Expert Financial Analysis and Reporting

Investment Perspective

Discovery's (DSCO) stock has languished since it announced before the opening on October 24, 2012 that it was delaying the launch of Surfaxin from November of 2012 until 2Q, 2013. The stock had closed at $2.75 on October 23 and it then closed on October 24 at $2.71. The initial investor reaction appeared to be that a delay of six months or so, while unwelcome news, was not a catastrophe. The early months of a hospital product launch are spent on gaining formulary acceptance, a process that can take as long as six months at some hospitals and during this time are minimal or zero. Considering this market dynamic, investors concluded that the delay in the launch might only shift the launch curve out slightly. However, this initial "shrug your shoulders and keep on trucking" reaction began to fade. Bears pointed to DSCO's past CMC issues that led to complete response letters and subsequent NDA resubmissions in February 2005, April 2006, May 2008 and April 2009 and they raised the legitimate concern that based on its record, there was uncertainty as to whether DSCO could deliver on its new launch guidance of 2Q, 2013. Bears also pointed ominously to the company's cash position of $36 million at the end of 3Q, 2012 and with the company's quarterly burn rate of $9 million or so, emphasized that the company had only enough cash to last until the end of 3Q, 2013.

As these two negatives began to sink in, the stock steadily declined to a low of $1.80 on November 16, 2012 and has subsequently recovered somewhat to trade in a range of $2.10 to $2.40. It was apparent that the company needed to raise about $30 million and an equity offering to raise that amount, if announced when the stock was trading at $2.20, would probably cause the stock trade down as much as 10% on the announcement. Moreover, buyers would likely demand another 7% discount beyond that when the deal closed. With all of these assumptions, the offering would be executed at a price of $1.84. Raising $30 million would result in the issuance of 16.3 million shares which would raise the share count from 43.4 million to 59.7 million. In addition, a deal like this would typically require 50% warrant coverage at a strike price 25% or so above the offering price or 8.2 million warrants at a strike price of $2.30.

The point of this note is to compare this type of deal that investors were dreading (and as just described) with the innovative deal that DSCO just announced. Theanticipated deal would have raised $30 million by issuing 16.3 million shares and 8.2 million warrants at a strike price of $2.30. Keep these numbers in mind when considering the deal thatwas just announced.

Innovative Deal

Discovery announced on February 13, 2013 that it will receive $30 million from Deerfield Capital contingent on issues that I will discuss shortly. Deerfield is a sophisticated and highly respected fund with a primary focus on healthcare stocks. Its willingness to put $30 million at risk based on belief in Surfaxin has to be seen as a validation of the promise of the product. Investors may recall that Deerfield did a very similar deal with Arena Pharmaceuticals (ARNA) at a time when many felt that that company's obesity drug, Belviq, would not be approved.

The Deerfield deal is unusual, highly interesting and quite favorable to existing shareholders when compared to the terms that I think DSCO might have gotten with the typical equity offering that I just described. I am not going to hit on all of the subtleties in the Deerfield deal, just the major points. I would suggest that investors who want to dig deeper refer to the 8-K that DSCO released on February 13, 2012.

Deerfield will lend DSCO $10 million immediately and another $20 million upon the first commercial sale of Surfaxin which is likely to be in 2Q, 2013. In other words, the rest of the money comes when Surfaxin gains approval. The repayment schedule for the loan is equal installments of $10 million in 2017, 2018 and 2019. However, if DSCO hits sales milestones that are consistent with the guidance that it has given the Street, it is likely that it will not have to repay the principal until 2019. The loan accrues interest on the outstanding principal at 8.75% which requires a cash payment of $2.6 million in each of the first three years. In addition Deerfield receives a transaction fee of 1.5% on the amount of funds dispersed. Assuming that $30 million is dispersed in 2013, this will result in another fee of $450,000. Finally, Deerfield will be issued 7 million warrants at a strike price of $2.81 if all of the $30 million is dispersed.

