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OSIR > SEC Filings for OSIR > Form 10-K on 15-Mar-2013All Recent SEC Filings

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Annual Report

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

When reviewing the discussion below, you should keep in mind the substantial risks and uncertainties that characterize our business. In particular, we encourage you to review the risks and uncertainties described under "Risk Factors" included as Item 1A in this Annual Report on Form 10-K. These risks and uncertainties could cause actual results to differ materially from those forecasted in forward-looking statements or implied by past results and trends. Forward-looking statements are statements that attempt to project or anticipate future developments in our business; we encourage you to review the examples of forward-looking statements included in this Annual Report on Form 10-K under Item 1 at the beginning of this report. These statements, like all statements in this report, speak only as of the date of this report (unless another date is indicated), and we undertake no obligation to update or revise the statements in light of future developments.

The following is a discussion and analysis of our financial condition, results of operations, liquidity and capital resources for each of the three years in the period ended December 31, 2012 and significant factors that could affect our prospective financial condition and results of operations. You should read this discussion together with our financial statements and notes included in "Item 8. Financial Statements and Supplementary Data."

Business Overview

We are a leading stem cell company headquartered in Columbia, Maryland and focused on developing and marketing products to treat medical conditions in the inflammatory, cardiovascular, orthopedic and wound healing markets. We currently market and distribute Grafix and Ovation for tissue repair. Our pipeline of internally developed biologic drug candidates under evaluation includes Prochymal for inflammatory, autoimmune and cardiovascular indications, as well as Chondrogen for arthritis in the knee. We believe our stem cell products have significant therapeutic potential because of their ability to regulate inflammation, promote tissue regeneration and prevent pathological scar formation.

We began operations on December 23, 1992 and were a Delaware corporation until, with approval of our stockholders, we reincorporated as a Maryland corporation on May 31, 2010.

We have two business segments, Therapeutics and Biosurgery. Our Therapeutics business is focused on developing biologic stem cell drug candidates from a readily available and non-controversial source-adult bone marrow. Our Biosurgery business, created in 2009 and operating as a separate segment since 2010, works to harness the ability of cells and novel constructs to promote the body's natural healing with the goals of improving surgical outcomes and offering better treatment options for patients and physicians.

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We believe cellular therapies have certain advantages over traditional medical approaches. For example, cell therapies can be targeted, avoiding many of the safety complications arising from systemic treatments. Cell therapies can also be responsive to their environment, turning on or off certain effects as conditions in the surrounding tissue change. Cell therapies can also be multifaceted. For example, the cells in Prochymal, our leading biologic drug candidate, have demonstrated the ability to not only downregulate inflammation, but also to promote repair of the damage caused by the inflammation.

We believe the combination of these unique properties will allow us to solve many of the more challenging questions facing medicine today. We have established ourselves as an industry leader in the emerging field of cell therapy, having developed the first commercially available stem cell product.

We are a fully integrated company, having developed capabilities in research, development, manufacturing, marketing and distribution of stem cell products. We have developed an extensive intellectual property portfolio to protect our technology in the United States and a number of foreign countries, including 50 U.S. and 156 foreign patents owned or licensed. We believe that our biologic drug candidates have advantages over other stem cell therapeutics in development for at least the following reasons:

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º Stem Cell Source. Our stem cells are obtained from adult bone marrow, a readily available source. The cells are drawn from the hips of volunteer donors between the ages of 18 and 30 years, using a simple needle and syringe aspiration. Because the cells are obtained from consenting adult donors, we are able to largely avoid the ethical controversy surrounding embryonic and fetal stem cell research.

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º Ability to Mass Produce. Through our proprietary manufacturing methods, we can grow mesenchymal stem cells ("MSC") in a controlled fashion to produce up to 10,000 treatments of our biologic drug candidates from a single bone marrow donation. Our ability to produce a large quantity of treatments from one donation provides us with manufacturing efficiencies and product consistency that are essential to commercialization.

