LSTA

Business Context and Reporting Period

This Form 10-K covers the fiscal year ended December 31, 2009, for NeoStem, Inc. (also referred to as NeoStem). During this period, the company transitioned from a U.S.-based adult stem cell service provider to a multi-dimensional international biopharmaceutical company. This transformation was driven by the October 30, 2009, acquisition of a 51% controlling interest in Suzhou Erye Pharmaceuticals Company Ltd. (Erye), a Chinese manufacturer of antibiotics. The company now operates three distinct business units: U.S. adult stem cells, China adult stem cells, and China pharmaceuticals.

Key Financial Metrics

Revenue Composition (2009): Approximately 98% of revenue ($11.35 million) was derived from Erye's pharmaceutical product sales (antibiotics and intermediates) for the two months following the acquisition. Stem cell revenues totaled $172,078.

Debt and Liquidity: The company held $2,197,500 in bank loans and $9,793,712 in notes payable (primarily related to Erye's operations). Cash flow from operating activities was negative $(8,648,022), while financing activities provided $17,067,704, largely due to private placements and the acquisition.

Material Changes vs. Prior Period

• Revenue Surge: Revenue increased from $83,541 in 2008 to $11.57 million in 2009, a direct result of consolidating Erye's financials for the two-month period post-acquisition.
• Increased Operating Expenses: Operating expenses rose 199% to $27.78 million. This was driven by $12.32 million in non-cash share-based compensation charges (including $6.26 million related to the Merger), increased R&D spending ($4.32 million vs. $0.79 million), and costs associated with establishing operations in China.
• Goodwill Recognition: Goodwill increased from $558,169 to $29.86 million due to the acquisition of China Biopharmaceuticals Holdings, Inc. (CBH).
• Capital Structure: The company issued Series C Convertible Preferred Stock and converted Series D Preferred Stock to common stock in connection with the Merger. Significant equity issuances were made to consultants and employees.

Guidance, Outlook, and Risks

Outlook and Capital Needs: Management expects to continue incurring operating losses and negative cash flow in the near term. The company requires substantial additional capital to fund R&D, marketing, and the completion of Erye's new $30 million production facility (of which $16 million was paid by year-end). Funding sources include a February 2010 public offering (raising ~$7.1 million), warrant exercises, and reinvested earnings from Erye.

Strategic Initiatives:

• Erye Relocation: Erye is relocating to a new facility in Suzhou, expected to be fully operational by 2011, to increase manufacturing capacity.
• China Stem Cell Expansion: The company is constructing a Beijing facility for stem cell processing and storage, with a projected cost of $3 million, commencing in April 2010.
• Medical Tourism: Plans to offer stem cell therapies in China to international patients seeking treatments unavailable in their home countries.

Material Risks:

• Internal Controls: The company identified material weaknesses in internal control over financial reporting inherited from CBH, specifically regarding insufficient U.S. GAAP qualified personnel in China and a lack of an internal audit system. Management concluded controls were not effective as of December 31, 2009.
• Regulatory Uncertainty: Significant risks exist regarding PRC regulations on foreign investment in stem cell research (requiring Variable Interest Entity structures), human genetic resources, and pharmaceutical pricing.
• Liquidity: The company has a history of losses and may be unable to raise additional capital on acceptable terms, which could impair its ability to continue as a going concern.
• Dividend Restrictions: Under the Joint Venture Agreement, only 6% of Erye's net profit is distributed to NeoStem for operating expenses; the remainder is reinvested in Erye's facility construction.

Key Facts for Investor Verification

• Acquisition Integration: Verify the timeline and cost overruns associated with Erye's relocation to the new $30 million facility and the impact on cash flow.
• Internal Control Remediation: Monitor the progress of remediation plans for the material weaknesses in internal controls, particularly the deployment of U.S. GAAP qualified personnel to China.
• Capital Sufficiency: Assess whether the $7.1 million raised in February 2010 and subsequent warrant exercises are sufficient to fund the $14 million remaining for Erye's facility and the $3 million Beijing stem cell facility.
• Revenue Sustainability: Confirm that Erye's revenue growth is sustainable beyond the initial two-month consolidation period and is not solely dependent on government pricing policies in China.
• Regulatory Compliance: Verify the status of regulatory approvals for the Variable Interest Entity (VIE) structure used for China stem cell operations and the potential for PRC government intervention.