 30, 2010 reflects an effectivetax rate of 22% compared to a U.S statutory tax rate of 35%. The effective taxrate reflects our estimated annual effective tax rate, which reflects ourexpectation that a portion of our income will be subject to the Federalalternative minimum tax.

 

Duringthe three and six months ended June 30, 2010 and 2009, we recognized thefollowing income tax expense (benefit):

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                           | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                           | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                           | ** ** | **($000)**             | ** ** | **($000)**           | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Tax expense (benefit) to continuing operations       |       | $                      | 535        |                 | $          | (1,650 | ) | $ | 1,217 |   | $ | (2,398 | ) |
| Tax expense of operations of discontinued operations |       | —                 |       | 43                   |       | — |   | 160 |   |
| Tax expense of sale of discontinued operations       |       | —                 |       | 950                  |       | — |   | 2,977 |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Total income tax expense (benefit)                   |       | $                      | 535        |                 | $          | (657 | ) | $ | 1,217 |   | $ | 739 |   |

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS (Continued)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

AtJune 30, 2010, the balance of our net operating loss and tax creditcarryforwards is $62.1 million, a decrease of $3.2 million fromDecember 31, 2009.  Our deferred taxassets have been fully reserved in both 2010 and 2009 since their ultimatefuture realization cannot be assured.

 

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

 

Investments available forsale consisted of the following as of June 30, 2010 and December 31,2009:

 
| ** **                                             | ** ** | **June 30, 2010** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **($000)**             | ** ** |
| ** **                                             | ** ** | ** **             | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | **Cost**               | ** ** | **Gain** | ** ** | **Loss** | ** ** | **Fair Value** | ** ** |
| **Cash equivalents:**                                  |       |                   |       |   |   |   |   |   |   |
| Money market funds & certificates of  deposit |       | $                      | 16,706     |   | $ | — |   | $ | (4 | ) | $ | 16,702 |   |
| Commercial paper                                       |       | 12,199                 |       | — |   | — |   | 12,199 |   |
|                                                   |       | 28,905                 |       |   |   | (4 | ) | 28,901 |   |
| **Short term investments:**                            |       |                   |       |   |   |   |   |   |   |
| Common stock                                           |       |                   |       |   |   |   |   |   |   |
| Corporate notes and bonds                              |       | 42,427                 |       | 14 |   | — |   | 42,441 |   |
| US government agencies                                 |       | 11,241                 |       | 6 |   | — |   | 11,247 |   |
|                                                   |       | 53,668                 |       | 20 |   | — |   | 53,688 |   |
|                                                   |       |                   |       |   |   |   |   |   |   |
| **Total investments available for  sale**              | ** ** | **$**                  | **82,573** | ** ** | **$** | **20** | ** ** | **$** | **(4** | **)** | **$** | **82,589** | ** ** |

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

 

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

 
| ** **                               | ** ** | **June 301, 2010  ($000)** | ** ** | **December 31, 2009  ($000)** | ** ** |
|------------------------------------------|------------|---------------------------------|------------|------------------------------------|------------|
| ** **                               | ** ** | **Cost**                        | ** ** | **Fair Value**                | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| **Maturities:**                          |       |                            |       |                               |       |   |   |   |   |
| Within  3-months                         |       | $                               | 75,357     |                               | $          | 75,370 |   | $ | 28,330 |   | $ | 28,240 |   |
| Between  3—12 months           |       | 2,173                           |       | 2,172                              |       | 65,824 |   | 65,819 |   |
| Between  1—2 years             |       | 5,043                           |       | 5,047                              |       | 5,343 |   | 5,350 |   |
| **Total investments available for sale** | ** ** | **$**                           | **82,573** | ** **                         | **$**      | **82,589** | ** ** | **$** | **99,497** | ** ** | **$** | **99,409** | ** ** |

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS (Continued)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

Realized gains and losses onthe sale of investments available for sale were $36,000 and $124,000,respectively, for the three and six months ended June 30, 2010, and havebeen included as a component of “Other income, net” in the accompanyingfinancial statements.

 

**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 occurin sufficient frequency and volume to provide pricing information on an ongoingbasis.

 

Thefair valued assets we hold that are generally included in this category aremoney market securities where fair value is based on publicly quoted prices.

 

*Level 2*                                 Inputs are other than quotedprices included in Level 1, which are either directly or indirectlyobservable for the asset or liability through correlation with market data atthe reporting date and for the duration of the instrument’s anticipated life.

 

The fair valued assets we hold that are generally included in thiscategory are investment grade short-term securities.

 

*Level 3*                                 Unobservable inputs that aresupported by little or no market activity and that are significant to the fairvalue of the assets or liabilities and which reflect management’s best estimateof what market participants would use in pricing the asset or liability at thereporting date. Consideration is given to the risk inherent in the valuationtechnique and the risk inherent in the inputs to the model.

 

We carry no investmentsclassified as Level 3.

