UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

STEMCELLS, INC.

3155 PORTER DRIVE
PALO ALTO, CA 94304

(650) 475-3100

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter periods that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes [X]  No  [  ]

Indicate by check mark whether the registrant is an accelerated filer as defined in Exchange Act Rule 12b-2.

Yes  [  ]  No  [X]

At October 25, 2004, there were 54,256,938 shares of Common Stock, $.01 par value, issued and outstanding.

STEMCELLS, INC.

INDEX

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PART I - ITEM 1 - FINANCIAL STATEMENTS

STEMCELLS, INC.

See accompanying notes to condensed consolidated financial statements.

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PART I - ITEM 1 - FINANCIAL STATEMENTS

STEMCELLS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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PART I — ITEM 1 — FINANCIAL STATEMENTS

STEMCELLS, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(unaudited)

[1] Under the terms of a license agreement with the California Institute of Technology (Cal Tech), fees of $10,000 and $5,000 were due on the issuance of two patents to which StemCells holds a license from Cal Tech, payable in cash or stock at the Company’s choice. Company elected to pay the fees in stock and issued 9,535 unregistered shares to Cal Tech.

[2] Under the terms of an amended license agreement with the Oregon Health Sciences University (OHSU), 4,000 shares of stock were due to OHSU on execution of the amended agreement.

See accompanying notes to condensed consolidated financial statements

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PART I — ITEM 1. — FINANCIAL STATEMENTS

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2004 and 2003

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

     The terms “StemCells”, the “Company”, “our”, “we” and “us” as used in this report refer to StemCells Inc. The accompanying unaudited, condensed consolidated financial statements have been prepared by the Company in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying financial statements include all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the financial position, results of operations and cash flows for the periods presented. Results of operations for the three and nine months ended September 30, 2004, are not necessarily indicative of the results that may be expected for the entire fiscal year ending December 31, 2004.

     The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required for complete financial statements in accordance with accounting principles generally accepted in the United States of America. For the complete financial statements, refer to the audited financial statements and footnotes thereto as of December 31, 2003, included on Form 10-K.

     The Company has incurred significant operating losses and negative cash flows since inception. It has not achieved profitability and may not be able to realize sufficient revenues to achieve or sustain profitability in the future. The Company has limited capital resources and it will need to raise additional capital from time to time to sustain its product development efforts, acquisition of technologies and intellectual property rights, preclinical and clinical testing of anticipated products, pursuit of regulatory approvals, acquisition of capital equipment, laboratory and office facilities, establishment of production capabilities, general and administrative expenses and other working capital requirements. To fund its operations, the Company relies on cash balances, proceeds from equity and debt offerings, proceeds from the transfer or sale of intellectual property rights, equipment, facilities or investments, and on government grants and collaborative arrangements. The Company cannot be certain that such funding will be available when needed. The 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.

Reclassifications

     Certain amounts reported in previous periods have been reclassified to conform to the 2004 presentation. These reclassifications had no effect on operating or net income.

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Use of Estimates

     The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from these estimates. Significant estimates include the accrued wind-down expenses.

Net Loss Per Share

     The Company has computed net loss per common share according to the Financial Accounting Standards Board Statement (“SFAS”) No. 128, “Earnings Per Share,” which requires disclosure of basic and diluted earnings per share. Basic earnings per share excludes any dilutive effects of options, warrants and convertible securities, and is computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share includes the impact of potentially dilutive securities and is computed using the weighted average of common and diluted equivalent stock options, warrants and convertible securities outstanding during the period. Stock options, warrants and convertible securities that are antidilutive are excluded from the calculation of diluted loss per common share.

The Company has excluded outstanding stock options, warrants and convertible securities from the calculation of diluted loss per common share because all such securities are anti-dilutive for all applicable periods presented. These outstanding securities consist of the following potential common shares:

Stock-Based Compensation

     The Company’s employee stock option plan is accounted for under Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” The Company grants qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. In these circumstances in accordance with APB 25, the Company recognizes no compensation expense for qualified stock option grants. The Company also issues non-qualified stock options for a fixed number of shares to employees with an exercise price less than the fair market value of the shares at the date of grant. When such options vest, the Company recognizes the difference between the exercise price and fair market value as compensation expense in accordance with APB 25.

     For purposes of disclosures pursuant to Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123) as amended by Statement of Financial Accounting Standards No. 148,

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“Accounting for Stock-Based Compensation — Transition and Disclosure,” (SFAS 148), the estimated fair value of options is amortized to expense over the options’ vesting period. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation:

     The effects on pro forma net loss and net loss per share of expensing the estimated fair value of stock options are not necessarily representative of the effects on reporting the results of operations for future years. As required by SFAS 123, the Company has used the Black-Scholes model for option valuation, which method may not accurately value the options described.

     The Company accounts for stock options granted to non-employees in accordance with SFAS 123 and Emerging Issues Task Force (EITF) 96-18 — “Accounting For Equity Instruments That Are Issued To Other Than Employees For Acquiring, Or In Conjunction With Selling, Goods Or Services”, and accordingly, recognizes as expense the estimated fair value of such options as calculated using the Black-Scholes valuation model. The fair value is remeasured during the service period and is amortized over the vesting period of each option or the recipient’s contractual arrangement, if shorter.

