News & Events > Press Releases > November 14, 2002

StemCells, Inc. (ticker: STEM, exchange: NASDAQ) News Release - Nov. 14, 2002

10-Q: STEMCELLS INC

(EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial OF OPERATIONS

The following discussion of the our financial condition and the results of our operations for the three and nine-month period ended September 30, 2002 and 2001 should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and the related footnotes thereto.

This report includes forward-looking statements. You can identify these statements by forward-looking words such as "may," "could," "will," "possibly," "expect," "anticipate," "project," "believe," "estimate," "continue" or similar words. You should read statements that contain these words carefully because they discuss our future expectations, contain projections of our future results of operations or of our financial condition, or state other "forward-looking" information. We believe that it is important to communicate our future expectations to our investors. However, there will be events in the future that we have not been able to accurately predict or control and that may cause our actual results to differ materially from those discussed. For example, contaminations at our facilities, changes in the pharmaceutical or biotechnology industries, competition and changes in government regulations or general economic or market conditions could all have significant effects on our results. These factors should be considered carefully and readers should not place undue reliance on our forward-looking statements. Before you invest in our common stock, you should be aware that the occurrence of the events described in the "Cautionary Factors Relevant to Forward Looking Information" and "Business" sections included in our Form 10-K report as of December 31, 2001 could harm our business, operating results and financial condition. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements and risk factors contained or referred to herein.

Overview

Since our inception in 1988, we have been primarily engaged in research and development of human therapeutic products. As a result of a restructuring in the second half of 1999, our sole focus is now on our stem cell technology. As of September 30, 2002, we had available cash or cash equivalents equal to approximately $6.67 million, which we expect to be adequate to fund operations into the second quarter of 2003, depending on the outcome of our cost reduction program. We are pursuing various strategic avenues designed to attract sufficient financial resources to maintain uninterrupted operations beyond then, but there can be no assurance that these attempts will prove successful.

We have not derived any revenues from the sale of any products, 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 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 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.

In August 2002 we entered into an agreement pursuant to which we sold 1,028,038 shares of common stock to Triton West Group, Inc., an institutional investor, for aggregate proceeds of $1,100,000 or approximately $1.07 per share.

In 2001, we entered into two significant financing agreements: In May, we entered into an equity line enabling us to draw up to $30,000,000 subject to various restrictions, and we did draw down $4,000,000 in July; and in December, we issued 3% convertible preferred stock for $5,000,000. In addition, under the terms of the financing agreement we entered into in 2000 with Millennium Partners, LP, Millennium exercised its final option to purchase $2,000,000 of our common stock; that agreement has now terminated. (See "Liquidity and Capital Resources" below for further detail on each of these transactions.) The terms of the equity line restrict the amount of any draw down by a formula that depends in part on the trading volume of our stock over a certain period of time. Given the recent trading volumes and prices for our Common Stock, at this time the Company does not consider the equity line to be a viable source of financing.

In addition, we received two grants from the National Institutes of Health in 2001, one for work on hepatitis to be carried out jointly by us and Stanford University, and one focusing on the effort to identify liver stem and progenitor cells for the treatment of liver diseases. Although the grants are relatively small ($300,000 a year for two years and $225,000 a year for four years, respectively) and dependent on availability of funds and satisfactory progress, we are very pleased by this recognition of our work by the agency.

In September 2002, after reviewing our operating cost structure, we initiated a cost reduction program that curtails expenditures on our discovery research activities in favor of channeling resources into accelerating preclinical development of our propriety cells for the treatment of neural and liver disease. A major component of the program is the attempt to negotiate a substantial reduction in operating lease rent. The plan also includes a twenty-five percent reduction of staff and expenses once fully implemented by year-end 2002. These measures are reflected in the estimate given in the first paragraph of this Overview.

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 changes in the sublease income and rental and other expenses to lease and maintain our facilities in Rhode Island and changes in the costs associated with our move to a larger facility in California. To expand and provide high quality systems and support to our Research and Development programs, we would need to hire more personnel, which would lead to higher operating expenses.

We believe the following critical accounting policies affect the 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 requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from these estimates.

STOCK-BASED COMPENSATION

Our employee stock option plan is accounted for under Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees." We grant qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. In accordance with APB 25, we recognize no compensation expense for qualified stock option grants. We also issue non-qualified stock options for a fixed number of shares to employees with an exercise price less than the fair market value of the shares at the date of grant. When such options vest, we recognize the difference between the exercise price and fair market value as compensation expense in accordance with APB 25.