 

Whenquoted prices in active markets for identical assets are available, we usethese quoted market prices to determine the fair value of financial assets andclassify 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 havenever had any assets that were 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 yet adoptedthe guidance with respect to the roll forward activity in Level 3 fair valuemeasurements. The adoption of the updated guidance for Levels 1 and 2 fairvalue measurements did not have an impact on the Company’s consolidated resultsof operations or financial condition, as there were no transfers to or fromLevels 1 and 2 to date in 2010.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS (Continued)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2010 AND 2009**

 

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

 
| ** **                                             | ** ** | **June 30, 2010** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **($000)**             | ** ** |
| ** **                                             | ** ** | **Level I**            | ** ** | **Level II** | ** ** | **Level III** | ** ** | **Total** | ** ** |
| **Assets**                                             |       |                   |       |   |   |   |   |   |   |
| Cash  Equivalents                                      |       | $                      | 15,706     |   | $ | — |   | $ | — |   | $ | 15,706 |   |
| Government  Obligations                                |       | 11,247                 |       |   |   |   |   | 11,247 |   |
| Certificates  of Deposit                               |       |                   |       | 996 |   |   |   | 996 |   |
| Agency  Obligations                                    |       |                   |       | 39,693 |   |   |   | 39,693 |   |
| Corporate  Debt Securities & Commercial Paper |       |                   |       | 14,072 |   |   |   | 14,072 |   |
| Municipal  Securities                                  |       |                   |       | 100 |   |   |   | 100 |   |
| Foreign  Bonds                                         |       |                   |       | 776 |   |   |   | 776 |   |
|                                                   |       |                   |       |   |   |   |   |   |   |
| **Short Term Investments Available for Sale**          | ** ** | **$**                  | **26,953** | ** ** | **$** | **55,636** | ** ** | **$** | **—** | ** ** | **$** | **82,589** | ** ** |

 
| ** **                                        | ** ** | **December 31, 2009** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **($000s)**           | ** ** |
| ** **                                        | ** ** | **Level I**           | ** ** | **Level II** | ** ** | **Level III** | ** ** | **Total** | ** ** |
| **Assets**                                        |       |                  |       |   |   |   |   |   |   |
| Cash Equivalents                                  |       | $                     | 18,456     |   | $ | — |   | $ | — |   | $ | 18,456 |   |
| Government Obligations                            |       | 11,367                |       |   |   |   |   | 11,367 |   |
| Common Stock                                      |       | 490                   |       |   |   |   |   | 490 |   |
| Certificates of Deposit                           |       |                  |       | 5,251 |   |   |   | 5,251 |   |
| Agency Obligations                                |       |                  |       | 38,691 |   |   |   | 38,691 |   |
| Corporate Debt Securities &  Commercial Paper |       |                  |       | 23,795 |   |   |   | 23,795 |   |
| Foreign Bonds                                     |       |                  |       | 1,259 |   |   |   | 1,259 |   |
| Municipal Securities                              |       |                  |       | 101 |   |   |   | 101 |   |
|                                              |       |                  |       |   |   |   |   |   |   |
| **Short Term Investments  Available for Sale**    | ** ** | **$**                 | **30,313** | ** ** | **$** | **69,096** | ** ** | **$** | **—** | ** ** | **$** | **99,409** | ** ** |

 

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

 

We evaluated our June 30,2010 financial statements for subsequent events through the date the financialstatements were issued. We are not aware of any subsequent events which wouldrequire recognition or disclosure in the financial statements.

 

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**Item 2.**                                   **Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.**

 

**CautionaryStatements About Forward-Looking Information**

 

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

 

Forward-looking statementsreflect management’s current views with respect to future events andperformance and are based on currently available information and management’sassumptions regarding future events. While management believes that itsassumptions are reasonable, forward-looking statements are subject to variousknown and unknown risks and uncertainties and actual results may differmaterially from those expressed or implied herein. In connection with the “safeharbor provisions” of the Private Securities Litigation Reform Act of 1995, theCompany notes that certain factors, among others, which could cause futureresults to differ materially from the forward-looking statements, expectations andassumptions expressed or implied herein are discussed in greater detail in ourAnnual 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 are cautioned thatall forward-looking statements attributable to us or persons acting on ourbehalf apply only as of the date of this Quarterly Report and are expresslyqualified in their entirety by the cautionary statements included herein. Weundertake no obligation to publicly update or revise any forward-lookingstatements to reflect subsequent events or circumstances and do not intend todo so.

 

You should read thefollowing management’s discussion and analysis of our financial condition andresults of operations in conjunction with our audited Financial Statements andrelated notes thereto and other disclosures included as part of our AnnualReport on Form 10-K for the year ended December 31, 2009, and ourunaudited Condensed Financial Statements for the three and six months endedJune 30, 2010 and 2009 and other disclosures included in this QuarterlyReport on Form 10-Q.  Our Condensed Financial Statements have beenprepared in accordance with U.S. generally accepted accounting principles andare 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 Marylandcorporation.

 

**Introduction and Overview**

 

The following is adiscussion and analysis of our financial condition and results of operations forthe three and six month periods ended June 30, 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.”

 

We are a leading stem cellcompany headquartered in Columbia, Maryland and focused on developing andmarketing products to treat serious medical conditions in the inflammatory,autoimmune, orthopedic, and cardiovascular areas.  We believe our stem cell products havesignificant therapeutic potential because of their ability to regulate inflammation,promote tissue regeneration and prevent pathological scar formation. We wereincorporated in Maryland in March 2010. Our predecessor company wasorganized in 1992. We have two business segments, Therapeutics andBiosurgery.  Our Therapeutics business isfocused on developing biologic stem cell drug candidates from a readilyavailable and non-controversial source — adult bone marrow. Our Biosurgerydivision works to harness the ability of cells and novel constructs to promotethe body’s natural healing with the goals of improving surgical outcomes andoffering better treatment options for patients and physicians.

