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Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.

In May, the Delaware Supreme Court upheld a 2011 ruling by Vice Chancellor Parsons that SIGA (NASDAQ:SIGA) had breached its contractual obligation to negotiate in good faith with PharmAthene (NYSEMKT:PIP), but remanded the Vice Chancellor's remedy, which had consisted of a single "equitable income stream." On July 3, I proposed a three-part alternative remedy that would be more equitable and less susceptible to manipulation by SIGA, and projected how adopting this remedy would affect PharmAthene's share price under various scenarios. On July 12, PharmAthene submitted a brief justifying its proposal to re-open the record before the Vice Chancellor responds to the Supreme Court's instructions. Below, I explain how elements in the brief provide a basis for (1) believing that the Vice Chancellor will allow the record to be re-opened, and (2) revising both my proposed remedy and my projections regarding PharmAthene's share price.

Background Information

In 2006, SIGA found itself financially strapped while trying to conduct R&D on Arestvyr (formerly known as ST-246, its antiviral drug for treating smallpox). It signed two agreements that said that if a merger was not completed, the parties would negotiate in good faith to execute a definitive license agreement. If successfully negotiated, the license would grant PharmAthene control over Arestvyr in accordance with the terms of a License Agreement Terms Sheet (LATS) that was attached as an exhibit to both documents, but never signed. When the research efforts proved favorable enough for SIGA to land an NIH grant, it torpedoed the negotiations by proposing economic terms that were so different from those contained in the LATS that PharmAthene sued.

The Vice Chancellor imposed expectation damages on SIGA in the form an "equitable income stream," which consisted of a 50/50 split of net profits after the first $40 million of net profit. Although the Supreme Court remanded the "case for reconsideration of the damages award consistent with [its] opinion" (p. 38), it did not comment one way or the other on whether an equitable stream was an appropriate remedy, or whether his proposed equitable stream was too large.

My proposed remedy had been based on three ideas.

1. Because SIGA already has a record of bad faith, the remedy would be fairer to the injured party if the goal of the equitable streams related to domestic contracts was to estimate how much PharmAthene would receive under the Vice Chancellor's remedy, but use a formula for calculating the payments that was less susceptible to accounting manipulation.

2. Since the parameters for the current contract with BARDA are now known but different from those of future BARDA contracts (because of the $40 million), the current contract could be used to calculate a fair restoration payment per course of Arestvyr for future domestic contracts.

3. Since contracts with the U.S. government were to be treated differently in the LATS, the remedy should also treat foreign contracts differently from domestic contracts.

My earlier remedy consisted of three separate equitable income streams, one each for the current supply contract with BARDA, for future contracts with BARDA, and for future contracts with foreign governments.

Key Elements in PharmAthene's Brief

You can obtain a copy of the July 12 brief from PharmAthene's investor relations representative at Stacey.Jurchison@pharmathene.com. It contains elements related to opening the record, crafting an equitable remedy, and projecting PharmAthene's share price can be divided into four categories: those that relate to, respectively, Delaware law, the current supply contract with BARDA, future domestic contracts, and future foreign contracts.

Elements Related to Delaware Law

This section is important because if the Vice Chancellor does not find PharmAthene's arguments regarding re-opening the record to be persuasive, then most of the remainder of this article will be irrelevant to finalizing the remedy. But PharmAthene's opening gambit is strong: "Both the Delaware Supreme Court and this Court have recognized that trial courts have discretion to reopen the record in the interests of justice. The Supreme Court has stated, for example, that 'there is no absolute bar in Delaware to admitting new evidence in a second trial after reversal and remand'" (Brief, p.12)

Thereafter, PharmAthene reviews the three factors that the Supreme Court takes into account, which are consistent with the seven factors that, in Carlson v. Hallinan, the Court of Chancery considered. Below is the gist of why PharmAthene believes each of the Carlson factors favors re-opening the record in this case.

(1) Whether the evidence has come to the moving party's knowledge since the trial. PharmAthene asserts that the first two criteria favor re-opening the record since almost all of the evidence consists of SIGA SEC filings and earnings call transcripts that occurred after the Vice Chancellor's ruling in 2011. The exception was data related to HGSI's accounting practices, that did not become relevant until 2013, when SIGA revealed for the first time that it was voluntarily electing to delay revenue recognition as long as possible.

