Microbot Medical Inc. - Quarter Report: 2006 June (Form 10-Q)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

STEMCELLS, INC.

(Exact name of registrant as specified in its charter)

DELAWARE		94-3078125
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer identification No)

3155 PORTER DRIVE
PALO ALTO, CA 94304
(Address of principal executive offices including zip code)

(650) 475-3100
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter periods that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large accelerated filer o

Accelerated filer þ

Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

At July 26, 2006, there were 77,777,174 shares of Common Stock, $.01 par value, issued and outstanding.

 

 

STEMCELLS, INC.

INDEX

		Page Number
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)		3
Condensed Consolidated Balance Sheets at June 30, 2006 and December 31, 2005		3
Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005		4
Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005		5
Notes to Condensed Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		13
Item 3. Quantitative and Qualitative Disclosures About Market Risk.		22
Item 4. Controls and Procedures		22
PART II. OTHER INFORMATION		23
Item 1. Legal Proceedings		23
Item 1A. Risk Factors		23
Item 2. Changes in Securities and Use of Proceeds		23
Item 3. Defaults Upon Senior Securities		23
Item 4. Submission of Matters to a Vote of Security-Holders		23
Item 5. Other Information		24
Item 6. Exhibits		24
SIGNATURES		25
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

STEMCELLS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

		June 30, 2006				December 31, 2005
		(unaudited)
Assets
Current assets:
Cash and cash equivalents		$	59,907,206			$	34,540,908
Receivables			563,854				201,919
Other current assets			1,190,050				386,966
Total current assets			61,661,110				35,129,793
Marketable securities			2,100,887				3,720,794
Property, plant and equipment, net			3,927,279				3,282,588
Other assets, net			2,604,332				2,705,513
Total assets		$	70,293,608			$	44,838,688
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable		$	1,246,970			$	637,122
Accrued expenses			814,787				1,483.300
Accrued wind-down expenses, current portion			1,255,124				1,118,796
Capital lease obligations, current portion			54,676				54,676
Bonds payable, current portion			259,167				254,167
Total current liabilities			3,630,724				3,548,061
Bonds payable, less current maturities			1,221,250				1,351,250
Deposits and other long-term liabilities			522,866				522,866
Accrued wind-down expenses, non-current portion			5,814,115				6,186,930
Deferred rent			1,054,939				853,997
Total liabilities			12,243,894				12,463,104
Stockholders’ equity:
Common stock, $.01 par value; 125,000,000 shares authorized; 77,777,174 and 65,396,022 shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively			777,771				653,960
Additional paid in capital			253,375,404				217,919,336
Accumulated deficit			(194,126,048)	)			(185,943,565	)
Accumulated other comprehensive loss			(1,977,413	)			(254,147	)
Total stockholders’ equity			58,049,714				32,375,584
Total liabilities and stockholders’ equity		$	70,293,608			$	44,838,688

See accompanying notes to condensed consolidated financial statements.

STEMCELLS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

		Three months ended								Six months ended
		June 30,								June 30,
		2006				2005				2006				2005
Revenue:
Revenue from grants		$	—			$	26,092			$	37,550			$	52,184
Revenue from licensing agreements			20,535				10,677				24,535				19,906
Total revenue			20,535				36,769				62,085				72,090
Operating expenses:
Research and development			3,187,513				1,969,096				5,879,394				3,588,029
General and administrative			1,412,513				954,542				3,089,837				2,459,744
Wind-down expenses			174,901				1,197,226				331,018				1,718,200
Total operating expenses			4,774,927				4,120,864				9,300,249				7,765,973
Loss from operations			(4,754,392	)			(4,084,095	)			(9,238,164	)			(7,693,883	)
Other income (expense):
License and settlement agreement, net			103,359								103,359
Interest income			703,551				261,389				1,043,365				489,152
Interest expense			(38,505	)			(45,345	)			(77,098	)			(91,756	)
Other income (expense)			(3,372	)			(235	)			(13,947	)			(20,632	)
Total other income (expense)			765,033				215,809				1,055,679				376,764
Net loss applicable to common stockholders		($	3,989,359	)		($	3,868,286	)		($	8,182,485	)		($	7,317,119	)
Net loss per share applicable to common stockholders; basic and diluted		($	0.05	)		($	0.06	)		($	0.11	)		($	0.12	)
Weighted average shares used to compute net loss per share applicable to common stockholders; basic and diluted			77,105,128				63,072,873				71,306,311				62,741,639

See accompanying notes to condensed consolidated financial statements.

STEMCELLS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

		Six months ended
		June 30,
		2006				2005
Cash flows from operating activities:
Net loss			($8,182,485	)			($7,317,119	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization			528,755				552,237
Amortization of deferred compensation			—				69,501
Stock-based compensation expense			1,040,263				65,280
Loss on disposal of fixed assets			1,197				—
Income from license and settlement agreement			(103,359	)			—
Changes in operating assets and liabilities:
Accrued interest receivable			(120,284	)			(4,481	)
Receivables			(241,651	)			39,289
Other current assets			(803,084	)			(337,584	)
Other assets			106,271				52,947
Accounts payable and accrued expenses			(58,665	)			(712,355	)
Accrued wind-down expenses			(236,486	)			1,146,341
Deposits received (refunded)			—				(76,941	)
Deferred rent			200,942				42,839
Net cash used in operating activities			(7,868,586	)			(6,480,046	)
Cash flows from investing activities:
Purchase of property, plant and equipment			(1,111,357	)			(235,280	)
Acquisition of other assets			(68,375	)			(50,000	)
Net cash used in investing activities			(1,179,732	)			(285,280	)
Cash flows from financing activities:
Proceeds from the exercise of stock options			123,186				309,026
Proceeds from the exercise of warrants			994,896				1,937,952
Proceeds from issuance of common stock			33,421,534				—
Repayments of capital lease obligations			—				(25,890	)
Repayment of debt obligations			(125,000	)			(119,749	)
Net cash provided by financing activities			34,414,616				2,101,339
Decrease in cash and cash equivalents			25,366,298				(4,663,987	)
Cash and cash equivalents, beginning of period			34,540,908				41,059,532
Cash and cash equivalents, end of period		$	59,907,206			$	36,395,545
Supplemental disclosure of cash flow information:
Interest paid		$	77,098			$	91,756

See accompanying notes to condensed consolidated financial statements

Notes to Condensed Consolidated Financial Statements (Unaudited)
June 30, 2006 and 2005

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

     The terms “StemCells”, the “Company”, “our”, “we” and “us” as used in this report refer to StemCells Inc. The accompanying unaudited, condensed consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying financial statements include all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the financial position, results of operations and cash flows for the periods presented. Results of operations for the six months ended June 30, 2006, are not necessarily indicative of the results that may be expected for the entire fiscal year ending December 31, 2006.

