Seeking Alpha
Long only
Profile| Send Message|
( followers)  

Report Summary

With a number of cash infusions from a public offering, an ATM drawdown and warrant exercises, Discovery Laboratories (NASDAQ:DSCO) has built a strong cash position. There remain a number of possible scenarios for how much more cash will come into the company depending on the exercise of the Green Shoe associated with the public offering; exercise of additional outstanding warrants and options; and a probable year end partnering deal. In my most probable outcome, I project that DSCO will end 2012 with $67 million of cash and 2013 with $41 million. The number of fully diluted shares would approximate 55 million.

Investment Opinion

Discovery Laboratories has two products approved for U.S. marketing with Surfaxin and Affectair and controls worldwide rights to these products with the exception of Surfaxin LS and Aerosurf in Spain and Portugal. Surfaxin LS is a meaningful improvement over Surfaxin and Aerosurf is conceptually one of the most intriguing biotechnology products in development with worldwide sales potential of $750 million to $1 billion. The pipeline potential is bright.

These cash infusions have given DSCO the financial strength needed to control its destiny. It has the necessary financial resources to commercialize its products in the US and carefully choose a partner for most of the remainder of the world. It also has sufficient resources to complete development of Surfaxin LS and also complete a phase IIb proof of concept trial for Aerosurf by 2014. The phase IIb trial, if successful, would be a major catalyst for the stock. DSCO is no longer a cash strapped forced to serially finance at low valuations as has been the case for the last several years. I have built into my thinking an equity offering in 2014 based on the assumption that DSCO may need the money to finance phase III development of Aerosurf, but it is possible that the company will not need to do another public offering.

The market capitalization of the company based on 55.1 million fully diluted shares is $155 million. In my initiation report, I projected that Surfaxin and Surfaxin LS could reach sales of $54.7 million in 2017 and Affectair could reach $43.3 million which would result in 2017 corporate sales of $98.0 million. Based on a study of comparable companies, I think that in 2016, the market might value these sales at a 4 to 6 multiple resulting in a market capitalization of $392 million to $588 million.

In line with the thinking just presented, I am assuming 10 million more shares are issued sometime in 2014 to 2016 period which would bring the share count to 65.1 million shares. Dividing my 2016 market capitalization estimates by 65.1 million shares results in a 2016 price target of $6.00 to $9.00. This is without attributing any value to Aerosurf. If the phase IIb trial is successful for Aerosurf, it would significantly enhance the value of the stock

There is a frenzy of acquisition activity going on in biotechnology and with its approved products, unpartnered worldwide rights to these products, strong cash position and the promise of Aerosurf; DSCO has almost certainly come up on the radar screens of many acquisition minded companies. Importantly, there is a scarcity value to its market position. It is the only company that I am aware of with focus and new product potential in neonatology. In most other product categories there are several competitors. In oncology, for example, there are over 100 small biotechnology companies competing. I think that DSCO's proprietary position in its product niche would enhance its value to a potential acquirer.

This Was a Painful, But Necessary Offering

Discovery Laboratories completed a public offering of 16,071,429 shares at a price of $2.80. The market exacted a very significant price discount from the company. I had been expecting an equity offering of 6 million shares at $4.00 per share. This discount was no doubt due to DSCO's long history of disappointing investors stemming from four Complete Response Letters from the FDA issued over a span of seven years. This put the company in financial stress and forced them to do serial financings at ever lower valuations. As a result, shareholders have suffered enormous dilution over the years and management has been blamed and labeled incompetent and uncaring of shareholders. Despite the approval of Surfaxin and Affectair, the market did not forgive and exacted a painful discount from Discovery in order to complete this offering.

The safety and efficacy of Surfaxin was never an issue for the FDA. Instead, it was a series of manufacturing issues and most of all validation of a quality assurance test called frBAT that led to an eight year delay in approval. It can be argued that indecision and lack of clarity on the part of the FDA about the data it required for approval was a major component of the delay. It looked from my standpoint that the FDA unpredictably shifted positions more than once. After the FDA squarely addressed the issue and gave "clear" guidance on what it would require to approve Surfaxin, the matter was completed and led to an approval of Surfaxin in two years.