(2) Whether the exercise of reasonable diligence would have caused the moving party to discover the evidence for use at trial. See the reasoning immediately above.

(3) Whether the evidence is so material and relevant that it will likely change the outcome. PharmAthene asserts that the evidence is "beyond question." PharmAthene said "The Supreme Court has recognized that later arising evidence related to damages is appropriately considered on remand. Moreover, Delaware courts look to post-breach events in determining damages, even where damages are measured at the time of the breach" (Brief, p. 15, fn. 48, internal citations deleted). Although PharmAthene did not explicitly explain how the information might change the outcome, I infer that, at minimum, its legal team seeks a remedy that (1) is yoked to when SIGA receives income from BARDA, not to when SIGA elects to recognize the income as revenue; and (2) takes account of the income that has already been received.

(4) Whether the evidence is material and not merely cumulative. Materiality and relevance are addressed immediately above. Rather than explain why the evidence is not merely cumulative, PharmAthene merely asserts that it is not. I infer that they are convinced that the evidence is not cumulative because it is not more of the same, but rather that details relating to the existing supply contract, accounting procedures, and income already received is different in kind as opposed to different in amount.

(5) Whether the moving party has made a timely motion. PharmAthene addresses timeliness by pointing out that it brought up the issue shortly after remand (at the status conference a month after the Supreme Court opinion).

(6) Whether undue prejudice will inure to the nonmoving party. PharmAthene asserts "There is no prejudice to Siga in the admission of its own public statements and publicly filed corporate reports, its contract with BARDA for the supply of ST246, BARDA's own public statements in support of its decision not to put the contract out for competitive bidding, the SEC revenue recognition release, [and of] certain SEC filings of Human Genome Sciences, Inc. (HGSI)" (Brief, p. 15

(7) Considerations of judicial economy. PharmAthene argues that, "the burden placed on the parties by limited supplementation is de minimis (especially given that no witness testimony will be presented and that the supplemental evidence is documentary in nature and much of it representing statements of the Defendant)" (Brief, p. 14). Furthermore, PharmAthene points out (with a footnote buttressing its point) that "the refusal to permit supplementation at this juncture may result in PharmAthene seeking to supplement the record in a future appeal, and a subsequent remand for this Court to consider the evidence PharmAthene now proffers" (Brief, p. 14).

Elements Related to the Current Supply Contract

The current contract with BARDA is divided into two components: a procurement component related to manufacturing, storing, and shipping Arestvyr (hereafter referred to as "the supply contract"), and a component to support further R&D related to Arestvyr. The PharmAthene brief provided clarity regarding the size of the supply contract as well as how SIGA's cash position depends upon milestones and contingencies. It also provided information that SIGA has elected to adopt accounting procedures that could result in postponing court-ordered payments to PharmAthene for a substantial and indeterminate period. Each is described in turn.

The size of the supply contract. PharmAthene states that SIGA will receive $307,358,816 for delivering 1.7 million courses of treatment, which will be increased by $102,452,939 if Arestvyr receives FDA approval (see below for details about what FDA approval entails).

Milestones and contingencies affecting SIGA's cash balance. I will not describe milestones that have already been met, or those that link payments to delivered courses, except to report that according to SIGA's July 16 press release, 590,000 course have already been delivered, enough to start invoicing BARDA. This section will focus upon four contingencies: FDA approval, evidence that Arestvyr has a seven-year shelf-life, the sequester, and the possibility that SIGA may be required to replace already-delivered courses at no cost.

1. FDA approval. PharmAthene makes only one statement about FDA approval that is not linked to issues of timing and payment, and that statement will be quoted in the discussion of foreign orders. However, it does provide this sobering quote from SIGA's 2012 Form 10K: "The Secretary of HHS concluded that, prior to award of the BARDA Contract in May 2011, ST246, now also known as Arestvyr, will qualify within eight years for approval by FDA for therapeutic use against smallpox" (Brief, p. 8).