     The balance sheet at December 31, 2005 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required for complete financial statements in accordance with accounting principles generally accepted in the United States of America. For the complete financial statements, refer to the audited financial statements and footnotes thereto as of December 31, 2005, included on Form 10-K.

     The Company has incurred significant operating losses and negative cash flows since inception. It has not achieved profitability and may not be able to realize sufficient revenues to achieve or sustain profitability in the future. The Company has limited capital resources and it will need to raise additional capital from time to time to sustain its product development efforts, acquisition of technologies and intellectual property rights, preclinical and clinical testing of anticipated products, pursuit of regulatory approvals, acquisition of capital equipment, laboratory and office facilities, establishment of production capabilities, general and administrative expenses and other working capital requirements. To fund its operations, the Company relies on cash balances, proceeds from equity and debt offerings, proceeds from the transfer or sale of intellectual property rights, equipment, facilities or investments, and on government grants and collaborative arrangements. The Company cannot be certain that such funding will be available when needed. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

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. Significant estimates include the accrued wind-down expenses and the grant date fair value of share based awards recognized as compensation expense in accordance with the provisions of Statement of Financial Accounting Standards No. 123 (Revised 2004) “Share-Based Payment” (SFAS 123R). See “Stock-Based Compensation” below.

Marketable securities

     In accordance with Statement of Financial Accounting Standards No. 115 “Accounting for Certain Investments in Debt and Equity Securities,” the Company has classified the Company’s short-term investments as available-for-sale marketable securities in the accompanying consolidated financial statements. The marketable securities are stated at fair market value, with unrealized gains and losses reported in other comprehensive income. Management reviews securities with unrealized losses for other than temporary impairment. A decline in the fair value of securities that is deemed other than temporary is charged to earnings when so deemed.

Reclassification

     Certain reclassifications of prior year amounts have been made to conform to current year presentation. Patent related expenses of $133,266 and $339,264 for the three and six-month period ended June 30, 2005 have been reclassified from research and development expense to general and administrative expense on the consolidated statements of operations for that period to conform with current year presentation.

Net Loss Per Share

     The Company has computed net loss per common share according to the Statement of Financial Accounting Standards (SFAS) No. 128 “Earnings Per Share,” which requires disclosure of basic and diluted earnings per share. Basic earnings per share excludes any dilutive effects of options, warrants and convertible securities, and is computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share includes the impact of potentially dilutive securities and is computed using the weighted average of common and diluted equivalent stock options, warrants and convertible securities outstanding during the period. Stock options, warrants and convertible securities that are anti-dilutive are excluded from the calculation of diluted loss per common share.

		Three months ended								Six months ended
		June 30,								June 30,
		2006				2005				2006				2005
Net loss applicable to common stockholders			($3,989,359	)			($3,868,286	)			($8,182,485	)			($7,317,119	)
Weighted average shares used in computing net loss per share applicable to common stockholders, basic and diluted.			77,105,128				63,072,873				71,306,311				62,741,639
Net loss per share applicable to common stockholders, basic and diluted.			($0.05	)			($0.06	)			($0.11	)			($0.12	)

     The Company has excluded outstanding stock options and warrants from the calculation of diluted loss per common share because all such securities are anti-dilutive for all applicable periods presented. These outstanding securities consist of the following potential common shares:

		Outstanding at June 30,
		2006				2005
Outstanding options			7,048,220				6,741,787
Outstanding warrants			1,930,658				4,187,439
Total			8,978,878				10,929,226

Stock-Based Compensation

     In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123R. SFAS 123R requires all share-based payments to employees, or to non-employee directors as compensation for service on the Board of Directors, to be recognized as compensation expense in the consolidated financial statements based on the fair values of such payments. The Company maintains shareholder approved stock-based compensation plans, pursuant to which it grants stock-based compensation to its employees, and to non-employee directors for Board service. These grants are primarily in the form of options that allow a grantee to purchase a fixed number of shares of the Company’s common stock at a fixed exercise price equal to the market price of the shares at the date of the grant (“qualified stock option grants”). The options may vest on a single date or in tranches over a period of time, but normally they do not vest unless the grantee is still employed by or a director of the Company on the vesting date. The compensation expense for these grants will be recognized over the requisite service period which is

typically the period over which the stock-based compensation awards vest. The Company made no modifications to outstanding options with respect to vesting periods or exercise prices prior to adopting SFAS 123R. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107), which provides guidance on the implementation of SFAS 123R. The Company applied the principles of SAB 107 in conjunction with its adoption of SFAS 123R.

     The Company adopted SFAS 123R effective January 1, 2006, using the modified-prospective transition method. Under this transition method, compensation expense will be recognized based on the grant date fair value estimated in accordance with the provisions of SFAS 123R for all new grants effective January 1, 2006, and for options granted prior to but not vested as of December 31, 2005. Prior periods were not restated to reflect the impact of adopting the new standard and therefore do not include compensation expense related to qualified stock option grants for those periods. In accordance with SFAS 123R, the Company recognized stock option related compensation expense of approximately $519,000 and $908,000 for the three and six month periods ended June 30, 2006. All options granted in the three and six month period ended June 30, 2006 were qualified stock options and the related compensation expense was recognized on a straight line basis over the vesting period of each grant net of estimated forfeitures. The Company’s estimated forfeiture rates are based on its historical experience within separate groups of employees. The estimated fair value of the options granted during 2006 and prior years was calculated using a Black Scholes Merton option pricing model (Black Scholes model). The following summarizes the assumptions used in the Black Scholes model as applied in the first and second quarter of 2006:

		First Quarter				Second Quarter
		2006				2006
Risk —free interest rate(1)			4.72	%			5.08	%
Volatility(2)			119.5	%			110.76	%
Dividend yield(3)			0	%			0	%
Expected term (years until exercise)(4)			6.25				6.25

     At June 30, 2006, approximately $4,873,000 of unrecognized compensation expense related to stock options is expected to be recognized over a weighted average period of approximately 1.51 years. The resulting effect on net loss and net loss per share attributable to common stockholders is not likely to be representative of the effects in future periods, due to changes in forfeiture rates, additional grants and subsequent periods of vesting.

