Edesa Biotech, Inc.: Form 10-Q for the period ended Jun 30, 2015

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 June 30, 2015 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 June 30, 2015 and August 31, 2014, and for the three months and nine months ended June 30, 2015 and 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”), which was included in our Quarterly Report on Form 10-Q, for the quarter ended December 31, 2014, as filed with the Securities and Exchange Commission on February 9, 2015.

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, contracted manufacturing and testing, and allocated manufacturing overhead for custom manufacturing in process at the end of the period. Finished goods include custom manufactured products that are complete, but not yet shipped to the customers.

Results of Operations

Comparison of Nine Months Ended June 30, 2015 and 2014

Our net loss for the nine months ended June 30, 2015 was $1,305,655, or ($0.02) per basic share, as compared to a net loss of $3,602,718, or ($0.05) per basic share, for the nine months ended June 30, 2014. The decrease in net loss reported in the nine months ended June 30, 2015 compared to the prior period was primarily due to a significant noncash change in the fair value of warrant liability, increased sales and decreased research and development expenses.

Revenue for the nine months ended June 30, 2015 totaled $558,036, as compared to revenue of $245,734 in the nine months ended June 30, 2014. 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 nine months ended June 30, 2015 included product sales of $408,036, as compared to $70,994 in the prior period. The increase in revenue for the nine months ended June 30, 2015 was due to an increase in customers and associated greater product sales volume including sales under supply agreements and custom manufactured products. Contract services revenue was $150,000 for the nine months ended June 30, 2015, as compared to $147,000 in the prior period. The increase in contract services revenue for the nine months ended June 30, 2015 was due to the net impact of services performed under a collaboration agreement entered into mid-December 2013 and completion of services in December 2014 related to a supply agreement. Grant revenue for the nine months ended June 30, 2014 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 nine months ended June 30, 2015.

Expenses for the nine months ended June 30, 2015 decreased to $3,948,669, as compared to expenses of $4,654,121 incurred in the nine months ended June 30, 2014. Costs of production and aquaculture for the nine months ended June 30, 2015 increased to $661,644, as compared to costs of $442,820 incurred in the nine months ended June 30, 2014, consistent with the increase in sales revenues. Research and development was $830,115 for the nine months ended June 30, 2015, as compared to $1,824,554 for the prior period. The decrease for the nine months ended June 30, 2015 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 KLH™ products in response to increased demand. General and administration expenses increased to $2,346,019 for the nine months ended June 30, 2015, as compared to $2,280,268 in the prior period. The increase in general and administration expenses for the nine months ended June 30, 2015 was caused by the net impact of increased corporate development expenses related to our transition to reporting as a U.S. domestic issuer rather than a foreign private issuer, partially offset by 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 $244,781 for the nine months ended June 30, 2015, which was a decrease from share-based compensation of $770,777 recorded in the nine months ended June 30, 2014. 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 gain of $2,112,778 for the nine months ended June 30, 2015, as compared to $826,869 for the nine months ended June 30, 2014. The most significant factor in the change for the nine months ended June 30, 2015 as compared to the prior period resulted from the noncash change in fair value of warrant liability, which fluctuated to a gain of $2,455,361 for the nine months ended June 30, 2015 from $833,862 in the prior period. These fair value gains and losses occur in inverse relation to changes in our share price that affect the valuation model. The increase in overall gain for the nine months ended June 30, 2015 was offset by an increase in foreign exchange loss to $391,190 for the nine months ended June 30, 2015, as compared to $52,527 for the nine months ended June 30, 2014. The change was due to unfavorable exchange rates for our Canadian cash and cash equivalents. The portion of foreign exchange loss realized in cash was $13,517 for the nine months ended June 30, 2015, and $188,795 for the nine months ended June 30, 2014.

