| Description of Business and Significant Accounting Policies | 1. Description of Business and Significant Accounting Policie s
Description of Business
Osiris Therapeutics, Inc. ("we," "us," "our," or the "Company") is a Maryland corporation headquartered in Columbia, Maryland. 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 are a leading cellular regenerative medicine company focused on researching, developing and marketing products in the wound, orthopaedic, and sports medicine markets.
From 2010 to 2013, we operated our business in two segments, Biosurgery and Therapeutics. We now operate only our Biosurgery business, as a result of the sale of our Therapeutics segment assets in the fourth quarter of 2013, as discussed further below. Our Biosurgery business focuses on products for wound care, orthopaedic, and sports medicine to harness the ability of cells and novel constructs to promote the body's natural healing. Until it was sold, our Therapeutics business focused on developing biologic stem cell drug candidates from a readily available and non-controversial source—adult bone marrow.
Our Biosurgery business has continued to grow since its inception, and we have increased our organizational focus on the development and commercialization of products in this segment. Consistent with this organizational focus, as discussed further in Note 2— Discontinued Operations below, on October 10, 2013, we entered into a Purchase Agreement to sell our Therapeutics segment, including all of our culture expanded mesenchymal stem cell business, including Prochymal® and other related assets. We eliminated the Therapeutics segment from our continuing operations as a result of the disposal transaction, and have presented the assets, liabilities, and results of the segment's operations as a discontinued operation for all periods presented. Our continuing operations now represent the portion of our business previously referred to as our Biosurgery segment.
Unaudited Interim Financial Statements
Except for the Balance Sheet as of December 31, 2014, which was derived from audited financial statements, the accompanying condensed financial statements are unaudited. The accompanying condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by US GAAP for complete financial statements. In the opinion of management, these statements include all adjustments (consisting of normal recurring adjustments) considered necessary to present a fair statement of our results of operations, financial position and cash flows. Operating results for any interim period are not necessarily indicative of the results that may be expected for the full year. This Quarterly Report on Form 10-Q should be read in conjunction with our financial statements and footnotes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2014.
Correction of Prior Period Financial Statements
In connection with preparing the Company’s financial statements for the quarter ended September 30, 2015, the Company reviewed the timing of revenue recognition under contracts with its distributors. As a result of this review, the Company determined to correct the revenue recognition for three contracts which will result in a decrease in product revenues of $1.8 million in the first quarter of 2015, a decrease in product revenue of $1.0 million in the second quarter, an increase in product revenues of $0.8 million in the third quarter of 2015 and a decrease in product revenues of $1.1 million in 2014.
Background
Under US GAAP, revenue is generally recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed and determinable, a nd collectability is probable. The Company previously recognized revenue under these three distributor contracts which was reflected in the Company’s audited financial statements in its Annual Report on Form 10-K for the year ended December 31, 2014 and its unaudited financial statements in its Quarterly Reports on Form 10-Q for the quarters ended March 31, 2015 and June 30, 2015.
Upon subsequent review in connection with the Company’s review of its third quarter 2015 financial statements, the Company determined, in consultation with its independent registered public accounting firm, that the transaction s did not meet certain conditions for revenue recognition in the fourth quarter of 2014, and the first and second quarters of 2015. Specifically to the transaction in the fourth quarter of 2014, the Company determined that the persuasive evidence of an arrangement was not met until January 2015 and the price was not fixed and determinable in the quarter that the revenues were previously recognized . As a result, the Company is required to account for the contract with this distributor under the cash basis of accounting, which means that revenues are recognized when cash receipts are actually received. Correcting this revenue recognition error in one contract will result in an increase in product revenues of approximately $0.8 million , net of cost of sales, in the third quarter of 2015 and a decrease in product revenues of approximately $1.1 million , net of cost of sales, in 2014. The approximate $0.3 million difference between the $0.8 million increase in product revenues for the third quarter of 2015 and the $1.1 million decrease in product revenues in 2014 will not be included as an accounts receivable as of the end of the third quarter of 2015, but will be recorded as product revenue in future periods when and if such amounts are actually received.