We account for certain stock options granted to non-employees in accordance with FAS NO. 123—Accounting for Stock-Based Compensation and EITF 96-18—Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, and accordingly, recognize as expense the estimated fair value of such options as calculated using the Black-Scholes valuation model. The estimated fair value is re-determined each quarter using the methodologies allowable by FAS No. 123, and the cost is amortized over the vesting period of each option or the recipient's contractual arrangement, if shorter.

LONG-LIVED ASSETS

We routinely evaluate the carrying value of our long-lived assets. We record impairment losses on long-lived assets used in operations when events and circumstances indicate that assets may be impaired and the undiscounted cash flows estimated to be generated by the assets are less than the carrying amount of those assets. If

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an impairment exists, the charge to operations is measured as the excess of the carrying amount over the fair value of the assets.

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.

Results of Operations

Three months ended September 30, 2002 and 2001

For the three months ended September 30, 2002, revenue from grants and licensing agreements totaled approximately $89,000, which includes $32,000 that is a part of the grant awarded by the National Institutes of Health's Small Business Innovation Research (SBIR) office, $56,000 that is a part of the grant awarded by the National Institute of Diabetes & Digestive & Kidney Disorders of the National Institutes of Health, and $1,000 in licensing revenue. For the three months ended September 30, 2001, revenue from grants totaled approximately $277,000, which includes $78,000 that is a part of the grant awarded by the National Institutes of Health's Small Business Innovation Research (SBIR) office and $199,000 that is a part of the grant awarded by the National Institute of Diabetes & Digestive & Kidney Disorders of the National Institutes of Health.

Research and development expenses totaled $1,873,000 for the three months ended September 30, 2002, compared with $1,555,000 for the same period in 2001. The increase of $318,000 or approximately 20% from 2001 to 2002 was primarily attributable to the effect of the lower valuation of non-qualified stock options on compensation cost in 2001 as compared to 2002, and an increase in costs related to an increase in personnel to facilitate the expansion of our research programs and initiate development. At September 30, 2002, we had 28 full time employees for research and development and laboratory support services, compared with 19 full time employees at September 30, 2001.

General and administrative expenses were $892,000 for the three months ended September 30, 2002, compared with $564,000 for the same period in 2001. The increase of $328,000 or 58%, from 2001 to 2002 was primarily attributable to the effect of a lower valuation of non-qualified stock options in compensation cost in 2001, and the inclusion of $112,000 in expenses of our Rhode Island facilities in general and administrative expenses. For the same period in year 2001, $329,000 in expenses for the Rhode Island facilities was booked against a wind-down reserve. At December 31, 2000,we had created this wind-down reserve of $1,780,000 related to the carrying costs for the Rhode Island facilities through 2001. As we cannot predict the exact disposal date of these properties, effective 2002, we record these expenses as normal general and administrative expenses.

Interest income for the three months ended September 30, 2002 and 2001 was $30,000 and $55,000 respectively. The decrease in interest income in 2002 was attributable to lower average investment balance. Interest expense was $55,000 for the three months ended September 30, 2002. For the three months ended September 30, 2001, interest expense was $59,000 and was charged against the wind-down reserve, as the expense was part of the bond payments related to the Rhode Island facilities. The decrease in 2002 was attributable to lower outstanding debt and capital lease balances in 2002 compared to 2001.

For the three months ended September 30, 2002, we recorded a deemed dividend of $320,000 related to the 3% Cumulative Convertible Preferred Stock which includes the accretion of common stock warrants, the accretion of the beneficial conversion feature and the accretion of related issuance costs.

Nine months ended September 30, 2002 and 2001

For the nine months ended September 30, 2002, revenue from grants and licensing agreements totaled approximately $326,000, which includes $119,000 that is a part of the grant awarded by the National Institutes of Health's Small Business Innovation Research (SBIR) office and $169,000 that is a part of the grant awarded by the National Institute of Diabetes & Digestive & Kidney Disorders of the National Institutes of Health. Revenue from licensing agreements totaled approximately $38,000. For the nine months ended September 30, 2001, revenue from

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grants totaled approximately $377,000, which includes $78,000 that is a part of the grant awarded by the National Institutes of Health's Small Business Innovation Research (SBIR) office and $299,000 that is a part of grants related to our neural program. For the nine months ended September 30, 2001 revenue from the assignment of rights related to technology totaled $300,000; there was no such revenue for the same period in 2002.