Nevertheless, because BARDA will hold back ¼ of the money until Arestvyr has received FDA approval, I have included some additional information that is relevant to investors. First, a quotation from SIGA's CEO, Eric Rose: "I think it's been encouraging to see the FDA make approvals using the Animal Rule. In just the last quarter, they approved raxibacumab from BMS . . . [W]e had been concerned that we might have to be the first company out of the gate to get a new molecular entity approved by the mechanism" (Earnings call, 3/6/13).

Later, in the same earnings call, he provided additional information: "[T]here are multiple development activities that include both animal models and, at some point . . . , a pivotal human safety study as well. But . . . because of the remarkably safe toxicology and lack of adverse events in the studies that we've had before, . . . until there is further animal work, . . . additional confirmatory human safety studies are not necessary at this point . . . with regard to the procurement" (Earnings call, 3/6/13).

Finally, here is some information that is reassuring to both SIGA and PharmAthene about the prospects for FDA approval:

"Human clinical trials have shown that ST-246 is safe and well-tolerated in healthy human volunteers. . . . No severe adverse events . . . were observed, and no subject was withdrawn due to ST-246. . . . Based upon data from preliminary animal efficacy studies, an oral dose of approximately 3 mg/kg in non-fasted non-human primates confers 100 per cent protection from death following intravenous injection of monkeypox virus. . . . ST-246 has also been successfully used in four cases where individuals contracted orthopoxvirus disease after accidental exposure to a virus. . . . ST-246 was used as an emergency Investigational New Drug (NYSE:IND) in these unusual cases, with positive outcomes for each individual. [SIGA's Dr. Henry] Hruby has been encouraged by these results: 'Although conclusions are difficult to make . . . , the empirical data supports the concept that the drug is likely to be both safe and effective.'" ("Solutions to the smallpox threat", pp. 6-7)

2. Evidence that Arestvyr has a seven-year shelf-life. PharmAthene did not mention this milestone, but I include this quote from Rose because it is of relevance to SIGA and PharmAthene investors: "[O]ur target shelf life is five years. We are incented and expect [to get] bonus payments if we can prove seven years of shelf life" (Earnings call, 11/5/12). To my knowledge, SIGA has not publicly disclosed either the current age of the existing product that will be tested when it is seven years old, or the size of the possible bonus.

3. The sequester. PharmAthene does not mention the sequester, but because some investors may be concerned about it, here is how Rose and CFO Dan Luckshire responded when asked about it.

Rose: Our understanding of our contract is that it's in budgets that are not part of the sequester.

Luckshire: The money funding our contract came from a special reserve fund that was appropriated… in 2004. So it was not part of an annual appropriation process. And so that amount has been obligated to our contract. (Earnings call, 3/6/13)

4. The possibility that SIGA may be required to replace already-delivered courses. PharmAthene states: "Under its contract with the U.S. Government, SIGA is required to replace product at no cost to the government if 'final FDA approved product is different from any product previously delivered'" (Brief, p. 9). Note that this contingency only arrives if Arestvyr receives FDA approval, and if it does, whether or not SIGA will be obligated to replace any product will be known at that time.

PharmAthene includes an observation by Rose that could affect the timing of payments in the Vice Chancellor's revised remedy: "[B]y the time the Court reissues a ruling on a remedy in this case, SIGA should (1) have received no less than $136.5 million under its 2011 supply contract with the U.S. Government and (2) complete remaining product delivery in less than 18 months" (Brief, p. 6).

Accounting procedures. At the heart of PharmAthene's effort to re-open the record is a newly revealed link that SIGA has made between BARDA's replacement right (described immediately above) and how income from BARDA will be recognized for accounting purposes. The link was announced in SIGA's 2013 1st Quarterly Report on Form 10Q and its 2012 Annual Report on Form 10K, both of which state: "The BARDA Contract provides certain product replacement rights with respect to delivered courses. For this reason, recognition of revenue that might otherwise occur upon delivery of courses is expected to be deferred until the Company's obligations related to potential replacement of delivered courses are satisfied." (Brief, p. 6).