 

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Our lead biologic drugcandidate, Prochymal (remestemcel-L), is being evaluated in Phase 3 trialsfor four indications, including steroid refractory acute graft versus hostdisease (“GvHD”), newly diagnosed acute GvHD, Crohn’s disease and for therepair of gastrointestinal injury resulting from radiation exposure (animalrule), and is the only stem cell therapeutic currently granted both Orphan Drugand Fast Track status by the United States Food and Drug Administration (“FDA”).Prochymal is also being developed for the repair of heart tissue following aheart attack, for protection of pancreatic islet cells in patients withtype 1 diabetes, and the treatment of pulmonary disease. Our pipeline ofinternally developed biologic drug candidates under evaluation also includesChondrogen for osteoarthritis in the knee.

 

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

 

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

 

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

 

In August 2009, weannounced the creation of a Biosurgery Division focused on developing andmarketing high-end biological products for use in surgical procedures. Weintend to build on the success of our first generation implantable product,Osteocel which generated over $40 million of revenue for us before beingsold for $85.0 million in 2008. We introduced our first potential biologicproduct from the Biosurgery Division during March 2010 and are currentlydistributing the product only for clinical evaluation.

 

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

 

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

 

·                                                       **StemCell Source.**   Our stem cells are obtained from adult bonemarrow, a readily available source. The cells are drawn from the hips ofvolunteer donors between the ages of 18 and 30 years, using a simpleneedle and syringe aspiration. Because the cells are obtained from consentingadult donors, we are able to largely avoid the ethical controversy surroundingembryonic and fetal stem cell research.

 

·                                                       **Abilityto Mass Produce.**   Through our proprietary manufacturingmethods, we can grow MSCs in a controlled fashion to produce up to 10,000treatments of our biologic drug candidates from a single bone marrow donation.Our ability to produce a large quantity of treatments from one donationprovides us with manufacturing efficiencies and product consistency that areessential to commercialization.

 

·                                                       **UniversalCompatibility.**   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. Thisuniversal compatibility allows us to produce a standardized product availableto all patients in almost any medical setting.

 

·                                                       **Treatmenton Demand.**   Our biologic drug candidates can be storedfrozen at end-user medical facilities until they are needed. We anticipate thatmedical facilities will be able to prescribe and dispense these products inmuch the same way as conventional drugs. In contrast, other stem celltechnologies under development require weeks to prepare after a patient’s 

 

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need is identified. This isa key feature of our technology, as many patients in the critical care settingrequire prompt treatment.

 

The following tablesummarizes key information about our biologic drug candidates.

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

 

***Prochymal,*** our lead biologic drug candidate, is beingevaluated in Phase 3 trials for four indications including the first linetreatment of acute graft versus host disease (“GvHD”), steroid refractory acuteGvHD, biologics refractory Crohn’s disease and for the repair ofgastrointestinal 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 is also being developedfor the repair of heart tissue following a heart attack, for protection ofpancreatic islet cells in patients with type 1 diabetes, and the treatmentof pulmonary disease.

 

*Prochymalfor Treatment-Resistant GvHD*

 

GvHD is a life threateningimmune system reaction that commonly affects one or more of the skin,gastrointestinal tract, and liver in patients who have received a bone marrowtransplant. Although in the U.S. there are no drugs approved for treating GvHD,the disease is commonly treated off-label with steroids. GvHD that does notrespond to this treatment is known as steroid refractory GvHD. A large majorityof steroid refractory GvHD patients die within six months. In a Phase 2trial for treatment refractory GvHD, we enrolled patients that did not respondto treatment with steroids and at least one second line therapy. Of thesepatients, all responded to treatment with Prochymal, and 59% achieved completeresolution of their disease. Prochymal has been granted Fast Track status byFDA as well as Orphan Drug status by FDA and the European Medicines Agency forGvHD.

 

In May 2008, wereceived clearance from the FDA to initiate an expanded access treatmentprogram making Prochymal available to children with life threatening GvHD.Under the program, children, 2 months to 17 years of age, with GradesB-D acute GvHD that hasn’t responded to steroids are eligible for treatment.Upon completion of enrollment of the Phase 3 trials evaluating Prochymalin adults with GvHD, the expanded access program was broadened to includepatients 18 to 70 years of age. The expanded access programs for Prochymalin treating adult and pediatric patients with refractory GvHD are ongoing.

 

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

 

In September 2009, weannounced the preliminary results for the two Prochymal Phase 3 GvHDtrials described below. While the trials did not reach significance in theirprimary endpoints, the studies did reveal several important findings:

 

·                          The primary endpoint for the steroid-refractory GvHD trial(durable complete response) for the per protocol population approachedstatistical significance (40% Prochymal vs. 28%, standard of care, p=0.087,n=179);

 

·                          Prochymal significantly improved response insteroid-refractory liver (76% vs. 47%, p=0.03) and gastrointestinal GvHD (82%vs. 68%, p=0.03);

 

·                          In the sickest patients—those with GvHD affecting all threeorgans, skin, liver and gastrointestinal tract—treatment with Prochymalresulted in a 63% overall response rate, while none of the placebo-treatedpatients responded (p<0.05);

 

·                          Children receiving Prochymal had an overall response rate of64% compared to 36% in patients receiving placebo; and

 

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·                          In children with steroid-refractory GvHD, Prochymal more thandoubled complete response rates (64% vs. 29%) and reduced disease progressionby half (21% vs. 43%).