The Company also sold product to the same distributor during the first quarter of 2015. The Company is also recognizing this sale on the cash-basis of accounting. Correcting this revenue recognition error will result in a decrease in product revenues of approximately $0.8 million, net of cost of sales, in the first quarter of 2015. The $0.8 million of accounts receivable will not be included as an accounts receivable as of the end of the first quarter of 2015, but will be recorded as product revenue in future periods when and if such amounts are actually received.
Also during the first quarter of 2015, the C ompany recognized a $0.7 million sale , net of cost of sales, to a distributor that ordered products for sale outside of the United States. During its review of all distributor contracts undertaken during the third quarter 2015 period close process, the Company also dete rmined that revenue recognition of this first quarter 2015 transaction is appropriate in a future period when the distributor achieves full regulatory approval in the country where they will be selling the product. This determination was made because the distributor has the right to return the product if regulatory approval is not achieved.
During the third quarter of 2015, the C ompany received true-up information from a nother distributor which showed the average price for product sales during the year. This distributor first sold product for the C ompany during the first quarter 2015. The distributor has the right to sell the product at any price, as long as it sell above a set minimum price. The impact of this price adjustment was $0.3 million revenue reduction during the first quarter 2015 and $1.0 million reduction during the second quarter 2015. The revenue adjustment was offset by a reduction in costs of goods sold, commissions and fees for that revenue. This adjustment was preliminarily recorded during the third quarter of 2015 but a determination was made to adjust previous quarters to reflect the proper impact of the adjustment to previously reported periods.
Materiality Assessment
The Company evaluated the effect of the adjustment in accordance with the Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 99 (SAB 99) and SEC Staff Accounting Bulletin No. 108, "Effects of Prior Year Misstatements on Current Year Financial Statements" (SAB 108) and determined the cumulative impact of the adjustment was not material to our previously issued annual audited financial statements for the year ended December 31, 2014 and therefore, amendments of our previously filed 2014 Form 10-K is not required. We restated previously reported results for the three months ended December 31, 2014 and the year ended December 31, 2014 in this Quarterly Report on Form 10-Q for the quarter ended September 30,2015 . The accompanying condensed financial statements as of September 30, 2015 reflect the aforementioned immaterial correction s .
The following tables present the effects of the corrections on the Company’s financial statements for December 31, 2014:
As Previously Reported
Q1 2014
Q2 2014
Q3 2014
Q4 2014
2014
Product revenues
$
$
$
$
$
Cost of product revenue
Gross profit
Income (loss) from continuing operations
Net income (loss)
Diluted income (loss) per share
$
$
$
$
$
Trade accounts receivable, net
$
Inventory
$
Total stockholders' equity
$
Adjustments
Q1 2014
Q2 2014
Q3 2014
Q4 2014
2014
Product revenues
$
—
$
—
$
—
$
$
Cost of product revenue
—
—
—
Gross profit
—
—
—
Income (loss) from continuing operations
—
—
—
Net income (loss)
—
—
—
Diluted income (loss) per share
$
—
$
—
$
—
$
$
Trade accounts receivable, net
$
$
Inventory
$
$
Total stockholders' equity
$
$
Restated
Q1 2014
Q2 2014
Q3 2014
Q4 2014
2014
Product revenues
$
$
$
$
$
Cost of product revenue
Gross profit
Income (loss) from continuing operations
Net income (loss)
Diluted income (loss) per share
$
$
$
$
$
Trade accounts receivable, net
$
Inventory
$
Total stockholders' equity
$
Percentage Change
Q1 2014
Q2 2014
Q3 2014
Q4 2014
2014
Product revenues
%
%
%
%
%
Cost of product revenue
%
%
%
%
%
Gross profit
%
%
%
%
%
Income (loss) from continuing operations
%
%
%
%
%
Net income (loss)
%
%
%
%
%
Diluted income (loss) per share
%
%
%
%
%
Trade accounts receivable, net
%
Inventory
%
Total stockholders' equity
%
