Edesa Biotech, Inc.: Form 10-Q for the period ended Dec 31, 2014

The following management’s discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed interim consolidated financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q as of December 31, 2014 and our audited consolidated financial statements for the year ended August 31, 2014 included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on November 14, 2014, as amended on November 21, 2014.

This Quarterly Report on Form 10-Q contains forward-looking statements. When used in this report, the words “expects,” “anticipates,” “suggests,” “believes,” “intends,” “estimates,” “plans,” “projects,” “continue,” “ongoing,” “potential,” “expect,” “predict,” “believe,” “intend,” “may,” “will,” “should,” “could,” “would” and similar expressions are intended to identify forward-looking statements. You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the risks described in this report, the risks described in our Annual Report on Form 10-K for the year ended August 31, 2014 and other reports we file with the Securities and Exchange Commission. Although we believe the expectations reflected in the forward-looking statements are reasonable, they relate only to events as of the date on which the statements are made. We do not intend to update any of the forward-looking statements after the date of this report to conform these statements to actual results or to changes in our expectations, except as required by law.

The discussion and analysis of our financial condition and results of operations are based on our unaudited condensed interim consolidated financial statements as of December 31, 2014, September 30, 2014 and August 31, 2014, and for the three months ended December 31, 2014 and 2013 and the one month ended September 30, 2014 included in Part I, Item 1 of this Quarterly Report on Form 10-Q, which we have prepared in accordance with U.S. generally accepted accounting principles. 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 such estimates and judgments, including those described in greater detail below. 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.

Overview

Stellar Biotechnologies, Inc. (“Stellar,” the “Company,” “we,” “our” and “us”) is a biotechnology company engaged in the aquaculture, research and development, manufacture and commercialization of Keyhole Limpet Hemocyanin, or KLH, protein. KLH is a high molecular weight, immune-stimulating protein with an extensive history (over 40 years) of safe and effective use in immunological applications.

KLH can be used as an active pharmaceutical ingredient, or API, and combined with a disease-targeting agent to create immunotherapies targeting cancer, immune disorders, Alzheimer’s disease, and inflammatory diseases, or it can be used as a finished, injectable product in the immunodiagnostic market for measuring immune response in patients and research settings. Our mission is to become the world leader in the sustainable manufacture of KLH and use our unique, proprietary methods and intellectual property to serve the growing demand for KLH in immunotherapeutic and immunodiagnostic markets.

Change in Fiscal Year End

On June 3, 2014, the Company’s Board of Directors approved a change in the Company’s fiscal year end from August 31 to September 30 of each year, with effect from September 1, 2014. As a result, the Company had a one-month transition period from September 1, 2014 to September 30, 2014 (“Transition Period”). The discussion below includes, where applicable, the results of the Transition Period, together with comparative information for the period from September 1, 2013 to September 30, 2013.

Significant Accounting Policies and Estimates

For a discussion of our significant accounting policies and estimates, refer to Item 7., “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Annual Report on Form 10-K for the fiscal year ended August 31, 2014, as filed with the Securities and Exchange Commission on November 14, 2014, as amended on November 21, 2014. There are no material changes in our significant accounting policies and estimates from the disclosure provided in our Annual Report on Form 10-K for the fiscal year ended August 31, 2014, except that we have established the following accounting policy for inventory:

Inventory

Inventory is recorded for custom manufacturing of products for specific customers, including manufacturing under supply agreements. Raw materials include inventory of manufacturing supplies. Work in process includes manufacturing supplies, direct and indirect labor and allocated manufacturing overhead for custom manufacturing in process at the end of the period.

Results of Operations

Comparison of Three Months Ended December 31, 2014 and 2013

Our net loss for the three months ended December 31, 2014 was $1,343,477, or ($0.02) per basic share, as compared to a net loss of $5,577,190, or ($0.08) per basic share, for the three months ended December 31, 2013. The decrease in net loss reported in the three months ended December 31, 2014 compared to the prior period was primarily due to a significant noncash change in the fair value of warrant liability.

