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 March 31, 2019 and our audited consolidated financial statements for the year ended September 30, 2018 included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on November 30, 2018.

This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the Securities Act) and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act) and, as such, may involve known and unknown risks, uncertainties and assumptions. Forward-looking statements are based upon our current expectations, speak only as of the date hereof, are subject to change and include statements concerning our financial performance, including expectations to incur additional losses and plans to fund the Company. Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters. You can generally identify forward-looking statements as those statements containing the words “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “may,” “will,” “would,” “could,” “should,” “might,” “potential,” “continue” or other similar expressions. You should not rely on our forward-looking statements as they are not a guarantee of future performance. There can be no assurance that forward-looking statements will prove to be accurate because the matters they describe are subject to assumptions, known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control. Our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, including the risks described in our Annual Report on Form 10-K for the year ended September 30, 2018 and other reports we file with the Securities and Exchange Commission. Risks and uncertainties include, among others, the possibility that we may be unable to obtain shareholder approval required for the issuance of shares in the proposed Exchange, the expected timing and likelihood of completion of the proposed Exchange, the possibility that our working capital decreases prior to the Exchange, and therefore, that our shareholders are subject to decreased ownership in the combined company, the inability to successfully integrate the businesses or the risk that such integration may be more difficult, time-consuming or costly than expected, the occurrence of any event, change or other circumstances that could give rise to the termination of the share exchange agreement, the inability of the parties to meet expectations regarding the accounting and tax treatments of the proposed Exchange, the potential for the proposed Exchange to involve unexpected costs, the risk that the parties may not be able to satisfy the conditions to the proposed Exchange in a timely manner or at all, risks related to disruption of management time from ongoing business operations due to the proposed Exchange, the risk that the expected benefits of the proposed Exchange are not realized, the risk that any announcements relating to the proposed Exchange could have adverse effects on the market price of our common shares, the availability of funds and resources to pursue our research and development projects, the successful and timely completion of preclinical or clinical studies by third parties in which our products are utilized, our ability to meet the goals of our strategic partnerships, the degree of market acceptance for our products or for other companies’ products in which our products are components, our ability to take advantage of business opportunities in the pharmaceutical industry, changes in our strategy or development plans, our ability to protect our intellectual property, uncertainties related to governmental regulations and regulatory processes, the volatility of our common share price, the effect of competition, the effect of technological changes, reliance on key personnel, our ability to successfully estimate the impact of certain accounting and tax matters, and general changes in economic or business conditions. Except as required by law, we undertake no obligation to update forward-looking statements.

The discussion and analysis of our financial condition and results of operations are based on our unaudited condensed interim consolidated financial statements as of March 31, 2019 and September 30, 2018, and for the six months ended March 31, 2019 and 2018 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

We are a biotechnology company engaged in the aquaculture, research and development, manufacture and commercialization of Keyhole Limpet Hemocyanin (KLH). KLH is an immune-stimulating protein with an extensive history of safe and effective use in immunological applications.

Immunotherapies (also known as therapeutic vaccines) are an emerging class of treatments that involve using the body’s own immune system to target and treat disease. Today, multiple companies and institutions are developing drugs that combine disease-targeting agents with KLH. These disease-targeting agents do not evoke a robust immune response by themselves and thus require a carrier molecule like KLH.

The versatility of the KLH molecule and its use in multiple drug development pipelines provide numerous commercial opportunities for us. The successful commercialization of one or more drug development pipelines, especially in a major indication, could have a significant impact on the industry’s ability to produce sufficient quantities of KLH. The protein is derived only from the Giant Keyhole Limpet, a scarce ocean mollusk that is native to a limited stretch of Pacific Ocean coastline. Due in part to the inherent limitations of utilizing wild sources of KLH, we believe that aquaculture production methods and technologies will be required to provide scalable, fully traceable supplies of KLH.

We market our products under the brand Stellar KLH, including clinical grade KLH produced using Current Good Manufacturing Practices (GMP). Our customers and partners have included multinational biotechnology and pharmaceutical companies, academic institutions, clinical research organizations and research centers. We have multiple agreements to license and supply Stellar KLH and other technology in exchange for fees, revenues or royalties. Our customers manage and fund all product development and regulatory submissions for their respective drug products that utilize our KLH protein. By the time our customers are ready to file marketing applications referencing our products, we will need to upgrade and scale our manufacturing operations to produce KLH suitable for commercial drugs. This will involve, in part, transferring our manufacturing method to a new Stellar-operated location or to a contract manufacturing organization or partner. The timing of such decision will be based on customer demand for Stellar KLH, among other considerations.

