A Case For Buying Both Siga And PharmAthene

| About: SIGA Technologies (SIGA)

Anyone who has read any of my prior Seeking Alpha articles on the court case between SIGA (NASDAQ:SIGA) and PharmAthene (NYSEMKT:PIP) -- "PharmAthene's Damage Award Will Be Limited To Reliance Damages"; "PharmAthene Vs. Siga: An Open Letter To Delaware's Vice Chancellor Parsons" and "SIGA Or Pharmathene: Who Really Won?" -- knows that I think SIGA will not have to pay out a significant damage award to PharmAthene.

I still believe I am right about the probable future outcome of the legal battle between these two companies. However, when I analyzed the overall situation, I think there is a strong argument to own shares in both companies. In fact, I think that SIGA's current share price, which is around $3.16, values SIGA as though they will have to pay a huge damage award to PharmAthene while PharmAthene's current share price, which is around $2.03, is valued as though they won't receive any award from SIGA. Obviously both of these things cannot be true and the outcome will probably be somewhere in between. By owning both of these companies, you should have a positive return on your investment regardless of who actually wins the legal battle between these two companies.

So that we understand a part of what these two companies are fighting over, we have to look to SIGA's BARDA government contract as well as to the most recent financial statements filed by SIGA in their November 6, 2013 10-Q for the 3rd quarter of 2013. I think fellow Seeking Alpha author, Francisco Javier Garcia, had an interesting article- "How The BARDA Government Contract Will Impact SIGA's Share Value" which derived an estimate SIGA share value of $12.96 even after splitting future profits from that contract 50-50 between SIGA and PharmAthene above the $40 million threshold. However I don't think he adequately broke out the true future profit value of that BARDA contract which was exposed in the 3rd quarter 10-Q.

In that 2013 3rd quarter 10-Q we find out that SIGA has broken out all prior payments received from that BARDA contract as "Deferred revenues" in the long term liability section of the balance sheet as well as SIGA has also broken out the direct costs (future "Cost of goods sold") matching those deferred revenues as "deferred costs" per this excerpt from note 2. Procurement Contract and Research Agreements:

"In accordance with the authoritative accounting principles, the Company has recognized revenue for reimbursement of certain BARDA Contract research and development services. Cash inflows related to procurement activities will continue to be recorded as deferred revenue. In addition, direct costs incurred by the Company to fulfill the requirements under the BARDA Contract are being deferred and will be recognized as expenses over the same period that the related deferred revenue is recognized as revenue.

As of September 30, 2013 and December 31, 2012, deferred direct costs under the BARDA Contract of approximately $21.9 million and $2.8 million, respectively, are included in deferred costs on the consolidated balance sheets. As of September 30, 2013, the Company recorded $162.1 million as deferred revenue for the delivery of approximately 725,000 courses of Arestvyr to the Strategic Stockpile in 2013 and certain research and development services provided as part of the BARDA Contract."

Note: Deferred revenues as of December 31, 2012 were listed as $57,053,020 as derived directly from the Condensed Consolidated Balance Sheets

From these numbers we can begin to estimate the gross profits from this BARDA contract which will be recognized at some time in the future, possibly when Arestvyr receives FDA approval. It appears that some of the payments already received prior to 2013 for the contract had higher markup percentages since at December 31, 2012 the direct costs were only $2.8 million compared to $57 million in matching deferred revenues. This would be equal a markup percentage of 95% (($57 million minus $2.8 million) divided by $57 million). This markup percentage declined during the nine month period ending September 30th 2013, as the balance sheet listed $21.9 million dollars (an increase of $19.1 million) in deferred costs and $162.1 million in deferred revenues (an increase of $105.1 million), resulting in an incremental markup percentage of 82% (($105.1 million minus $19.1 million) divided by $105.1 million).

Included in the $162.1 million in deferred revenues reported were $96 million in BARDA payments per this excerpt from SIGA's 3rd quarter 2013 10Q:

"As of September 30, 2013, the Company has delivered an aggregate of approximately 725,000 courses of Arestvyr ™ (tecovirimat), also known as ST-246®, to the U.S. Strategic National Stockpile (the "Strategic Stockpile"). As a result, SIGA has met a key requirement of its procurement contract with the Biomedical Advanced Research and Development Authority ("BARDA") (refer to Note 2) and received payment of approximately $96 million in the third quarter of 2013 for the courses of product delivered as of September 30, 2013."