Research and development expenses totaled $5,525,000 for the nine months ended September 30, 2002, compared with $6,058,000 for the same period in 2001. The decrease of $533,000 or 9% from 2001 to 2002 was primarily attributable to the initial cost of moving into a new facility in 2001, offset by the effect of the lower valuation of non-qualified stock options on compensation cost in 2001 and by costs related to an increase in personnel in 2002 to facilitate the expansion of our research programs and initiate development. At September 30, 2002, we had 28 full time employees for research and development and laboratory support services, compared with 19 full time employees at September 30, 2001.

General and administrative expenses were $3,282,000 for the nine months ended September 30, 2002, compared with $2,661,000 for the same period in 2001. The increase of $621,000 or 23%, from 2001 to 2002 was primarily attributable to the inclusion of $534,000 in expenses of our Rhode Island facilities in general and administrative expenses and an increase in personnel, offset by the effect of the lower valuation of non-qualified stock options on compensation cost. For the same period in year 2001, $1,223,000 in expenses for the Rhode Island facilities was booked against a wind-down reserve. At December 31, 2000,we had created this wind-down reserve of $1,780,000 related to the carrying costs for the Rhode Island facilities through 2001. As we cannot predict the exact disposal date of these properties, effective 2002, we record these expenses as normal general and administrative expenses.

During the nine-month period ended September 30, 2001, we sold 126,193 Modex shares for total proceeds and a realized gain of approximately $7,782,000. We no longer hold any shares of Modex.

Interest income for the nine months ended September 30, 2002 and 2001 was $90,000 and $180,000 respectively. The decrease in interest income in 2002 was primarily attributable to a decrease in the yield on money market funds. Interest expense was $174,000 for the nine months ended September 30, 2002. For the nine months ended September 30, 2001, interest expense was $190,000 and was charged against the wind-down reserve, as the expense was part of the bond payments related to the Rhode Island facilities. The decrease in 2002 was attributable to lower outstanding debt and capital lease balances in 2002 compared to 2001.

For the nine months ended September 30, 2002, we recorded a deemed dividend of $960,000 related to the 3% Cumulative Convertible Preferred Stock which includes the accretion of common stock warrants, the accretion of the beneficial conversion feature and the accretion of related issuance costs. We also recorded a total stock-dividend distribution of $165,000 value to our preferred shareholders. For the nine months ended September 30, 2001, we recorded deemed dividends of $802,000 related to the 6% Cumulative Convertible Preferred Stock to reflect the increase in the beneficial conversion feature resulting from the decrease in the effective conversion price. The aggregate accretion value associated with the warrants, beneficial conversion feature and issuance costs were included in the calculation of net loss applicable to common stockholders.

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 unrestricted cash and cash equivalents totaling $6,671,000 as of September 30, 2002. Cash equivalents are invested in US Treasuries and money market funds with maturities of less than 90 days.

Our liquidity and capital resources were, in the past, significantly affected by our relationships with corporate partners. These relationships are now terminated, and we have not yet established corporate partnerships with respect to our stem cell technology. Our liquidity and capital resources have, in the past, also been affected by our holdings of stock of Modex, all of which have now been sold.

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On May 10, 2001, we entered into a common stock purchase agreement with Sativum Investments Limited for the potential future issuance and sale of up to $30,000,000 of our common stock ($4 million drawn to date). This facility, sometimes termed an equity line, is subject to restrictions and other obligations which limit how often we can exercise a draw down and the amount of each draw down. The restrictions include functions of the trading volume and average price of the shares during periods prior to the draw down. As a result of these and other restrictions, this facility cannot be used to provide significant funding for the Company unless and until the underlying market conditions for our stock improve.

We continue to have outstanding obligations in regard to our former facilities in Lincoln, Rhode Island, including lease payments and operating costs of approximately $1,000,000 for 2002, net of subtenant income. We have subleased a portion of these facilities and are actively seeking to sublease, assign or sell our remaining interests in these facilities. Our failure to do so has had and will continue to have a material adverse effect on our liquidity and capital resources. Our subtenants are generally early stage biomedical companies, some of which have been and others of which may in the future be unable to meet their obligations to us. If our subtenants are unable to meet their obligations to us and we are unable to replace them, this will also have a material adverse effect on our liquidity and capital resources. Our total operating lease commitments on the Rhode Island scientific and administrative facility (SAF) from October 1, 2002 to June 30, 2013 are approximately $11.5 million, and our total capital lease commitments with respect to the Rhode Island pilot manufacturing facility for the years October 1, 2002 to August 1, 2014 amount to approximately $3.7 million.

