Osiris Therapeutics ( OSIR) hit a snag Tuesday in its quest to develop new stem-cell therapies when a study for a knee-repairing drug came up lame.

In a proof-of-concept study, Osiris injected a mixture of adult stem cells called Chondrogen into the knees of patients who had a torn or damaged meniscus, which is the spongy, shock-absorbing cartilage between the tibia and femur.

It was hoped that stem cells in Chondrogen would implant in the knee and regenerate into new meniscus tissue. But after six months, patients given Chondrogen showed no increase in meniscus volume compared to patients given a sham injection, the company reported.

On Tuesday, Osiris shares fell more than 10%, but had regained some of that loss on Wednesday; the stock was recently up 1.95% to $18.81.

The Chondrogen setback isn't the end of the road for Osiris. The Baltimore-based company has another, more advanced, stem-cell therapy in phase III studies, the last step before potentially seeking FDA approval. As such, the company is much further along than its stem-cell competitors. And Osiris derives its stem cells from adult bone marrow, so it sidesteps the ethical controversy around the use of embryonic stem cells.

But the disappointing data also should remind investors that stem-cell research, while groundbreaking and cool, is still very risky business. And Osiris is no exception.

The Osiris story centers around mesenchymal stem cells (MSCs), which are capable of differentiating into tissues that provide rigidity or stability in the body -- bone, cartilage, fat, tendon or muscle. MSCs may also possess anti-inflammatory properties and appear not to activate an immune response when transplanted into an unrelated or unmatched host.

The company's most advanced pipeline product (and the real driver of the stock's value) is Prochymal, an intravenous infusion containing cultivated MSCs. A phase III trial is currently under way testing Prochymal in patients with graft-versus-host disease who are not responding to steroids.

Graft-versus-host disease, or GVHD, is a potentially life-threatening immune reaction that can occur in patients who have had bone-marrow transplants. In GVHD, immune cells from the donated bone marrow attack the recipient's organs and tissue. There are no approved drugs to treat GVHD, although steroids and other immunosuppressants are often used.

In an interview, Osiris CEO Randal Mills says clinical data suggest that Prochymal might be the first "intelligent" treatment for inflammatory diseases, including GVHD. When injected into a patient, the MSCs in Prochymal migrate to, and target, the specific source of inflammation.

In the case of GVHD, for instance, that's often the gastrointestinal tract. Once there, the stem cells engraft and tamp down chemical signals causing inflammation. They also boost the production of anti-inflammatory chemical signals. When the inflammation dissipates, the stem cells go dormant, explains Mills.

"With steroids, the entire body becomes immune-suppressed, which leaves patients susceptible to infections," says Mills. Prochymal would allow doctors to target problems with much more specificity and without serious side effects, he adds.

Rik Derynk, an expert in mesenchymal stem cells at the University of California San Francisco, says he's not familiar with Prochymal specifically, but he's cautious about claims that MSCs might be used to treat inflammatory diseases.

"I'm concerned because when you inject MSCs into a patient, the cells go everywhere and we don't know what will happen. Most likely nothing, but we don't know," says Derynk, who serves as co-director of the UCSF Institution for Regeneration Medicine.

"I am comfortable with the use of MSCs to regenerate into new mesenchymal tissue, but when it comes to treating inflammatory diseases, I'm not comfortable because I don't think all the science is there yet," he added.

Last December, results from a phase II study of Prochymal used in combination with steroids in GVHD patients showed that 29 of 31 patients, or 94%, responded to Prochymal treatment, while 23 patients, or 74%, achieved a complete response, meaning they experienced a total clinical resolution of their GVHD. Osiris said the response shown by Prochymal was double what is typically seen when patients are treated with steroids alone.

But a closer look at this study reveals some flaws and suggests that Osiris might be overselling Prochymal's efficacy.

The patients in Osiris' GVHD study appear to be a relatively easy to treat. For instance, 100% of the GVHD patients enrolled received their bone-marrow transplants from matched donors, which makes them more likely to respond to treatment compared to patients who receive bone marrow from unmatched donors, according to published research.

In addition, 42% of the patients in the study had GVHD involving the skin only, which again, is easier to treat compared with GVHD affecting the GI tract or internal organs.

Osiris used a liberal definition of response to measure Prochymal's efficacy. In the study, a patient was measured for response on day 28 after treatment. Osiris says the complete response rate at that time point was 74%, double the historical rate.

But the study Osiris cites to make that comparison, published in 2002, defined complete response as total clinical resolution of GVHD at day 28, maintained for another 28 days without requiring any additional treatment.

There were nine patients in the Osiris study who required additional treatment after Prochymal to eliminate their GVHD, including four patients who Osiris deemed complete responders. These patients would not have counted as responders had Osiris used a stricter and more typical definition of efficacy.

Mills defended the design and conduct of the Prochymal study. "We used an incredible efficacy standard for GVHD. The fact that we had 74% of patients with a complete response at day 28 is remarkable," he says.

And he says the study design did not allow patients to be retreated with Prochymal, which explains why some patients required other, additional treatments even after they were deemed responders. "We have re-treatment data with Prochymal if GVHD returns, and it works very well, but not in this trial," he says.

The original design of the Prochymal phase II study called for a control arm to be enrolled, with patients receiving steroids alone that could have been used to more accurately assess Prochymal's efficacy. Response in the original study also called for a measurement at day 42.

But in 2005, right before the phase II study was to start, Osiris altered the study design to eliminate the control group and shorten the efficacy endpoint to measure response at day 28. The changes were made so the study could be run more quickly, the company says. That might be true, but it also lowered the bar by which Prochymal could be deemed a success.

This may also explain why the ongoing phase III trial is only enrolling GVHD patients who no longer respond to steroids (a sicker patient population than enrolled the phase II study.) Osiris is enrolling 240 patients in this phase III study, split between patients getting Prochymal injection and a placebo.

If positive, the company plans to seek FDA approval. Enrollment in the trial is expected to finish up this summer, with data ready for release by the end of the year. Treatment of steroid-refractory GVHD is an unmet medical need, but one with small commercial potential of around $30 million per year.

Investors are right to be excited by companies developing cutting-edge stem-cell therapies. But the path to innovative new cures and treatments for life-threatening diseases is not going to be smooth, as Tuesday's disappointing news from Osiris illustrates. And while the stem-cell headlines may look sensational, the details are what will ultimately count most.

Adam Feuerstein writes regularly for RealMoney.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. Feuerstein appreciates your feedback; click here to send him an email.

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