     Prior to January 1, 2006, the Company accounted for its stock-based compensation plans under Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees.” In accordance with APB 25, the Company recognized no compensation expense for qualified stock option grants, as the options were granted

at fair market price of the underlying shares on the date of the grant. For options issued with an exercise price less than the fair market value of the shares at the date of grant, the Company recognized the difference between the exercise price and fair market value as compensation expense in accordance with APB 25. Prior to January 1, 2006, the Company provided pro forma disclosure amounts in accordance with Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation,” (SFAS 123) as amended by Statement of Financial Accounting Standards No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure,” (SFAS 148). As compensation expense was disclosed but not recognized in periods prior to January 1, 2006, no cumulative adjustment for forfeitures was recorded in 2006. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation in the prior three and six-month periods ended June 30, 2005:

		Three months ended				Six months ended
		June 30, 2005				June 30, 2005
Net loss applicable to common stockholders — as reported		$	(3,868,286	)		$	(7,317,119	)
Add: Stock-based employee/director compensation expense included in reported net loss			—				—
Deduct: Total stock-based employee/director compensation expense under the fair value based method for all awards			(101,231	)			(238,693	)
Net loss applicable to common stockholders — pro forma		$	(3,969,517	)		$	(7,555,812	)
Basic and diluted net loss per share applicable to common stockholders as reported		$	(0.06	)		$	(0.12	)
Basic and diluted net loss per share applicable to common stockholders — pro forma		$	(0.06	)		$	(0.12	)
Shares used in basic and diluted loss per share applicable to common stockholder amounts			63,072,873				62,741,639

     The Company accounts for stock options granted to non-employees in accordance with SFAS 123 and Emerging Issues Task Force (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, recognizes as expense the estimated fair value of such options as calculated using the Black Scholes model. The fair value is remeasured during the service period and is amortized over the vesting period of each option or the recipient’s contractual arrangement, if shorter. No stock options were issued to non-employees other than options granted to non-employee members of the Board of Directors for service as Board members.

Revenue Recognition

     Revenues from collaborative agreements and grants 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 collaborative agreement. Payments received in advance of research performed are designated as deferred revenue. 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 at the time of receipt.

Recent Accounting Pronouncements

Accounting for Changes and Error Corrections

     In June 2005, the FASB issued Statement of Financial Accounting Standards No. 154 “Accounting Changes and Error Corrections” “SFAS 154). SFAS 154 replaces APB Opinion No. 20 “Accounting Changes” and SFAS No. 3 “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 requires that a voluntary

change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle. SFAS 154 also requires that a change in method of depreciating or amortizing a long- lived non-financial asset be accounted for prospectively as a change in estimate, and correction of errors in previously issued financial statements should be termed a restatement. SFAS 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. The implementation of SFAS 154 is not expected to have a material impact on the Company’s consolidated financial statements.

NOTE 2. RENEURON LICENSE AND SETTLEMENT AGREEMENT

     In July 2005, the Company entered into a license and settlement agreement with ReNeuron Limited, a wholly owned subsidiary of ReNeuron Group plc, a publicly listed UK corporation (collectively referred to as “ReNeuron”). As part of the agreement, the Company granted ReNeuron a license that allows ReNeuron to exploit their “c-mycER” conditionally immortalized adult human neural stem cell technology for therapy and other purposes. In return for the license, StemCells received a 7.5% fully-diluted equity interest in ReNeuron, subject to certain anti-dilution provisions, and a cross-license to the exclusive use of ReNeuron’s technology for certain diseases and conditions, including lysosomal storage diseases, spinal cord injury, cerebral palsy and multiple sclerosis. The agreement also provides for full settlement of any potential claims that either StemCells or ReNeuron might have had against the other in connection with any putative infringement of certain of each party’s patent rights prior to the effective date of the agreement. The agreement is Exhibit 10.71 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. An amendment to the agreement was entered on April 3, 2006, a copy of which was attached as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006. On June 29, 2006, ReNeuron issued additional shares of common stock, of which StemCells was entitled to 439,071 shares because of the anti-dilution provisions within the agreement and net of shares due to Neurospheres Ltd., an Alberta corporation from which StemCells has licensed some of the patent rights that are the subject of the agreement with ReNeuron. The Company recorded approximately $103,000 as other income for the additional shares. The fair market value of the Company’s holdings in ReNeuron common stock as of December 31, 2005 (8,835,766 shares) and June 30, 2006 (9,274,837 shares) was approximately $3,721,000 and $2,101,000 respectively. Changes in market value as a result of changes in market price per share or the exchange rate between the US dollar and the British pound are accounted for under “other comprehensive loss” if deemed temporary, as in this case, and are not recorded as “other income or loss” until the shares are disposed of and a gain or loss realized. The unrealized loss as of June 30, 2006, is approximately $1,977,000. A decline in the fair value of securities that is deemed other than temporary would be charged to earnings.

NOTE 3. LEASES

     The Company had undertaken direct financing transactions with the State of Rhode Island and received proceeds from the issuance of industrial revenue bonds totaling $5,000,000 to finance the construction of a pilot manufacturing facility related to its former encapsulated cell technology. The related leases are structured such that lease payments will fully fund all semiannual interest payments and annual principal payments through maturity in August 2014. Interest rates vary with the respective bonds’ maturities, ranging currently from 8.1% to 9.5%. The outstanding principal at June 30, 2006 was approximately $1,480,000. The bonds contain certain restrictive covenants, which limit among other things, the payment of cash dividends and the sale of the related assets.