The landlord on our SAF has asserted that we are in default under non-financial provisions of the lease on the SAF as a result of alleged defects in maintenance of the facility. A corrective action plan designed to cure any such defaults within the applicable cure period is in place, but there can be no assurance that we will be able to do so. There are also financial covenants in our lease for the SAF and under the bond financing for the Pilot Manufacturing Facility which we may be unable to satisfy early next year, if not sooner. If we were to default on the lease of our SAF, the landlord might seek liquidated damages or other remedies which we would likely be unable to satisfy. Similarly, any default under our bond obligations would result in acceleration of our obligations under the bonds, which we would also likely be unable to satisfy.

Our total operating lease commitment on the Palo Alto, California facility we occupy for the period from October 1, 2002 to January 31, 2006 is approximately $11.9 million.

We have limited liquidity and capital resources and must obtain significant additional capital resources in the future in order to sustain our product development efforts, for acquisition of technologies and intellectual property rights, for preclinical and clinical testing of our anticipated products, pursuit of regulatory approvals, acquisition of capital equipment, laboratory and office facilities, establishment of production capabilities and for general and administrative expenses. Until our operations generate significant revenues from product sales, we must rely on cash reserves and proceeds from equity and debt offerings, proceeds from the transfer or sale of our intellectual property rights, equipment, facilities or investments, and government grants and funding from collaborative arrangements, if obtainable, to fund our operations.

We intend to pursue opportunities to obtain additional financing in the future through equity and debt financings, grants and collaborative research arrangements. We also intend to pursue all other strategic alternatives available to the Company, including, without limitation, licensing activities, mergers and/or acquisitions, sale of Company assets or other form of business combination or extraordinary transaction. There can be no assurance that we will be able to enter into any such transaction. The source, timing and availability of any future financing or other transaction will depend principally upon market conditions and, more specifically, on our progress in our exploratory, preclinical and future clinical development programs. Funding may not be available when needed—at all, or on terms acceptable to us. While our cash requirements may vary, we currently expect that our existing capital resources will be sufficient to fund our operations into the second quarter of 2003. Default under any of our lease obligations could shorten the time period through which we currently expect to be able to continue to operate. Lack of necessary funds may require us to further delay, scale back or eliminate some or all of our research and product development programs and/or our capital expenditures or to license our potential products or technologies to third parties or to cease operations.

Nasdaq Listing Issues

The Nasdaq Stock Market, Inc. (Nasdaq) may delist our common stock from The Nasdaq National Market (the National Market) if we fail to meet their continued listing requirements. We may seek to have our Common Stock listed on The Nasdaq SmallCap Market (the SmallCap Market), provided that we meet the listing requirements of the SmallCap Market. The delisting of our common stock from either the National Market or (should we fail to meet its continued listing requirements) the SmallCap Market could adversely affect the market price and market liquidity of our common stock. If we were also delisted from the SmallCap Market, trading, if any, of our common stock would thereafter have to be conducted in the over-the-counter market on the "pink sheets" or, if available, the NASD's "Electronic Bulletin Board." In such an event, an investor could find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, our common stock, which could further severely limit the market liquidity of our common stock and the ability of investors to trade our common stock.

We currently are not in compliance with the $1.00 minimum bid price listing requirement for continued listing on the National Market and were notified by Nasdaq on October 25, 2002, that the Company's stock had failed to maintain a minimum bid price of $1.00 over the previous 30 consecutive trading days and that the stock will be delisted from the National Market unless, by January 23, 2003, we achieve a closing bid price of at least $1.00 per share for a minimum of 10 consecutive trading days.

In addition to the above, effective November 1, 2002, to qualify for continued listing on the National Market under "Maintenance Standard 1", we are required to maintain a minimum of $10,000,000 as "stockholders' equity" on our Balance Sheet. We currently are not in compliance. On September 30, 2002, our "stockholders' equity" was $4,990,163. We expect to be notified by Nasdaq of non-compliance within a week of filing this 10-Q. At such time, the Company would be requested to move to the SmallCap Market or to submit a plan to the Nasdaq Listings Qualifications Panel explaining how we planned to raise our "stockholders' equity" to $10,000,000. We can give no assurances that we will regain compliance with the continued listing requirement of the National Market or that we can meet or maintain compliance with the SmallCap Market listing requirements.

If we are delisted from or trading in our stock is suspended on the National Market, SmallCap Market or other exchange or principal market for our Common Stock, under certain circumstances we would then be in breach of certain registration rights agreements that we entered into with certain investors and may be required to pay liquidated or other damages to those investors. Under these circumstances, we also would not be able to draw down on our equity line of credit.

Received by Edgar Online Nov 14, 2002

CIK Code: 0000883975

Accession Number: 0000950135-02-005028

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