Why This is Good for Existing DSCO Shareholders

What does this mean for shareholders and why do I think it is attractive? In an earlier report, I laid out my case as to why I thought that the stock could sell at $8 to $11 in 2016. If in 2016, the company decided to raise $30 million to pay off the debt (an improbable assumption), it would have to sell perhaps 2.7 million 3.8 million shares. Under this assumption the Deerfield deal results in about 3.3 million more shares and 7 million warrants at a strike price of $2.81. This compares to the 16.3 million shares and 8.2 million warrants at $2.30 that an equity offering might have resulted in. However, if Surfaxin hits its sales targets, the $30 million debt repayment will be pushed off until 2019. At that time, DSCO could likely refinance the debt or pay it back out of internal cash flow. In this case the Deerfield deal results in no new shares being issued although there are 7.0 million warrants at a strike price of $2.81. This is the most likely scenario.

An additional important benefit of this deal is on the partnering side. DSCO is actively talking about partnering Surfaxin and its related drugs Surfaxin LS and Aerosurf (one of the most promising biotechnology drugs in development in my opinion) in 2013. I think that this financing puts DSCO in a much stronger position in its partnering talks and could enable it to retain more of worldwide rights to the benefit of its shareholders. This may allow it to keep all of most of the US rights to Surfaxin, Surfaxin LS and Aerosurf in the US market. These products will certainly be partnered in the rest of the world.

Impressive New Share Holders

I published a report on August 27, 2012 in which I stated that the beginning of coverage by two prominent Wall Street analysts would pay dividends for the company. While the stock price has languished for reasons I previously explained, there have been interesting new holders showing up since these analysts introduced coverage. Fidelity Management now owns 13.7% of the company and Blackrock Advisors and Wells Capital have recently become 7.5% shareholders. Along with the interest of Deerfield, we now have four highly sophisticated investors persuaded of the promise of Surfaxin, Surfaxin LS and Aerosurf.

An ATM is Put In Place

If Discovery is successful in the commercialization of Surfaxin and the clinical development of Surfaxin LS and Aerosurf, it is going to have to raise more capital, a whole lot more capital. This is a hallmark of successful biotechnology companies. The enormous amounts of money needed to develop and commercialize products mean that they constantly address the capital markets as they hit milestones that validate the promise of their marketed and pipeline products. However, this can be positive for existing shareholders if the company is able to invest the money at a higher rate of return than the cost of capital. This is econ 101. I know there will be some investors wringing their hands and worrying about dilution. However, this is only the case if the money cannot be profitably invested in the operations of the company.

One of my favorite financing instruments for a biotechnology company is the ATM (At The Market Offering) and DSCO has just contracted for a $25 million ATM. With this instrument, the company can establish a price below which they will not sell stock and which is usually at the market or above the current market price and the discount is usually in the 3% range. In general, an ATM can sell shares equivalent to up to 15% of the daily share volume without disturbing the stock price. When this instrument really becomes effective is when positive events drive the volume and stock price higher. The company can sell its stock in a rising market at a 3% discount. I think that every biotechnology company should have an ATM or a similar product, the Committed Equity Financing Facility of CEFF.

Investment Opinion

I think that this financing takes away the expectation of an equity deal being done at a depressed valuation and takes away a major depressant on the stock. The next big issue is if DSCO is able to deliver on its guidance of a 2Q, 2013 launch. At least, Deerfield and the other three major new investors seem to have such confidence. I would also expect a partnering deal in 2013 that should be well received. A concern to consider is that some investors routinely short new product launches expecting sales to not reach analysts' expectations. DSCO has carefully guided the Street on the launch of Surfaxin guiding investors to sales of $8 to 10 million in its first full year of marketing and $40 to $50 million in the fourth or fifth year. Comparable numbers for Afectair are $0.5 to 1.0million in the first twelve months and $10 million in four or five years. This conservative guidance minimizes the potential that the launch will be seen as not meeting expectations. From my standpoint, all systems are go to buy the stock, especially if there is a knee jerk negative reaction to the announcement of the financing. On a final note, I would also like to point out that DSCO has an almost entirely new board made up of successful biotechnology and pharmaceutical executives and a new CEO in John Cooper. There has been almost a complete changeover of management from that of the troubled late 2000s with the exception of Mr. Cooper who was previously CFO.