Expert Financial Analysis and Reporting

Investment Thesis

The equity offering by A.P. Pharma of 102 million shares at $0.52 per share has put pressure on the stock, but it is gradually recovering and the current price of $0.58 presents a buying opportunity in my opinion. I initiated coverage with a buy at $0.42 per share on April 25, 2012. I am reiterating a buy at the current level of $0.58 per share. For more details on the fundamental outlook for A.P. Pharma please refer to my initiation report. Adjusted for the equity offering, here are the key elements of my sales, earnings and cash projections.

My price target for late 2013 is based on applying a P/E ratio of 20 to projected 2014 EPS of $0.22 and results in a price target of $4.40. My model showing cash building on the balance sheet is highly unlikely to occur. I think that management would likely use the cash to make product or company acquisitions that would likely result in additional EPS contributions in the years 2014 through 2016. There is also the possibility for an outright sale sometime after the approval of APF530.

The next important event will be the refiling of the NDA for APF530 around September of this year followed by the acceptance of the filing by the FDA and hopefully approval in March of 2013. I am projecting a US launch of APF530 in 3Q, 2013.

This price target would be a seven fold increase from the current price of $0.60 and I recognize that a moonshot price target like this raises eyebrows and suspicions about the seriousness of my analysis. However, huge moves with biotechnology stocks can occur. Let me give you some recent examples. Arena (ARNA) was $1.92 on January 1, 2012 and rose to $11.68 at the close on June 21 (up 6 fold). Threshold Pharmaceuticals (THLD) went from $1.38 on January 1, 2012 to $8.80 on the close on March 30 (up 6 fold). Looking at some oldies but goodies, Human Genome Sciences (HGSI) soared from $3.32 on July 27, 2009 to $30.58 on December 31, 2009 (up 9 fold) and Dendreon (DNDN) from $4.02 on March 30, 2009 to $55.43 on May 3, 2010 (a 14 fold increase).

The Equity Offering

Investors often have a knee jerk reaction to an equity offering characterizing it as dilutive and bad for shareholders, but this is not necessarily the case. While the number of shares is obviously increased, this offering affords greater flexibility to management in the commercialization of APF530. It also takes away the risk of having to finance later this year in a disadvantageous position if APF530 is unexpectedly delayed or if partnering deals in Asia and Europe don’t come to fruition.

Without an equity offering, I estimate that the company would have ended 3Q, 2012 with $8 million in cash. I was then projecting that a European partnering deal would raise $15 million and an Asian partnering deal an additional $15 million in 4Q, 2012. This would have resulted in yearend cash of $36 million. However, there was the danger in this scenario that the partnering deals could be delayed in which case APPA would have only about $6 million of cash at yearend and there is also the danger that the FDA might move slowly in approving the APF530 NDA. Either event or a combination of the two could have put the company in a highly strained cash position and could have forced the company to raise cash at that point on substantially more dilutive terms.

With the equity deal, I now think that the company could end 2012 with $86 million of cash if the Asian and European partnering deals are consummated or $56 million if they are not. While I am confident that APF530 can be readily partnered in those two geographic areas, the strength in the cash position will allow APPA to bargain from strength and potentially improve the terms. More importantly, it gives the company the option of marketing APF530 on its own in the US. In my opinion, partnering a product is the most dilutive form of financing. With this offering, investors will now be in a position to capture all of the economic value of APF530.