Revenue Recognition

     Revenues from collaborative agreements and grants are recognized as earned upon either the incurring of reimbursable expenses directly related to the particular research plan or the completion of certain development milestones as defined within the terms of the collaborative agreement. Payments received in advance of research performed are designated as deferred revenue. Fees associated with substantive at risk, performance-based milestones are recognized as revenue upon their completion, as defined in the respective agreements. Incidental assignment of technology rights is recognized as revenue at the time of receipt.

New Accounting Standards

     During March 2004, the Financial Accounting Standards Board (FASB) issued an exposure draft of a new standard entitled Share Based Payment, which would amend Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation, and SFAS No. 95, Statement of Cash Flows. Among other items, the new standard would require the expensing of stock options issued by the Company in the financial statements using a fair-value-based method. The new standard, as proposed, would be effective for fiscal years beginning after December 15, 2004. In October 2004, the Financial Accounting Standards Board decided that public companies will be required to expense employee stock options in periods (both interim and annual) beginning after June 15, 2005. Calendar-year companies will have to begin complying as of the third quarter of 2005.

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Companies that have not already voluntarily adopted FAS 123 will be permitted, but not required, to restate earlier quarters in the year of adoption, using the FAS 123 values disclosed in their footnotes. Companies will also be permitted to restate all prior years presented, using their FAS 123 footnote values. FASB is encouraging companies to begin applying the new expensing requirements as of the beginning of 2005. A final standard still is expected in December 2004. See “Stock-based Compensation” above in this Note 1 for disclosures regarding the effect on net earnings and earnings per share if we had applied the fair value recognition provisions of the exposure draft and SFAS No. 123. Depending on the model used to calculate stock-based compensation expense in the future, that disclosure may not prove indicative of the stock-based compensation expense to be recognized in future financial statements.

NOTE 2. LEASES

     The Company had undertaken direct financing transactions with the State of Rhode Island and received proceeds from the issuance of industrial revenue bonds totaling $5,000,000 to finance the construction of a pilot manufacturing facility related to its former encapsulated cell technology. The related leases are structured such that lease payments will fully fund all semiannual interest payments and annual principal payments through maturity in August 2014. Interest rates vary with the respective bonds’ maturities, ranging currently from 8.1% to 9.5%. The outstanding principal at September 30, 2004 was approximately $1,910,000. The bonds contain certain restrictive covenants, which limit among other things, the payment of cash dividends and the sale of the related assets.

     The Company entered into a fifteen-year lease for a laboratory facility in connection with a sale and leaseback arrangement in 1997. The lease has escalating rent payments and accordingly, the Company is recognizing rent expense on a straight-line basis. At December 31, 2003 and September 30, 2004, the Company had deferred rent liability for this facility of $1,147,000 and $1,170,000 respectively; the deferred rent liability is presented as part of the wind-down accrual.

     Although the Company previously discontinued activities relating to encapsulated cell technology, the Company remains obligated under the leases for the pilot manufacturing facility and the laboratory facility. The Company has succeeded in subleasing the pilot manufacturing facility and part of the laboratory facility. The aggregate income received by the Company is significantly less than the Company’s aggregate obligations under the leases, and the Company’s continued receipt of rental income is dependent on the financial ability of the occupants to comply with their obligations under the subleases. As part of a subleasing agreement for the laboratory facility, the Company was required to provide the landlord with two letters of credit: one for $106,560, which expired on March 31, 2003, and the other for $159,000 which will automatically decrease to $106,053 on March 15, 2005 and $52,947 on March 15, 2006, with a final expiration date of March 31, 2007. The Company continues to seek to sublet the vacant portions of the Rhode Island facilities, to assign or sell its interests in all of these properties, or to otherwise arrange for the termination of its obligations under the lease obligations on these facilities. There can be no assurance, however, that the Company will be able to dispose of these properties in a reasonable time, if at all, or to terminate its lease obligations without the payment of substantial consideration.

     As of February 1, 2001, the Company entered into a 5-year lease for a 40,000 square foot facility located in the Stanford Research Park in Palo Alto, CA. The facility includes space for animals, laboratories, offices, and a GMP (Good Manufacturing Practices) suite. GMP facilities can be used to manufacture materials for clinical trials. On December 19, 2002 the Company negotiated an amendment to the lease, which resulted in reducing the average annual rent over the remaining term of the lease from approximately $3.7 million to $2.0 million. As part of the amendment the Company issued a letter of credit on January 2, 2003 for $503,079, which was an addition to the letter of credit in the amount of $275,000 issued at commencement of the lease, to serve as a deposit for the duration of the lease. As the lease involved an upfront payment as well as escalating rent payments, the Company is recognizing rent expense on a straight-line basis. At September 30, 2004, the Company had $617,000 in deferred rent liability for this facility. In 2001 and 2002, the Company entered into space-sharing agreements currently covering in total approximately 15,000 square feet of the 40,000 square foot facility. The Company expects to receive the amount of base rent plus the proportionate share of the operating expenses that it pays for such space over the term of these agreements.

