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[EZ2]

STEM ~~ 10-Q

Form 10-Q for STEMCELLS INC


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7-May-2007

Quarterly Report



ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and the results of our operations for the three-month periods ended March 31, 2007 and 2006 should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and the related footnotes thereto.
This report contains forward looking statements within the meaning of
Section 27A of the Securities Act and Section 21E of the Securities Exchange Act that involve substantial risks and uncertainties. Such statements include, without limitation, all statements as to expectation or belief and statements as to our future results of operations, the progress of our research, product development and clinical programs, the need for, and timing of, additional capital and capital expenditures, partnering prospects, costs of manufacture of products, the protection of and the need for additional intellectual property rights, effects of regulations, the need for additional facilities and potential market opportunities. Our actual results may vary materially from those contained in such forward-looking statements because of risks to which we are subject, including uncertainty as to whether the U.S. Food and Drug Administration (FDA) will permit us to proceed with clinical testing of proposed products despite the novel and unproven nature of our technology; the risk that our initial clinical trial could be substantially delayed beyond its expected dates or cause us to incur substantial unanticipated costs; uncertainties regarding our ability to obtain the capital resources needed to continue our current research and development operations and to conduct the research, preclinical development and clinical trials necessary for regulatory approvals; the uncertainty regarding our ability to obtain a corporate partner or partners if needed to support the development and commercialization of our cell-based therapeutics programs; the uncertainty regarding the outcome of the Company's Phase I clinical trial in NCL and any other trials we may conduct in the future; the uncertainty regarding the validity and enforceability of our issued patents; the uncertainty whether any products that may be generated in our cell-based therapeutics programs will prove clinically effective and not cause tumors or other side effects; the uncertainty whether we will achieve revenues from product sales or become profitable; uncertainties regarding our obligations in regard to our former encapsulated cell therapy facilities in Rhode Island; obsolescence of our technology; competition from third parties; intellectual property rights of third parties and litigation and other risks to which we are subject. All forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the cautionary statements and risk factors set forth in Item 1A (Risk Factors) and elsewhere in our Form 10-K for the year ended December 31, 2006 and the risk factors set forth in Part II, Item 1A (Risk Factors) and elsewhere in this Form 10-Q. Overview
Since our inception in 1988, we have been primarily engaged in research and development of human therapeutic products. Since the second half of 1999, our sole focus has been on our stem cell technology. We are currently conducting a Phase I clinical trial of our human neural stem cells as a treatment for infantile and late infantile neuronal ceroid lipofuscinosis (NCL), a fatal neurodegenerative disease often referred to as Batten disease. The trial is being conducted at Oregon Health & Science University's Doernbecher Children's Hospital in Portland, Oregon.
We have not derived any revenues from the sale of any products apart from license revenue for the research use of certain of our patented cells and media, and we do not expect to receive revenues from product sales for at least several years. We have not commercialized any product and in order to do so we must, among other things, substantially increase our research and development expenditures as research and product development efforts accelerate and clinical trials are initiated. We had expenditures for screening and enrolling patients and for preparing HuCNS-SC doses for our Phase I clinical trial and will incur more such expenditures for any future clinical trials. We previously had expenditures for toxicology and other studies in preparation for submitting the Investigational New Drug application (IND) for our Phase I trial for NCL to the FDA and getting it cleared by the FDA, and will incur more such expenditures for any future INDs. We have incurred annual operating losses since inception and expect to incur substantial operating losses in the future. As a result, we are dependent upon external financing from equity and debt offerings and revenues from collaborative research arrangements with corporate sponsors to finance