In its March 6, 2013 earnings call, SIGA CFO Dan Luckshire stated: "Cash receipts from the delivery of product when they occur in the future are expected to materially enhance our cash resources" (Brief, p. 6).

From the transcript of this same earnings call, PharmAthene quoted an exchanges involving AG Advisors analyst Fred Greenberg and SIGA's CFO regarding how cash received from BARDA can be used:

Greenberg: "[I]s that restricted? I assume you can use it for anything you want?"

Luckshire: "Correct, yes." (Brief, p. 7)

PharmAthene did not include the following exchange between Noble Financial Group analyst Nathan Cali and SIGA's CFO that took place in the same earnings call. I include it here because it describes SIGA's take on what happens if FDA does not approve Arestvyr, and sets forth SIGA's alleged reason for adopting this accounting procedure:

Cali: In a situation where you may not receive FDA approval, the monies that you generate from the initial 1.7 million courses, that will be recognized as revenue at some point no matter what, even if you don't receive FDA approval?

Luckshire: Well, at some point, if it becomes clear that we cannot achieve FDA approval . . . the deferred revenue will become revenue. But there would have to . . . [be a fulfilling of a] remaining element of the contract. That's a point far, far into the future, so we wouldn't really want to speculate about it. . . .

Cali: And is that something that BARDA is making you guys do, or is that something you're doing on your own as far as deferment of the revenues for the 1.7 million courses?

Luckshire: No, this is just GAAP. (Earnings call, 3/6/13)

Luckshire unequivocally asserted that although BARDA is not compelling SIGA to defer revenue recognition, GAAP requires that they do so. However, as PharmAthene points out: "In 2005, the SEC addressed the concern of vaccine manufacturers regarding the timing of 'revenue recognition for vaccines placed into stockpile related to the Vaccines for Children Program and the Strategic National Stockpile,' approving a revision to the general GAAP rule of not allowing revenue recognition prior to delivery by providing vaccine manufacturers the right to elect to recognize revenues sooner. The SEC adopted this change to mitigate the risk of manufacturers 'declin[ing] to participate in these critical stockpile programs.'" (Brief, p. 8)

PharmAthene then provided a head-to-head comparison of SIGA and Human Genome Sciences, Inc. (HGSI), which manufactures a treatment for anthrax. Both SIGA and HGSI have a clause that says that if the final FDA approved product differs from the product that had been delivered previously under the contract, then the company supplying the product is required to replace such previously delivered product. However, PharmAthene points out that, unlike SIGA, HGSI, in accordance with the revised SEC rule, elected in 2009 to recognize revenue as shipments occur, and continued to do so through December 2012, when it drug received FDA approval (see Brief, pp. 8-10).

Because of the importance of this revenue recognition issue, I shall recap the three main points and make an observation. The summary is that:

  • SIGA has adopted an accounting procedure that could result in postponing court-ordered payments to PharmAthene for a substantial and indeterminate period.
  • Meanwhile, cash will appear on balance sheet and may be used however SIGA chooses.
  • Contrary to what Luckshire said, this choice of accounting procedure is voluntary, and at least one biodefense company facing the same possibility of replacing delivered drugs at no cost has elected to recognize the revenue when it is received.

My observation: Although PharmAthene presented the above evidence without editorializing, it would not be surprising if the Vice Chancellor's review of the record led him to characterize SIGA's voluntary selection as a continuation of its previous bad faith

Elements Related to Future Domestic Contracts

PharmAthene included this summary of events familiar to many investors following SIGA: "[I]n May 2011, the U.S. Government entered into a contract with SIGA to purchase 1.7 MM courses of therapy of ST246, with an option to purchase up to additional 12 MM courses of therapy. As a result of a protest by a competitor, in June 2011 the supply contract was amended to remove the 12 MM course option. In its press release disclosing the contract modification, SIGA stated that '[t]he contract modification does not prevent BARDA from purchasing additional courses of ST246 or other products in the future if it desires.'" (Brief, pp. 3-4)