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º Universal Compatibility. Many stem cell therapies under development can elicit a rejection response in the recipient and therefore require donor-to-recipient matching or potentially harmful immunosuppression. This greatly reduces manufacturing efficiencies and creates a risk of mismatch which can result in an acute inflammatory response and, potentially, in death. Based on our clinical experience, we believe that our biologic drug candidates are not rejected by the patient's immune system and so, like type O negative blood, do not require donor-to-recipient matching. This universal compatibility allows us to produce a standardized product available to all patients in almost any medical setting.

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º Treatment on Demand. Our biologic drug candidates can be stored frozen at end-user medical facilities until they are needed. We anticipate that medical facilities will be able to prescribe and dispense these products in much the same way as conventional drugs. In contrast, other stem cell technologies under development require weeks to prepare after a patient's need is identified. This is a key feature of our technology, as many patients in the critical care setting require prompt treatment.

In the third fiscal quarter of 2009, we created our Biosurgery segment focused on developing, manufacturing and distributing high-end biologic products for use in surgical procedures. We launched our first biologic product during third quarter of fiscal 2010, and our Biosurgery business has continued to grow since that time. We anticipate continuing to increase our organizational focus on the development and commercialization of products in this segment as the revenues generated from Bisourgery products increase in the foreseeable future.

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Financial Operations Overview


Biosurgery Segment. Beginning in fiscal 2010, we started to account for our Biosurgery business as a separate segment. We manufacture human tissue based products in our Columbia, Maryland facility and distribute these products through a network of independent distributors as well as employee sales personnel. We presently manufacture and distribute Grafix for the treatment of chronic wounds and burns and Ovation for orthopedic surgeries. Both of these products are cryo-preserved and stored in special freezers at -80 degrees Celsius. Customers have the product shipped to them in dry ice. Legal title passes to the customer when the product leaves our shipping dock. Due to the nature of the products and the manufacturing process, we do not allow sales returns.

We launched our first Biosurgery product for limited commercial distribution during the third quarter of 2010. We began distribution of a second Biosurgery product in early fiscal 2011, and have continued to increase our distribution volume throughout fiscal 2011 and 2012, both through in-house personnel as well as through our expanding distributor network. The increase in revenue and gross profit since commercial launch is due to volume increases. We anticipate continuing to increase our organizational focus on the development and commercialization of products in this segment in the foreseeable future.

Therapeutics Segment. In the fourth quarter of 2008, we entered into a collaboration agreement with Genzyme Corporation, then an independent and now a Sanofi company, for the development and commercialization of Prochymal and Chondrogen. Under the terms of the agreement, we retained the rights to commercialize Prochymal and Chondrogen in the United States and Canada, and Genzyme was granted exclusive rights to commercialize Prochymal and Chondrogen in all other countries, except with respect to GvHD in Japan, where Prochymal has previously been licensed to JCR Pharmaceuticals Co., Ltd. Under the agreement, we were paid $130.0 million for these rights. During the fiscal quarter ended March 31, 2012 we recognized revenue of $3.3 million, which was the final deferred revenue associated with the $130.0 million upfront payment. We recognized $40.0 million of revenue from the amortization of the upfront payment during each of the fiscal year 2011 and 2010.

The collaboration agreement provided that it would expire upon the completion of all development plans stipulated in the agreement and the expiration of all payment obligations; however, in addition to certain opt out rights, Genzyme could terminate the agreement early and without further obligation at any time, and either party could terminate the agreement due to non-performance, material breach or insolvency.

In February 2012, Sanofi issued a press release which included an update on their R&D pipeline, stating that it had "discontinued" its project with Prochymal for GvHD, and in September 2012, we entered into a termination agreement with Sanofi that terminated the collaboration agreement and memorialized an amicable parting. Under the termination agreement, neither party has any continuing financial or other obligations to the other. We continue to proceed with our Prochymal regulatory and commercialization efforts.