Revenue for the three months ended December 31, 2014 totaled $212,661, as compared to revenue of $58,825 in three months ended December 31, 2013. As expected during this early stage of our development, our revenues have high volatility as we establish a market for our products and services. Revenue for the three months ended December 31, 2014 included product sales of $152,661, as compared to $16,085 in the prior period. The increase in revenue for the three months ended December 31, 2014 was due to an increase in customers and associated greater product sales volume. Contract services revenue was $60,000 for the three months ended December 31, 2014, as compared to $15,000 in the prior period. The increase in contract services revenue for the three months ended December 31, 2014 was due to services performed under a collaboration agreement entered into mid-December 2013. Grant revenue for the three months ended December 31, 2013 totaled $27,740 and related to the completion of work associated with our Phase II/IIB grants from the National Science Foundation (“NSF”) Small Business Innovation Research (“SBIR”) through the Technology Enhancement for Commercial Partnerships program. No grant revenue was recorded during the three months ended December 31, 2014.

Expenses for the three months ended December 31, 2014 decreased to $1,538,075, as compared to expenses of $1,754,432 incurred in the three months ended December 31, 2013. Research and development was $418,821 for the three months ended December 31, 2014, as compared to $548,225 for the prior period. The decrease for the three months ended December 31, 2014 was a result of the decreased use of contract research organizations due to a realignment of our focus from internal research and process development to manufacturing our Stellar KLHTM products in response to increased demand. General and administration expenses decreased to $942,153 for the three months ended December 31, 2014, as compared to $1,021,130 in the prior period. The decrease in general and administration expenses for the three months ended December 31, 2014 was caused by the net impact of increased corporate development expenses related to our transition to complying with the disclosure and reporting requirements under the Securities Exchange Act of 1934, as amended (“Exchange Act”) as a U.S. domestic issuer rather than a foreign private issuer, offset by certain decreases in share-based compensation. Share-based compensation is allocated to all expense types; however, the greatest portion of the expenses is recorded as general and administration expenses. Share-based compensation was recorded as $86,865 for the three months ended December 31, 2014, which was a decrease from share-based compensation of $468,717 recorded in the three months ended December 31, 2013. The fluctuations in share-based compensation relate to the timing of the grant of stock options, changes in our share price that affect the valuation model and the vesting of options granted in prior years.

Other income (loss) was an overall loss of $8,263 for the three months ended December 31, 2014, as compared to a loss of $3,880,783 for the three months ended December 31, 2013. The most significant factor in the change for the three months ended December 31, 2014 as compared to the prior period resulted from the noncash change in fair value of warrant liability, which fluctuated to a gain of $139,556 for the three months ended December 31, 2014 from a loss of $3,880,195 in the prior period. These gains and losses occur in inverse relation to changes in our share price that affect the valuation model. The decrease in overall loss for the three months ended December 31, 2014 was offset by an increase in foreign exchange loss to $161,112 for the three months ended December 31, 2014, as compared to $16,508 for the three months ended December 31, 2013. The change was due to unfavorable exchange rates for our Canadian funds.

Comparison of One Month Ended September 30, 2014 and 2013

Our net income for the one month ended September 30, 2014 was $1,127,904, or $0.01 per basic share, as compared to a net loss of $240,389, or nil per basic share, for the one month ended September 30, 2013. The net income reported in the one month ended September 30, 2014 was primarily due to a significant noncash change in the fair value of warrant liability.

Revenue for the one month ended September 30, 2014 totaled $52,786, as compared to revenue of $13,839 in the prior period. The increase in revenue was caused by greater sales volume and services performed under a collaboration agreement.

Expenses for the one month ended September 30, 2014 increased to $505,109, as compared to $351,189 incurred in the prior period. General and administration expenses increased to $293,130 for the one month ended September 30, 2014, as compared to $112,892 in the prior period, as a result of increased corporate development expenses related to our transition to complying with the disclosure and reporting requirements under the Exchange Act as a U.S. domestic issuer rather than a foreign private issuer.

Other income (loss) was an overall income of $1,584,027 in the one month ended September 30, 2014, as compared to overall income of $96,961 in the prior period. The most significant factor in the change for the one month ended September 30, 2014 as compared to the prior period resulted from the noncash change in fair value of warrant liability, which fluctuated to a gain of $1,680,040 for the one month ended September 30, 2014 from a gain of $203,021 in the prior period. These gains and losses occur in inverse relation to changes in our share price that affect the valuation model.