Elements Related to Future Foreign Contracts

As context to the sole item in the July 12 brief about possible future foreign contracts for Arestvyr, note how SIGA's Rose responded to a question about the interest of foreign governments: "I think there is considerable awareness of our drug, of its potential use in biodefense, and certainly, the acquisition of the drug into the United States SNS is something that is drawing attention from other countries. There is no analogous legal framework in other countries to the emergency use authorization type of mechanism that's the basis for the BARDA acquisitions of drugs like ours, and I'd say also like most of the other drugs that BARDA's acquired, which have later gone on, typically, to full approval. I think there is considerable interest on the part of policy people in these other countries . . . to explore potential mechanisms that would allow them to acquire drugs . . . at an earlier stage than FDA approval." (Earnings call, 3/6/13)

Yet PharmAthene's brief mentions that SIGA's 20212 10K told a different story: "Certain foreign jurisdictions, including the European Union, have adopted biodefense-specific regulation akin to that available in the United States such as a procedure similar to the 'animal rule' promulgated by FDA" (Brief, p. 6).

My Proposed Remedy, Revised

My revised remedy contains the same three equitable income streams, but with different values, derived via simpler calculations, using the data presented above.

Equitable stream for the current supply contract. The section "The size of the supply contract" says that for delivering 1.7 million courses of Arestvyr, SIGA will receive $307,358,816 + $102,452,939, which totals $409,811,755. Since the profit for Arestvyr is likely to equal or exceed 50% of its selling price (see my previous article), the revised estimate for profit from the supply contract (not counting a bonus for demonstrating that Arestvyr has a seven-year shelf-life) is ½ the total price = $204,905,877.50. Using the Vice Chancellor's principles that SIGA should retain the first $40 million and that subsequent profit should be divided equally between SIGA and PharmAthene, PharmAthene's share should be $82,452,938.75 plus half of any bonus if SIGA demonstrates that Arestvyr has a seven-year shelf life.

However, the $82 million needs to be viewed in terms of its two components:

  • $56,839,704 (derived from subtracting the $40 million from 50% of $307,358,816 and then splitting the remainder equally between SIGA and PharmAthene), and
  • $25,613,235 (derived from taking 50% of $102,452,939 and then splitting the remainder equally between SIGA and PharmAthene).

The larger component would be PharmAthene's share of income to SIGA that will have fully received in less than two years, within 30 days of delivering the final batch of Arestvyr under the current supply contract. The smaller component will not be received unless and until Arestvyr receives FDA approval. The Vice Chancellor could work out a specific schedule for SIGA paying PharmAthene's restoration payments for the larger component, while linking the smaller component (and half of any shelf-life bonus) to payments when and if they are received.

If PharmAthene is correct that SIGA will have received at least $136.5 million by the time that the Vice Chancellor issues his revised remedy, then PharmAthene would be justified in expecting an immediate payment of at least $14.125 million (derived from subtracting $40 million from 50% of $136.5 million and then splitting the remainder equally between SIGA and PharmAthene), plus whatever share of its legal costs the Vice Chancellor decides should be paid by SIGA. The remaining $42,714,704 could be divided into six payments of $7,119,117 due every three months.

Equitable stream for future domestic contracts. The total profit/course for the supply contract equals $204,905,877 divided by 1.7 million courses = $120.533. For future domestic contracts, PharmAthene should receive restoration payments of 25% of the total contract price or $60.266/course of Arestvyr, which is what PharmAthene's restoration payment/course would have been for the current supply contract without the one-time $40 million deduction. This restoration payment/course figure is derived from dividing $120.533 equally between SIGA and PharmAthene. SIGA should make its restoration payments within 90 days of receiving income from such contracts.

Equitable stream for future foreign contracts. Following the reasoning in my previous article, PharmAthene should receive 2/3 of the profit for foreign contracts. Thus for future foreign contracts, PharmAthene should receive restoration payments of 1/3 of the total contract price or $80.355/course of Arestvyr. SIGA should make its restoration payments within 90 days of receiving income from such contracts.

Implications for PharmAthene's Share Price

As before, estimating PharmAthene's two-year target price is a three-stage process. The first stage involves calculating, for various scenarios, PharmAthene's ten-year income from restoration payments by SIGA. The second involves calculating for each scenario a share price component solely attributable to restoration payments. The third involves estimating a two-year target share price that takes into account PharmAthene's pipeline of biodefense drugs.