 

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

 

*Phase 3Clinical Trial—Steroid Refractory Acute GvHD*

 

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

 

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

 

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

 

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

 

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

 

*Phase 3Clinical Trial—Biologics Refractory Crohn’s Disease.*

 

Based on our clinicalobservations of the effects of Prochymal on the gastrointestinal symptoms ofpatients with GvHD, we are developing Prochymal for the treatment of Crohn’sdisease. Crohn’s disease is a chronic condition that results in inflammation ofthe gastrointestinal tract. We completed patient enrollment in a Phase 2trial 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.

 

Patients were enrolled in aPhase 3 trial evaluating Prochymal for the treatment of moderate to severeCrohn’s disease that is refractory to biological therapy. Theplacebo-controlled, double-blind study was designed to enroll 270 patients, 18to 70 years of age, with a Crohn’s Disease Activity Index (“CDAI”) greaterthan 250. Patients were enrolled at approximately 60 leading centers in theUnited States and Canada. The trial evaluates patients with severe Crohn’sdisease that is not responsive to treatment with steroids, immunomodulators(azathioprine, 6-mercaptopurine, and methotrexate), and biologic agents(Remicade®, Hurmira®, and Cimzia®).

 

In April 2010 weannounced that we would resume enrollment in the Crohn’s program that had beensuspended in 2009 over concerns about the trial design.  The Crohn’s program initially consisted oftwo linked trials — one aimed at inducing remission (Protocol 603) and theother at maintaining response (Protocol 610) in patients who had failed otheravailable treatments for the disease.  The primary endpoint for Protocol 603 is theproportion of patients experiencing disease remission within 28 days ofinitiation of therapy with Prochymal, compared to 

 

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those patients receivingplacebo.  For a patient to reach the primary end-point of diseaseremission, their CDAI score must fall to below 150.  Concerns that the trial design would make itdifficult to detect a treatment effect led to the suspension.  The trialremained blinded, however, to permit an interim analysis of all 207 patientsenrolled in the study.  The findings of an interim analysis showed thatthe majority of patients enrolled thus far have failed at least twoimmunomodulators and two biological agents.  Patients are required tocomplete a “washout” period prior to study entry to ensure that residualbenefit from prior therapy does not influence their response.  There wereno 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. For the primary endpoint of diseaseremission, Prochymal is approaching statistical significance in the intent totreat (ITT) population, and has reached significance in the per protocolpopulation.  Additionally, the analysis showed that Prochymal continued todemonstrate a benign safety profile with no significant differences in any ofthe pre-defined safety outcomes compared to placebo. The results showed thatdespite the initial concerns, the effect size, or difference between theProchymal and placebo response rates, of one dose arm of Prochymal isconsistent with the original statistical assumptions of the protocol and issignificantly outperforming placebo. This led to the announcement that we areresuming enrollment in this clinical trial evaluating Prochymal for patientswith treatment resistant Crohn’s disease.

 

The decision to resumeenrollment was made following discussions with the Food and Drug Administration(FDA) about the results of the interim analysis.   Enrollment willnow continue with the best-performing Prochymal dose arm and the placebo arm,according to the pre-specified adaptive trial design.  The trial has beenrepowered to compensate for the statistical penalty incurred by the interimanalysis in the ITT population.  The follow-on maintenance trial (Protocol610) has been discontinued to remove the potential for bias.

 

*Phase 2Clinical Trial—Acute Myocardial Infarction.*

 

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

 

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

 

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

 

*Phase 2Clinical Trial—Early Onset Type 1 Diabetes Mellitus.*

 

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

 

*Phase 2Clinical Trial—Chronic Obstructive Pulmonary Disease*

 

Enrollment in the 62-patientPhase 2 clinical trial evaluating the safety and efficacy of Prochymal inconjunction with standard of care for improving pulmonary function in patientswith moderate to severe Chronic Obstructive Pulmonary Disease (“COPD”) wascompleted in the second half of 2008. Patients in the double-blind,placebo-controlled study were randomized to either Prochymal or placebo at a1:1 ratio and received 4 infusions over the course of 90 days.Measurements used in the trial to detect potential improvements in subjectstreated with Prochymal include pulmonary function tests, exercise capability,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.

 

At the six-month interimanalysis, the trial met its primary goal of demonstrating the safety ofProchymal in patients with compromised pulmonary function. Prochymalsignificantly decreased systemic inflammation in patients when compared tothose receiving placebo, as 

 

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determined by C-reactiveprotein (CRP). Despite this reduction in inflammation, however, pulmonaryfunction in patients receiving Prochymal was not significantly improvedcompared to those receiving placebo.

