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INTERNATIONAL STEM CELL CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 13, 2014

The following discussion of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes and other financial information included elsewhere herein. This information should also be read in conjunction with our audited historical consolidated financial statements which are included in our Form 10-K for the fiscal year ended December 31, 2013. The discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, expectations and intentions. Our actual results may differ significantly from management's expectations. The factors that could affect these forward looking statements are discussed in Item 1A of Part II of this report. This discussion should not be construed to imply that the results discussed herein will necessarily continue into the future, or that any expectations expressed herein will necessarily be indicative of actual operating results in the future. Such discussion represents only the best assessment by our management.

Business Overview

The Company had been in the development stage from inception through the quarter ended September 30, 2013. During the quarter ended December 31, 2013, the Company exited the development stage based on a consistently, increasing revenue trend and more significant revenue totals generated from our two commercial businesses. The Company has generated product revenues from our two commercial businesses of $1.6 million and $1.3 million for the three months ended March 31, 2014 and 2013, respectively. The Company currently has no revenue generated from its principal operations in therapeutic and clinical product development through research and development efforts.

Our products are based on multi-decade experience with human cell culture and a proprietary type of pluripotent stem cells, human parthenogenetic stem cells ("hpSCs"). Our hpSCs are comparable to human embryonic stem cells ("hESCs") in that they have the potential to be differentiated into many different cells in the human body. However, the derivation of hpSCs does not require the use of fertilized eggs or the destruction of viable human embryos and also offers the potential for the creation of immune-matched cells and tissues that are less likely to be rejected following transplantation. ISCO's collection of hpSCs, known as UniStemCell™, currently consists of fifteen stem cell lines. We have facilities and manufacturing protocols that comply with the requirements of Good Manufacturing Practice (GMP) standards as promulgated by the U.S. Code of Federal Regulations and enforced by the U.S. Food and Drug Administration ("FDA").

Market Opportunity and Growth Strategy

Therapeutic Market - Clinical Applications of hpSCs for Disease Treatments. With respect to therapeutic research and product candidates, we focus on applications where cell and tissue therapy is already proven but where there is an insufficient supply of safe and functional cells or tissue. We believe that the most promising potential clinical applications of our technology are: 1) Parkinson's disease ("PD"); 2) metabolic/liver diseases; and 3) corneal blindness. Using our proprietary technologies and know-how, we are creating neural stem cells from hpSCs as a potential treatment of PD, liver cells from hpSCs that may be able to treat a variety of hepatic and metabolic liver diseases and corneal like structures from hpSCs that may be suitable for cornea transplantation and corneal healing in humans.

Cosmeceutical Market - Skin Care Products. Our wholly-owned subsidiary Lifeline Skin Care, Inc. ("LSC") develops, manufactures and markets cosmetic skin care products using an extract derived from our pluripotent stem cells. These proprietary products include a Defensive Day Serum, Recovery Night Serum and Firming Eye Complex, all of which include our patented stem cell extract. LSC's products are regulated as cosmetics. LSC's products are sold nationally and internationally through a branded website, through professional channels (including dermatologists, plastic surgeons, medical, day and resort spas) and distributors. Domestically, we plan to increase distribution of our products by increasing brand awareness and resonance through advertising, sales promotion and public relations. Internationally, we are increasing distribution and sales through agreements with specialty distributors in both Latin America and Asia.

Biomedical Market - Primary Human Cell Research Products. Our wholly-owned subsidiary Lifeline Cell Technology, LLC ("LCT") develops, manufactures and commercializes over 130 human cell culture products, including frozen human "primary" cells and the reagents (called "media") needed to grow, maintain and differentiate the cells, in order to address this significant market opportunity. LCT's scientists have used a technology called basal medium optimization to systematically produce optimized products designed to culture specific human cell types and to elicit specific cellular behaviors. These techniques also produce products that do not contain non-human animal proteins, a feature desirable to the research and therapeutic markets. Each LCT cell product is quality tested for the expression of specific markers (to assure the cells are the correct type), proliferation rate, viability, morphology and absence of pathogens. Each cell system also contains associated donor information and all informed consent requirements are strictly followed. LCT's research products are marketed and sold by its internal sales force, OEM partners and LCT brand distributors in Europe and Asia.

