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OCERA THERAPEUTICS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 13, 2014

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013. This discussion contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under "Risk Factors" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2013, our actual results may differ materially from those anticipated in these forward-looking statements. Overview We are a clinical stage biopharmaceutical company focused on the development and commercialization of a clinical candidate, OCR-002 (ornithine phenylacetate), for the treatment of hepatic encephalopathy, or HE. HE is a serious complication of liver failure marked by mental changes including confusion, impaired motor skills, disorientation in time and space, and, in its more severe form, stupor, coma and even death. Common causes of liver malfunction leading to HE include alcoholism, viral hepatitis and auto-immune diseases, as well as obesity, Type II diabetes, and acetaminophen overdose. OCR-002 is an ammonia scavenger and has been granted orphan drug designation and Fast Track status by the U.S. Food and Drug Administration, or FDA, for the treatment of hyperammonemia and resultant hepatic encephalopathy, or HE, in patients with acute liver failure and acute on chronic liver disease. Our strategy is to focus clinical development activities on the intravenous form of OCR-002 to treat acute HE in hospitalized patients while continuing formulation work on the oral form of OCR-002 which would focus on acute-to-chronic care of HE patients. OCR-002 Development We are now conducting a randomized, placebo-controlled double blind Phase 2b clinical trial to evaluate the efficacy of intravenous administration of OCR-002 in reducing the severity of HE symptoms among hospitalized HE patients. We expect to complete trial enrollment in mid-2015. In addition, there are two investigator-sponsored Phase 2a clinical trials underway, one in Spain studying ammonia levels in a double blind trial of patients with upper gastrointestinal bleeding and the other an open label NIH-sponsored trial of the safety of OCR-002 in patients with hyperammonemia and HE due to acute liver failure or injury. "Stop HE" Phase 2b Trial We are currently conducting a randomized, placebo-controlled double blind Phase 2b clinical trial in 140 patients to evaluate the efficacy of intravenously administered OCR-002 in reducing the severity of HE symptoms among hospitalized HE patients. We commenced this trial in the fourth quarter of 2013 and enrolled our first patient in January 2014. We plan to conduct the trial at approximately 100 sites in the United States and Europe. To increase the pace of enrollment, we amended our trial protocol in March 2014 to broaden the eligible patient selection criteria. In April 2014, we further amended the protocol to increase patient dosage to 20 grams per day based on our review of preliminary pharmacokinetic data from the two ongoing Phase 2a trials discussed below. This increased dosage level remains below the maximum tolerated dose of 40 grams per day observed in our Phase 1 trial. The primary efficacy endpoint of this trial is time to clinically meaningful improvement in HE symptoms. Secondary endpoints include severity of HE, ammonia reduction, length of hospital stay and time in the intensive care unit, among others. We expect to complete trial enrollment in mid-2015 and expect to announce the results from this study in the second half of 2015. Investigator Sponsored Phase 2a Trials In addition, there are two investigator-sponsored Phase 2a trials of OCR-002 underway. One of these trials is being conducted in Spain, to assess ammonia lowering in patients with upper gastrointestinal bleeding. The first phase of this trial was conducted on an open label basis and has been completed. The investigators observed a rapid decline in ammonia in the 10 patients who received OCR-002 at 10 grams per day in addition to the standard of care. The second phase of the trial is a double-blind placebo controlled study of 38 patients. The second trial, sponsored by National Institutes of Health, or NIH, is a pilot open label dose ranging study of up to 10 grams per day, assessing safety and pharmacokinetics of OCR-002 in patients with acute liver failure/injury and hyperammonemia. In the NIH trial, 13 of 14 evaluable patients have recovered and one patient died. Phase 1 Pharmacokinetic Trial 16 -------------------------------------------------------------------------------- We completed Phase 1 pharmacokinetic and safety trials of OCR-002 in a parallel ascending dose