 

*Phase 3Development—Animal Rule—Acute Radiation Syndrome.*

 

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

 

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

 

**Financial Operations Overview**

 

*Revenue*

 

In 2008, we entered into a CollaborationAgreement with Genzyme for the development and commercialization of Prochymaland Chondrogen, and providing for non-contingent, non-refundable upfrontpayments to us 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 two quarters of2010 and 2009, related to this agreement.

 

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

 

In 2003, we entered into anagreement with 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 JCRalso provides for additional milestone payments of up to $8.5 million forregulatory and sales milestones, as well as royalty payments on sales of thedrug in Japan.

 

Under the DoD contractawarded to us in January 2008, we are seeking, in partnership withGenzyme, to develop Prochymal for the repair of gastrointestinal injuryresulting from acute radiation exposure. Under the terms of the contract, theDoD provides funding to us for development. We recognized $113,000 in revenueunder the terms of this contract in the first half 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 2 clinical trial evaluatingProchymal as a treatment for type 1 diabetes mellitus. Under thiscollaborative agreement,  JDRF will provide up to $4.0 million ofcontingent milestone funding to support the development of Prochymal for thepreservation of insulin production in patients with newly diagnosed type 1diabetes mellitus. The contingent milestone payments under the agreement areamortized into revenue on a straight line basis over the duration of ourobligations under the collaborative agreement as they are received and earned.We recognized $420,000 in revenue during the first six months of 2010 underthis agreement.

 

*Researchand Development Costs*

 

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

 

Consistent with our focus onthe development of biologic drug candidates with potential uses in multipleindications, many of our costs are not attributable to a specificallyidentified product. We use our employee and infrastructure resources acrossseveral projects. Accordingly, we do not account for internal research anddevelopment costs on a project-by-project basis. From inception in December 1992through June 30, 2010, we incurred aggregate research and developmentcosts of approximately $380 million.

 

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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 timegenerally varies substantially according to the type, size of trial andintended use of a biologic drug candidate. The cost of clinical trials may varysignificantly over the life of a project as a result of a variety of factors,including:

 

·                       the number ofpatients who participate in the trials;

 

·                       the number ofsites included in the trials;

 

·                       the length oftime required to enroll trial participants;

 

·                       the duration ofpatient treatment and follow-up;

 

·                       the costs ofproducing supplies of the biologic drug candidates needed for clinical trialsand regulatory submissions;

 

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

 

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

 

As a result of these uncertainties,we are unable to determine with any significant degree of certainty theduration and completion costs of our research and development projects or whenand to what extent we will generate revenues from the commercialization andsale 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 2010 and2009, we recorded a provision for income taxes to recognize the U.S. Federalalternative minimum tax on our taxable income.

 

The tax provision for thethree and six months ended June 30, 2010, reflects an effective tax ratefor continuing 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.

 

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**CriticalAccounting Policies**

 

There have been no materialchanges in our critical accounting policies, estimates and judgments during thesix months ended June 30, 2010 compared to the disclosures in Part II, Item 7of 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 EndedJune 30, 2010 and 2009***

 

*Revenues from Collaborative Research Licenses &Grants*

 

Revenues were $10.3 millionfor the three months ended June 30, 2010 compared to $10.5 million for thesecond quarter of fiscal 2009.  During the three months ended June 30,2010, we recognized $10.0 million in revenue from our collaborative agreementwith Genzyme and $210,000 from our collaborative agreement with JDRF. Ourrevenues for the three month period also include $27,000 from our contract withthe DoD to develop Prochymal for the treatment of acute radiation syndrome,plus royalties on MSCs sold for research purposes.  Revenues fromcontinuing operations for the three months ended June 30, 2009 consistedof $10.0 million from the Genzyme agreement, $120,000 from the JDRFcollaboration and $261,000 from the DoD contract, plus other minor royalties.

 

*Researchand Development Expenses*

 

Research and developmentexpenses for the three months ended June 30, 2010 were $6.5 million ascompared to research and development expenses of $18.5 million for the sameperiod of 2009.  The second quarter 2010 expenses include $1.3 million ofdevelopment and initial manufacturing costs associated with our BiosurgeryDivision. The reduction in research and development expenses during thesecond quarter of 2010 when compared to the comparable period of the prior yearreflects the completion of enrollment in our Phase 3 clinical trials and theassociated reduction in site and patient costs, and reductions in our contractmanufacturing activities as a result of the need for fewer clinical batches ofProchymal.  We also incur research and development expenses in connectionwith the preparation of our applications for marketing approval as we worktowards the commercialization of Prochymal for an initial indication.

 

*Generaland Administrative Expenses*

 

General and administrativeexpenses were $1.6 million for the three months ended June 30, 2010compared to $2.3 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 and reductions inour legal expenses related to our intellectual property. The non cash chargefor share-based compensation, including share grants to members of our Board ofDirectors, allocated to general and administrative expenses during the fiscalquarter ended June 30, 2010 was $253,000 as compared to $511,000 for thesame period last year.

 

*OtherIncome (Expense), Net*

 

Investment income, net was$36,000 for the three months ended June 30, 2010, compared to $155,000 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 (Loss) from Discontinued Operations*

 

Our Osteocel operations weresold during fiscal 2009 for $85.0 million, all of which was received during2009.  During the second quarter of fiscal 2009, we recognized $1.1million of loss from discontinued operations. The loss from discontinuedoperations in the second fiscal quarter of 2009 was primarily the effect of theincrease in the estimated effective income tax rate for the full fiscal year,which increased to 12.7% in the second quarter when it was estimated to be 8.6%during the quarter ended March 31, 2009.