Using the above information, we can derive that SIGA was paid approximately $132 per course ($96 million divided by 725,000 courses). Using a conservative 80% markup percentage, derived above, this would indicate an approximate $26 per course direct cost (1- .80) * $132). In the below quote, derived from Seeking Alpha's transcript of SIGA's 3rd quarter 2013 conference call, Eric Rose also disclosed that SIGA has made significant progress on their contract with the U.S. government and expected to complete all currently contracted shipments within the next year:

"With the receipt of payments for delivery of product, SIGA had $105 million of cash, cash equivalents and investments as of September 30. And going forward, we plan to deliver more than 1 million additional courses within the next year, of which approximately 975,000 courses will be invoiced for the government, and the remaining courses will be free of charge."

If we combine all of the information derived from SIGA's 3rd quarter 10-Q, we can compute an estimate of gross profits for all of the 2 million courses to be shipped to the government per the current BARDA contract:

9/30/13 Deferred Revenues- $162.1 million

9/30/13 Deferred Costs - $21.9 million

9/30/13 Deferred Gross Profits - $140.2 million ($162.1 million - $21.9 million)

Calculation of next 12 months profit on shipments:

975,000 remaining courses times ($132 per course minus $26 cost per course) = $103.4 million in gross profit300,000 free courses times $26 = $7.8 million cost

From the above numbers, we can calculate an estimate of expected gross profit from the current BARDA contract:

$140.2 million + $103.4 million - $7.8 million cost = $235.8 million in future gross profits

Mr. Crane, PharmAthene's attorney, at the August 15th 2013 hearing stated that SIGA could potentially get an additional $100 Million dollars of pure profit if Arestvyr is approved as is by the FDA:

"An additional $600 per course is reserved dependent upon FDA approval. If FDA approves -- it totals another hundred million, if they have to replace-- they don't have to refund the $300 million, Your Honor. They get the additional $100 million to produce the replacement drug. If they don't have to reproduce or replace the drug, the hundred million is all profit."

So from the above information, we can derive that the greatest potential gross profit from SIGA's current BARDA contract is $335.8 million ($235.8 million + $100 million). If the FDA does not approve the current drug and we assume the replacement cost per course will be the same ($26 per course), then we can calculate the gross profit for the current BARDA contract, in the worst case scenario, which would be $283.8 million ($235.8 million + $100 million less $52 million (cost of 2 million replacement courses X $26)).

So it should be obvious that these two companies are fighting over a significant amount of gross profit especially when taking into effect that both companies only have around 53 million shares outstanding (52.3 million for PIP and 53 million for SIGA per my TD Ameritrade account). That equals $6.34 per share ($335.8 million divide by 53 million shares) in the best case scenario and $ 5.35 per share ($283.8 million divided by 53 million shares) in the worst case scenario of future gross profits to be recognized between the two companies regardless of who wins the law suit.

I am sure everyone is thinking that this is future gross profit and not net profit. However, I can assure you that a large percentage of this future gross profit will go directly to net profit for either or both of these companies since future operating expenses for either company won't increase significantly as a result of the recognition of these deferred gross profits. Also since both companies have significant tax loss carry forwards, it will limit, if not totally eliminate, the requirement to pay any taxes on those net profits.

The reason most of this future gross profit will go directly to future net profits is that there won't be any additional expenditures required beyond normal operating expenses to recognize these profits. Any extra operating expenses in delivering the drug to BARDA has or will have already have been incurred. In fact, SIGA's operating expenses should be going down as a result of SIGA's 3rd quarter announcement of an optimization program. Here is the announcement by Daniel J. Luckshire, Chief Financial Officer of SIGA from the Q3 2013 earnings call transcript:

"Going forward, we're targeting approximately $6 million in annual cost savings from the optimization program. We expect to implement most of the changes by the end of this year. We expect to layer on the remaining changes during 2014."

In that 2013 3rd quarter 10-Q SIGA has broken out expected tax benefits from tax loss carry forwards as "Deferred tax assets". As of September 30, 2013 this future tax benefit is split between the short term ($19.4 million) and the long term ($31.6 million) asset section of the balance sheet for a total future net tax benefit of $51.0 million per this excerpt from note 10. Income Taxes:

"Deferred tax assets, net were $51.0 million on September 30, 2013 and $43.7 million on December 31, 2012, respectively, net of valuation allowances of $4.3 million and $4.3 million, respectively."