The following tables present the effects of the corrections on the Company’s financial statements for each quarter during 2015:
As Previously Reported
Q1 2015
Q2 2015
2015
Product revenues
$
$
$
Cost of product revenue
Gross profit
Selling, general, and administrative expenses
Income taxes expense
Income (loss) from continuing operations
Net income (loss)
Diluted income (loss) per share
$
$
$
Trade accounts receivable, net
$
$
Inventory
$
$
Total liabilities
$
$
Total stockholders' equity
$
$
Adjustments
Q1 2015
Q2 2015
2015
Product revenues
$
$
$
Cost of product revenue
—
Gross profit
Selling, general, and administrative expenses
Income taxes expense
Income (loss) from continuing operations
Net income (loss)
Diluted income (loss) per share
$
$
$
Trade accounts receivable, net
$
$
Inventory
$
$
Total liabilities
$
$
Total stockholders' equity
$
$
Restated
Q1 2015
Q2 2015
2015
Product revenues
$
$
$
Cost of product revenue
Gross profit
Selling, general, and administrative expenses
Income taxes expense
Income (loss) from continuing operations
Net income (loss)
Diluted income (loss) per share
$
$
$
Trade accounts receivable, net
$
$
Inventory
$
$
Total liabilities
$
$
Total stockholders' equity
$
$
Percentage Change
Q1 2015
Q2 2015
2015
Product revenues
%
%
%
Cost of product revenue
%
%
%
Gross profit
%
%
%
Selling, general, and administrative expenses
%
%
%
Income taxes expense
%
%
%
Income (loss) from continuing operations
%
%
%
Net income (loss)
%
%
%
Diluted income (loss) per share
%
%
%
Trade accounts receivable, net
%
%
Inventory
%
%
Total liabilities
%
%
Total stockholders' equity
%
%
Use of Estimates
The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Due to the inherent uncertainty involved in making those assumptions, actual results could differ from those estimates. We believe that the most significant estimates that affect our financial statements are those that relate to deferred tax assets, inventory valuation, allowance for doubtful accounts, and share-based compensation.
Reclassifications
We have reclassified certain prior-year amounts for comparative purposes. These reclassifications did not affect our results of operations or financial positions for the periods presented.
Cash and Cash Equivalents
Amounts listed as cash on our balance sheets are maintained in depository accounts at commercial banks, which include $2.2 million denominated in Australian dollars from the sale of our Mesoblast shares. Cash and cash equivalents, which include highly liquid investments with maturities of three months or less when purchased, held in our brokerage investment accounts are classified as investments available for sale, as the amounts represent investments that have matured and are anticipated to be reinvested in debt securities in the near future, and are disclosed at fair value, which approximates cost.
Investments Available for Sale
Investments available for sale consist primarily of marketable securities with maturities less than one year. Investments available for sale are valued at their fair value, with unrealized gains and losses reported as a separate component of stockholders' equity in accumulated other comprehensive income (loss). All realized gains and losses on our investments available for sale are recognized in results of operations as other income (expense).
Investments available for sale are evaluated periodically to determine whether a decline in their value is "other than temporary." The term "other than temporary" is not intended to indicate a permanent decline in value. Rather, it means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the security. We review criteria such as the magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in value is other than temporary. If a decline in value is determined to be other than temporary, the carrying value of the security is reduced and a corresponding charge to earnings is recognized.
Trading Securities - Derivative and Securities Received in Business Disposition
As discussed in Note 2 – Discontinued Operations , we disposed of our Therapeutics segment in October 2013. A portion of the consideration for the sale of that business was stock of Mesoblast Limited (“Mesoblast”), the parent of the purchaser. We were required to hold that stock for one year from the date of receipt. Mesoblast is a public company and its stock is traded on the Australian stock exchange.