     The Company entered into a fifteen-year lease for a laboratory facility in connection with a sale and leaseback arrangement in 1997. The lease has escalating rent payments and accordingly, the Company is recognizing rent expense on a straight-line basis. At December 31, 2005 and June 30, 2006, the Company had deferred rent liability for this facility of approximately $1,208,000 and $1,223,000 respectively; the deferred rent liability is presented as part of the wind-down accrual.

     Although the Company previously discontinued activities relating to encapsulated cell technology, the Company remains obligated under the leases for the pilot manufacturing facility and the laboratory facility. The Company has succeeded in subleasing the pilot manufacturing facility and part of the laboratory facility. The aggregate income received by the Company is significantly less than the Company’s aggregate obligations under the leases, and the Company’s continued receipt of rental income is dependent on the financial ability of the occupants to comply with their obligations under the subleases. The Company continues to seek to sublet the vacant portions of the Rhode Island facilities, to assign or sell its interests in all of these properties, or to otherwise arrange for the termination of its obligations under the lease obligations on these facilities. There can be no assurance, however,

that the Company will be able to dispose of these properties in a reasonable time, if at all, or to terminate its lease obligations without the payment of substantial consideration

     As of February 1, 2001, the Company entered into a 5-year lease for 40,000 square feet of an approximately 68,000 square foot facility located in the Stanford Research Park in Palo Alto, CA. The facility includes space for animals, laboratories, offices, and a GMP (Good Manufacturing Practices) suite. GMP facilities can be used to manufacture materials for clinical trials. On December 19, 2002 the Company negotiated an amendment to the lease, which resulted in reducing the average annual rent over the remaining term of the lease from approximately $3.7 million to $2.0 million. As part of the amendment the Company issued a letter of credit on January 2, 2003 for $503,079, which was an addition to the letter of credit in the amount of $275,000 issued at commencement of the lease, to serve as a deposit for the duration of the lease. The Company negotiated an amendment to the lease effective April 1, 2005, which extends the term of the lease through March 31, 2010, includes an immediate reduction in the rent per square foot, and provides for an expansion of the leased premises by approximately 28,000 additional square feet effective July 1, 2006. In addition, the Company sublet some of the additional space for the period from April 1, 2005 through June 30, 2006. The average annual rent due from the Company under its lease for the period commencing April 1, 2005 to March 31, 2010 is approximately $2 million before subtenant income. The lease has escalating rent payments, which the Company is recognizing on a straight-line basis. At June 30, 2006, the Company had deferred rent liability for this facility of approximately $1,055,000. At June 30, 2006 the Company has a space-sharing agreement covering in total approximately 11,000 square feet of this facility. The Company receives the amount of base rent plus the proportionate share of the operating expenses that it pays for such space over the term of these agreements.

NOTE 4. RELOCATION TO CALIFORNIA FROM RHODE ISLAND

     In October 1999, the Company relocated to California from Rhode Island and established a wind down reserve for the estimated lease payments and operating costs of the Rhode Island facilities through an expected disposal date of June 30, 2000. The Company did not fully sublet the Rhode Island facilities in 2000. Even though the Company intends to dispose of the facility at the earliest possible time, the Company’s management cannot determine with certainty a fixed date by which such disposal will occur. In light of this uncertainty, the Company periodically re-evaluates and adjusts the reserve. The Company considers various factors such as the Company’s lease payments through to the end of the lease, operating expenses, the current real estate market in Rhode Island, and estimated subtenant income based on actual and projected occupancy. At December 31, 2005 the reserve was approximately $6,098,000. For the three and six-month period ended June 30, 2006, the Company incurred approximately $298,000 and $582,000 in operating expenses, which was recorded against the reserve. After evaluating the afore-mentioned factors the Company re-valued the reserve to $5,847,000 at June 30, 2006 by booking an additional $156,000 and $175,100 at March 31, 2006 and June 30, 2006, respectively, as wind-down expenses.

Wind-down reserve

														January to
		January to March				April to June				January to June				December 31,
		31, 2006				30, 2006				30, 2006				2005
Accrued wind-down reserve at beginning of period		$	6,098,000				5,970,000			$	6,098,000			$	4,350,000
Less actual expenses recorded against estimated reserve during the period			(284,000	)			(298,000	)			(582,000	)			(1,079,000	)
Additional expense recorded to revise estimated reserve at period-end			156,000				175,000				331,000				2,827,000
Revised reserve at period-end			5,970,000				5,847,000				5,847,000				6,098,000
Add deferred rent at period end (See Note 3)			1,215,000				1,223,000				1,223,000				1,208,000

														January to
		January to March				April to June				January to June				December 31,
		31, 2006				30, 2006				30, 2006				2005
Total accrued wind-down expenses at period-end (current and non current portion)		$	7,185,000			$	7,070,000			$	7,070,000			$	7,306,000
Accrued wind-down expenses Current portion
Current portion		$	1,182,000			$	1,255,000			$	1,255,000			$	1,119,000
Non current portion			6,003,000				5,815,000				5,815,000				6,187,000
Total Accrued wind-down expenses		$	7,185,000			$	7,070,000			$	7,070,000			$	7,306,000

NOTE 5. GRANTS

     In September 2004, the National Institutes of Health (NIH) awarded the Company a Small Business Technology Transfer grant of $464,000 for studies in Alzheimer’s disease, consisting of approximately $308,000 for the first year and approximately $156,000 for the remainder of the grant term, September 30, 2005 through March 31, 2006. The studies have been conducted by Dr. George A. Carlson of the McLaughlin Research Institute (MRI) in Great Falls, Montana, which will receive approximately $222,000 of the total award. The remaining $242,000 has been recognized by the Company as grant revenue as and when resources were expended for this study. For the six month period ended June 30, 2006, the Company recognized approximately $38,000; the Company has now drawn down in full its share of the grant.

NOTE 6. STOCKHOLDERS’ EQUITY

     In March 2006, a warrant issued as part of the June 16, 2004 financing arrangement was exercised to purchase an aggregate of 526,400 shares of the Company’s common stock at $1.89 per share. The Company issued 526,400 shares of its common stock and received proceeds of approximately $995,000. On April 6, 2006, the Company sold 11,750,820 shares of its 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 placement under the Company’s effective shelf registration statement previously filed with the Securities and Exchange Commission. For the three and six month period ended June 30, 2006, the Company issued 43,308 and 103,932 shares from activity related to its stock option plans. The following table presents the activity of the Company’s stock option plans for the six month periods ended June 30, 2006 and 2005.