Comparison of Three Months Ended June 30, 2015 and 2014

Our net income for the three months ended June 30, 2015 was $463,986, or $0.01 per basic share, as compared to $3,408,326, or $0.04 per basic share, for the three months ended June 30, 2014. The decrease in net income reported in the three months ended June 30, 2015 compared to the prior period was primarily due to a significant noncash change in the fair value of warrant liability and decreased research and development expenses.

Revenue for the three months ended June 30, 2015 totaled $157,748, as compared to revenue of $72,538 in the three months ended June 30, 2014. 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 June 30, 2015 included product sales of $112,748, as compared to $12,538 in the prior period. The increase in revenue for the three months ended June 30, 2015 was due to an increase in customers and associated greater product sales volume. Contract services revenue was $45,000 for the three months ended June 30, 2015, as compared to $60,000 in the prior period. The decrease in contract services revenue for the three months ended June 30, 2015 was due to completion of services in December 2014 related to a supply agreement. No grant revenue was recorded during the three months ended June 30, 2015 or 2014.

Expenses for the three months ended June 30, 2015 decreased to $1,033,333, as compared to expenses of $1,344,683 incurred in the three months ended June 30, 2014. Costs of production and aquaculture for the three months ended June 30, 2015 increased to $251,004, as compared to costs of $147,907 incurred in the three months ended June 30, 2014, due to additional manufacturing activities required for increased product demand. Research and development was $129,710 for the three months ended June 30, 2015, as compared to $543,233 for the prior period. The decrease for the three months ended June 30, 2015 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 KLH™ products in response to increased demand. General and administration expenses increased to $618,185 for the three months ended June 30, 2015, as compared to $612,468 in the prior period. The general and administration expenses for the three months ended June 30, 2015 was comparable to the prior period. Many of the increased corporate development expenses related to our transition to reporting as a U.S. domestic issuer rather than a foreign private issuer occurred prior to the three months ended June 30, 2015.

Other income (loss) was an overall income of $1,348,571 for the three months ended June 30, 2015, as compared to $4,689,471 for the three months ended June 30, 2014. The most significant factor in the change for the three months ended June 30, 2015 as compared to the prior period resulted from the noncash change in fair value of warrant liability, which fluctuated to a gain of $1,254,029 for the three months ended June 30, 2015 from $4,528,450 in the prior period. These fair value gains and losses occur in inverse relation to changes in our share price that affect the valuation model. The decrease in overall other income for the three months ended June 30, 2015 was offset by a decrease in foreign exchange gain to $77,468 for the three months ended June 30, 2015, as compared to $146,302 for the three months ended June 30, 2014. The change was due to improved exchange rates for our Canadian cash and cash equivalents from the end of the prior quarters. The portion of foreign exchange loss realized in cash was $4,765 for the three months ended June 30, 2015, and $167,588 for the three months ended June 30, 2014.

Capital Expenditures

Our capital expenditures, which primarily consist of scientific, manufacturing, and aquaculture equipment, for the nine months ended June 30, 2015 and 2014 are as follows:

Liquidity and Capital Resources

Our working capital position at June 30, 2015 was $8,944,753, including cash and cash equivalents of $10,161,458 and noncash current portion of our warrant liability of $1,235,905. Management believes the current working capital is sufficient to meet our present requirements, including all contractual obligations and anticipated research and development expenditures for at least 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 may raise additional capital through the sale of our equity or debt securities in the public or private markets or through strategic collaborations. We cannot provide any assurances that we will be able to raise additional capital on commercially acceptable terms.

Nine Months Ended June 30, 2015

As of June 30, 2015, our working capital position was $8,944,753, as compared to working capital of $13,751,301 as of September 30, 2014, our new fiscal year-end. Working capital is reduced by the noncash current portion of our warrant liability in the amount of $1,235,905 and $460 at June 30, 2015 and September 30, 2014, respectively.

Our cash and cash equivalents totaled $10,161,458 at June 30, 2015, as compared to cash and cash equivalents of $13,769,953 at September 30, 2014, which represented a decrease of $3,608,495 over the nine month period.