 

***Comparison of Six Months EndedJune 30, 2010 and 2009***

 

*Revenues from Collaborative Research Licenses &Grants*

 

Revenues were $21.7 millionfor the six months ended June 30, 2010 compared to $23.2 million for thefirst half of fiscal 2009.  During the six months ended June 30,2010, we recognized $20.0 million in revenue from our collaborative agreementwith Genzyme, $1.0 million from our collaboration with JCR, and $420,000 fromour collaborative agreement with JDRF. Our revenues for the six month periodalso include $113,000 from our contract with the DoD to develop Prochymal forthe treatment of acute radiation syndrome, plus royalties on MSCs sold forresearch purposes.  Revenues for the six months ended June 30, 2009consisted of $20.0 million from the Genzyme agreement, $212,000 from the JDRFcollaboration and $2.8 million from the DoD contract, plus other royalties.

 

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*Researchand Development Expenses*

 

Research and developmentexpenses for the six months ended June 30, 2010 were $13.0 million ascompared to research and development expenses of $37.1 million for the sameperiod of 2009.  The first half 2010 expenses include $2.4 million ofdevelopment and initial manufacturing costs associated with our BiosurgeryDivision. The reduction in research and development expenses during thefirst half of 2010 when compared to the comparable period of the prior yearreflects the completion of enrollment in our Phase 3 clinical trials and theassociated reduction in site and patient costs, and reductions in our contractmanufacturing activities as a result of the need for fewer clinical batches ofProchymal. .  We also incur researchand development expenses in connection with the preparation ofour applications for marketing approval as we work towards the commercializationof Prochymal for an initial indication.

 

*Generaland Administrative Expenses*

 

General and administrativeexpenses were $3.4 million for the six months ended June 20, 2010 comparedto $5.2 million for the comparable period in fiscal 2009.  The decrease ingeneral and administrative expenses is primarily attributable to reductions inincentive compensation, non cash share-based compensation expense andreductions in our legal expenses related to our intellectual property. The noncash charge for share-based compensation, including share grants to members ofour Board of Directors, allocated to general and administrative expenses duringthe six months ended June 30, 2010 was $436,000 as compared to $1.3million for the same period last year

 

*OtherIncome (Expense), Net*

 

Investment income, net was $124,000for the six months ended June 30, 2010, compared to $253,000 in thecorresponding period in fiscal 2009.  Our investments available for saleconsist of relatively short-term, investment grade securities with a focus onavoiding 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 half of fiscal 2009, we recognized $21.6 millionof income from discontinued operations.

 

**Liquidityand Capital Resources**

 

***Liquidity***

 

At June 30, 2010, wehad $84.1 million in cash and investments available for sale.  We did nothave any outstanding debt at any time during fiscal 2010 to date, or during allof fiscal 2009. Although there can be no assurance, we believe that we havesufficient liquidity on hand as of June 30, 2010 to fund our operationsthrough the commercialization of our first biological drug candidate.

 

***Cash Flows***

 

***Comparison of Six Months Ended June 30, 2010 and 2009***

 

Cashused in operating activities of continuing operations for the six months ended June 30,2010 was $16.2 million compared to $31.3 million in the corresponding fiscalperiod of the prior year.  The 2010 income from continuing operations of$4.2 million was offset by net decreases in working capital, primarily accountspayable, accrued expenses, and deferred revenue.  Cash used by operatingactivities of continuing operations during the first half of 2009 reflect ourloss from continuing operations of $16.5 million, which was increased primarilyby a reduction in deferred revenue.

 

Cashused by operating activities of discontinued operations for the first half offiscal 2010 was $0.4 million, compared to cash used in operating activities ofdiscontinued operations of $1.8 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 ofDecember 31, 2009.  The 2009 amount reflects the cash portion of theincome from discontinued operations generated in 2009, offset by a decrease inreceivables and inventory.

 

Cashprovided by investing activities during the first half of 2010 was $16.8million compared to $33.5 million in the same period of the prior year. The 2010 amount primarily reflects the sale of investments and minor propertyand equipment purchases.  In thecomparable period of fiscal 2009, we sold $23.7 million of investments andrealize $9.9 million in net proceeds from the sale of our Osteocel business.

 

Cashused in financing activities during the first half of 2010 was $2,000. Cashused in financing activities during the first half of 2009 was $110,000, andconsisted of the $536,000 increase in restricted cash to collateralize lettersof credit, partially offset by the proceeds from the issuance of common stockpursuant to option exercises.

 

***Capital Resources***

 

Our future capitalrequirements will depend on many factors, including:

 

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·                  the scope and results of ourresearch and preclinical development programs;

 

·                  the scope and results of ourclinical trials, particularly regarding the number of patients required for ourPhase 3 trials;

 

·                  the timing of and the costsinvolved in obtaining regulatory approvals for our biologic drug candidates,which could be more lengthy or complex than obtaining approval for a newconventional drug, given the FDA’s limited experience with late-stage clinicaltrials and marketing approval for stem cell therapeutics;

 

·                  the timing and achievementof contingent milestone payments under the Genzyme and JCR collaborationagreements;

 

·                  the costs of maintaining,expanding and protecting our intellectual property portfolio, includingpossible litigation costs and liabilities; and

 

·                  the costs of expanding ourwork force consistent with expanding our business and operations and status asa public company.