The Mesoblast stock was previously subject to limited price protection for the one year required holding period. To the extent the value of those shares decreased during the holding period, Mesoblast was required to pay us for the decrease in value. This payment was to be made at least one half in cash and at the option of Mesoblast, up to one half in additional shares of Mesoblast stock. Any additional Mesoblast stock would also have to be held for one year during which period there was no further price protection. The price protection was accounted for as a derivative under ASC 815, Derivatives and Hedging , and, as such was recorded on the balance sheets at fair value, with changes recognized in net income. We elected to measure the Mesoblast stock at fair value with changes in fair value reflected in net income, as permitted under ASC 825-10, Financial Instruments — Fair Value Option . In December 2014, the price protection on these shares expired and we extended the restriction period to May 2015 in exchange for Mesoblast paying us the difference between the prevailing market value of the Mesoblast stock and $ 15 million in cash, thereby eliminating the derivative. As of December 31, 2014, this $15 million was shown as $10.6 million in Trading Securities and $4.4 million in Other Receivables on our Balance Sheets. In June 2015, we received $6.2 million in cash from Mesoblast for the difference between the market value of the Mesoblast stock and the $15 million agreed to be paid to us by Mesoblast. Also in June 2015, we began selling the shares of Mesoblast stock through a stockbroker in Australia. As of September 30, 2015, we sold 1,557,551 shares of Mesoblast stock and realized a loss of $13,000 . As of September 30, 2015, the market value of the remaining 1,391,178 shares of Mesoblast stock held by us was $3.1 million. For the three and nine months ended September 30, 2015, we recognized an unrealized loss on the value of the Mesoblast stock of $933,000 and $1.2 million, respectively, as a component of Other Expense, Net. We expect to sell all of the Mesoblast shares by the end of this fiscal year.
Trade Accounts Receivable
Trade accounts receivable are reported at their net realizable value. We charge off uncollectible receivables when the likelihood of collection is remote. We set credit terms with individual customers, and consider receivables outstanding longer than the time specified in the respective customer's contract, typically 45 -days, to be past due. As of September 30, 2015 and December 31, 2014, accounts receivable in the accompanying balance sheets is each reported net of $411,000 and $1.3 million allowance for doubtful accounts, respectively. During the nine months ended September 30, 2015, we entered into a settlement agreement with a former customer and wrote off $995,000 of accounts receivable against the allowance for doubtful accounts. This amount was fully reserved as of December 31, 2014.
Trade accounts receivable balances are not collateralized. We incurred $150,000 of bad debt expense during the three months and nine months period ended September 30, 2015. We incurred $200,000 and $250,000 of bad debt expense during the three months and nine months period ended September 30, 2014, respectively.
Other Receivables
Other receivables at December 31, 2014 included the $5.0 million fee payable from Stryker, as further described below, and the $4.4 million difference between the market value of the Mesoblast ordinary shares and the $15 million agreed to be paid to us by Mesoblast as described above under “Trading Securities.” The $5.0 million fee from Stryker was received in February 2015 and the true-up payment from Mesoblast was received in June 2015.
Inventory
We began carrying inventory of our Biosurgery products on our balance sheet following commercial launch of such products. Inventory consists of raw materials, biologic products in process, and products available for distribution. We determine our inventory values using the first-in, first-out method. Inventory is valued at the lower of cost or market, and excludes units that we anticipate distributing for clinical evaluation. Materials and supplies purchased for product development and product improvement activities are expensed as incurred.
Property and Equipment
Property and equipment, including improvements that extend useful lives, are valued at cost, while maintenance and repairs are charged to operations as incurred. Depreciation is calculated using the straight-line method based on estimated useful lives ranging from three to seven years for furniture, equipment and internal use software. Leasehold improvements and assets under capital leases are amortized over the shorter of the estimated useful life of the asset or the term of the lease.