clinical trial of 48 healthy volunteers and 43 stable cirrhotic patients. No serious adverse events, deaths or discontinuations were reported. The most common dose-related toxicities included dizziness, headache, nausea and blurred vision. Through this trial, we established the pharmacokinetic profile of OCR-002 and identified safety margins. Pre-clinical Studies Preclinical studies of OCR-002 were performed in two animal models, rat with bile duct ligation as a model for chronic liver disease and pig with hepatic artery ligation as a model for acute liver failure. In the rat model, OCR-002 significantly reduced arterial ammonia, and in the pig model, OCR-002 significantly reduced arterial ammonia, brain ammonia and intracranial pressure. Critical Accounting Policies and Estimates Our management's discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments related to each of our critical accounting areas. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We discussed accounting policies and assumptions that involve a higher degree of judgment and complexity within our Annual Report on Form 10-K for the year ended December 31, 2013. Other than those discussed below, there have been no material changes to our critical accounting policies and estimates as disclosed in our Annual Report on Form 10-K. Merger with Tranzyme, Inc. On July 15, 2013, Terrapin Acquisition, Inc., a Delaware corporation ("Merger Sub") and wholly owned subsidiary of Tranzyme, Inc., a Delaware corporation ("Tranzyme"), completed its merger (the "Merger") with and into Ocera Therapeutics, Inc., a private Delaware corporation ("Private Ocera"). Private Ocera is considered the acquiring company in the Merger for accounting purposes. In connection with the Merger, the combined company changed its name to Ocera Therapeutics, Inc. and the name of Private Ocera was changed to Ocera Subsidiary, Inc. Discontinued Operations The results of operations of the components to be disposed of, related restructuring costs and gain on disposal of assets have been classified as net income (loss) from discontinued operations from their acquisition on July 15, 2013 through June 30, 2014. The assets and liabilities of Tranzyme Pharma have been classified as assets and liabilities, respectively, of discontinued operations. 17 -------------------------------------------------------------------------------- Results of Operations Three and Six Months Ended June 30, 2014 and 2013 (in thousands): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 Change 2014 2013 Change Revenue: Royalty revenue $ 33 $ - $ 33$ 78 $ - $ 78 Total Revenue 33 - 33 78 - 78 Operating expenses: Research and development 4,826 365 4,461 7,292 434 6,858 General and administrative 2,421 1,652 769 5,154 2,223 2,931 Amortization of intangibles 41 - 41 82 - 82 Total operating expenses 7,288 2,017 5,271 12,528 2,657 9,871 Total other income (expense), net 12 (70 ) 82 25 (161 ) 186 Net loss from continuing operations (7,243 ) (2,087 ) (5,156 ) (12,425 ) (2,818 ) (9,607 ) Net income from discontinued operations 20 - 20 1,137 - 1,137 Net loss (7,223 ) (2,087 ) (5,136 ) (11,288 ) (2,818 ) (8,470 ) Unrealized gain on investments (1 ) - (1 ) 1 - 1 Comprehensive loss $ (7,224 )$ (2,087 )$ (5,137 )$ (11,287 )$ (2,818 )$ (8,469 ) Revenues Revenue for the three and six months ended June 30, 2014 was $33,000 and $78,000, respectively, consisting of royalty revenue from a licensing agreement. No revenue was reported in the three and six months ended June 30, 2013 as the license agreement was acquired in connection with our Merger in July 2013. Costs and Expenses Research and Development Expenses Our research and development expenses increased by $4.5 million for the three months ended June 30, 2014 compared to the three months ended June 30, 2013. This increase was due primarily to costs associated with our clinical development of OCR-002, an increase in headcount related to the Merger and an increase in stock compensation expense. Our research and development expenses increased by $6.9 million for the six months ended June 30, 2014 compared to the six months ended June 30, 2013. This increase was also due primarily to costs associated with our clinical development of OCR-002, an increase in headcount related to the Merger and an increase in stock compensation expense. Our expenses related to clinical trials are based on estimates of patient enrollment and related expenses at clinical investigator sites as well as estimates for the services received and efforts expended pursuant to contracts with multiple research institutions and contract research organizations that may be used to conduct and