 

**Off-Balance Sheet Arrangements.**

 

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

 

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

 

*InterestRate Risk*

 

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

 

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

 

*ForeignCurrent Exchange Rate Risk*

 

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

 

*DerivativeInstruments*

 

We do not enter into hedgingor derivative instrument arrangements.

 

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

 

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

 

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

 

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**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**.

 

There have not been anymaterial changes in the risk factors previously disclosed under the heading “RiskFactors” in Part I — Item 1A of our Annual Report on Form 10-K for thefiscal year ended December 31, 2009, as filed with the Securities andExchange Commission on March 12, 2010 (the “Annual Report”), exceptinsofar as certain of those risk factors do not recognize that, as a result ofour reincorporation as a Maryland corporation effective May 31, 2010, weare now organized under Maryland and not Delaware law, and governed by theMaryland General Corporation Law (“MGCL”), and our Maryland charter andMaryland bylaws.  As a result, thefollowing risk factors replace the risk factors found in our Annual Reportunder the subheadings  “Certainprovisions of Delaware law and of our charter and bylaws contain provisionsthat could delay and discourage takeover attempts and any attempts to replaceour current management by stockholders” and “Concentration of ownership of our common stockamong our existing executive officers, directors and principal stockholders mayprevent new investors from influencing significant corporate decisions”,both under the heading “Risks Related to our Common Stock”.

 

***Certain provisions ofMaryland law and of our charter and bylaws contain provisions that could delayand discourage takeover attempts and any attempts to replace our currentmanagement by stockholders***

 

Certain provisions ofMaryland law and of our charter and bylaws contain provisions that may make itmore difficult for or prevent a third party from acquiring control of us orchanging our Board of Directors and management. These include, but are not limited to, the following:

 

·              classification of the board ofdirectors with staggered terms of three years, which prevents a majority of theincumbent directors from being replaced at a single annual stockholders’meeting;

 

·              authorization of the board ofdirectors to issue shares of preferred stock generally without stockholderapproval;

 

·              requirements that special meetingsof stockholders may only be called by the chairman of the board of directors,upon request of stockholders holding at least 20% of the capital stock issuedand outstanding, or upon a resolution adopted by, or an affirmative vote of, amajority of the board of directors; and

 

·              requirements that our stockholderscomply with advance notice procedures in order to nominate candidates forelection to our Board of Directors or to place stockholders’ proposals on theagenda for consideration at meetings of stockholders.

 

Maryland law also prohibits “businesscombinations” between us and an interested stockholder or an affiliate of aninterested stockholder for five years after the most recent date on which theinterested stockholder becomes an interested stockholder.  These business combinations include a merger,consolidation, share exchange or, in certain circumstances specified in thestatute, an asset transfer or issuance or reclassification of equitysecurities.  Maryland law defines aninterested stockholder as any person who beneficially owns 10% or more of thevoting power of the corporation’s stock, or an affiliate or associate of thecorporation who, at any time within the two-year period prior to the date inquestion, was the beneficial owner of 10% or more of the voting power of thecorporation’s then-outstanding voting stock. A person is not an interested stockholder if the board of directors ofthe corporation approved in advance the transaction by which the personotherwise would have become an interested stockholder.  However, such approval may be conditional.

 

After the five-yearprohibition, any business combination between the corporation and an interestedstockholder or an affiliate of an interested stockholder generally must berecommended by the board of directors and approved by the affirmative vote ofat least 80% of the votes entitled to be cast by holders of thethen-outstanding shares of voting stock, and two-thirds of the votes entitledto be cast by holders of the voting stock other than stock held by theinterested stockholder with whom or with whose affiliate the businesscombination is to be effected or stock held by an affiliate or associate of theinterested stockholder.  Thesesuper-majority vote requirements do not apply if the holders of the commonstock receive a minimum price, as defined under Maryland law, for their stockin the form of cash or other consideration in the same form as previously paidby the interested stockholder for its stock.

 

The statute permits variousexemptions from its provisions, including business combinations that areapproved or exempted by the board of directors before the time that theinterested stockholder becomes an interested stockholder.  Our Board of Directors has not exempted usfrom the business combination statute. Consequently, unless the Board of Directors adopts an exemption from thisstatute in the future, the statute will be applicable and may affect businesscombinations between us and other persons. The statute may discourage others from trying to acquire control of usor increase the difficulty of consummating any such acquisition.

 

Our bylaws also contain aprovision exempting us from the “control share acquisition” provisions of theMGCL (Sections 3-701 through 3-709).  Wecan provide no assurance that such provision of our bylaws will not be amendedor eliminated in the future. Should this 

 

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happen, the control shareacquisition provisions would become effective and may discourage others fromtrying to acquire control of us and increase the difficulty of consummating anyoffer.