Capital Expenditures

Our capital expenditures, which primarily consist of scientific, manufacturing, and aquaculture equipment, for the three months ended December 31, 2014 and 2013, and the one month ended September 30, 2014 and 2013 are as follows:

Liquidity and Capital Resources

Our working capital position at December 31, 2014 was $9,064,895, including cash and cash equivalents of $12,763,533 and net of $3,318,103 in the noncash current portion of our warrant liability. Management believes the current working capital is sufficient to meet our present requirements, including all contractual obligations and anticipated research and development expenditures for the next 12 months. We expect to finance our future expenditures and obligations through revenues from product sales, contract services income, grant revenues, and sales of our equity and debt securities. We expect to continue incurring losses for the foreseeable future and may need to raise additional capital to pursue our business plan and continue as a going concern. We cannot provide any assurances that we will be able to raise additional capital. Our management believes that we have access to capital resources through possible public or private equity offerings, debt financings, corporate collaborations or other means, if needed; however, we have not secured any commitment for new financing at this time, nor can we provide any assurance that new financing will be available on commercially acceptable terms, if needed.

Three Months Ended December 31, 2014

As of December 31, 2014, our working capital position was $9,064,895, as compared to working capital of $13,751,301 as of September 30, 2014. Working capital is reduced by the noncash current portion of our warrant liability in the amount of $3,318,103 and $460 at December 31, 2014 and September 30, 2014, respectively.

Our cash and cash equivalents totaled $12,763,533 at December 31, 2014, as compared to cash and cash equivalents of $13,769,953 at September 30, 2014, which represented a decrease of $1,006,420.

During the three months ended December 31, 2014, operating activities used cash of $1,285,544. Items not affecting cash included: depreciation and amortization of $37,535; share-based compensation related to the issuance and vesting of stock options of $86,865; unrealized foreign exchange loss of $161,112; and gain in fair value of warrant liability of $139,556 due to the adjustment to the fair value of warrants previously issued. Changes in non-cash working capital items include a decrease in accounts receivable of $8,045; increase in inventory related to custom manufacturing orders in process of $99,417; decrease in prepaid expenses of $36,469; and decrease in accounts payable and accrued liabilities of $33,120.

Investing activities provided cash of $404,062. The acquisition of property, plant and equipment used cash of $38,849. Proceeds on maturities of short-term investments provided cash of $442,911. The effect of exchange rate changes on cash and cash equivalents was a reduction of $153,657 due to a decline in Canadian dollars relative to U.S. dollars.

Financing activities provided cash of $28,719 related to proceeds from the exercise of warrants, broker units and options. As a result of such exercises, 126,800 common shares were issued during the period.

Three Months Ended December 31, 2013

As of December 31, 2013, our working capital position was $14,884,777, as compared to working capital of $12,663,239 as of September 30, 2013. Working capital is reduced by the noncash current portion of our warrant liability in the amount of $1,321,979 and $2,391,399 at December 31, 2013 and September 30, 2013, respectively.

Our cash and cash equivalents totaled $16,725,570 at December 31, 2013, as compared to cash and cash equivalents of $15,478,038 at September 30, 2013, which represented an increase of $1,247,532.

During the three months ended December 31, 2013, operating activities used cash of $1,086,888. Items not affecting cash included: depreciation and amortization of $31,811; share-based compensation related to the issuance and vesting of stock options of $468,717; unrealized foreign exchange loss of $16,508; and loss in fair value of warrant liability of $3,880,195 due to adjustment to fair value of warrants previously issued. Changes in non-cash working capital items include a decrease in accounts receivable of $158,284 related mostly to grants; decrease in prepaid expenses of $2,101; and decrease in accounts payable and accrued liabilities of $67,314.

Investing activities used cash of $209,129 for the acquisition of property, plant and equipment. The effect of exchange rate changes on cash and cash equivalents was a reduction of $14,165 due to a decline in Canadian dollars relative to U.S. dollars.

Financing activities provided cash of $2,557,714 related to proceeds from exercise of warrants, broker units and options, particularly “in-the-money” warrants and broker units expiring November 14, 2013. As a result of such exercises, 4,217,101 common shares were issued during the period.

One Month Ended September 30, 2014

As of September 30, 2014, our working capital position was $13,751,301, as compared to working capital of $12,650,004 as of August 31, 2014. Working capital is reduced by the noncash current portion of our warrant liability of $460 and $879,040 at September 30, 2014 and August 31, 2014, respectively.

Our cash and cash equivalents totaled $13,769,953 at September 30, 2014, as compared to cash and cash equivalents of $13,427,404 at August 31, 2014, which represented an increase of $342,549.

