Expert Financial Analysis and Reporting

Investment Thesis
I believe that the recent stock offering by Discovery Laboratories (DSCO) removes the financing overhang that has been holding the stock back. The Company now has enough cash to see it through two years of the Surfaxin launch, phase IIa data on Aerosurf in mid-2014, phase IIb data on Aerosurf in mid-2015 and still have cash on the balance sheet at the end of 2015.

On a fully diluted basis in which I assume that all outstanding warrants and shares are exercised, the Company has 96 million fully diluted shares and a market capitalization of $208 million based on the recent price of $2.17. I believe that with a successful Surfaxin launch and encouraging Aerosurf data that the market capitalization and the stock could double over the next one to two years. This is based on a comparison of the market capitalizations of other companies with strong cash positions and promising product and pipeline outlooks.

The key risks in the stock are that the Surfaxin launch is disappointing or that the phase II data on Aerosurf is disappointing. A central point of this note is that there is no near term risk of a financing overhanging the stock.

Are All Equity Offerings Bad for Shareholders?
There seems to be a dogma among some investors that public equity offerings are bad (period) because they create new shares and dilute existing shareholders. However, this is not always the case and let me cite two examples from companies that I have been involved with to make that point.

I wrote an article on Trius on January 21, 2013 called Trius: Why Last Friday’s Equity Offering is good for the Stock (TSRX, $4.90). The stock was trading at about $5.30 before the offering and the deal was done at $4.90. The offering brought in $32 million of cash and bolstered the cash balance to $84 million, enough to fund two years of operations. The stock had been struggling in anticipation that the Company would issue stock upon the completion of a phase III trial later that year. Rather than letting the stock languish, Trius management elected to get the financing behind them. This removed the financial overhang and also put the Company in a position of financial strength to negotiate with potential partners. The Company was subsequently acquired by Cubist in September 2013 for $13.50 per share and a contingent value right that might be worth $2.00.

As of December 31, 2011 Celldex (CLDX) had $53.3 million of cash, there were 39.5 million shares issued and the stock was selling at $3.70. Over the ensuing 21 months, the Company released exciting data on four products in its pipeline. Interwoven with the release of clinical data were the following share offerings: January 2013, 2.4 million shares through an ATM; February 2013, 10.5 million shares in a public offering; and February 2013, 13.8 million shares through a public offering. As in the case of Trius, this took away the financing overhang. All of these offerings were priced at $7.50 or below and brought in an aggregate amount of $153 million.

The operating cash burn for Celldex over this 21 month period was about $103 million. The end result was that as of September 30, 2013 the company had $165 million of cash, 81.1 million issued shares and, by the way, the stock price had increased from $3.50 at year end 2011 to $35.43. The takeaway message for me is that raising money on the basis of promising clinical results and removing a financial overhang by pre-emptive equity issuance can be very rewarding for shareholders although this increases the number of issued shares.

These are two examples of why the “stock issuance is dilutive” dogma can be wrong. However, I don’t maintain that this is always the case. Probably all of us can recall situations in which a company’s product development plans failed and they issued new shares to begin developing some other new product and also to keep management employed. This is often the scenario that results in penny stocks that have hundreds of millions or billions of shares outstanding.

This Is a New Day for Discovery
Discovery has been grouped companies whose share issuance has not benefitted shareholders due to a long string of financings that were needed to keep the Company alive while it sought regulatory approval for Surfaxin over a course of nine long years. However, DSCO differs from these companies in that Surfaxin was not a failure and was ultimately approved. The financings were necessary to keep the Company alive and I believe that despite the enormous increase in the number of shares, it was ultimately in the interest of shareholders to get the Company to this point. The alternative was going out of business or a fire sale of assets.

With the announcement on October 4, 2013 that the FDA had agreed to new manufacturing specifications, the last hurdle to marketing of Discovery Laboratory’s first product Surfaxin was cleared and the Company has just recorded its first commercial sale. The stock traded up sharply on the announcement as the price jumped 37% to $2.70 on the news. However, it then traded steadily lower to around $2.30 largely due to concerns about a financing overhang. When the Company announced that it was issuing shares at a price of $2.00, the stock price dropped to that level.

The past is the past and despite the enormous financial loss that was incurred by long term shareholders, this is a new day. Discovery has just launched and recorded its first commercial sales of Surfaxin and is poised to enter phase II trials for Aerosurf, which is in my opinion one of the most exciting new drugs in development in biotechnology. The Company has just taken the same strategy as Trius and Celldex in undertaking a pre-emptive financing to remove the financing overhang.

The Company ended 2Q, 2013 with $31.3 million of cash. The equity offering raised $54.0 million and with the first commercial sale of Surfaxin, Deerfield issued the second $20 million tranche of the debt facility with Discovery. I am estimating that the 3Q, 2013 and 4Q, 2013 burn rates were and will be 9.97 million and 10.23 million respectively. This infusion of $74 million of cash suggests a yearend 2013 cash balance of $85 million. This is roughly two years of cash that will see the Company through the nearly two years of the Surfaxin launch, phase IIa data on Aerosurf in mid-2014, phase IIb data on Aerosurf in mid-2015 and still have cash on the balance sheet.

Just How Many Shares Are Now Outstanding and what is the Market Capitalization?
The earliest that the Company needs to raise cash is pushed off until 2015 or later if a partnering deal for Aerosurf is reached. Like Trius and Celldex, Discovery has taken away the financial overhang for the next year or two. The final question to address is at what price to shareholders as regards the number of shares outstanding. The Company had issued 43.7 million shares at the end of 2012. In May 2013, they sold 9.5 million shares and in this recent offering they issued 28.8 million shares bringing the number of shares issued to 81.9 million shares.

There are also 4.9 million warrants that are exercisable by investors of prior offering at $1.50, 4.9 million warrants issued to Deerfield and are exercisable at $2.81 and another 1.0 million warrants exercisable at around $6.00. There are also 4.0 million options outstanding at prices at which they are likely to be exercised. Assuming that all of the warrants and options are going to be exercised, the fully diluted share count for Discovery is 96.3 million shares. In thinking of market capitalization I use this 96.3 million shares and the current price to come up with a current market capitalization of $218 million.

The final question to address is whether a $218 million market capitalization precludes significant upside for the stock. I think that if DSCO did not have the checkered history that it does that investors would be intrigued by a company that has just launched its first commercial drug with Surfaxin, has Aerosurf, a drug with blockbuster potential about to enter phase II and a balance sheet that has cash to fund two years of operations. These types of fundamentals could support a market price of $400 million or higher market capitalization.

It is hard to draw a clear parallel between the experience with Trius and Celldex due to the dissimilarities of products. Still, I note that Trius sold at a market capitalization of $188 million when it removed the financing overhang and went on to be acquired at $646 million. Celldex’s market capitalization went from $140 million on December 31, 2011 to $2.9 billion on September 30, 2013. Against this backdrop, a $400 million market capitalization. up from the current $208 million, at some point in the next year or two seems reasonable if the Surfaxin launch is successful and the phase II data on Aerosurf is encouraging.