manage clinical trials on our behalf. We generally accrue expenses related to clinical trials based on contracted amounts applied to the level of patient enrollment and activity. If timelines or contracts are modified based upon changes in the clinical trial protocol or scope of work to be performed, we modify our estimates of accrued expenses accordingly on a prospective basis. Due to the significant risks and uncertainties inherent in the clinical development and regulatory approval processes, we cannot reasonably estimate the cost to complete projects and development timelines for their completion. Enrollment in clinical trials might be delayed or occur faster than anticipated for reasons beyond our control, requiring additional cost and time or accelerating spending. Results from clinical trials might not be favorable, or might require us to perform additional unplanned clinical trials, accelerating spending, requiring additional cost and time, or resulting in termination of the project. Regulatory reviews can also be delayed. Process development and manufacturing scale-up for 18 -------------------------------------------------------------------------------- production of clinical and commercial product supplies might take longer and cost more than our forecasts. As a result, clinical development and regulatory programs are subject to risks and changes that might significantly impact cost projections and timelines. We will need to raise additional money to advance development and commercialization of OCR-002 which may include entering into strategic alliances. General and Administrative Expenses Our general and administrative expenses increased by $0.8 million for the three months ended June 30, 2014 compared to the three months ended June 30, 2013. The increase was due primarily to an increase in legal and accounting fees and other expenses associated with our corporate governance including directors and officer insurance and fees, an increase in headcount and stock compensation expense. Partially offsetting these increases was a decrease in costs related to preparatory activities associated with the Merger, which was consummated in July 2013. Our general and administrative expenses increased by $2.9 million for the six months ended June 30, 2014 compared to the six months ended June 30, 2013. The increase was due primarily to an increase in legal and accounting fees and other expenses associated with our corporate governance including directors and officer insurance and fees, an increase in stock compensation expense, headcount and rent. Partially offsetting these increases was a decrease in costs related to preparatory activities associated with the Merger, which was consummated in July 2013. We expect that our general and administrative expenses may increase in the future as we expand our operating activities, maintain and expand our patent portfolio, and incur additional costs associated with public company support including legal and accounting fees and director and officers' liability insurance. Amortization of intangibles For the three and six months ended June 30, 2014, we recognized $41,000 and $82,000, respectively, for amortization of intangibles. No amortization was recorded in the three and six months ended June 30, 2013 as the intangible assets were acquired in the Merger in July 2013. Other Income (Expense), Net For the three and six months ended June 30, 2014, we recognized $12,000 and $25,000, respectively, of other income (expense), net, which was attributable to interest income earned on our investment portfolio. For the three and six months ended June 30, 2013, we recognized $(70,000) and $(161,000), respectively, of other income (expense), net, which primarily consisted of interest accrued and amortization of debt issuance costs on convertible notes payable and change in fair value of warrant liability. No interest and other expense was recorded in the three and six months ended June 30, 2014 due to the conversion of convertible notes payable to common stock as a result of the Merger in July 2013. Net income from discontinued operations During the six months ended June 30, 2014, we completed our obligations under the Technology Transfer and License Agreement with Genentech, Inc. and F. Hoffman-La Roche, Ltd., and recognized a gain on disposal of assets of $1.1 million within discontinued operations. During the three months ended June 30, 2014, we recognized $20,000 income due to the true-up of certain Canadian tax liabilities related to the subsidiary operations of Tranzyme Pharma. 19 --------------------------------------------------------------------------------