		2006								2005
						Weighted								Weighted
						Average Exercise								Average Exercise
		Options				Price				Options				Price
Outstanding at January 1			6,608,109			$	3.02				6,682,201			$	2.67
Granted			746,887			$	3.33				384,895			$	4.08
Exercised			(103,932	)		$	1.91				(194,475	)		$	1.62
Canceled			(202,844	)		$	2.18				(130,834	)		$	2.27
Outstanding at June 30			7,048,220			$	3.10				6,741,787			$	2.79
Options exercisable at June 30			4,583,297			$	2.98				3,687,643			$	2.97

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 and six month periods ended June 30, 2006 and 2005 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 to clinical testing of proposed products despite the novel and unproven nature of our technology; the risk that, even if approved, 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; failure to obtain a corporate partner or partners if needed to support the development and commercialization of our stem cell programs; the uncertainty regarding the outcome of the Phase I clinical trial and any other trials we may conduct in the future; the uncertainty regarding the validity and enforceability of issued patents; the uncertainty whether any products that may be generated in our stem cell 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; 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, 2005 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. In March 2006, we initiated a Phase I clinical trial of our human neural stem cells as a treatment for the infantile and late infantile forms of neuronal ceroid lipofuscinosis (NCL) at Doernbecher Children’s Hospital at Oregon Health & Science University (OHSU) in Portland, Oregon. NCL, which is often referred to as Batten disease, is a rare, fatal neurodegenerative disease afflicting infants and young children. We are currently enrolling patients in the trial and expect to dose the first patient later this year.

     We have not derived any revenues from the sale of any products apart from license revenue for the research use of our human neural stem cells and other 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 toxicology and other studies in preparation for submitting the Batten disease IND 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 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 support to our Research and Development programs, we will need to hire more personnel, which will lead to higher operating expenses.

     Our program in neural stem and progenitor cells 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 Batten disease mentioned above. In our liver cell program, we are engaged in evaluating our proprietary human liver engrafting cell in various in vivo assays. We plan to advance our liver 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.” This Statement 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 will reduce our reported earnings. See “Stock Based Compensation” under Note 1 for the current and potential impact on net loss and net loss per share attributable to common shareholders.

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 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 2005 was approximately 64%, varying from 49% to 80%. As of June 30, 2006, based on current information available to management, the vacancy rate is projected to be 91% for the remainder of 2006, 84% for 2007, and approximately 70% from 2008 through the end of the lease. These estimates are based on actual occupancy in 2006, expiration of subleases in 2006 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 June 30, 2006, then the reserve would have increased or decreased by approximately $230,000. Similarly, a 5% increase or decrease in the operating expenses for the facility from 2006 would have increased or decreased the reserve by approximately $124,000, and a 5% increase or decrease in the assumed average rental charge per square foot would have increased or decreased the reserve by approximately $66,000. 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, 2005 was $6,098,000. For the three and six-month period ended June 30, 2006, we recorded actual expenses against this reserve of approximately $298,000 and $582,000 respectively. Based on management’s evaluation of the factors mentioned, and particularly the projected vacancy rates described above, we adjusted the reserve to $5,847,,000 by recording an additional $331,000 for the six month period ended June 30, 2006. See Note 4 for a breakdown of these figures by quarter.

RESULTS OF OPERATIONS

Three months ended June 30, 2006 and 2005

Revenue

     Revenue in the second quarter of 2006, as compared with the same quarter in 2005, is summarized in the table below:

		2006				2005				Change from previous year
										$				%
Revenue:
Revenue from grants		$	—			$	26,092				($26,092	)			—
Revenue from licensing agreements			20,535				10,677				9,858				92	%
Total revenue		$	20,535			$	36,769				($16,234	)			(44	)%

     For the three months ended June 30, 2005, revenue from grants totaled approximately $26,000. The revenue from grants was part of a $464,000 Small Business Technology Transfer grant for studies in Alzheimer’s disease. By March 31, 2006, the Company had drawn down in full its share of the grant. Total revenue includes

licensing revenue of approximately $20,000, and $11,000 for the three-month periods ended June 30, 2006 and 2005, respectively.

Operating Expenses

     Operating expenses in the second quarter of 2006, as compared with the same quarter in 2005, is summarized in the table below:

		2006				2005				Change from previous year
										$				%
Operating expenses:
Research and development		$	3,187,513			$	1,969,096			$	1,218,417				62	%
General and administrative			1,412,513				954,542				457,971				48	%
Wind-down expenses			174,901				1,197,226				(1,022,325	)			(85	)%
Total operating expenses		$	4,774,927			$	4,120,864			$	654,063				16	%

     Research and development expenses totaled approximately $3,188,000 for the three months ended June 30, 2006, compared with approximately $1,969,000 for the same period in 2005. The increase of $1,218,000, or approximately 62%, from 2005 to 2006 was primarily attributable to expansion of our operations in cell processing and clinical development, which consisted of an increase in personnel costs of approximately $585,000 and an increase in external services of approximately $399,000, with the remainder due to increases in supplies, rent and other operating expenses. Of the approximately $585,000 increase in personnel costs, approximately $311,000 was attributable to the expensing of stock option compensation as required by the new accounting pronouncement SFAS 123R (see “Stock Based Compensation” under Note 1 above), with the balance attributable to an increase in head count. At June 30, 2006, we had 36 full-time employees working in research and development and laboratory support services as compared to 30 at June 30, 2005.