In 2007, we also partnered with Genzyme to develop Prochymal as a medical countermeasure to nuclear terrorism and other radiological emergencies. In the first quarter of 2008, we were awarded a contract from the United States Department of Defense ("DoD") pursuant to which we, in partnership with Genzyme, sought to develop and stockpile Prochymal for the repair of gastrointestinal injury resulting from acute radiation exposure. Under the terms of this contract, we recognized $470,000 in revenue in fiscal 2010. No work is continuing under this contract and we are not presently pursuing other government contracts in partnership with Genzyme, or otherwise.

In prior years, we entered into strategic agreements with other companies for the development and commercialization of Prochymal for specific indications and geographic markets. In 2007, we entered

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into a collaborative agreement with the Juvenile Diabetes Research Foundation (JDRF) to conduct a Phase 2 clinical trial evaluating Prochymal as a treatment for type 1 diabetes mellitus. This collaborative agreement provided for JDRF to provide $4.0 million of contingent milestone funding to support the development of Prochymal for the preservation of insulin production in patients with newly diagnosed type 1 diabetes mellitus. The contingent milestone payments under the agreement have been amortized into revenue on a straight line basis over the duration of our obligations under the collaborative agreement as they were earned. As of December 31, 2011, we had achieved all $4.0 million of the milestones available under the contract and recognized the entire funding as revenue. In fiscal 2011, we recognized $960,000 in revenue and in fiscal 2010, we recognized $1.2 million in revenue. We recognized no revenue in connection with this project in 2012, and although we continue to follow patients who participated in the studies supported by this arrangement, our work is substantially complete.

In 2003, we entered into an agreement with JCR Pharmaceuticals, granting it exclusive rights to Prochymal for the treatment of GvHD and other hematological malignancies in Japan. During the first quarter of 2010, we achieved a $1.0 million milestone from JCR for development progress in Japan. The collaboration with JCR also provides for additional milestone payments of up to $5.5 million for regulatory and sales milestones, as well as royalty payments on sales of the drug in Japan.

Research and Development Costs

Our research and development costs consist of expenses incurred in identifying, developing and testing biologic drug candidates and biologic tissue based products. These expenses consist primarily of salaries and related expenses for personnel, fees paid to professional service providers for independent monitoring and analysis of our clinical trials, costs of contract research and manufacturing, costs of facilities, and the costs of manufacturing clinical batches of biologic drug candidates, quality control supplies and material to expand biologic drug candidates.

Consistent with our focus on the development of biologic drug candidates with potential uses in multiple indications, many of our costs are not attributable to a specifically identified product. We use our employee and infrastructure resources across several projects. Accordingly, we do not account for internal research and development costs on a project-by-project basis. From inception in December 1992 through December 31, 2012, we incurred aggregate research and development costs of approximately $424 million.

Beginning in 2010, with the creation of our Biosurgery segment, we began to separately track research and development costs by segment. Research and development expenses for our Therapeutics segment were $9.6 million, $15.8 million, and $19.1 million for fiscal years 2012, 2011, and 2010, respectively. Biosurgery research and development expenses for the comparable periods were $4.5 million, $3.3 million, and $4.4 million, respectively, which includes costs incurred for the study designed to allow for the collection of data necessary to obtain the permanent HCPCS Q-codes that began during the second fiscal quarter of 2012.

As described above, we do not track internal development costs by project. We do, however, track external research and development costs on a project basis. During 2012, we incurred $2.0 million in external research and development costs on our acute myocardial infarction clinical trial, $1.2 million for the diabetic foot ulcer trial for our Biosurgery segment, $752,000 on our Refractory Crohn's disease clinical trial, $681,000 on Treatment-resistant GvHD and $638,000 on smaller projects. During fiscal 2011, we incurred $6.3 million in external research and development costs on our acute myocardial infarction clinical trial, $1.4 million on our Refractory Crohn's disease clinical trial, $830,000 on Treatment-resistant GvHD and $400,000 on smaller projects. For 2010, our external research and development costs were approximately $2.8 million for Prochymal to treat first line and steroid refractory acute GvHD, $905,000 for Prochymal to treat Crohn's disease, $4.1 million for Prochymal to

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repair heart tissue following a heart attack, $1.7 million for Prochymal for the protection of pancreatic islet cells in patients with type 1 diabetes, $700,000 for Prochymal to treat COPD, and approximately $225,000 for smaller projects.