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NOTE 3. WIND-DOWN OF ENCAPSULATED CELL TECHNOLOGY RESEARCH AND DEVELOPMENT PROGRAM

     In 1999, in connection with exiting its former corporate headquarters and encapsulated cell technology facilities, the Company created a reserve for the estimated lease payments and operating expenses of the Rhode Island facilities through June 30, 2000, when it expected to fully sublease, assign or sell its remaining interests in the property. The Company did not fully sublet the Rhode Island facilities as expected and therefore made a change in estimate in June 2000 to accrue additional expenses of $3,327,000 to cover operating lease payments and operating expenses (including utilities, taxes, insurance, maintenance, interest and other non-employee expenses) through 2001. At December 31, 2001, the $3,327,000 reserve was exhausted and the Company recorded an additional reserve of $575,000. This reserve was based on information provided by the Company’s broker/realtor that estimated, based on assumptions relevant to the real estate market conditions as of the end of 2001, the time it would be likely to take until the facility would be fully sub-leased. In 2002, the Company incurred $964,000 in lease payments and operating expenses, net of subtenant income for this facility, of which $575,000 was recorded against the reserve created at the end of 2001 and the remainder recorded as wind-down expenses. At the end of December 2002, based on an analysis of the real estate market conditions at that time, the Company revised the reserve to $775,000. In 2003 the Company incurred $984,000 in lease payments and operating expenses, net of subtenant income for this facility of which $775,000 was recorded against the reserve and the remainder recorded as wind-down expenses. After considering various factors such as the Company’s experience in subleasing the facility since exiting the facility in 1999, its lease payments through to the end of the lease, facility operating expenses, the current real estate market in Rhode Island, and estimated subtenant income based on both actual and projected occupancy, the Company revised the reserve at December 31, 2003 to $2,676,000. For the December 31, 2003 financial statement presentation, the deferred rent of $1,147,000 (see NOTE 2) related to this facility was included in the wind-down accrual shown on the balance sheet. For the nine months ending September 30, 2004 the Company recorded $876,000 against the reserve. At March 31, 2004, June 30, 2004 and September 30, 2004 the Company, as a result of its periodic review, re-evaluated its estimate and adjusted the reserve to $2,510,000, $2,680,000 and $3,743,000 respectively, by recording an additional $130,000 at March 31, 2004, $468,000 at June 30, 2004 and $1,345,000 at September 30, 2004 as wind-down expenses. The third quarter adjustment was substantially higher than those for the previous two quarters, due in significant part to the failure to secure an anticipated sublease and to recent deterioration in the Rhode Island real estate market. For the September 30, 2004 financial statement presentation, the total accrued wind-down expenses (current portion and non-current portion) of $4,913,000, represents the total of the deferred rent related to this facility of $1,170,000 and the reserve of $3,743,000. Even though it is the intent of the Company to sublease, assign or sell its interests in the facility at the earliest possible time, it cannot determine with certainty a fixed date by which such events will occur. In light of this uncertainty, based on estimates, the Company will periodically re-evaluate and adjust the reserve, as necessary.

Wind-down reserve

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NOTE 4. GRANTS

     On September 30, 2001, the Company was awarded a four-year, $225,000 per year grant from the National Institute of Diabetes & Digestive & Kidney Disorders of the National Institutes of Health for the Company’s liver stem cell program which focuses on identifying liver stem and progenitor cells for the treatment of liver diseases. The grant is subject to the availability of funds and satisfactory progress of the project. For this award, the Company has recognized revenue of $56,250 in 2001, $225,000 for 2002 and $112,500 for 2003. The Company does not intend to draw further funds from this grant since it will no longer pursue the particular research it covered. In September 2003 the Company was awarded a one year, $342,000, Small Business Innovation Research grant from the National Institute of Neurological Disease and Stroke (NINDS), to further its work in the treatment of spinal cord injuries. For this award, the Company has recognized revenue of $143,000 in 2003, and $92,000 for the nine months ended September 30, 2004. The remaining $107,000 will go towards reimbursing a subcontractor. In September 2004, the National Institutes of Health (NIH) awarded the Company a Small Business Technology Transfer grant of $464,000 for studies in Alzheimer’s disease, consisting of $308,000 for the first year and $156,000 for the remainder of the grant term, September 30, 2004 through March 31, 2006. The studies will be conducted by Dr. George A. Carlson of the McLaughlin research Institute (MRI) in Great Falls, Montana, which will receive approximately $222,000 of the total award. A multi-year grant was awarded by the NIH to the Reeve-Irvine Center at the University of California-Irvine to fund new studies by Drs. Aileen J. Anderson and Brian J. Cummings of the human central nervous system stem cell (hCNS-SC) grafts in the treatment of spinal cord injuries. The Company will not receive any funds from this grant, but will collaborate with Drs. Anderson and Cummings by providing its proprietary cells for the studies.

NOTE 5. STOCKHOLDERS’ EQUITY

     On June 16, 2004, the Company entered into a definitive agreement with institutional and other accredited investors with respect to the private placement of approximately 13,160,000 shares of its common stock at a purchase price of $1.52 per share, for gross proceeds of approximately $20,000,000. Investors also received warrants exercisable for five years to purchase approximately 3,290,000 shares of common stock at an exercise price of $1.90 per share. C.E. Unterberg, Towbin LLC (Unterberg) served as placement agent for the transaction. For acting as the Company’s placement agent, Unterberg received fees totaling $1,200,192, expense reimbursement of approximately $25,000 and a five year warrant to purchase 526,400 shares of the Company’s common stock at an exercise price of $1.89 per share.

