LSTA

Business Context and Reporting Period

This Form 10-K covers the fiscal year ended December 31, 2010, for NeoStem, Inc. (referred to as NeoStem). The company operates as an international biopharmaceutical firm with three reportable segments: Cell Therapy – United States, Regenerative Medicine – China, and Pharmaceutical Manufacturing – China. A significant strategic development occurred shortly after the reporting period: on January 19, 2011, NeoStem completed the acquisition of Progenitor Cell Therapy, LLC (PCT), a cell therapy manufacturing and development company, marking a transition from a service provider to a therapeutics company.

Key Financial Metrics

Revenue Composition: Approximately 99.6% of 2010 revenue ($69.6 million) was derived from the Pharmaceutical Manufacturing segment (Erye). The Cell Therapy and Regenerative Medicine segments contributed a combined $0.24 million.

Debt and Liquidity: The company held $3.0 million in bank loans and $9.6 million in notes payable (primarily related to Erye's operations). Total debt obligations and commitments were significant, including a $10 million Series E Preferred Stock issuance in November 2010 with mandatory monthly redemption payments.

Material Changes vs. Prior Period

• Revenue Growth: Total revenue increased by 504% year-over-year, driven almost entirely by the inclusion of Erye (Pharmaceutical Manufacturing – China) for a full fiscal year in 2010, compared to only two months in 2009.
• Operating Expenses: Operating expenses increased by 41% to $39.0 million. This was primarily due to Erye's full-year inclusion, increased marketing for the Cell Therapy segment, and amortization of intangible assets from the Erye merger.
• Share-Based Compensation: Charges related to equity and equity-linked instruments decreased by $4.9 million to $7.4 million, largely due to the absence of non-recurring expenses tied to the Erye Merger completion in 2009.
• Goodwill Impairment: The company recorded a $0.56 million goodwill impairment charge related to the Cell Therapy – United States segment due to lower-than-expected growth and rejected patent applications.
• Facility Relocation: Erye began transferring operations to a new manufacturing facility in 2010, incurring a $1.35 million charge for asset disposal and significant capital expenditures ($14.0 million in 2010).

Guidance, Outlook, and Risks

Outlook and Strategy: Management views the PCT acquisition as foundational to capturing the "paradigm shift to cell therapy." The company intends to leverage PCT's cGMP manufacturing capabilities to transition from a service provider to a therapeutics company. In China, the company is expanding its stem cell banking and therapy network, with pricing approvals for orthopedic treatments at Wendeng Hospital. Erye is expected to continue growing as it completes its facility relocation and benefits from China's healthcare reform.

Liquidity Needs: The company expects to continue incurring operating losses and negative cash flow. It anticipates a need for additional financing to fund operations, the PCT integration, and R&D. Cash flow from Erye is restricted; under the Joint Venture Agreement, only 6% of Erye's net profit is distributed to NeoStem for operating expenses, while 90% is reinvested into Erye's facility construction.

Key Risks:

• Internal Controls: The company identified a material weakness in internal control over financial reporting related to the accounting for share-based payment arrangements.
• China Operations: Risks include regulatory changes, currency exchange restrictions, and the use of Variable Interest Entities (VIEs) to conduct stem cell business due to foreign investment restrictions.
• Regulatory: The cell therapy industry is highly regulated by the FDA and Chinese authorities. Delays in approvals or changes in regulations could materially impact the business.
• Preferred Stock: The Series E Preferred Stock carries mandatory redemption payments and repurchase rights triggered by specific events (e.g., change in control, failure to list), which could strain liquidity.

Investor Verification Checklist

• Internal Control Remediation: Verify the progress of remediation plans for the material weakness in share-based compensation accounting.
• PCT Integration: Assess the financial impact and operational integration of the Progenitor Cell Therapy (PCT) acquisition completed in January 2011.
• Erye Cash Flow Restrictions: Confirm the ability to access cash from Erye given the Joint Venture Agreement's requirement to reinvest 90% of profits into facility construction.
• Series E Preferred Stock Obligations: Review the terms of the Series E Preferred Stock, specifically the mandatory redemption schedule and potential cash outflows if equity conditions are not met.
• China Regulatory Environment: Monitor changes in Chinese regulations regarding stem cell therapies and foreign investment structures (VIEs).
• Capital Requirements: Evaluate the company's ability to raise additional capital given its history of operating losses and the dilutive nature of recent financing.