     General and administrative expenses were approximately $1,413,000 for the three months ended June 30, 2006, compared with approximately $955,000 for the same period in 2005. The increase of $458,000, or approximately 48%, from 2005 to 2006 was primarily attributable to an increase in personnel costs of approximately $332,000, of which approximately $235,000 was attributable to the expensing of stock option compensation as required by the new accounting pronouncement SFAS 123R (see “Stock Based Compensation” under Note 1 above) with the balance attributable to an increase in head count. The remaining increase in costs was attributable to an increase in costs related to auditor’s fees, investor relations, listing fees, facilities and other 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 March 31, 2006, the reserve was approximately $5,970,000. For the three months ended June 30, 2006, expenses of $298,000 net of subtenant income were recorded against this reserve (see Note 4 for a breakdown of these figures by quarter). At June 30, 2006, we re-evaluated the estimate and adjusted the reserve to approximately $5,847,000 by recording an additional $175,000 as wind-down expenses. Wind-down expenses recorded for the same period in 2005 were $1,197,000. 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 in the second quarter of 2006, as compared with the same quarter in 2005, is summarized in the table below:

		2006				2005				Change from previous year
										$				%
Other income (expense):
License and settlement agreement, net		$	103,359			$	—			$	103,359				—
Interest income			703,551				261,389				442,162				169	%
Interest expense			(38,505	)			(45,345	)			6,840				(15	)%
Other income (expense)			(3,372	)			(235	)			(3,137	)			*
Total other income (expense)		$	765,033			$	215,809			$	549,224				254	%

     For the three months ended June 30, 2006, under the terms of a license and settlement agreement with ReNeuron (see Note 2 for details), we recorded approximately $103,000 as other income upon receipt of additional shares of ReNeuron common stock due to us because of an anti-dilution provision within the agreement.

     Interest income for the three months ended June 30, 2006 and 2005 was approximately $704,000 and $261,000, respectively. The increase in interest income in 2006 was primarily attributable to higher yield on investments.

     Interest expense for the three months ended June 30, 2006 and 2005 was approximately $39,000 and $45,000 respectively. The decrease in interest expense in 2006 was attributable to lower outstanding debt and capital lease balances in 2006 compared to 2005.

     Increase in other expense in 2006 was primarily attributable to an approximate $1,000 loss on write-off of equipment and an increase of $2,000 in franchise tax paid.

Six months ended June 30, 2006 and 2005

Revenue

     Revenue for the six months ended June 30, 2006, as compared with the same period in 2005, is summarized in the table below:

		2006				2005				Change from previous year
										$				%
Revenue:
Revenue from grants		$	37,550			$	52,184				($14,634	)			(28	)%
Revenue from licensing agreements			24,535				19,906				4,629				23	%
Total revenue		$	62,085			$	72,090				($10,005	)			(14	)%

     For the six months ended June 30, 2006 and June30, 2005, revenue from grants totaled approximately $38,000 and $52,000 respectively. The revenue from grants was part of a $464,000 Small Business Technology Transfer grant for studies in Alzheimer’s disease. By March 31, 2006, we had drawn down in full our share of the grant. Total revenue includes licensing revenue of $25,000 and $20,000 for the six-month periods ended June 30, 2006 and 2005, respectively.

Operating Expenses

     Operating expenses for the six months ended June 30, 2006, as compared with the same period in 2005, is summarized in the table below:

		2006				2005				Change from previous year
										$				%
Operating expenses:
Research and development		$	5,879,394			$	3,588,029			$	2,291,365				64	%

		2006				2005				Change from previous year
										$				%
General and administrative			3,089,837				2,459,744				630,093				26	%
Wind-down expenses			331,018				1,718,200				(1,387,182	)			(81	)%
Total operating expenses		$	9,300,249			$	7,765,973			$	1,534,276				20	%

     Research and development expenses totaled approximately $5,879,000 for the six months ended June 30, 2006, compared with approximately $3,588,000 for the same period in 2005. The increase of $2,291,000, or approximately 64%, from 2005 to 2006 was primarily attributable to expansion of our operations in cell processing and clinical development, which consisted of an increase in personnel costs of approximately $1,127,000 and an increase in external services of approximately $596,000, with the remainder attributable to increases in supplies, rent and other operating expenses. Of the approximately $1,127,000 increase in personnel costs, approximately $528,000 was attributable to the expensing of stock option compensation as required by the new accounting pronouncement SFAS 123R (see “Stock Based Compensation” under Note 1 above), with the balance attributable to an increase in head count. At June 30, 2006, we had 36 full-time employees working in research and development and laboratory support services as compared to 30 at June 30, 2005.

     General and administrative expenses were approximately $3,090,000 for the six months ended June 30, 2006, compared with approximately $2,460,000 for the same period in 2005. The increase of $630,000, or approximately 26%, from 2005 to 2006 was primarily attributable to an increase in personnel costs of approximately $713,000, of which approximately $434,000 was attributable to the expensing of stock option compensation as required by the new accounting pronouncement SFAS 123R (see “Stock Based Compensation” under Note 1 above) with the balance attributable to an increase in head count. The increase in personnel costs was partially offset by a decrease of approximately $83,000 in other operating expenses mainly attributable to a decrease in recruiting fees.

     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, 2005 the reserve was approximately $6,098,000. For the six months ended June 30, 2006, expenses of $582,000 net of subtenant income were recorded against this reserve. At June 30, 2006 we re-evaluated the estimate and adjusted the reserve to approximately $5,847,000 by recording an additional $331,000 (including the March 31, 2006 adjustment of $156,000) as wind-down expenses (see Note 4 for a breakdown of these figures by quarter). Wind-down expenses recorded for the same period in 2005 were $1,197,000. 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 six months ended June 30, 2006, as compared with the same period in 2005, is summarized in the table below:

		2006				2005				Change from previous year
										$				%
Other income (expense):
License and settlement agreement, net		$	103,359			$	—			$	103,359				—
Interest income			1,043,365				489,152				554,213				113	%
Interest expense			(77,098	)			(91,756	)			14,658				(16	)%
Other income (expense)			(13,947	)			(20,632	)			6,685				(32	)%
Total other income (expense)		$	1,055,679			$	376,764			$	678,915				180	%

     For the six months ended June 30, 2006, as part of a license and settlement agreement with ReNeuron (see Note 2 for details), we recorded approximately $103,000 as other income for additional shares of ReNeuron common stock due to us because of an anti-dilution provision within the agreement.

     Interest income for the six months ended June 30, 2006 and 2005 was approximately $1,043,000 and $489,000 respectively. The increase in interest income in 2006 was primarily attributable to higher yield on investments.