If part of SIGA's gross profit from their current BARDA contract is awarded to PharmAthene, then PharmAthene should be able to use part of its accumulated deficit as a tax loss carry forward that would offset part if not all of any monetary award received from SIGA. In order to understand why SIGA has been able to record "Deferred tax assets" on its balance sheet while PharmAthene has not been able to report a deferred tax benefit for their prior losses, you can read the following excerpt from the Summary of Statement No. 109 issued by the Financial Accounting Standards Board:

"Measurement of a Deferred Tax Liability or Asset

This Statement establishes procedures to (A) measure deferred tax liabilities and assets using a tax rate convention and (B) assess whether a valuation allowance should be established for deferred tax assets. Enacted tax laws and rates are considered in determining the applicable tax rate and in assessing the need for a valuation allowance.

All available evidence, both positive and negative, is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed for some portion or all of a deferred tax asset. Judgment must be used in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed.

This statement makes it clear that there is a high level of positive evidence required as to the likelihood of future revenues being received which will result in future taxable income in order to demonstrate that loss carry forwards will be used to offset taxable income. Since SIGA has the certainty of a contract with BARDA, it was able to record deferred tax assets on its balance sheet. PharmAthene, which doesn't have as high of level of certainty for future revenues, currently cannot report deferred tax assets on their balance sheet. However, if PharmAthene is able to receive a large award from the lawsuit against SIGA, PharmAthene will be able to use some or all of its large accumulated deficit ($206,903,216 as of September 30, 2013) to offset part or all of its taxable income from any award.

In addition to having between $5.35 and $6.34 per share of future gross profits from the BARDA contract that will be split between these two companies at some future time, both companies have several additional opportunities for additional significant future revenues that justify a much higher share price than the current combined share price of $5.19 (SIGA- $3.16 & PIP- $2.03). Of course, SIGA will most likely negotiate additional revenues from their current drug, Arestvyr, with BARDA as well as with other potential governments around the World. On August 1 of this year, SIGA announced the selection of a lead candidate for their Dengue Antiviral Program which Dr. Eric A. Rose, SIGA'S c Chief Executive Officer believes has huge potential as per his comments excerpted from that press release:

"Tens of millions of people around the world contract some form of dengue fever each year, and the geographic reach of the disease appears to be expanding. Even the United States is not immune, with cases documented in three states over the last decade. Ultimately, we believe our work could benefit millions of people, including those living in regions where dengue is endemic, travelers to those regions, and commercial or military personnel deployed in those areas. The recent outbreaks of dengue fever in Africa and Asia underscore the need for an effective antiviral to treat this debilitating disease."

Not to be outdone, on September 13, 2013 PharmAthene announced another advance for a new product:

"New Non-Clinical Data Confirm SparVax® Anthrax Vaccine Can Provide Protection Against Lethal Anthrax Challenge"

This announcement by PharmAthene is in addition to its other product candidates listed below-

  • rBChE bioscavenger - a medical countermeasure for nerve agent poisoning by organophosphorous compounds, including nerve gases and pesticides
  • Valortim® - a fully human monoclonal antibody for the prevention and treatment of anthrax infection

My article should make it obvious that as a result of the existing BARDA contract either SIGA, PharmAthene, or both companies are going to come out of their lawsuit with hundreds of millions of dollars of cash on their balance sheets as well as many other opportunities to add to that. Either company won't have to use much or potentially any of that money to pay taxes as a result of both companies having large tax loss carry forwards. In addition to these obvious potential stock share price movers, SIGA investors need to read my Seeking Alpha blog post: "Don't Be Surprised If SIGA Has A Major Deal Lined Up!"

If you decide to invest in both companies, you can either buy the same number shares of each company, or buy more shares of the company which you believe will end up in the best position after the lawsuit. You can read my Seeking Alpha articles that I mentioned at the start of this article to see why I think SIGA should be the stock to invest most of your money in. However, if you agree with any of the opposing articles, then you should skew your investment to overweight in PharmAthene shares. I know by owning both SIGA and PharmAthene shares I am going to be a winner whatever the legal battle outcome may be.

Disclosure: I am long SIGA, PIP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.