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We were originally incorporated in Delaware on June 7, 2005 as BTHC III, Inc. to effect the reincorporation of BTHC III, LLC, a Texas limited liability company, mandated by a plan of reorganization. On December 28, 2006 pursuant to a Share Exchange Agreement, BTHC III, Inc. issued 33,156,502 shares of common stock, representing approximately 93.7% of the common stock outstanding immediately after the transaction, to the shareholders of International Stem Cell Corporation, a California corporation ("ISC California"), in exchange for all outstanding stock of ISC California. This transaction is being accounted for as a "reverse merger" for accounting purposes.

ISC California was incorporated in California in June 2006 for the purpose of restructuring the business of LCT, which was organized in California in August 2001. As a result of the restructuring, LCT became wholly-owned by ISC California, which in turn is wholly-owned by us. LSC was formed in the State of California on June 5, 2009 and is a wholly-owned subsidiary of ISC California.

Results of Operations

Revenues

Revenue for the three months ended March 31, 2014, totaled $1.65 million, compared to $1.29 million for the three months ended March 31, 2013. LCT contributed $846,000 or 51% of total revenue for the three months ended March 31, 2014, compared to $635,000 or 49% for the three months ended March 31, 2013. The increase of $211,000 or 33% in LCT's revenue for 2014 was driven primarily by higher sales to OEM customers and international distributors. LSC's revenue of $803,000 for the three months ended March 31, 2014 accounted for 49% of total revenue, compared to $650,000 or 51% of total revenue for the three months ended March 31, 2013. The increase of $153,000 or 24% in LSC's revenue is due to our strategic efforts to expand and diversify sources of revenue across all channels. We saw the greatest sales growth in website sales and professional accounts.

Cost of sales

Cost of sales for the three months ended March 31, 2014 was $439,000 or 27% of revenue, compared to $334,000 or 26% of revenue for the three months ended March 31, 2013. The increase in cost of sales as a percentage of revenue is partially attributable to a 4% increase in costs for LCT partially offset by a 1% decrease in costs for LSC. LCT's cost of sales for the three months ended March 31, 2014 was $358,000 or 45% of sales, compared to $263,000 or 41% of sales for the three months ended March 31, 2013. The increase in cost of sales for LCT is primarily due to a shift in sales mix from higher margin products to lower margin products for the three months ended March 31, 2014, compared to the corresponding period in 2013. LSC's cost of sales was $81,000 or 10% of sales for the three months ended March 31, 2014, compared to $72,000 or 11% of sales for the three months ended March 31, 2013. The decrease in cost of sales for LSC is primarily attributable to continued improvements in the manufacturing and supply chain management for LSC's products.

Cost of sales reflects direct costs including salaries and benefits related to manufacturing, third party manufacturing costs, materials, general laboratory supplies and an allocation of overhead. We aim to continue refining our manufacturing processes and supply chain management to further improve the cost of sales as a percentage of revenue for both LCT and LSC.

Research and Development ("R&D")

Research and development expenses were $958,000 for the three months ended March 31, 2014, compared to $721,000 for the same period in 2013. The increase of $237,000 or 33% is primarily due to increased stem cell line research and clinical testing expenses of $225,000, employee-related spending of $19,000, and laboratory supplies of $4,000, offset by a decrease in stock-based compensation expense of $14,000.