     Interest expense for the six months ended June 30, 2006 and 2005 was approximately $77,000 and $92,000 respectively. The decrease in interest expense in 2006 was attributable to lower outstanding debt and capital lease balances in 2006 compared to 2005. Decrease in other expense from approximately $21,000 to $14,000 was primarily attributable to a decrease in estimated franchise tax payable in 2006.

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 $59,907,207 at June 30, 2006. 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 six month periods.

		2006				2005				Change from previous year
										$				%
Net cash used in operating activities			($7,868,586	)			($6,480,046	)			($1,388,540	)			21	%
Net cash used in investing activities			(1,179,732	)			(285,280	)			(894,452	)			314	%
Net cash provided (used) by financing activities			34,414,616				2,101,339				32,313,277				1,538	%
Increase (decrease) in cash and cash equivalents		$	25,366,298				($4,663,987	)		$	30,030,285				*

     The increase from 2005 to 2006 of approximately $1,389,000, or 21%, in cash used in operating activities was primarily attributable to an increase in personnel costs and external services, and the increase of $894,000, or 314%, in cash used in investing activities was primarily attributable to an increase in equipment costs, all resulting from the expansion of our operations in cell processing and clinical development.

     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 placement under the Company’s effective shelf registration statement previously filed with the U.S. Securities and Exchange Commission (SEC). We received total proceeds, net of offering expenses and placement agency fees, of approximately $33,200,000. UBS Investment Bank (UBS) acted as placement agent in this offering. For acting as our placement agent, UBS received fees of approximately $2,150,000 and expense reimbursement of approximately $50,000. No warrants were issued as part of this financing transaction.

Key financing arrangements in the previous three years include the following:

•

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

$1,350,000 and expense reimbursement of approximately $40,000. No warrants were issued as part of this financing transaction.

	•		On June 16, 2004, we entered into a definitive agreement with institutional and other accredited investors with respect to the private placement of approximately 13,160,000 shares of our common stock at a purchase price of $1.52 per share, for gross proceeds of approximately $20,000,000. Investors also received warrants exercisable for five years to purchase approximately 3,290,000 shares of common stock at an exercise price of $1.90 per share. Unterberg served as placement agent for the transaction. For acting as our placement agent, Unterberg received fees totaling $1,200,192, expense reimbursement of approximately $25,000 and a five year warrant to purchase 526,400 shares of our common stock at an exercise price of $1.89 per share.
	•		On December 10, 2003 we completed a $9.5 million financing transaction with Riverview Group L.L.C. (Riverview), through the sale of 5,000,000 shares of common stock at a price of $1.90 per share. The closing price of our common stock on that date was $2.00 per share.
	•		Pursuant to a Stock Purchase Agreement dated May 7, 2003, we issued 4,000,000 shares of our common stock to Riverview for $6.5 million, or $1.625 per share. On the date of the agreement, the price was above the trading price of our common stock, which closed at $1.43 per share on that date. We also agreed to issue a 2-year warrant to Riverview to purchase 1,898,000 shares of common stock at $1.50 per share. In November 2003 and May 2005, Riverview exercised this warrant, resulting in gross proceeds to us of $2,847,000.
	•		As disclosed above, 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 net proceeds to us of approximately $33,200,000.

Future Contractual Cash Obligations

     We continue to have outstanding obligations in regard to our former facilities in Lincoln, Rhode Island, and expect to pay in 2006, based on past experience and current assumptions, approximately $1,000,000 in lease payments and other operating expenses net of sub-tenant income. We have subleased a portion of these facilities and are actively seeking to sublease, assign or sell our remaining interests in these facilities. Failure to do so within a reasonable period of time will have a material adverse effect on our liquidity and capital resources.

     The following table summarizes our future contractual cash obligations (including both Rhode Island and California leases, but excluding interest income and sub-lease income):

						Payable
						July to																				Payable in
						December				Payable in				Payable in				Payable in				Payable in				2011 and
		Total				2006				2007				2008				2009				2010				beyond
Capital lease payments		$	2,177,727			$	256,088			$	332,545			$	244,531			$	244,572			$	242,560			$	857,431
Operating lease payments			16,571,954				1,557,456				3,165,162				3,469,017				3,536,843				1,767,304				3,076,172
Total contractual cash obligations		$	18,749,681			$	1,813,544			$	3,497,707			$	3,713,548			$	3,781,415			$	2,009,864			$	3,933,603

     We have incurred significant operating losses and negative cash flows since inception. We have not achieved profitability and may not be able to realize sufficient revenues to achieve or sustain profitability in the future. We do not expect to be profitable in the next several years, but rather expect to incur additional operating losses. We have limited liquidity and capital resources and must obtain significant additional capital resources 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, for general and administrative expenses and other working capital requirements. We rely on cash balances 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 have a shelf registration covering shares of our common stock up to a value of approximately $64 million that could be available for financings. The source, timing and availability of any future financing will depend principally upon market conditions, interest rates 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. Lack of necessary funds may require us to delay, scale back or eliminate some or all of our research and product development programs, planned clinical trials, and/or our capital expenditures or to license our potential products or technologies to third parties.