NOTE 6. SUBSEQUENT EVENTS

     On October 26, 2004, the Company entered into definitive agreements with institutional investors with respect to the registered direct placement of 7,500,000 shares of its common stock at a purchase price of $3.00 per share, for gross proceeds of $22,500,000. C.E. Unterberg, Towbin, LLC and Shoreline Pacific, LLC served as placement agents for the transaction. The Company sold these shares under a shelf registration statement previously filed with and declared effective by the U.S. Securities and Exchange Commission.

     On October 28, 2004, three holders of warrants issued as part of the June 16, 2004 financing arrangement, exercised their right to purchase an aggregate of 115,131 shares of the Company’s common stock at $1.90 per share. The Company issued 115,131 shares of its common stock and received proceeds of $218,750.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     The following discussion of our financial condition and the results of our operations for the three- and nine-month periods ended September 30, 2004 and 2003 should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and the related footnotes thereto.

     This report includes forward-looking statements. You can identify these statements by forward-looking words such as “may,” “could,” “will,” “possibly,” “expect,” “anticipate,” “project,” “promising,” “believe,” “estimate,” “continue” or similar words. You should read statements that contain these words carefully because they discuss our future expectations, contain projections of our future results of operations or of our financial condition, or state other “forward-looking” information. These forward-looking statements include, for example, all statements as to expectation or belief and statements as to our future results of operations, the progress of our research, product development and clinical programs, the need for, and timing of, additional capital and capital expenditures, partnering prospects, costs of manufacture of products, the protection of and the need for additional intellectual property rights, effects of regulations, the need for additional facilities and potential market opportunities. We believe that it is important to communicate our future expectations to our investors. However, there will be events in the future that we have not been able to accurately predict or control and that may cause our actual results to differ materially from those discussed. For example, failure to obtain a corporate partner or partners to support the development of our stem cell programs, inability to sell, assign or sublease our interest in our facilities related to our former encapsulated cell technology program, risks of delays in, or adverse results from, our research, development and clinical testing programs, obsolescence of our technology, lack of available funding, contaminations at our facilities, changes in the pharmaceutical or biotechnology industries, competition from third parties, intellectual property rights of third parties, failure of our collaborators to perform, regulatory constraints, litigation, changes in government regulations or general economic or market conditions and other risks could all have significant effects on our results. These factors should be considered carefully and readers should not place undue reliance on our forward-looking statements. Before you invest in our common stock, you should be aware that the occurrence of the events described in the “Cautionary Factors Relevant to Forward Looking Information” and “Business” sections included in our Form 10-K report as of December 31, 2003 could harm our business, operating results and financial condition. All forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the cautionary statements and risk factors contained or referred to herein.

     OVERVIEW

     Since our inception in 1988, we have been primarily engaged in research and development of human therapeutic products. As a result of the acquisition of StemCells California Inc. in 1997 and restructuring in the second half of 1999, our sole focus is now on our stem cell technology.

     We have not derived any revenues from the sale of any products, and we do not expect to receive revenues from product sales for at least several years. We have not commercialized any product and in order to do so we must, among other things, substantially increase our research and development expenditures as research and product development efforts accelerate and clinical trials are initiated. We have incurred annual operating losses since inception and expect to incur substantial operating losses in the future. As a result, we are dependent upon external financing from equity and debt offerings and revenues from collaborative research arrangements with corporate sponsors to finance our operations. There are no such collaborative research arrangements at this time and there can be no assurance that such financing or partnering revenues will be available when needed or on terms acceptable to us.

     Since 2001, we have entered into a number of financing arrangements including an equity line (which has now expired) from which we drew $4.6 million; sale of 1 million shares of common stock for $1.1 million; sale of 4 million shares of common stock for $6.5 million; issuance of convertible preferred stock for $5 million (all of which has now been converted), sale of 5 million shares of common stock for a total of $9.5 million, and on June 16 2004, the sale of 13.2 million shares of common stock for a total of $20 million before financing costs. (See “Liquidity and Capital Resources” below for further detail on each of these transactions. See also Note 6, “Subsequent Events”).

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     We are currently concentrating all our resources on our primary goal, which is to research, develop, and evaluate the potential of stem and progenitor cell technology to treat or cure some of the world’s most debilitating diseases. We have identified the human neural stem cell and candidate pancreas and liver stem or progenitor cells, and have issued patents and pending patent applications to protect our proprietary position. Our most advanced program is focused on the development of our human neural stem cells. To date, we have obtained pre-clinical proof of concept in various animal models including spinal cord injury, stroke, myelin disorders and neuronal ceroid lipofuscinoses (NCLs). In 2003, studies were conducted at the Stanford University laboratory of Dr. William Mobley and at our own laboratories in mice designed to model a specific form of NCL. The NCLs, which include Batten Disease, are a set of several closely related genetic lysosomal storage disorders caused by a deficiency of specific enzymes required for normal cell metabolism. The deficiency results in storage of toxic waste materials and the death of certain neurons. The NCLs primarily affect infants and young children, and are always fatal. In the studies, our proprietary human neural stem cells were transplanted into the mice, resulting in widespread engraftment, persistent production of the enzyme that is deficient in the disease, reduction in the toxic waste material and preliminary indications of improved neuronal survival. Based on these results, we embarked upon a plan to file our first IND (Investigational New Drug filing) with the Food and Drug Administration by the first quarter of 2005, in order to begin a clinical trial in Infantile and Late-Infantile NCL. (Since all of the NCLs are commonly referred to as Batten disease the term will be used in this report). Preparation for and conduct of the Batten disease clinical trial will entail an increase in expenditures for both internal and external resources and we shall probably require further infusions of capital from time to time in order to fund our clinical trials program. As part of the IND process, the FDA requires us to qualify the cell bank as a suitable source of the cells to be used in the proposed clinical trials to conduct extensive pre-clinical safety testing (i.e., pharmacology and toxicology studies) in various animal models and to submit, details of the proposed clinical plan. We remain on track to file our IND in the first quarter of 2005 we previously announced. There can be no assurance, however, that the FDA will approve our trial for Batten disease.