Valuation of Long-lived Assets
We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or group of assets may not be fully recoverable. These events or changes in circumstances may include a significant deterioration of operating results, changes in business plans, or changes in anticipated future cash flows. If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets. Assets are grouped at the lowest level for which there is identifiable cash flows that are largely independent of the cash flows generated by other asset groups. If the total of the expected undiscounted future cash flows is less than the carrying amount of the asset, an impairment loss is recognized for the difference between the fair value and carrying value of assets. Fair value is generally determined by estimates of discounted cash flows. The discount rate used in any estimate of discounted cash flows would be the rate required for a similar investment of like risk. There were no impairment losses recognized during the first nine months of fiscal 2015 or during fiscal year 2014.
Biosurgery Revenue Recognition
We recognize revenue from product distribution when title passes to the customer. Title usually passes when the product is shipped to the customer and leaves our loading dock. On occasion, customers purchase product and request that the Company store the purchased product in segregated freezers at the Company’s facility. In those cases, title passes to the customer and the customer accepts all risks associated with the purchased product. Customers may request this service of the Company in instances where they want to ensure that supply of product is available to them and they do not have the capability to store the product themselves in special freezers at -80 degrees Celsius. In some situations, we store consigned inventory on site in freezers at hospital or clinic facilities. No revenue is recognized upon the placement of inventory into consignment as we retain title and maintain the inventory on our balance sheets. For these products, revenue is recognized when we receive appropriate notification that the product has been used in a surgical procedure. We verify the condition and status of all consigned inventory on at least a quarterly basis. Due to the nature of our products and the need to ensure they are maintained at the proper frozen temperature, we generally do not allow product returns.
In December 2014, we entered into an exclusive distribution agreement with a subsidiary of Stryker Corporation for the marketing and distribution of BIO 4™ , our viable bone matrix allograft. Pursuant to the agreement, Stryker has been granted worldwide distribution rights to the product and any improvements, for all surgical applications. We are responsible for supply, processing, inventory management, shipments to customers, continued research and product improvement activities. The amount we recognized as revenue is based on our list prices for the allograft. We reconcile and record the difference, if any, between the revenue previously recognized and the selling price when we receive the data from Stryker on a monthly basis. Commissions and administrative fees paid to Stryker are accounted for as selling expenses, as Stryker is acting as outside sales and marketing agent for Osiris. We received an initial exclusivity fee of $5.0 million in the first nine months of fiscal 2015 and are entitled to receive additional fees upon any exercise by Stryker of its right to extend the initial term, whether on an exclusive or non-exclusive basis. The exclusivity fee and any extension fees subsequently received are considered to be adjustments of the selling expenses. As such, we recognize the exclusively fee as deferred revenue, which will be amortized over the related exclusivity period in proportion to the expected fees to be paid to Stryker, as an offset to selling expenses. We amortized $236,000 and $611,000 for the three and nine months ended September 30, 2015, respectively. At December 31, 2014, we recorded a $5.0 million receivable with the offset to short-term deferred commissions of $1.7 million and long-term deferred commissions of $3.3 million. At September 30, 2015, the short-term and long-term deferred commissions were $1.7 million and $2.7 million, respectively.
In October 2014, we entered into an exclusive commercial and development partnership for our cartilage product, Cartiform®, with Arthrex, Inc. The agreement provides Arthrex with exclusive commercial distribution rights to Cartiform beginning in 2015. We are responsible for product processing, continued research and product improvement activities. The responsibilities related to the design and conduct of future clinical development programs are shared between both organizations. Pursuant to the agreement, Arthrex is entitled to a certain commission on Cartiform sales. We recognize the full sales price as revenue and account for the payment to Arthrex as commission expense.
Research and Development Costs
We expense internal and external research and development (“R&D”) costs, including costs of funded R&D arrangements and the processing and production of clinical batches of Biosurgery products used in clinical trials, in the period incurred.