R&D is focused on the development of treatments for Parkinson's disease (PD), metabolic liver diseases (such as Crigler-Najjar syndrome, (CNS) and Alpha 1-antitrypsin deficiency (A1AD)), diseases of the eye and the creation of new cGMP grade human parthenogenetic stem cell lines. These projects are long-term investments that involve developing both new stem cell lines and new differentiation techniques that can provide higher purity populations of functional cells. We do not expect these projects to provide near-term revenue, although we have published milestones including the release of preclinical rodent and non-human primate (NHP) PD study data in the first quarter of 2013. Building on the NHP PD pilot study, in May 2013 we initiated a large-scale pharmacology/toxicology primate study, which is intended to form a critical component of our Investigational New Drug (IND) application that we anticipate filing in late 2014 or early 2015. We anticipate increased R&D expenditures in 2014 and 2015 as a result of this large-scale primate study and the added costs associated with the preparation of the IND application.

Research and development expenses are expensed as they are incurred, and are accounted for on a project by project basis. However much of our research has potential applicability to each of our projects.

Selling and Marketing Expense

Selling and marketing expenses for the three months ended March 31, 2014 were $669,000, reflecting an increase of $158,000 or 31%, as compared to $511,000 for the three months ended March 31, 2013. The increase in spending was primarily due to increased employee-related spending of $69,000, increased consulting expenses of $64,000, and increased expenses for marketing materials, samples and printing of $54,000. As a result of increased sales there was higher commission expense of $34,000. The increase was partially offset by a reduction of $76,000 in advertising expense.

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We continued to intensify our marketing efforts by refining our sales and marketing strategies, and expanding our sales channels and strengthening our operations to achieve target sales goals.

General and Administrative Expenses

General and administrative expenses for the three months ended March 31, 2014 were $1.65 million, reflecting an increase of $216,000 or 15%, compared to $1.43 million for the same period in 2013. The increase is primarily attributable to an increase in consulting fees for investor relations of $162,000, increased professional accounting fees and corporate governance of $73,000, increased temporary labor of $42,000, increased employee-related spending of $27,000, and increased impairment of intangible assets of $17,000. The increase was partially offset by a decrease in stock-based compensation expense of $65,000, by lower board of director fees of $8,000, and a decrease in stock-based compensation for services provided by consultants of $32,000.

Other Income/Expense

Other income was $630,000 for the three months ended March 31, 2014, primarily due to recognizing income of $623,000 for the change in fair value of the warrant liability from our registered stock and warrant offering completed in July 2013, due to the subsequent revaluation of the warrant liability at each balance sheet date. In 2013, we recorded other income of $1,000.

Liquidity and Capital Resources

As of March 31, 2014, our cash and cash equivalents totaled $991,000, compared to $2.2 million as of December 31, 2013. At March 31, 2014, we had a working capital deficit of $2.5 million, compared to a $2.4 million deficit as of December 31, 2013. The working capital deficit is primarily due to the fair value of warrant liability of $4.3 million and $4.9 million at March 31, 2014 and December 31, 2013, respectively, resulting from our registered stock and warrant offering completed in July 2013.

Operating Cash Flows

Net cash used in operating activities was $2.03 million for the three months ended March 31, 2014, compared to $1.85 million for the corresponding period in 2013. The primary factor contributing to the variability in the reported cash flow amounts relates to the net loss after non-cash adjustments totaling $1.5 million in the three months ended March 31, 2014, compared to $1.1 million for the same period in 2013.

Investing Cash Flows

Net cash used in investing activities was $156,000 for the three months ended March 31, 2014, compared to $168,000 in the same period in 2013. The decrease was the result of lower payments for patent licenses and trademarks of $25,000 offset by capital expenditure spending of $13,000.

Financing Cash Flows

Net cash provided by financing activities was $935,000 for the three months ended March 31, 2014, compared to $3.27 million in the same period in 2013. The net proceeds of $935,000 received in 2014 was attributable to the issuance of 5.2 million shares of common stock for approximately $1.1 million, net of stock issuance costs of $169,000 under the purchase agreement with Lincoln Park Capital, LLC ("Lincoln Park"), which we entered into in December 2013. Under our purchase agreement with Lincoln Park, we may sell from time to time up to an aggregate of $10.25 million of shares of common stock to Lincoln Park through January 2017.