 

Subtitle 8 of Title 3 of theMGCL (“Subtitle 8”) permits a Maryland corporation with a class of equitysecurities registered under the Securities Exchange Act of 1934, as amended(the “Exchange Act”), and with at least three independent directors to elect tobe subject to any or all of five provisions:

 

·              a classified board;

 

·              a two-thirds vote requirement toremove a director;

 

·              a requirement that the number ofdirectors be fixed only by the vote of the directors;

 

·              a requirement that a vacancy onthe board be filled only by the remaining directors and for the remainder ofthe full term of the directorship in which the vacancy occurred rather thanuntil the next annual meeting of stockholders as would otherwise be the case;and

 

·              a majority requirement for thecalling of a special meeting of stockholders.

 

An eligible Marylandcorporation like us can elect into this statute by provision in its charter orbylaws or by a resolution of its board of directors, without stockholderapproval.  Furthermore, we can elect tobe subject to the above provisions regardless of any contrary provisions in thecharter or bylaws.  Pursuant to Subtitle8, we have elected  to provide thatvacancies on our Board of Directors may be filled only by the remainingdirectors and for the remainder of the full term of the class of directors inwhich the vacancy occurred.  Throughprovisions in our charter and bylaws unrelated to Subtitle 8, we have aclassified board, and the number of our directors may be fixed only by the voteof the directors.

 

***Concentration of ownership of our common stock among our existingexecutive officers, directors and principal stockholders  may prevent others from influencingsignificant corporate decisions, and provisions in our charter allowing for astockholder vote by consent in lieu of a meeting may make it easier forstockholders holding a majority of our common stock to take action.***

 

Our executive officers,directors and beneficial owners of 5% or more of our common stock and theiraffiliates, in aggregate, beneficially own approximately 55% of our outstandingcommon stock as of June 30, 2010. Included among this 55%, Peter Friedli, the Chairman of the Board ofDirectors, and certain entities with which he is affiliated, beneficially ownapproximately 44% of our outstanding common stock as of June 30,2010.  These persons, acting together,will be able to significantly influence all matters requiring stockholderapproval, including the election and removal of directors and any merger orother significant corporate transactions. The interests of this group ofstockholders may not coincide with our interests or the interests of otherstockholders.

 

Moreover, as permitted bythe MGCL, our charter provides that the holders of common stock entitled tovote generally in the election of directors may take action or consent to anyaction by delivering a consent in writing or by electronic transmission of thestockholders entitled to cast not less than the minimum number of votes (whichis generally either a majority of votes cast or a majority of votes entitled tobe cast) that would be necessary to authorize or take the action at astockholders meeting if the corporation gives notice of the action not laterthan ten (10) days after the effective date of the action to each holderof the class of common stock and to each stockholder who, if the action hadbeen taken at a meeting, would have been entitled to notice of the meeting.

 

Accordingly, these personsacting together, and Mr. Friedli specifically, currently has, and willcontinue to have, a significant influence over the outcome of all corporateactions requiring stockholder approval, including any actions that may be takenby stockholder consent in lieu of a meeting.

 

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

 

None.

 

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

 

None.

 

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

 

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

 

None.

 

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

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.1                 |       | Articles of Restatement of  the Registrant as filed with the State Department of Assessments and Taxation  of Maryland on June 4, 2010                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.2                 |       | Bylaws of Osiris  Therapeutics, Inc., a Maryland corporation. (Incorporated herein by  reference to Exhibit 3.3 to the Current Report on Form 8- K filed  by the Registrant with the SEC on June 2, 2010).                                                                                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.1                 |       | Articles of Merger between  Osiris Therapeutics, Inc., a Delaware corporation, and Osiris  Maryland, Inc. a Maryland corporation, as survivor, changing the name of  “Osiris Maryland Inc.” to “Osiris Therapeutics, Inc.”, as filed with the  State Department of Assessments and Taxation of Maryland on May 27,  2010, and effective May 31, 2010. (Incorporated herein by reference to  Exhibit 3.2 to the Current Report on Form 8-K filed by the  Registrant with the SEC on June 2, 2010). |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.1                |       | Amended and Restated 2006  Omnibus Plan, effective as of May 27, 2010. (Incorporated herein by  reference to Exhibit 10.1 to the Current Report on Form 8-K filed  by the Registrant with the SEC on June 2, 2010).                                                                                                                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.1.1              |       | Certification of Principal  Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) under  the Securities Exchange Act of 1934, as amended (Section 302 of the  Sarbanes-Oxley Act of 2002).                                                                                                                                                                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.2.1              |       | Certification of Principal  Financial Officer pursuant to Rule 13a-14(a) and  15d-14(a) under the Securities Exchange Act of 1934, as amended (Section 302  of the Sarbanes-Oxley Act of 2002).                                                                                                                                                                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 32.1                |       | Certification of Principal  Executive Officer and Principal Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                           |

 

**SIGNATURES**

 

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

 
|                      | **Osiris  Therapeutics, Inc.**                    |
|---------------------------|--------------------------------------------------------|
|                      |                                                   |
| Date: August 6, 2010 | /s/ PHILIP R. JACOBY, JR.                              |
|                      | Philip R. Jacoby, Jr.                             |
|                      | Chief Financial Officer  (Principal Financial Officer) |
|                      |                                                   |
| Date: August 6, 2010 | /s/ MATTHEW NEUMAYER                                   |
|                      | Matthew Neumayer                                       |
|                      | Corporate Controller  (Principal Accounting Officer)   |

 

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