Recent Developments

Share Exchange Agreement

On March 7, 2019, we entered into a Share Exchange Agreement (the Exchange Agreement) with Edesa Biotech Inc., a privately-held Canadian company focused on the development of innovative therapeutics for dermatological and gastrointestinal indications with clear unmet medical needs (Edesa), and the shareholders of Edesa. Upon the terms and subject to the satisfaction of the conditions described in the Exchange Agreement, including approval of the transaction by Stellar’s shareholders, Stellar will acquire the entire issued share capital of Edesa in exchange for newly-issued Stellar common shares, with Edesa becoming a wholly-owned subsidiary of Stellar (the Exchange). Following the closing of the Exchange, current Stellar shareholders are expected to own approximately 10%, and the current shareholders and option holders of Edesa are expected to own approximately 90%, of the combined company on a fully-diluted basis, subject to a 2% upward or downward adjustment based upon the amount of Stellar's working capital balance on the day before closing. Following closing of the Exchange, Stellar will change its name to "Edesa Biotech Inc." Considering the focus of the combined company, we intend to develop a new strategic plan for our current operations following closing of the Exchange.

The Exchange Agreement contains customary representations, warranties and covenants made by Stellar and Edesa, including covenants relating to Stellar’s and Edesa’s conduct of their respective businesses between the date of signing the Exchange Agreement and the closing and customary no-solicitation and standstill provisions. Edesa will seek approval from Nasdaq for the combined entity’s continuation of Stellar’s current listing on the Nasdaq Capital Market.

Mexico Subsidiary

On March 29, 2019, Stellar Biotechnologies, Inc. entered into an agreement to sell BioEstelar, S.A. de C.V., a wholly owned subsidiary based in Ensenada, Baja California, Mexico, for a nominal consideration rather than pursue a more costly wind-down of the subsidiary. The loss on disposition of subsidiary of $0.02 million is included in general and administrative expenses in the accompanying condensed interim consolidated financial statements. Since 2017, BioEstelar has managed early-stage aquaculture research and development projects and a site suitability study in Mexico for Stellar. In connection with the sale, BioEstelar intends to cancel its current lease agreements for undeveloped land in Baja California and office space in Ensenada. We disposed of approximately $0.03 million leasehold improvements which is included in research and development expenses in the accompanying condensed interim consolidated financial statements.

Neostell Joint Venture

In May 2016, we entered into a joint venture agreement with Neovacs S.A, a Paris-based biotechnology company, for the formation of a joint venture company to manufacture and sell conjugated therapeutic vaccines.  In July 2016, Neostell S.A.S., a French simplified stock corporation (Neostell), was formed to carry out the business of the joint venture.  Neostell is expected to produce Neovacs’ product candidates that utilize Stellar KLH as a carrier molecule and may also manufacture and sell other KLH-based immunotherapy products for third-party customers. We hold a 30% equity interest in the joint venture in exchange for an initial capital contribution of €120,000. One-half of the initial contribution, approximately $67,000, was paid in June 2016 with the balance due upon the occurrence of certain defined future events. Pursuant to the joint venture agreement, on December 31, 2018, we notified the other party that we no longer wished to pursue the project and the parties subsequently agreed to proceed with actions to dissolve and liquidate the joint venture company by mutual consent.

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 September 30, 2018, as filed with the Securities and Exchange Commission (SEC) on November 30, 2018. 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 September 30, 2018 except that the Company adopted Accounting Standards Codification (ASC) 606  Revenue Recognition – Revenue from Contracts with Customers  on October 1, 2018, as discussed in Note 2 to this quarterly report.

Results of Operations

Comparison of the Six Months Ended March 31, 2019 and 2018

Our total revenues increased by $0.09 million to $0.17 million for the six months ended March 31, 2019 compared to $0.08 million for the same period last year primarily due to increased sales of higher value, clinical-grade KLH products. Product sales volumes are subject to variability associated with the rate of development and progression of clinical studies of third-party products that utilize Stellar KLH.