The following table summarizes the results of discontinued operations for the quarter ended June 30, 2014 (in thousands):

Three Months Ended



Six Months Ended

June 30, 2014 June 30, 2014 Proceeds recognized pursuant to Technology Transfer and License Agreement $ - $ 4,000



Less carrying value of assets sold:

Intangible assets - (2,053 ) Property and equipment - (356 ) Goodwill - (442 ) Net gain on disposal of assets - 1,149 Other income (expenses) of discontinued operations 20 (6 ) Recognition of accumulated translation adjustments upon deconsolidation of subsidiary - (6 ) Net income from discontinued operations $ 20 $ 1,137 Liquidity and Capital Resources Cash Flows The following table summarizes our cash flows for the six months ended June 30, 2014 and 2013 (in thousands): Six Months Ended June 30, 2014 2013 Cash flow from: Continuing operating activities $ (10,017 )$ (1,591 ) Discontinued operating activities (407 ) - Continuing investing activities 5,835 (2 ) Discontinued investing activities 1,165 - Continuing financing activities 398 20



Net decrease in cash and cash equivalents $ (3,026 )$ (1,573 )

Comparison of the Six Months Ended June 30, 2014 and 2013 The primary use of cash in continuing operating activities for the six months ended June 30, 2014 was the result of our net loss from continuing operations of $12.4 million plus changes in working capital of $0.2 million. These changes were partially offset by non-cash charges of $2.6 million including depreciation expense, share-based compensation expense and the amortization of intangible assets acquired in the Merger. Cash used in continuing operating activities for the six months ended June 30, 2013 was related primarily to our net loss of $2.8 million, partially offset by non-cash charges of $0.2 million including depreciation expense, share-based compensation expense and non-cash debt and investment related expenses and changes in working capital of $1.0 million. Cash used in discontinued operating activities for the six months ended June 30, 2014 was due primarily to payment of accrued liabilities of discontinued operations. Cash provided by continuing investing activities for the six months ended June 30, 2014 related to $15.0 million of investment maturities, partially offset by purchases of short-term and long-term investments of $9.2 million. For the six months ended June 30, 2013, net cash used by continuing investing activities related to purchases of property and equipment. Cash provided by discontinued operations represents cash proceeds related to the Technology Transfer and License Agreement with the Genentech and Roche Group for rights to the MATCH discovery platform and collection of other receivables. Net cash provided by continuing financing activities for the six months ended June 30, 2014 and June 30, 2013 related to proceeds from the exercise of stock options. 20

-------------------------------------------------------------------------------- Capital Resources and Funding Requirements We will require additional funds to support future operations including our development activities associated with the IV and oral forms of OCR-002. Our future funding requirements depends on many factors, including, but not limited to the progress, timing, scope and costs of our nonclinical studies and clinical trials, including the ability to enroll patients on a timely basis in our ongoing and potential future clinical trials, the time and cost necessary to respond to technological, market or governmental developments, and the cost of filing, prosecuting, defending and enforcing any patent claims or other intellectual property rights. We expect to fund expenses from our current cash and cash equivalents, possible strategic opportunities and potential additional financing transactions. We believe that our current cash and cash equivalents, including proceeds from our July 2014 public offering of common stock, will be sufficient to fund our operations for at least the next twelve months. We have based our estimates of our cash needs on a number of assumptions that may prove to be wrong, and changing circumstances beyond our control may cause us to consume capital more rapidly than we currently anticipate. For example, our OCR-002 Phase 2b clinical trial may cost more than we expect, or development of the oral formulation of OCR-002 may involve the license of proprietary technology. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidate, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical trials. If adequate funds are not available to us on a timely basis, or at all, we may be required to terminate or delay clinical trials or other development activities for OCR-002. Our ability to finance operations beyond our current resources will depend heavily on our ability to obtain favorable results in clinical trials of OCR-002 and to develop and commercialize OCR-002 successfully. Additional financing may not be available when we need it or may not be available on terms that are favorable to us. We may elect to raise additional funds even before we need them if the conditions for raising capital are favorable. We may seek to raise additional capital through a combination of private and public equity offerings and debt financings. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of existing stockholders will be diluted, and the terms may include liquidation or other preferences that adversely affect the rights of existing stockholders. Debt financing, if available, would result in increased fixed payment obligations and may involve agreements that include covenants limiting or restricting our ability to take specific actions such as incurring debt, making capital expenditures or declaring dividends. On July 10, 2014 we priced an underwritten public offering of 4,200,000 shares of our common stock at an offering price of $6.00 per share. The offering raised gross proceeds of $25.2 million before deducting the underwriting discount of $1.5 million and other offering expenses. The net proceeds from the offering are expected to be used primarily to continue our clinical development of OCR-002 and for working capital and other general corporate purposes. Contractual Obligations The following is a summary of our non-cancellable future minimum lease payments for operating leases at June 30, 2014 (in thousands): Years ending December 31: 2014 (Six Months) $ 113 2015 38 Total $ 151 In the normal course of business, we enter into various firm purchase commitments related to active pharmaceutical ingredients, clinical studies and research studies. As of June 30, 2014, the Company has approximately $2.0 million in non-cancellable contractual obligations and commitments. Off-Balance Sheet Arrangements We do not currently have, and did not have during the periods presented, any off-balance sheet arrangements, as defined under SEC rules. 21



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