We expect our research and development expenses to continue to be substantial in the future, as we continue our clinical trial activity for our existing biologic drug candidates as they advance through the development cycle, and as we invest in additional product opportunities and research programs. Clinical trials and preclinical studies are time-consuming and expensive. Our expenditures on current and future preclinical and clinical development programs are subject to many uncertainties. We test our products in several preclinical studies, and we then conduct clinical trials for those biologic drug candidates that we determine to be the most promising. As we obtain results from clinical trials, we may elect to discontinue or delay trials for some biologic drug candidates in order to focus our resources on more promising biologic drug candidates. Completion of clinical trials may take several years or more, but the length of time generally varies substantially according to the type, size of trial and intended use of a biologic drug candidate. The cost of clinical trials may vary significantly over the life of a project as a result of a variety of factors, including:

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º the number of patients who participate in the trials;

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º the number of sites included in the trials;

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º the length of time required to enroll trial participants;

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º the duration of patient treatment and follow-up;

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º the costs of producing supplies of the biologic drug candidates needed for clinical trials and regulatory submissions;

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º the efficacy and safety profile of the biologic drug candidate; and

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º the costs and timing 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 the duration and completion costs of our research and development projects or when and to what extent we will generate revenues from the commercialization and sale of any of our biologic drug candidates.

General and Administrative Expenses

General and administrative expenses consist primarily of the costs associated with our general management, including salaries, allocations of facilities and related costs, and professional fees such as legal and accounting expenses. Generally, we have experienced a decrease in general and administrative costs as the result of our continued cost cutting efforts and the refinement of many of our general business processes, as well as a reduction in share-based compensation expense. Beginning in fiscal 2012, we incurred additional general and administrative expenses related to increased distribution efforts for our Biosurgery products. We expect future expense increases to continue as a result of hiring additional operational, financial, accounting, facilities engineering and information systems personnel as we continue to increase distribution of our Biosurgery products and approach the commercial launch of Prochymal for an initial indication.

Other Income, Net

Other income consists of interest earned on our cash and investments available for sale and realized gains and losses incurred on the sale of these investments. Interest expense consists of interest incurred on capital leases. We do not expect to incur material interest expense in the future as we do not have a material amount of equipment under capital lease or any outstanding debt.

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Income Taxes

Until fiscal 2010, we have not recognized any net deferred tax assets or liabilities in our financial statements since we cannot assure their future realization. Because realization of deferred tax assets is dependent upon future earnings, a full valuation allowance has been recorded on the net deferred tax assets, which relate primarily to net operating loss and research and development carry-forwards. In the event that we become profitable within the next several years, we have net deferred tax assets (before a 100% valuation allowance) of approximately $93.6 million that may be utilized prior to us having to recognize any income tax expense or make payments to the taxing authorities other than the alternative minimum tax. The income from the upfront fees we received from Genzyme Corporation was required to be recognized over several years from 2008 through 2012 for financial statement reporting purposes. For income tax purposes, the income was required to be fully recognized in 2009 and 2010. This resulted in our releasing $3.2 million of the valuation allowance on our net deferred tax assets in fiscal 2010. We recognized $1.0 million of the resulting deferred tax asset in 2011, and recognized the remaining $2.2 million deferred tax asset in 2012.