During the one month ended September 30, 2014, operating activities used cash of $296,692. Items not affecting cash included: depreciation and amortization of $12,529; share-based compensation related to the issuance and vesting of stock options of $36,509; unrealized foreign exchange loss of $97,866; and gain in fair value of warrant liability of $1,680,040 due to the adjustment to the fair value of warrants previously issued. Changes in non-cash working capital items included: a decrease in accounts receivable of $12,352; increase in inventory related to custom manufacturing orders in process of $34,891; decrease in prepaid expenses of $490; increase in accounts payable and accrued liabilities of $58,922; and increase in deferred revenue of $71,677 related to an advance payment from a customer for a custom manufacturing order.

Investing activities used cash of $15,968, of which $13,477 was for the acquisition of property, plant and equipment. Reinvestment of investment earnings on short-term investments used cash of $2,491. The effect of exchange rate changes on cash and cash equivalents was a reduction of $84,083 due to a decline in Canadian dollars relative to U.S. dollars.

Financing activities provided cash of $739,292 related to proceeds from exercise of warrants, broker units and options, particularly “in-the-money” warrants and broker units expiring October 2, 2014. As a result of such exercises, 1,151,000 common shares were issued.

Geographic Concentrations

The geographic markets of our potential customers are principally Europe, the United States and Asia. The geographic breakdown of revenues for: the three months ended December 31, 2014 was 54% Europe, 15% U.S, and 31% Asia; the three months ended December 31, 2013 was 63% Europe, 35% U.S. and 2% Asia, and the one month ended September 30, 2014 was 10% Europe, 62% U.S., and 28% Asia. The increase in revenues from Asia for the three months ended December 31, 2014 is principally due to income received from a collaboration agreement with our Taiwanese customer.

Research and Development

Our core business is developing and commercializing natural, sustainable KLH for use in immunotherapy and immunodiagnostic applications. Our internal research includes, among other activities, continual improvement of methods for the culture and growth of Giant Keyhole Limpet, innovations in aquaculture systems and infrastructure, biophysical and biochemical characterization of the KLH molecule, analytical processes to enhance performance of our products, KLH manufacturing process improvements, new KLH formulations, and early development of potential new KLH-based immunotherapies. However, from time to time we may engage in non-related research and development activities as opportunities arise.

Research and development costs, including materials and salaries of employees directly involved in research and development efforts, are expensed as incurred.

The following table includes our research and development costs for each of the three months ended December 31, 2014 and 2013, and the one month ended September 30, 2014 and 2013:

Disclosure of Contractual Obligations

We lease three buildings and facilities used in operations under sublease agreements with the Port Hueneme Surplus Property Authority. In September 2010, we exercised our option to extend these sublease agreements for an additional five-year term. We have an option to extend the lease for a second five-year term.

We also lease facilities used for executive offices and laboratories, and we must pay a portion of the common area maintenance. In July 2014, we exercised our option to extend this lease for a two-year term.

We have purchase commitments for contract research organizations and consultants.

There have been no material changes in our contractual obligations previously disclosed in our Annual Report on Form 10-K for the fiscal year ended August 31, 2014, as filed with the Securities and Exchange Commission on November 14, 2014, as amended on November 21, 2014.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements, including unrecorded derivative instruments, that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

We are exposed to financial market risks associated with foreign exchange rates, concentration of credit, and liquidity. In accordance with our policies, we manage our exposure to various market-based risks and where material, these risks are reviewed and monitored by our Board of Directors. For a discussion of our market risk exposure, refer to Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in our Annual Report on Form 10-K for the fiscal year ended August 31, 2014, as filed with the Securities and Exchange Commission on November 14, 2014, as amended on November 21, 2014. There are no material changes in market risk from the disclosure provided in our Annual Report on Form 10-K for the fiscal year ended August 31, 2014.

Disclosure Controls and Procedures

Our management is responsible for establishing and maintaining disclosure controls and procedures to provide reasonable assurance that material information related to our Company, including our consolidated subsidiaries, is made known to senior management, including our Chief Executive Officer and Chief Financial Officer, by others within those entities on a timely basis so that appropriate decisions can be made regarding public disclosure.

We carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer and our Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) under the Securities and Exchange Act of 1934, as amended) as of December 31, 2014. Our Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures, as of December 31, 2014, were effective to give reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Exchange Act is (i) recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and (ii) accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the one month ended September 30, 2014 or the quarter ended December 31, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

There have been no material changes in the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended August 31, 2014, as filed with the Securities and Exchange Commission on November 14, 2014, as amended on November 21, 2014.