     Our results of operations have varied significantly from year to year and quarter to quarter and may vary significantly in the future due to the occurrence of material recurring and nonrecurring events including, without limitation, the receipt and payment of licensing payments, the initiation or termination of research collaborations, the changes in the sublease income and rental and other expenses to lease and maintain our facilities in Rhode Island and changes in the costs associated with our move to a larger facility in California. To expand and provide high quality systems and support to our research and development programs, we would need to hire more personnel, which would lead to higher operating expenses.

CRITICAL ACCOUNTING POLICIES

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Use of Estimates

     The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from these estimates. The significant estimates include the accrued wind-down expenses related to our Rhode Island facilities.

Stock-Based Compensation

     As permitted by the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” and Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” our employee stock option plan is accounted for under Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” We grant qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. In these circumstances in accordance with APB 25, we recognize no compensation expense for qualified stock option grants. We also issue non-qualified stock options for a fixed number of shares to employees with an exercise price less than the fair market value of the shares at the date of

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grant. When such options vest, we recognize the difference between the exercise price and fair market value as compensation expense in accordance with APB 25. Note 11 of the Notes to the Consolidated Financial Statements, included in our Annual Report on Form 10K, describes our equity compensation plans, and Note 1 of the Notes to the Condensed Consolidated Financial Statements elsewhere in this report contains a summary of the pro forma effects to reported net loss and loss per share for the three and nine months ended September 30, 2004 and 2003 as if we had elected to recognize compensation cost based on the fair value of the options granted at grant date, as prescribed by SFAS No. 123. We account for certain stock options granted to non-employees in accordance with SFAS No. 123 and Emerging Issues Task Force (“EITF”) 96-18 — accounting for equity instruments that are issued to other than employees for acquiring, or in conjunction with selling, goods or services, and accordingly, we recognize as expense the estimated fair value of such options as calculated using the Black-Scholes valuation model, and as re-measured during the service period. Fair value is determined using methodologies allowable by SFAS No. 123. The cost is amortized over the vesting period of each option or the recipient’s contractual arrangement, if shorter.

Long-Lived Assets

     We adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” at the beginning of 2002. As permitted by the transition rules of SFAS No. 144, long-lived assets classified as held for sale as a result of activities that were initiated prior to this Statement’s initial application shall continue to be accounted for in accordance with SFAS No. 121. If, however, the criteria for classifying long-lived assets held for sale under SFAS No. 144 were not met by the end of the fiscal year in which this Statement is initially applied, the related long-lived assets were to be reclassified as held and used. At December 31, 2002, the criteria under SFAS No. 144 for classifying the Company’s long-lived assets held for sale were not met and accordingly, such assets were reclassified as held and used on the balance sheet.

     We routinely evaluate the carrying value of our long-lived assets. We record impairment losses on long-lived assets used in operations when events and circumstances indicate that assets may be impaired and the undiscounted cash flows estimated to be generated by the assets are less than the carrying amount of those assets. If an impairment exists, the charge to operations is measured as the excess of the carrying amount over the fair value of the assets.

Research and Development Costs

     We expense all research and development costs as incurred. Research and Development costs include costs of personnel, external services, supplies, facilities and miscellaneous other costs.

Wind-down and Exit Costs

     In connection with the wind-down of our former encapsulated cell technology operations, our research and manufacturing operations in Lincoln, Rhode Island, and the relocation of our remaining research and development activities and corporate headquarters to California, in October 1999, we provided a reserve for our estimate of the exit cost obligation in accordance with EITF 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” As the lease for our former research facility in Rhode Island terminates in 2013, we will adjust our reserve on an ongoing basis by reevaluating our estimated costs to exit this facility. The estimates are based on assumptions and experience relevant to the real estate market conditions for the facility. Such re-evaluation will include lease payments over the lease term, occupancy and sublease rental rates, and facility operating expenses. We are seeking to sublease, assign, sell or otherwise divest itself of our interest in the facility at the earliest possible time, but we cannot determine with certainty a fixed date by which such events will occur.

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RESULTS OF OPERATIONS

Three months ended September 30, 2004 and 2003

     For the three months ended September 30, 2004, revenue from licensing agreements totaled approximately $5,000. For the three months ended September 30, 2003, revenue from grants and licensing agreements totaled approximately $33,000, which included $30,000 that is part of the $342,000 Small Business Innovation Research grant from the National Institute of Neurological Disease and Stroke, and $3,000 in licensing revenue).

