Bronchopulmonary dysplasia (BPD) and emphysema are characterized by arrested alveolar development or loss of alveoli; both are significant global health problems and currently lack effective therapy. Bone marrow-derived mesenchymal stem cells (BMSCs) prevent adult lung injury, but their therapeutic potential in neonatal lung disease is unknown. We hypothesized that intratracheal delivery of BMSCs would prevent alveolar destruction in experimental BPD. In vitro, BMSC differentiation and migration were assessed using co-culture assays and a modified Boyden chamber. In vivo, the therapeutic potential of BMSCs was assessed in a chronic hyperoxia-induced model of BPD in newborn rats. In vitro, BMSCs developed immunophenotypic and ultrastructural characteristics of type II alveolar epithelial cells (AEC2) (surfactant protein C expression and lamellar bodies) when co-cultured with lung tissue, but not with culture medium alone or liver. Migration assays revealed preferential attraction of BMSCs toward oxygen-damaged lung versus normal lung. In vivo, chronic hyperoxia in newborn rats led to air space enlargement and loss of lung capillaries, and this was associated with a decrease in circulating and resident lung BMSCs. Intratracheal delivery of BMSCs on Postnatal Day 4 improved survival and exercise tolerance while attenuating alveolar and lung vascular injury and pulmonary hypertension. Engrafted BMSCs coexpressed the AEC2-specific marker surfactant protein C. However, engraftment was disproportionately low for cell replacement to account for the therapeutic benefit, suggesting a paracrine-mediated mechanism. In vitro, BMSC-derived conditioned medium prevented O(2)-induced AEC2 apoptosis, accelerated AEC2 wound healing, and enhanced endothelial cord formation. BMSCs prevent arrested alveolar and vascular growth in part through paracrine activity. Stem cell-based therapies may offer new therapeutic avenues for lung diseases that currently lack efficient treatments.