I am not trying to say that the FDA was the only reason for the delay. Early in the process, DSCO management was too anxious to get the product to market and did not have a strong relationship with FDA. There was a failure of communication on both sides and it is unfair to put all of the blame on DSCO. Investors should also give credit to the perseverance and skill of current management to finally resolve the situation and gain Surfaxin's approval.

Let me take a look at the recent financing. I know that some investors will say that an incompetent management has done another disastrous financing that again has again substantially diluted shareholders. Here is how I see the situation. There appears to me to have been three potential options for the company after the approval of Surfaxin. The company could raise cash; sell the company or partner Surfaxin and Affectair. Regardless of the option chosen, DSCO had to move swiftly. At the end of the December, the company had $10 million of cash and was burning $5 million of cash per quarter. This was a desperate situation in which the company was rapidly running out of cash. Doing nothing was not an option.

Partnering and selling the company are long and uncertain processes and could have taken until late in the year to consummate. In addition, with its weak financial position the company would have had limited bargaining power and terms would likely have been harsh. I believe that the decision to aggressively raise cash was the best option for the company and its shareholders.

The Value of Not Partnering

Having forgone the partnering option, with the exception of having partnered Surfaxin LS and Aerosurf in Spain and Portugal, DSCO now controls worldwide rights to Surfaxin, Surfaxin LS and Aerosurf and worldwide rights to Affectair. As I will discuss shortly, they now are in the position of choosing whether to commercialize Surfaxin, Surfaxin LS, Affectair and Aerosurf on their own, partner the products in some or all regions of the world or sell the company outright. Was the dilution caused by this offering more than justified by the value to shareholders of a strengthened balance sheet and resultant strategic flexibility? I think so.

I have always believed, in sharp contrast to the accepted belief on Wall Street, that companies which raise money through equity offerings and retain rights to their products create more value for shareholders than those that partner. I would much rather issue a large number of shares and retain total control over the products than partner and cede full or partial control to another company and receive only half or less of the future economics.

Many small companies are forced to partner because the cost of commercialization and cost of developing the pipeline is just too much. DSCO is in the fortunate position that Surfaxin, Surfaxin LS and Aerosurf address a small and focused hospital-based neonatology market. The company estimates that it can launch Surfaxin at a cost of $12 to $13 million and that this infrastructure can then support the potential future launches of Surfaxin LS and Aerosurf in the US. It makes sense for DSCO to build a U.S. business around these products and partner them abroad. In addition, the company estimates that the cost of developing Surfaxin LS for marketing and doing a phase II proof of concept trial for Aerosurf is only $15 million or so. By my calculations, DSCO has raised enough cash to accomplish all of these objectives.

Calculating the Number of Fully Diluted Shares Outstanding

I want to look at two issues in some detail; the number of fully diluted shares that are now outstanding and the current and potential cash position of the company. Prior to the equity offering, there were 27.16 million shares outstanding as of March 9, 2012. This included the earlier exercise of 2.19 million warrants that expire in May 2012 and 0.05 million shares in connection with a drawdown of the ATM. The share offering resulted in the issuance of 16.07 million shares bringing the share count to 43.23 million shares.

There is the potential for more shares to be issued. The underwriter has the option to exercise a Green Shoe that could result in the issuance of 2.41 million additional shares at $2.80. There remain 2.81 million warrants that are exercisable at $2.94 and expire in May 2012. There are 4.96 million warrants that are exercisable at $3.24 that expire before May 2016. There are also 1.70 million options that expire at various times at an estimated price of $1.70. If all of these events occur, it could cause an additional 11.88 million shares to be issued bringing the fully diluted share count to about 55.11 million shares.

Calculation of Fully Diluted EPS

Shares Currently Outstanding

Shares outstanding at March 9, 2012

27,158,938

Shares offered

16,071,429

Sub-total

43,230,367

Shares That Could Be Issued in Short Term

Green shoe

2,410,714

Warrants exercisable at $2.94, expiring in May 2012

2,814,000

Total

5,224,714

Other Shares That Could Be Issued Before 2016

Warrants exercisable at $3.24 in May 2016

4,955,000

Options potentially exercisable

1,700,000

Total

6,655,000

Fully diluted shares, potentially

55,110,081

Looking at the Cash Position

Let's now look at the cash that has been brought into the company in addition to the $10.20 million which the company had at the end of 2011. The equity offering brought in $42.5 million. The exercise of the 2.86 million May 2012 warrants brought in $6.9 million and the ATM drawdown another $1.5 million. This amounts to $50.9 million.