During the first quarter of 2013, we issued a total of 1.2 million shares of common stock on various dates from January 1, 2013 through March 15, 2013, raising $264,000 from stock purchases by Aspire Capital, issued a total of 10.1 million shares of common stock on January 22, 2013 for proceeds of $2,025,000 from Dr. Andrey Semechkin, our Co-Chairman and Chief Executive Officer and Dr. Simon Craw, our Executive Vice President Business Development, and issued 5 million shares of common stock on March 12, 2013 for gross proceeds of $1,000,000 from a stock purchase by Dr. Andrey Semechkin and by other investors with long-standing relationships with and who closely follow the Company. For further discussion of these transactions, see Note 6, Capital Stock, Common Stock transactions to our condensed consolidated financial statements.

Management is currently evaluating various financing sources and options to raise working capital to help fund our current research and development programs and operations. We will need to obtain significant additional capital from sources including equity and/or debt financings, license arrangements, grants and/or collaborative research arrangements to sustain our operations and develop products. Thereafter, we will need to raise additional working capital. Unless we obtain additional financing, we do not have sufficient cash on hand to operate for 12 months from the condensed consolidated balance sheet date. The timing and degree of any future capital requirements will depend on many factors, including:

• the accuracy of the assumptions underlying our estimates for capital needs in 2014 and beyond; 30



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Table of Contents • the extent that revenues from sales of LSC and LCT products cover the related costs and provide capital; • scientific progress in our research and development programs; • the magnitude and scope of our research and development programs and our ability to establish, enforce and maintain strategic arrangements for research, development, clinical testing, manufacturing and marketing; • our progress with preclinical development and clinical trials; • the time and costs involved in obtaining regulatory approvals; • the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing patent claims; and • the number and type of product candidates that we pursue.



Additional financing through strategic collaborations, public or private equity financings or other financing sources may not be available on acceptable terms, or at all. Additional equity financing could result in significant dilution to our stockholders. Additional debt financing may be expensive and require us to pledge all or a substantial portion of our assets. Further, if additional funds are obtained through arrangements with collaborative partners, these arrangements may require us to relinquish rights to some of our technologies, product candidates or products that we would otherwise seek to develop and commercialize on our own. If sufficient capital is not available, we may be required to delay, reduce the scope of or eliminate one or more of our product initiatives.

During the quarter ended December 31, 2013, we exited the development stage based on a consistently, increasing revenue trend and more significant revenue totals generated from our two commercial businesses. We had been in the development stage from inception through to the quarter ended September 30, 2013, and have accumulated losses from inception through the quarter ended March 31, 2014, and expect to incur additional losses in the near future. We currently have no revenue generated from our principal operations in therapeutic and clinical product development through research and development efforts. We need to raise additional working capital. The timing and degree of any future capital requirements will depend on many factors. For the quarter ended March 31, 2014 our average burn rate was approximately $677,000 per month, excluding capital expenditures and patent costs averaging $52,000 per month. There can be no assurance that we will be successful in maintaining our normal operating cash flow and that the timing of our capital expenditures will result in cash flow sufficient to sustain our operations through 2014. Based on the factors above, there is substantial doubt about our ability to continue as a going concern. The condensed consolidated financial statements were prepared assuming that we will continue to operate as a going concern. The condensed consolidated 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. Management's plans in regard to these matters are focused on managing our cash flow, the proper timing of our capital expenditures, and raising additional capital or financing in the future.

We do not currently have any obligations for milestone payments under any of our licensed patents other than the minimum license fee of $75,000 annually, payable in two installments per year to Advanced Cell Technology pursuant to the amended UMass IP license agreement. No licenses are terminable at will by the licensor. For further discussion of our patents, see Note 4 to our condensed consolidated financial statements.

From April 1, 2014 through to May 2, 2014, we sold a total of 2.2 million shares of common stock for an aggregate of approximately $360,000, as discussed in Note 12, Subsequent Events, to our condensed consolidated financial statements.

Off-Balance Sheet Arrangements

As of March 31, 2014, we did not have any off-balance sheet arrangements.

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