Income Taxes
Deferred tax liabilities and assets are recognized for the estimated future tax consequences of temporary differences, income tax credits and net operating loss carry-forwards. Temporary differences are primarily the result of the differences between the tax bases of assets and liabilities and their financial reporting values. Deferred tax liabilities and assets are measured by applying the enacted statutory tax rates applicable to the future years in which deferred tax liabilities or assets are expected to be settled or realized. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense, if any, consists of the taxes payable for the current period and the change during the period in deferred tax assets and liabilities.
We recognize in our financial statements the impact of a tax position, if that position is more likely than not to be sustained upon an examination, based on the technical merits of the position. Interest and penalties related to income tax matters are recorded as income tax expense. At September 30, 2015 and December 31, 2014 we had no accruals for interest or penalties related to income tax matters.
Income (Loss) per Common Share
Basic income (loss) per common share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted income (loss) per common share adjusts basic income (loss) per share for the potentially dilutive effects of common share equivalents, using the treasury stock method, and includes the incremental effect of shares that would be issued upon the assumed exercise of stock options and warrants.
Diluted loss per common share for the three months ended September 30, 2015 excludes al l 1,573,742 of our outstanding options as of that date, as on their impact on our net loss is anti-dilutive. Diluted income per common share for the nine months ended September 30, 2015 includes the dilutive impact of options equivalent to 495,087 shares.
Diluted income per common share for the three months ended September 30, 2014 includes the dilutive impact of options equivalent to 348,350 shares. Diluted loss per common share for the nine months ended September 30, 2014 excludes all 1,544,070 of our outstanding options as of that date, as their impact on our net loss is anti-dilutive.
Share-Based Compensation
We account for share-based payments using the fair value method.
We recognize all share-based payments to employees and non-employee directors in our financial statements based on their grant date fair values, calculated using the Black-Scholes option pricing model. Compensation expense related to share-based awards is recognized on a straight-line basis for each vesting tranche based on the value of share awards that are expected to vest on the grant date, which is revised if actual forfeitures differ materially from original expectations.
Comprehensive Income
Comprehensive income consists of net income and all changes in equity from non-stockholder sources, which consist of changes in unrealized gains and losses on investments.
Concentration of Risk
We maintain cash and short-term investment balances in accounts that exceed federally insured limits, although we have not experienced any losses on such accounts. We also invest excess cash in investment grade securities, generally with maturities of one year or less. We have historically provided credit in the normal course of business to contract counterparties and to the end user customers and distributors of our products. Trade accounts receivable in the accompanying balance sheets consist primarily of amounts due from end user customers and distributors of our Biosurgery products within the United States. During the first nine months of fiscal 2015 and 2014, revenues from one of the distributors of our Biosurgery products, Stability Biologics, comprised approximately 11% and 9% , respectively, of our total Biosurgery product revenues. As of September 30, 2015 and December 31, 2014, receivables from this distributor comprised 2% and 13% , respectively, of our trade receivables. As discussed under “Trade Accounts Receivable,” we have incurred $150,000 bad debt expense for the three and nine months ended September 30, 2015. We incurred $200,000 and $250,000 of bad debt expense for the three and nine months ended September 30, 2014.
Recent Accounting Guidance at September 30, 2015
In July 2015, the FASB issued Accounting Standards Update No. 2015-11, “ Simplifying the Measurement of Inventory ” (“ASU 2015- 11”). ASU 2015-11 requires an entity to measure inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. Subsequent measurement is unchanged for inventory measured using last-in, first-out (“LIFO”) or the retail inventory method. It is effective for annual reporting periods beginning after December 15, 2016. The amendments should be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. The Company is currently in the process of evaluating the impact of adoption of ASU 2015-11 on its balance sheets. No other new accounting pronouncements, issued or effective during the third quarter of 2015, have had or are expected to have a significant impact on the Company’s financial statements. |