Our total operating expenses increased by $0.44 million to $3.26 million for the six months ended March 31, 2019 compared to $2.82 million for the same period last year:

Our total other income (loss) increased by $0.05 million to an overall gain of $0.03 million for the six months ended March 31, 2019 compared to an overall loss of $0.02 million for the same period last year primarily due to increased investment income, and reduced foreign exchange loss due to less funds held in Canadian dollars and fluctuations in Canadian exchange rates.

Our net loss for the six months ended March 31, 2019 was $3.06 million, or $0.57 per basic share, compared to a net loss of $2.75 million, or $1.83 per basic share, for the six months ended March 31, 2018.

Comparison of the Three Months Ended March 31, 2019 and 2018

Our total revenues increased by $0.06 million to $0.12 million for the three months ended March 31, 2019 compared to $0.06 million for the same period last year primarily due to increased sales of higher value, clinical-grade KLH products. Product sales volumes are subject to variability associated with the rate of development and progression of clinical studies of third-party products that utilize Stellar KLH.

Our total operating expenses increased by $0.39 million to $1.80 million for the three months ended March 31, 2019 compared to $1.41 million for the same period last year.

Our total other income (loss) increased by $0.04 million to an overall gain of $0.03 million for the three months ended March 31, 2019 compared to an overall loss of $0.01 million for the same period last year primarily due to increased investment income, and foreign exchange gain due to fluctuations in Canadian exchange rates.

Our net loss for the three months ended March 31, 2019 was $1.66 million, or $0.31 per basic share, compared to a net loss of $1.35 million, or $0.90 per basic share, for the three months ended March 31, 2018.

Capital Expenditures

Our capital expenditures, which primarily consist of scientific, manufacturing, and aquaculture equipment, and facility leasehold improvements were $0.01 million and $0.21 million for the six months ended March 31, 2019 and 2018, respectively. The decrease was due primarily to a decrease in construction in progress related to the completion of construction of renovated ocean-front space for aquaculture production and related activities at our facility located at the Port of Hueneme.

Liquidity and Capital Resources

Our operations have historically been funded by the issuance of common shares, exercise of warrants, grant revenues, contract services revenue and product sales. For the six months ended March 31, 2019 and 2018, the Company reported net losses of $3.06 million and $2.75 million, respectively. We plan to finance company operations over the course of the next twelve months with cash and investments on hand and product sales. Management has flexibility to adjust planned expenditures based on a number of factors including the size and timing of capital expenditures, staffing levels, inventory levels, and the status of customer clinical trials. In light of the proposed share exchange agreement with Edesa Biotech Inc, management has taken steps to conserve working capital, while maintaining our core competencies, technology and associated activities. To help fund its operations and meet its obligations, the Company may also seek additional financing through debt and/or equity financings.

On May 15, 2018, we completed a registered public offering resulting in net proceeds of $4.64 million. On May 29, 2018, we closed an offering with certain holders of our warrants, pursuant to a warrant exercise agreement, resulting in net proceeds of $2.49 million. During May and June 2018, other warrant exercises resulted in net proceeds of $1.64 million.

At March 31, 2019, we had cash, cash equivalents and short-term investments in U.S. Treasury Bills of $7.68 million, working capital of $7.26 million, shareholders’ equity of $8.27 million and an accumulated deficit of $53.49 million.

Geographic Concentrations

We primarily market and distribute our products directly to biotechnology and pharmaceutical companies, academic institutions, clinical research organizations and research centers. Products are shipped to our customers using a common carrier chosen by the customer. The geographic markets of our customers are principally North America, Europe and Asia. We had the following concentrations of revenues by geographic areas:

The geographic concentration of our product sales revenue fluctuates quarter over quarter, sometimes significantly, depending on the volume of sales from our customers in each of our principal geographic markets.

Research and Development

Our core business is developing and commercializing Keyhole Limpet Hemocyanin for use in immunotherapy and immunodiagnostic applications. Our internal research has included, 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.

Research and development costs, including (i) materials, (ii) KLH designated for internal research use only and (iii) salaries of employees directly involved in research and development efforts, are expensed as incurred. From time to time, we produce saleable KLH as a byproduct of our research and development activities. The cost of this KLH is not assigned to inventory.

Our research and development costs were $0.85 million and $1.12 million for the six months ended March 31, 2019 and 2018, respectively. The decrease from the comparable period was primarily due to a decrease in contracted research services and materials.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements 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.