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our operations. There are no such collaborative research arrangements at this time and there can be no assurance that such financing or partnering revenues will be available when needed or on terms acceptable to us.
Our results of operations have varied significantly from year to year and quarter to quarter and may vary significantly in the future due to the occurrence of material recurring and nonrecurring events, including without limitation the receipt and payment of recurring and nonrecurring licensing payments, the initiation or termination of research collaborations, the on-going expenses to lease and maintain our facilities in Rhode Island and the increasing costs associated with our facility in California. To expand and provide high quality systems and support to our Research and Development programs, as well as to enhance our internal controls over financial reporting, we will need to hire more personnel, which will lead to higher operating expenses.
Our Neural Program ranges from the preclinical stage, in which we test human neural stem cells in small animal models of human diseases, both in-house and through external academic collaborators, through the development phase, in which we evaluate improvements to expansion methods and the toxicology of the cells, through the clinical development phase, with respect to the Phase I clinical trial in NCL mentioned above. In our Liver Program, we are engaged in evaluating our proprietary liver engrafting cell in various in vivo assays, and are planning to advance our liver stem cell program into product development as rapidly as we can. Our pancreas program is still in the discovery stage and further evaluation of the therapeutic potential of the candidate human pancreatic stem/progenitor cell will be required.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from these estimates. The significant estimates include the accrued wind-down expenses related to our Rhode Island facilities and the grant date fair value of share based awards recognized as compensation expense in accordance with the provisions of SFAS 123R.
Stock-Based Compensation
In December 2004, FASB issued SFAS 123R "Share-Based Payment," which is a revision of SFAS 123 "Accounting for Stock-Based Compensation" and amends SFAS No. 95 "Statement of Cash Flows." SFAS 123R supersedes APB Opinion No. 25 "Accounting for Stock Issued to Employees" and its related implementation guidance. SFAS 123R covers a wide range of share-based compensation arrangements including stock options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The new standard is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. We adopted SFAS 123R effective January 1, 2006. Adoption of the expensing requirements has increased our losses. Research and Development Costs
We expense all research and development costs as incurred. Research and development costs include costs of personnel, external services, supplies, facilities and miscellaneous other costs. Wind-down and Exit Costs
In connection with the wind-down of our former encapsulated cell technology operations, our research and manufacturing operations in Lincoln, Rhode Island, and the relocation of our remaining research and development activities and corporate headquarters to California in October 1999, we provided a reserve for our estimate of the exit cost obligation in accordance with EITF 94-3 "Other Cost to Exit an Activity." The reserve reflects estimates of the ongoing costs of our former research and administrative facility in Lincoln, which we hold on a lease that terminates on June 30, 2013. We are seeking to sublease, assign, sell or otherwise divest ourselves of our interest in



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the facility at the earliest possible time, but we cannot determine with certainty a fixed date by which such events will occur, if at all.
In determining the facility exit cost reserve amount, we are required to consider the Company's lease payments through to the end of the lease term and estimate other relevant factors such as facility operating expenses, real estate market conditions in Rhode Island for similar facilities, occupancy rates and sublease rental rates projected over the course of the leasehold. We re-evaluate the estimate each quarter, taking account of changes, if any, in each underlying factor. The process is inherently subjective because it involves projections over time - from the date of the estimate through the end of the lease - and it is not possible to determine any of the factors except the lease payments with certainty over that period.
Management forms its best estimate on a quarterly basis, after considering actual sublease activity, reports from our broker/realtor about current and predicted real estate market conditions in Rhode Island, the likelihood of new subleases in the foreseeable future for the specific facility and significant changes in the actual or projected operating expenses of the property. We discount the projected net outflow over the term of the leasehold to arrive at the present value, and adjust the reserve to that figure. The estimated vacancy rate for the facility is an important assumption in determining the reserve because changes in this assumption have the greatest effect on estimated sublease income. In addition, the vacancy rate estimate is the variable most subject to change, while at the same time it involves the greatest judgment and uncertainty due to the absence of highly predictive information concerning the future of the local economy and future demand for specialized laboratory and office space in that area. The average vacancy rate of the facility for years 2001 through 2006 was approximately 67%, varying from 49% to 80%. As of March 31, 2007, based on current information available to management, the vacancy rate is projected to be 91% for the remainder of 2007, and approximately 75% for 2008 and 70% from 2009 through the end of the lease. These estimates are based on actual occupancy in 2007, expiration of subleases in 2007 and 2008, predicted lead time for acquiring new subtenants, historical vacancy rates for the area and assessments by our broker/realtor of future real estate market conditions. If the assumed vacancy rate for 2008 to the end of the Lease had been five percentage points higher or lower at March 31, 2007, then the reserve would have increased or decreased by approximately $232,000. Similarly, a 5% increase or decrease in the operating expenses for the facility from 2007 would have increased or decreased the reserve by approximately $121,000, and a 5% increase or decrease in the assumed average rental charge per square foot would have increased or decreased the reserve by approximately $70,000. Management does not wait for specific events to change its estimate, but instead uses its best efforts to anticipate them on a quarterly basis.
The wind-down reserve at the end of December 31, 2006 was $5,512,000. For the three -month period ended March 31, 2007 we recorded actual expenses against this reserve of approximately $381,000. Based on management's evaluation of the factors mentioned, and particularly the projected vacancy rates described above, we adjusted the reserve to $5,353,000 by recording an additional $222,000 for the three-month period ended March 31, 2007. Recent Accounting Pronouncements
In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity's financial statements in accordance with SFAS No. 109, "Accounting for Income Taxes," and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on subsequent derecognition of tax positions, financial statement classification, recognition of interest and penalties, accounting in interim periods, and disclosure and transition requirements. We adopted the provisions of FIN 48 on January 1, 2007. Previously, we had accounted for tax contingencies in accordance with Statement of Financial Accounting Standards 5, "Accounting for Contingencies". As required by FIN 48, we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. At the adoption date, we applied FIN 48 to all tax positions for which the statute of limitations remained