There is a strong probability that the Green shoe will be exercised and this would bring in $6.7 million and also that the 2.8 million warrants exercisable at $2.94 could be exercised bringing in another $8.3 million. This would add $15 million of cash increasing the amount of cash raised to $65.9 million.

The company has actively guided investors to expect a partnering deal for Surfaxin LS and Aerosurf outside of the U.S. I estimate that this could bring in $25 to $50 million. This raises the potential cash infusion in 2012 to $90.9 million to $115.9 million.

There remain 4.96 million warrants exercisable in May 2016 at $3.24 that could raise $16.0 million and the 1.70 million options that could bring in $3.4 million. These are not as likely to be exercised in 2012, but if they were, it would result in $19.4 million. This raises the potential cash infusion in 2012 to $110.3 to $135.3 million.

The burn rate for DSCO in 1Q, 2012 is estimated to be $5.0 million and with the preparation for and launch of Surfaxin, I am estimating that the burn rate for the last three quarters of 2012 will be $24 million bring the full year cash burn to $29 million.

I have thrown a lot of numbers at the reader and there are a number of potential outcomes. Let me try to present the most negative, most positive and most probable cash position outcomes and the dilution that result.

In the most probable case I project that DSCO could end 2013 with $41 million of cash and 55.1 million fully diluted shares. This assumes that the Green Shoe and the remaining May 2012 warrants are exercised. I also assume a year end partnering deal that brings in $25.0 million for Surfaxin LS and Aerosurf in foreign markets. I have estimated the yearly cash burns for 2012 and 2013 and the resultant year end cash positions along with the number of fully diluted shares. The results are shown below:

Most Probable Yearend Cash Positions for 2012 and 2013

Cash on hand December 31, 2011

$10.2

Cash from issuance of 16.1 million shares

$42.5

Already exercised May 2012 warrants

$6.4

Money raised through ATM

$1.5

Sub-total

$60.6

Money that could be coming in shortly

Exercise of Green Shoe of 2,4 million shares

$6.7

Exercise of 2.8 million May 2012 warrants

$6.4

Sub-total

$13.1

Yearend partnering deal

$25.0

Projected 2012 cash burn

($32.1)

Year End 2012 cash position

$66.6

Fully diluted shares that result

55.1

Projected 2013 cash burn

($26.0)

Year End 2013 cash position

$40.6

Fully diluted shares that result

55.1

I have also created a most positive cash position scenario in which the May 2016 warrants are exercised, the options are exercised and the partnering deal comes in at $50.0 million. The results are shown below:

Most Positive Yearend Cash Positions for 2012 and 2013

Cash on hand December 31, 2011

$10.2

Cash from issuance of 16.1 million shares

$42.5

Already exercised May 2012 warrants

$6.4

Money raised through ATM

$1.5

Sub-total

$60.6

Money that could be coming in shortly

Exercise of Green Shoe of 2,4 million shares

$6.7

Exercise of 2.8 million May 2012 warrants

$6.4

Sub-total

$13.1

Yearend partnering deal

$50.0

Additional, but less likely cash to come in

Exercise of 4.96 million May 2016 warrants

$16.1

Exercise of 1.7 million options at $1.70

$2.9

Sub-total

$19.0

Projected 2012 cash burn

($32.1)

Year End 2012 cash position

$142.7

Fully diluted shares that result

55.1

Projected 2013 cash burn

($26.0)

Year End 2013 cash position

$116.7

Fully diluted shares that result

55.1

Finally, I have created a most negative scenario in which there is no partnering deal, no exercise of the Green Shoe and no further exercise of warrants and options. The results are as follows:

Most Negative Potential Year End Cash Positions for 2012 and 2013

Cash on hand December 31, 2011

$10.2

Cash from issuance of 16.1 million shares

$42.5

Already exercised May 2012 warrants

$6.4

Money raised through ATM

$1.5

Total

$60.6

Projected 2012 cash burn

($32.1)

Year End 2012 cash position

$28.5

Fully diluted shares that result

49.9

Projected 2013 cash burn

($26.0)

Year End 2012 cash Position

$2.5

Fully diluted shares that result

49.9

Disclosure: I am long DSCO.

Source: Cash Infusions Provide Needed Financial Strength For Discovery Laboratories