     Research and development expenses totaled $2,075,000 for the three months ended September 30, 2004, compared with $1,444,000 for the same period in 2003. The increase of $631,000 or approximately 44% from 2003 to 2004 was primarily attributable to the expenditures required for pre-clinical pharmacology and toxicology studies, supplies, personnel and other external services in preparation for submitting our first IND (Investigational New Drug filing) to the FDA, to evaluate the safety and efficacy of our human neural stem cells as a treatment for Batten disease. In addition, the increase reflects higher patent prosecution fees and costs than incurred in the same period in 2003. At September 30, 2004, we had twenty-five full-time employees working in research and development and laboratory support services as compared to twenty at September 30, 2003.

     General and administrative expenses were $904,000 for the three months ended September 30, 2004, compared with $783,000 for the same period in 2003. The increase of $121,000 or 15%, from 2003 to 2004 was primarily attributable to the cost of external services incurred in the evaluation of our internal control systems so as to meet the requirements of and be in compliance with the new Securities and Exchange Commission rules issued under section 404 of the Sarbanes-Oxley Act.

     In 1999, in connection with exiting our former research facility in Rhode Island, we created a reserve for the estimated lease payments and operating expenses related to it. The reserve has been re-evaluated and adjusted based on assumptions relevant to real estate market conditions and the estimated time until we could either fully sublease, assign or sell our remaining interests in the property. At June 30, 2004 the reserve was $2,680,000. For the three months ending September 30, 2004, expenses of $282,000 net of subtenant income was recorded against this reserve. At September 30, 2004 we re-evaluated the estimate and adjusted the reserve to $3,743,000 by recording an additional $1,345,000 as wind-down expenses. Wind-down expenses for the same period in 2003 were $224,000. Expenses for this facility will fluctuate based on changes in tenant occupancy rates and other operating expenses related to the lease. Even though it is our intent to sublease, assign, sell or otherwise divest ourselves of our interests in the facility at the earliest possible time, we cannot determine with certainty a fixed date by which such events will occur. In light of this uncertainty, based on estimates, we will periodically re-evaluate and adjust the reserve, as necessary.

     Interest income for the three months ended September 30, 2004 and 2003 was $83,000 and $13,000 respectively. The increase in interest income in 2004 was primarily attributable to a higher average investment balance. Interest expense for the three months ended September 30, 2004 and 2003 was $46,000 and $50,000 respectively. The decrease in interest expense in 2004 was attributable to lower outstanding debt and capital lease balances in 2004 compared to 2003.

     Other expenses net of other income for the three months ended September 30, 2004, was $54,000, consisting of a loss of $51,000 as result of writing off obsolete lab equipment and $3,000 in state franchise tax. For the three months ended September 30, 2003, other income net of other expenses was $27,000, consisting of income received from the leasing of equipment to subtenants amounting to $28,000 less $1,000 in state franchise tax

     For the three months ended September 30, 2003, we recorded deemed dividends of $170,000. The deemed dividends were related to the 3% cumulative convertible preferred stock and included the accretion of common stock warrants, the beneficial conversion feature and the related issuance costs. There is no longer any preferred stock outstanding as all of the Company’s previously outstanding 3% and 6% cumulative convertible preferred stock, was converted to the Company’s common stock prior to the end of 2003.

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Nine months ended September 30, 2004 and 2003

     For the nine months ended September 30, 2004, revenue from grants and licensing agreements totaled approximately $103,000, which included $93,000 that is part of the $342,000 Small Business Innovation Research grant from the National Institute of Neurological Disease and Stroke, and $10,000 in licensing revenue. For the nine months ended September 30, 2003, revenue from grants and licensing agreements totaled approximately $152,000, which included $112,000 that is a part of the grant awarded by the National Institute of Diabetes & Digestive & Kidney Disorders of the National Institutes of Health, $30,000 that is part of the $342,000 Small Business Innovation Research grant from the National Institute of Neurological Disease and Stroke, and $10,000 in licensing revenue. Beginning the third quarter of 2003 we did not draw further funds from the National Institute of Diabetes & Digestive & Kidney Disorders grant since we were no longer pursuing the particular research it covered.

     Research and development expenses totaled $5,882,000 for the nine months ended September 30, 2004, compared with $4,524,000 for the same period in 2003. The increase of $1,358,000 or approximately 30% from 2003 to 2004 was primarily attributable to the expenditures required for pre-clinical pharmacology and toxicology studies, supplies, personnel and other external services in preparation for submitting our first IND to the FDA, to evaluate the safety and efficacy of our human neural stem cells as a treatment for Batten disease. In addition, the increase reflects higher patent prosecution fees and costs than incurred in the same period in 2003. At September 30, 2004, we had twenty-five full-time employees working in research and development and laboratory support services as compared to twenty at September 30, 2003.

     General and administrative expenses were $2,645,000 for the nine months ended September 30, 2004, compared with $2,381,000 for the same period in 2003. The increase of $264,000 or 11%, from 2003 to 2004 was primarily attributable to an increase in costs related to the printing, mailing and filing of our annual report (Form 10-K) and proxy statement in 2004 as compared to 2003. The increase in cost was attributable to the separate printing of our proxy statement and our Form 10-K and the effect of a greater number of shareholders in 2004 when compared to 2003 on these costs. The increase in general and administrative expenses was also partly attributable to the external auditor fees and other external services fees incurred in the first quarter of 2004 as a result of the restatement of our prior year financials, and in addition, the cost of external services incurred in the evaluation of our internal control systems so as to meet the requirements of and be in compliance with the new Securities and Exchange Commission rules issued under section 404 of the Sarbanes-Oxley Act.