     With the exception of operating leases for facilities, we have not entered into any off-balance sheet financial arrangements and have not established any special purpose entities. We have not guaranteed any debts or commitments of other entities or entered into any options on non-financial assets.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     In July 2005, the Company entered into a license and settlement agreement with ReNeuron. As part of the agreement, the Company granted ReNeuron a license that allows ReNeuron to exploit their “c-mycER” conditionally immortalized adult human neural stem cell technology for therapy and other purposes. In return for the license, StemCells received a 7.5% fully-diluted equity interest in ReNeuron, subject to certain anti-dilution provisions, and a cross-license to the exclusive use of ReNeuron’s technology for certain diseases and conditions, including lysosomal storage diseases, spinal cord injury, cerebral palsy and multiple sclerosis. The agreement also provides for full settlement of any potential claims that either StemCells or ReNeuron might have had against the other in connection with any putative infringement of certain of each party’s patent rights prior to the effective date of the agreement. The agreement is Exhibit 10.71 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. An amendment to the agreement was entered on April 3, 2006, a copy of which is attached as an exhibit to this Report on Form 10-Q. On June 29, 2006, ReNeuron issued additional shares of common stock, of which StemCells was entitled to 439,071 shares because of the anti-dilution provisions within the agreement and net of shares due to Neurospheres Ltd., an Alberta corporation from which StemCells has licensed some of the patent rights that are the subject of the agreement with ReNeuron. The Company recorded approximately $103,000 as other income for the additional shares. The fair market value of the StemCells holdings in ReNeuron’s common stock as of December 31, 2005 (8,835,766 shares) and June 30, 2006 (9,274,837 shares) was approximately $3,721,000 and $2,101,000 respectively. Changes in market value as a result of changes in market price per share or the exchange rate between the US dollar and the British pound are accounted for under “other comprehensive loss” if deemed temporary, and are not recorded as “other income or loss” until the shares are disposed of and a gain or loss realized. The unrealized loss as of June 30, 2006, is approximately $1,977,000. A decline in the fair value of securities that is deemed other than temporary would be charged to earnings.

Expected

Share price at

Exchange Rate at

Market Value in

Future

Company/Stock

No. of Shares at

June 30,2006 in

June 30, 2006

USD at June 30,

Cash

Symbol

Exchange

Associated Risks

June 30, 2006

GBP (£)

1 GBP = USD

2006

Flows

ReNeuron Group plc/RENE

AIM (AIM is the London Stock Exchange’s Alternative Investment Market)

- Lower share price - Foreign currency      translation - Liquidity - Bankruptcy

9,274,837

0.1225

1.8491

$

2,100,887

(1

)

(1)

We have not formally adopted a liquidation plan for this investment. Liquidation may be necessary in the future to meet operating cash flow requirements. Although we are not legally restricted from selling the stock, the share price is subject to change and the volume traded has been very small since the stock was listed on the AIM on August 12, 2005. The performance of ReNeuron Group plc stock since its listing does not predict its future value.

     Other than the above, no significant changes have occurred in our quantitative and qualitative information about market risks disclosed in our Annual Report on Form 10-K for the fiscal year ending December 31, 2005.

ITEM 4. CONTROLS AND PROCEDURES

     In response to the requirement of the Sarbanes-Oxley Act of 2002, as of the end of the period covered by this report, our chief executive officer and chief financial officer, along with other members of management, reviewed the effectiveness of the design and operation of our disclosure controls and procedures. Such controls and procedures are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the chief executive officer and the chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Based on this evaluation, the chief executive officer and chief financial officer have concluded that the Company’s disclosure controls and procedures are effective.

     During the most recent quarter, there were no changes in internal controls over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, these controls of the Company.

PART II—OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     Geron Corporation has opposed two of our European patents that relate to neural stem cells and their uses, alleging that each patent should be revoked on multiple grounds. The oppositions were filed with the European Patent Office on December 11, 2003 (Patent No. EP-B-0594669) and February 13, 2004 (Patent No. EP-B-0669973). We filed responses to both oppositions on September 23, 2004. Both oppositions were heard in 2005, and the patents were maintained in somewhat altered form by the Opposition Division of the European Patent Office. The written opinion was issued on May 24, 2006 in the case concerning Patent No. EP-B-0669973, but the time for appeal has not yet expired. The written opinion has not yet been issued in the case concerning Patent No. EP-B-0594669; the time for appeal will begin to run in that case when the Opposition Division opinion issues. There can be no assurance that Geron will not appeal in either or both cases. While we are confident that, should either decision be appealed by Geron, the decision will be upheld, there can be no guarantee of this. If we were ultimately unsuccessful in our defense of the opposed patents, all claimed rights in the opposed patents would be lost in Europe. U.S. counterparts to these patents are part of our issued patent portfolio; they are not subject to opposition, since that procedure does not exist under U.S. patent law, but other types of proceedings may be available to third parties to contest our U.S. patents.

ITEM 1A. RISK FACTORS

     There have been no material changes from the risk factors disclosed in Part 1, Item 1A, of our Annual Report on Form 10-K for the fiscal year ending December 31, 2005.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

     None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

     None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     On June 21, 2006, we held our Annual Meeting of Shareholders. Martin McGlynn, President and CEO of StemCells, and Roger Perlmutter, M.D., Ph.D., were re-elected to the Board as Class III directors, with terms expiring in 2009. The remaining members of the Board, whose terms continued after the Annual Meeting, are Eric Bjerkholt, Ricardo Levy, Ph.D., John Schwartz, Ph.D., and Irving Weissman, M.D. The shareholders also ratified the selection of Grant Thornton LLP as StemCells’ independent public accountants for the fiscal year ending December 31, 2006 and adopted the Company’s 2006 Equity Incentive Plan.

     The number of proxies finally tabulated represented 71,617,330 of the 77,733,866 eligible shares, or 92.131 percent of eligible shares. The votes on each of the proposals were as follows:

						Authority
		For				Withheld				Against				Abstain
Election of Martin McGlynn as director			69,057,032				2,560,298
Election of Roger Perlmutter, M.D., Ph.D., as director			69,078,635				2,538,695
Ratification of Grant Thornton LLP as independent accountants for 2006			69,871,355								1,446,519				299,455
Adoption of 2006 Equity Incentive Plan			10,905,995								2,741,322				330,391

PART II

ITEM 5. OTHER INFORMATION

     There were no matters required to be disclosed in a current report on Form 8-K during the fiscal quarter covered by this report that were not so disclosed.

PART II

ITEM 6. EXHIBITS

Exhibit 31.1 — Certification of Martin McGlynn under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2 — Certification of Rodney K. B. Young under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1 — Certification of Martin McGlynn Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2 — Certification of Rodney K. B. Young Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		STEMCELLS, INC.
		(name of Registrant)
July 31, 2006		/s/ Rodney K. B. Young
		Rodney K. B. Young
		Chief Financial Officer

Exhibit Index

PART II — ITEM 6. EXHIBITS

Exhibit 31.1 — Certification of Martin McGlynn under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2 — Certification of Rodney K. B. Young under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1 — Certification of Martin McGlynn Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2 — Certification of Rodney K. B. Young Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002