Ten-Year Income From Restoration Payments (Under Various Scenarios)

The figure below displays ten-year income under eight scenarios. The first variable is how many courses of Arestvyr BARDA will purchase from SIGA beyond the current supply contract. BARDA has indicated its desire to purchase 12 million courses, and the four points on the number-of-courses-purchased-from-SIGA continuum ranging from 50% to 100% of these 12 million courses.

The second variable is how many courses of Arestvyr foreign countries will purchase from SIGA. There are two points on this second dimension: "Only Domestic Orders" (meaning no foreign contracts) or "Domestic and Foreign Orders (Excluding China and Russia)."

The foreign order estimate assumed that:

  • Israel, a small, wealthy, and besieged country would seek to protect proportionally half as many of its citizens (2.27%) as the U.S. (4.545%); this would result in Israel ordering 181,955 doses.
  • Non-Chinese foreign countries with the largest economies would seek to protect proportionally 1/8 as many of its citizens (0.57%); this would result in Japan, Germany, France, Brazil, and the UK collectively ordering 3,007,398 doses (This 3 million dose figure contemplates that while some of these countries many not place any orders, others may place larger orders, and/or other countries not on the list might place orders).

(click to enlarge)

Share Price Component Solely Attributable to Restoration Payments (Under Various Scenarios)

To estimate a two-year price target for PharmAthene shares under these eight scenarios, I made four more assumptions:

  1. Its restoration payment income is dispersed evenly across the next ten years.
  2. Given that according to PharmAthene's last earnings call, lost 2.1 million during the last quarter. If this were annualized, it would be losing $8.4 million/year. And if it lost money for its R&D pipeline at double the rate (since it would now have more money to invest), its net income under any scenario would then be its income from the restoration payments under that scenario minus $16.8 million. Note, however, that during the entire quarter during which PharmAthene lost $2.1 million loss (which I then multiplied by 8), its centerpiece anti-anthrax program was on clinical hold, meaning that PharmAthene was not receiving any income for SparVax R&D from BARDA. Now that the clinical hold has been lifted, PharmAthene would be expected to incur a smaller loss.
  3. Since there are 49.46 million shares outstanding, PharmAthene's net income per share under a scenario would then be its net income under that scenario divided by 49.46 million shares.
  4. PharmAthene's P/E ratio will equal 1/2 of its industry average, which according to Yahoo Finance, is 19.12. This would mean a P/E of 9.56. This 50 percent discount is very conservative, and is based on the uncertainty related to the litigation. The P/E ratio would certainly increase once the litigation was finally settled and after PharmAthene starting at least doubling its R&D expenditures as suggested above.

The figure below displays my two-year price target for PharmAthene shares for the same eight scenarios.

(click to enlarge)

Taking Into Account PharmAthene's Pipeline of Bio Defense Drugs

In my previous article, I quoted a 2010 article in which James Altucher suggested that SparVax might be worth "$10 in value for the stock." Without much basis other than a conservative inclination, I suggested that perhaps it was worth at least a third of that ($3.33/share). During the last two weeks, I have been learning more about PharmAthene's pipeline, and intend to write an article describing what I learned. At this point, I think that Altucher may have been closer to the mark than I was.

One other consideration: In my previous article, I had made estimates that included sales to China and Russia. On the one hand, they have huge populations and are very defense-conscious. On the other hand, they are unlikely to be willing to pay to protect anywhere the same proportion of its population. If China and Russia collectively purchased enough courses of treatment to protect proportionally 1/32 as many of its citizens (0.14%) as the U.S. seeks to protect, then it would order 2,122,223 courses of Arestvyr, which would yield $170,531,229 over ten years and add $3.30 to the target share price.

Next Steps

The deadline for SIGA to respond to PharmAthene's brief is July 30. PharmAthene will then have a deadline of August 8 to submit its final brief. Vice Chancellor will have his new clerk in the middle of August, and the litigation will proceed. When it is finally settled, investors in both companies will be rewarded for their patience.

Source: Revelations From PharmAthene's Legal Brief: Implications For Investors