In fiscal 2010, we recorded a provision for income taxes to recognize the U.S. Federal alternative minimum tax on our taxable income. In fiscal 2011, we recorded a provision for income taxes of $43,000 to recognize a true-up of the 2010 payables account that was identified when we filed our 2010 Federal income tax return. The effective tax rate of .3%, as compared to a U.S. statutory rate of 35%, reflects this adjustment. We do not expect to be subject to the U.S. Federal alternative minimum tax in fiscal 2011. The tax provision for 2010 reflects an effective tax rate for continuing operations of 1.8% compared to a U.S. statutory tax rate of 35%. The effective tax rate reflects our estimated annual effective tax rate, which reflects our expectation that a portion of our income will be subject to the Federal alternative minimum tax in 2010, which is almost entirely offset by a release of valuation allowance discussed above. In fiscal 2012 we recognized an income tax benefit of $37,000, in connection with truing up our tax asset accounts in connection with the filing of our 2011 income tax returns.

Critical Accounting Policies


Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which we have prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, inventory valuation, deferred tax assets, share-based compensation, and contingencies. We base our estimates on historical experience and on various other assumptions that we believe are reasonable. These results form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe that the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

As discussed in Note 3-Segment Reporting below, in 2010 we began operations of our Biosurgery segment, focused on developing high-end biologic products for use in wound healing and surgical procedures. We commenced the manufacturing of our first Biosurgery product, Grafix, a regenerative wound care product, during the first quarter of 2010. During the first and second quarters of 2010, we distributed the product only for initial clinical evaluation. We launched the product for limited commercial distribution during the third quarter of 2010. We began distribution of a second Biosurgery

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product, Ovation in early fiscal 2011, and continued to increase our distribution volume throughout fiscal 2011 and 2012. We recognized revenues of $7.8 million and $1.3 million on distribution of our Biosurgery products in 2012 and 2011, respectively, compared to $183,000 subsequent to commercial launch in fiscal 2010.

We recognize revenue on the distribution of our Biosurgery products when we ship the frozen product to our customers. Legal title passes to the customers when the product leaves our shipping dock. Due to the nature of the products and the manufacturing process, we do not allow sales returns or refunds.

To date, our Therapeutics segment has generated revenues primarily from collaborative agreements and research licenses. We evaluate revenues from agreements that have multiple elements to determine whether the components of the arrangement represent separate units of accounting. To recognize a delivered item in a multiple element arrangement, the delivered items must have value on a standalone basis and the delivery or performance must be probable and within our control for any delivered items that have a right of return. The determination of whether multiple elements of a collaboration agreement meet the criteria for separate units of accounting requires us to exercise judgment.

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

In October 2008, we entered into a Collaboration Agreement with Genzyme Corporation, then an independent and now a Sanofi company ("Genzyme"), for the development and commercialization of our biologic drug candidates, Prochymal and Chondrogen®. Under this agreement, Genzyme made non-contingent, non-refundable cash payments to us, totaling $130.0 million. The agreement provided Genzyme with certain rights to intellectual property developed by us, and required that we continue to perform certain development work related to the subject biologic drug candidates. In February 2012, Sanofi issued a press release which included an update on their R&D pipeline, stating that it had discontinued its project with Prochymal for GvHD. In September 2012, we reached agreement with Sanofi to conclude the Collaboration Agreement without either party having any continuing obligation to the other. We are continuing to proceed with our Prochymal regulatory approval and commercialization efforts.

We evaluated the deliverables related to the upfront payments made to us under the Genzyme collaboration agreement, and concluded that the various deliverables represent a single unit of accounting. For this reason, we deferred the recognition of revenue related to the upfront payments, and amortized these amounts to revenue on a straight-line basis over the estimated delivery period of the required development services, which extended through January 2012.

Accordingly, we recognized $3.3 million of revenue from this agreement during 2012, all of which came during the first fiscal quarter corresponding with the estimated end point date in January of 2012, compared to $40.0 million of revenue in each of the years ended December 31, 2011 and 2010 related to the amortization of the upfront payments.

In 2007, we also partnered with Genzyme to develop Prochymal as a medical countermeasure to nuclear terrorism and other radiological emergencies. In January 2008, we were awarded a contract from the United States Department of Defense ("DoD") pursuant to which we sought, in partnership with Genzyme, to develop and stockpile Prochymal for the repair of gastrointestinal injury resulting

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