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open. The amount of unrecognized tax benefits as of January 1, 2007 was zero. There have been no material changes in unrecognized tax benefits since January 1, 2007. We are subject to income taxes in the U.S. federal jurisdiction and various state jurisdictions. As of January 1, 2007, due to the carry forward of unutilized net operating losses and research and development credits, the Company is subject to U.S. Federal income tax examinations for the tax years 1992 through 2006, and to state income tax examinations for the tax years 1999 through 2006. We recognize accrued interest related to unrecognized tax benefits in interest expense and penalties in operating expense. No amounts were accrued for the payment of interest and penalties at January 1, 2007. Our adoption of FIN 48 did not have a material effect on our financial condition, results of operations or cash flows (See Note 7).
In September 2006, the FASB issued FASB Statement No. 157, "Fair Value Measurements" (SFAS 157), which defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. SFAS 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. We are currently evaluating the requirements of SFAS 157; however, we do not believe that its adoption will have a material effect on our consolidated financial statements.
In February 2007, the FASB issued Statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115" (SFAS 159). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. SFAS 159's objectives are to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 is effective as of the beginning of an entity's first fiscal year beginning after November 15, 2007. We are currently evaluating the potential impact, if any, that the adoption of SFAS159 will have on our condensed consolidated financial statements
RESULTS OF OPERATIONS
Three months ended March 31, 2007 and 2006 Revenue
Revenue for the three-month period ended March 31, 2007, as compared with the same period in 2006, is summarized in the table below:


2007 2006 Change from previous year
$ %
Revenue:
Revenue from grants and licensing agreements $ 5,946 $ 41,550 $ (35,604 ) (86 %)


Total revenue $ 5,946 $ 41,550 $ (35,604 ) (86 %)




For the three months ended March 31, 2007 and 2006, revenue from grants and licensing agreements totaled approximately $6,000 and $42,000 respectively. The decrease in revenue from 2006 to 2007 was primarily attributable to the completed draw down by March 31, 2006 of a September 2004 Small Business Technology Transfer grant for studies in Alzheimer's disease. The grant of $464,000 for studies in Alzheimer's disease consisted of approximately $308,000 for the first year and approximately $156,000 for the remainder of the grant term, March 31, 2005 through March 31, 2006. Operating Expenses
Operating expenses for the three-month period ended March 31, 2007, as compared with the same period in 2006, is summarized in the table below:



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2007 2006 Change from previous year
$ %
Operating expenses:
Research and development $ 4,019,138 $ 2,691,881 $ 1,327,257 49 %
General and administrative 2,264,548 1,677,324 587,224 35 %
Wind-down expenses 221,765 156,117 65,648 42 %


Total operating expenses $ 6,505,451 $ 4,525,322 $ 1,980,129 44 %




Research and development expenses totaled approximately $4,019,000 for the three months ended March 31, 2007, compared with approximately $2,692,000 for the same period in 2006. The increase of $1,327,000, or approximately 49%, from 2006 to 2007 was primarily attributable to expansion of our operations in cell processing and clinical development, which consisted of an increase in personnel costs of approximately $353,000 and an increase in external services and clinical study costs of approximately $747,000 with the remainder due to increases in supplies, rent and other operating expenses. At March 31, 2007, we had 36 full-time employees working in research and development and laboratory support services as compared to 33 at March 31, 2006.
General and administrative expenses were approximately $2,265,000 for the three months ended March 31, 2007, compared with approximately $1,677,000 for the same period in 2006. The increase of $587,000, or approximately 35%, from 2006 to 2007 was primarily attributable to an increase in personnel costs of approximately $309,000, of which approximately $283,000 was attributable to an increase in stock based compensation expense for grant of stock options and stock appreciation rights. The increase was also attributable to an increase in external services of $271,000 primarily for legal and recruiting fees with the remainder due to a net increase in other operating expenses.
In 1999, in connection with exiting our former research facility in Rhode Island, we created a reserve for the estimated lease payments and operating expenses related to it. The reserve has been re-evaluated and adjusted based on assumptions relevant to real estate market conditions and the estimated time until we could either fully sublease, assign or sell our remaining interests in the property. At December 31, 2006, the reserve was approximately $5,512,000. For the three months ended March 31, 2007, expenses of $381,000 net of subtenant income were recorded against this reserve (See Note 4). At March 31, 2007, we re-evaluated the estimate and adjusted the reserve to approximately $5,353,000 by recording an additional $222,000 as wind-down expenses. Wind-down expenses recorded against the reserve for the same period in 2006 were approximately $284,000 and additional expenses recorded to adjust the reserve were approximately $156,000. Expenses for this facility will fluctuate based on changes in tenant occupancy rates and other operating expenses related to the lease. Even though it is our intent to sublease, assign, sell or otherwise divest ourselves of our interests in the facility at the earliest possible time, we cannot determine with certainty a fixed date by which such events will occur. In light of this uncertainty, based on estimates, we will periodically re-evaluate and adjust the reserve, as necessary. Other Income
Other income for the three-month period ended March 31, 2007, as compared with the same period in 2006, is summarized in the table below:


2007 2006 Change from previous year
$ %
Other income (expense):
License and settlement agreement, net $ 550,467 $ - $ 550,467 *
Realized gain on sale of marketable
securities 717,621 - 717,621 *
Interest income 653,606 339,814 313,792 92 %
Interest expense (33,317 ) (38,593 ) 5,276 (14 )%
Other (8,624 ) (10,575 ) 1,951 (18 )%


Total other income (expense) $ 1,879,753 $ 290,646 $ 1,589,107 547 %




* Percentage change cannot be calculated



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Income under licenses and settlement agreement were for the value of additional shares received from ReNeuron (See Note 2). As a consequence of the anti-dilution provisions included in the agreement between StemCells and ReNeuron, StemCells was entitled to approximately 822,000 shares net of approximately 12,000 shares to be transferred to Neurosphere. The Company recorded approximately $550,000 as other income for the fair value of the additional shares received.
Interest income for the three months ended March 31, 2007 and 2006 was approximately $654,000 and $340,000, respectively. The increase in interest income in 2007 was primarily attributable to a higher yield on a higher investment balance.
Interest expense for the three months ended March 31, 2007 and 2006 was approximately $33,000 and $39,000 respectively. The decrease in interest expense in 2007 was attributable to lower outstanding debt and capital lease balances in 2007 compared to 2006. Other income (expense) comprises primarily of state franchise tax paid.


LIQUIDITY AND CAPITAL RESOURCES
Since our inception, we have financed our operations through the sale of
common and preferred stock, the issuance of long-term debt and capitalized lease
obligations, revenues from collaborative agreements, research grants and
interest income.
We had cash and cash equivalents totaling $50,921,611 at March 31, 2007.
Cash equivalents are invested in US Treasury debt securities with maturities of
less than 90 days. The table below summarizes our cash flows for the respective
three-month periods.

2007 2006 Change from previous year
$ %
Net cash used in operating activities $( 5,252,048 ) $( 4,263,065 ) $( 988,983 ) 23 %
Net cash provided (used) by investing
activities 2,951,785 (211,531 ) 3,163,316 (1,495 )%
Net cash provided by financing
activities 1,426,345 809,562 616,783 76 %

Decrease in cash and cash equivalents $( 873,918 ) $( 3,665,034 ) $ 2,791,116 (76 )%




The increase from 2006 to 2007 of approximately $989,000, or 23%, in cash used in operating activities was primarily attributable to the increase in personnel costs and external services due to the expansion of our cell manufacturing process and the costs incurred in our clinical study. The increase from 2006 to 2007 of approximately $3,163,000, or 1,495%, for cash provided by investing activities was primarily attributable to the sale of approximately 5,275,000 ordinary shares of ReNeuron (See Note 2) held as marketable securities for net proceeds of approximately $3,077,000 The increase from 2006 to 2007 of approximately $617,000 for net cash provided by financing activities was primarily attributable to the sale of approximately 397,000 of our shares at an average price of $3.51 per share for net proceeds of approximately $1,325,000. These shares were sold under a sales agreement with Cantor (See Note 6).
Other financing arrangements in the previous three years include the following:
• On April 6, 2006, we sold 11,750,820 shares of our common stock to a limited number of institutional investors at a price of $3.05 per share, for gross proceeds of approximately $35,840,000. The shares were offered as a registered direct offering under an effective shelf registration statement previously filed with and declared effective by the SEC. We received total proceeds, net of offering expenses and



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placement agency fees, of approximately $33,422,000. No warrants were issued as part of this financing transaction.

• In 2005, an aggregate of 2,958,348 warrants were exercised. For the exercise of these warrants, we issued 2,842,625 shares of our common stock and received proceeds of approximately $5,939,000.

• On October 26, 2004, we entered into an agreement with institutional investors with respect to the registered direct placement of 7,500,000 shares of our common stock at a purchase price of $3.00 per share, for gross proceeds of $22,500,000. C.E. Unterberg, Towbin LLC (Unterberg) and Shoreline Pacific, LLC (Shoreline) served as placement agents for the transaction. We sold these shares under a shelf registration statement previously filed with and declared effective by the SEC. For acting as our placement agent Unterberg and Shoreline received fees of approximately . . .