During the nine months ended June 30, 2015, operating activities used cash of $3,497,293. Items not affecting cash included: depreciation and amortization of $119,410; share-based compensation related to the issuance and vesting of stock options of $244,781; unrealized foreign exchange loss of $391,190; and gain in fair value of warrant liability of $2,455,361 due to the adjustment to the fair value of warrants previously issued. Changes in noncash working capital items include an increase in accounts receivable of $69,242; increase in inventory related to custom manufacturing orders in process of $159,476; increase in prepaid expenses of $137,939; decrease in accounts payable and accrued liabilities of $211,667; and increase in deferred revenue of $86,666.

Investing activities provided cash of $216,286. The acquisition of property, plant and equipment used cash of $202,997. Proceeds on maturities of short-term investments provided cash of $419,283. The effect of fluctuations in exchange rate on cash and cash equivalents was a reduction of $356,207 due to a decline in the Canadian dollar relative to the U.S. dollar.

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.

Nine Months Ended June 30, 2014

As of June 30, 2014, our working capital position was $13,908,471, 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 $281,632 and $2,391,399 at June 30, 2014 and September 30, 2013, respectively.

Our cash and cash equivalents totaled $14,442,174 at June 30, 2014, as compared to cash and cash equivalents of $15,478,038 at September 30, 2013, which represented a decrease of $1,035,864.

During the nine months ended June 30, 2014, operating activities used cash of $3,660,304. Items not affecting cash included: depreciation and amortization of $120,507; share-based compensation related to the issuance and vesting of stock options of $770,777; unrealized foreign exchange loss of $52,527; and gain in fair value of warrant liability of $833,862 due to adjustment to fair value of warrants previously issued. Changes in noncash working capital items include a decrease in accounts receivable of $163,331 related mostly to grants; increase in prepaid expenses of $106,237; and decrease in accounts payable and accrued liabilities of $224,629.

Investing activities used cash of $278,401 for the acquisition of property, plant and equipment. The effect of exchange rate changes on cash and cash equivalents was a reduction of $60,321 due to a decline in Canadian dollars relative to U.S. dollars.

Financing activities provided cash of $2,963,162 related to proceeds from exercise of warrants, broker units and options, particularly “in-the-money” warrants and broker units that expired November 14, 2013. As a result of such exercises, 6,475,820 common shares were issued during the period.

Geographic Concentrations

The geographic markets of our customers are principally Europe, the United States and Asia. The geographic breakdown of revenues for the nine months ended June 30, 2015 was 43% Europe, 10% U.S, and 47% Asia and the nine months ended June 30, 2014 was 34% Europe, 10% U.S. 9% Canada, and 47% Asia. The increase in revenues from Asia for the nine months ended June 30, 2015 is due to contract income received under a collaboration agreement with our Taiwanese customer and sales of custom manufactured products for an Asian 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 nine months ended June 30, 2015 and 2014:

Disclosure of Contractual Obligations

We lease three buildings and facilities used in operations under sublease agreements with the Port Hueneme Surplus Property Authority. In June 2015, the Company exercised its option to extend these sublease agreements for an additional five-year term beginning in October and November 2015. The Company negotiated an option to extend the leases for two additional five-year terms.

We 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.

In June 2015, we leased undeveloped land in Baja California, Mexico to assess its suitability for the long-term development and potential expansion of our production capability. The first two years rent was prepaid in June 2015. The initial term is three years and we may terminate early with 30 days’ notice. If we decide to proceed with development of the site, we have options to extend the lease for 30 years.

We have purchase commitments for contract research organizations and consultants.

Our contractual obligations have increased from those 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, due to the exercise of options to extend leases. The approximate amounts of our contractual obligations at June 30, 2015 are as follows:

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 June 30, 2015. Our Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures, as of June 30, 2015, 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 quarter ended June 30, 2015 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.