     In 1999, in connection with exiting our former research facility in Rhode Island, we created a reserve for the estimated lease payments and operating expenses related to it. The reserve has been re-evaluated and adjusted based on assumptions relevant to real estate market conditions and the estimated time until we could either fully sublease, assign or sell our remaining interests in the property. At December 31, 2003 the reserve was $2,676,000. For the nine months ending September 30, 2004, expenses of $876,000 net of subtenant income was recorded against this reserve. At March 31, 2004, June 30, 2004 and September 30, 2004, as a result of our periodic review, we re-evaluated our estimate and adjusted the reserve to $2,510,000, $2,680,000 and $3,743,000 respectively, by recording an additional $130,000 at March 31, 2004, $468,000 at June 30, 2004 and $1,345,000 at September 30, 2004 as wind-down expenses. Wind-down expenses for the same period in 2003 were $698,000. Expenses for this facility will fluctuate based on changes in tenant occupancy rates and other operating expenses related to the lease. Even though it is our intent to sublease, assign, sell or otherwise divest ourselves of our interests in the facility at the earliest possible time, we cannot determine with certainty a fixed date by which such events will occur. In light of this uncertainty, based on estimates, we will periodically re-evaluate and adjust the reserve, as necessary.

     Interest income for the nine months ended September 30, 2004 and 2003 was $159,000 and $24,000 respectively. The increase in interest income in 2004 was primarily attributable to a higher average investment balance. Interest expense for the nine months ended September 30, 2004 and 2003 was $145,000 and $158,000 respectively. The decrease in interest expense in 2004 was attributable to lower outstanding debt and capital lease balances in 2004 compared to 2003.

     Other expenses net of other income for the nine months ended September 30, 2004, was $57,000, consisting of a loss of $51,000 as result of writing off obsolete lab equipment and $6,000 in state franchise tax. For the nine months ended September 30, 2003 other income net of other expenses was $33,000, consisting of income received from the leasing of equipment to subtenants amounting to $34,000 less $1,000 in state franchise tax.

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     For the nine months ended September 30, 2003, we recorded deemed dividends of $1,658,000. The deemed dividends were related to the 3% cumulative convertible preferred stock and included the accretion of common stock warrants, the beneficial conversion feature and the related issuance costs. For the nine months ended September 30, 2003, we recorded dividends of $47,000 which was paid in the form of common stock to our 6% cumulative convertible preferred stock holders. There is no longer any preferred stock outstanding as all of the Company’s previously outstanding 3% and 6% cumulative convertible preferred stock, was converted to the Company’s common stock prior to the end of 2003.

Liquidity and Capital Resources

     Since our inception, we have financed our operations through the sale of common and preferred stock, the issuance of long-term debt and capitalized lease obligations, revenues from collaborative agreements, research grants and interest income.

     We had cash and cash equivalents totaling $23,141,000 at September 30, 2004. Cash equivalents are invested in US Treasuries with maturities of less than 90 days. We used $7,827,000 and $6,556,000 of cash for the nine months ended September 30, 2004 and 2003 respectively, in our operating activities. The increase in cash used in 2004 in comparison to the same period in 2003 was primarily attributable to the expenses incurred in preparing to submit our first IND to the FDA, to evaluate the safety and efficacy of our human neural stem cells as a treatment for Batten disease. These expenses will increase as we approach the anticipated filing date in the first quarter of 2005. (See also Note 6, “Subsequent Events”)

     On June 16, 2004, we entered into a definitive agreement with institutional and other accredited investors with respect to the private placement of approximately 13,160,000 shares of our common stock at a purchase price of $1.52 per share, for gross proceeds of approximately $20,000,000. Investors also received warrants exercisable for five years to purchase approximately 3,290,000 shares of common stock at an exercise price of $1.90 per share. C.E. Unterberg, Towbin LLC (Unterberg) served as placement agent for the transaction. For acting as our placement agent Unterberg, received fees totaling $1,200,192, expense reimbursement of approximately $25,000 and a five year warrant to purchase 526,400 shares of our common stock at an exercise price of $1.89 per share.

     On December 10, 2003 we completed a $9.5 million financing transaction with Riverview Group L.L.C. (Riverview), through the sale of 5 million shares of common stock at a price of $1.90 per share. The closing price of our common stock on that date was $2.00 per share.

     Pursuant to a Stock Purchase Agreement dated May 7, 2003, we issued 4 million shares of our common stock to Riverview for $6.5 million, or $1.625 per share. On the date of the agreement, the price was above the trading price of our common stock, which closed at $1.43 per share on that date. We also agreed to issue a 2-year warrant to Riverview to purchase 1,898,000 shares of common stock at $1.50 per share. The exercise price is subject to adjustment for stock splits, dividends, distributions, reclassifications and similar events. The exercise price may be below the trading market price at the time of the exercise. In the event that certain conditions are met, including the closing sale price of the Common Stock remaining at or above $2.50 per share for 10 consecutive trading days, we may require Riverview to exercise the warrant with respect to any remaining warrant shares or relinquish the right to do so. We registered the resale of the purchased shares and the shares to be issued on exercise of the warrants. On November 7, 2003 and November 11, 2003 Riverview exercised a total of 1,098,000 of these warrants at $1.50 by which, we received gross proceeds of $1,647,000.

     On August 23, 2002, pursuant to an agreement with Triton West Group, Inc. (Triton), we sold 1,028,038 shares of common stock for aggregate proceeds of $1,100,000, or approximately $1.07 per share.

     On December 4, 2001, we issued 5,000 shares of 3% Cumulative Convertible Preferred Stock to Riverview. We received total proceeds of $4,727,515 net of applicable fees and other associated costs. Riverview converted 1,000 of the preferred shares on December 7, 2001, at a conversion price of $2.00 per share of common stock, receiving 500,125 shares of common stock; 2,000 of the preferred shares on April 9, 2003, at $0.80 per share, receiving 2,521,042 shares of common stock; and the remaining 2,000 preferred shares on November 11, 2003, for 1,010,833 shares of the Company’s common stock, all inclusive of accrued dividends. As a result of the above

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transactions all of the 3% cumulative convertible preferred stock was fully converted into our common stock before the mandatory redemption date of December 4, 2003.

     On May 10, 2001, we entered into a common stock purchase agreement with Sativum Investments Limited for the potential future issuance and sale of up to $30,000,000 of our common stock, at our discretion and subject to restrictions and other obligations. We drew down $4,000,000, $118,000 and $441,000 before applicable fees in 2001, 2002 and 2003 respectively. The equity line terminated in January of 2004.

     We continue to have outstanding obligations in regard to our former facilities in Lincoln, Rhode Island, including lease payments and operating costs of approximately $1,235,000 for 2004, net of subtenant income of $735,000. We have subleased a portion of these facilities and are actively seeking to sublease, assign or sell our remaining interests in these facilities. Failure to do so within a reasonable period of time will have a material adverse effect on our liquidity and capital resources.

     The following table summarizes our future contractual cash obligations (including both Rhode Island and California leases, but excluding interest income and sub-lease income):

     We have incurred significant operating losses and negative cash flows since inception. We have not achieved profitability and may not be able to realize sufficient revenues to achieve or sustain profitability in the future. We have limited capital resources and we will need to raise additional capital from to time to time to sustain our product development efforts, acquisition of technologies and intellectual property rights, preclinical and clinical testing of anticipated products, pursuit of regulatory approvals, acquisition of capital equipment, laboratory and office facilities, establishment of production capabilities, general and administrative expenses and other working capital requirements. To fund our operations, we rely on cash balances, proceeds from equity and debt offerings, proceeds from the transfer or sale of intellectual property rights, equipment, facilities or investments, and on government grants and collaborative arrangements. We cannot be certain that such funding will be available when needed. The 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.

     We intend to pursue opportunities to obtain additional financing in the future through equity and debt financings, grants and collaborative research arrangements. The source, timing and availability of any future financing will depend principally upon market conditions, interest rates and, more specifically, on our progress in our exploratory, preclinical and future clinical development programs. . Lack of necessary funds may require us to delay, scale back or eliminate some or all of our research and product development programs and/or our capital expenditures or to license our potential products or technologies to third parties.

     With the exception of operating leases for facilities, we have not entered into any off-balance sheet financial arrangements and have not established any special purpose entities. We have not guaranteed any debts or commitments of other entities or entered into any options on non-financial assets.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     No significant changes in our quantitative and qualitative disclosures from the Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES

     In response to the requirement of the Sarbanes-Oxley Act of 2002, as of the end of the period covered by this report, our chief executive officer and (acting) chief financial officer, along with other members of management, reviewed the effectiveness of the design and operation of our disclosure controls and procedures. Such controls and procedures are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the chief executive officer and the chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Based on this evaluation, the chief executive officer and acting chief financial officer have concluded that the Company’s disclosure controls and procedures are effective. During the most recent quarter, there were no changes in internal controls over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, these controls of the Company, and no corrective actions were undertaken.

PART II - ITEM 1

LEGAL PROCEEDINGS

     One party has opposed two of our issued European patent cases. While we are confident that we will overcome the opposition, there is no guarantee that we will prevail. If we are unsuccessful in our defense of the opposed patents, all claimed rights in the opposed patents will be lost in Europe.

PART II –ITEM 2

CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

Under the terms of a license agreement with the California Institute of Technology (Cal Tech), fees of $10,000 and $5,000 were due on the issuance of two patents to which StemCells holds a license from Cal Tech, payable in cash or stock at the Company’s choice. Company elected to pay the fees in stock and issued 9,535 unregistered shares to Cal Tech.

PART II – ITEM 3

DEFAULTS UPON SENIOR SECURITIES

     None

PART II – ITEM 4

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None

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PART II – ITEM 5

OTHER INFORMATION

     None

PART II – ITEM 6

EXHIBITS AND REPORTS ON FORM 8-K

(a) EXHIBITS

Exhibit 31.1 — Certification of Martin McGlynn under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2 — Certification of George Koshy under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1 — Certification of Martin McGlynn Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2 — Certification of George Koshy Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) REPORTS ON FORM 8-K

During the quarter ended September 30, 2004 we submitted the following reports on Form 8-K:

On July 30, 2004, we issued a press release reporting our financial results for the second quarter of fiscal year 2004

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SIGNATURE

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EXHIBIT INDEX

Exhibit 31.1 — Certification of Martin McGlynn under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2 — Certification of George Koshy under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1 — Certification of Martin McGlynn Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2 — Certification of George Koshy Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002