Expert Financial Analysis and Reporting

Investment Thesis

During the conference call on March 16, 2015 discussing 4Q, 2014 results, management announced that it had decided to find some type of partnership or licensing deal that will take over all of the financial and commercialization support for Surfaxin. It says that it is in advanced stages of discussions, but if nothing materializes it will cease all spending on Surfaxin and focus all spending on the phase 2b proof of concept trial for Aerosurf in babies with respiratory distress syndrome (RDS).

The phase 2a dose ranging trial of Aerosurf that is the necessary precursor to phase 2b should be completed in 2Q, 2015. Because this is an open label trial, management has seen most of the results. It has stated that it will go forward with the phase 2b trial based on results seen so far. The final results of the phase 2a are not yet available, but management provided its anecdotal interpretation of the data.

Management stated that Aerosurf in combination with nCPAP has the same safety and side effect profile as nCPAP alone. This is highly encouraging. In the third quarter conference call last year, management told investors that the rate of occurrence of pneumothoraxes in the Aerosurf arm of the phase 2a trial was higher than in the control arm although not statistically significant. However, with greater patient enrollment the incidence of occurrence in both arms is now the same; I meet this news with a sigh of relief. Management also states that it is seeing very encouraging signs that Aerosurf is having a therapeutic effect as Aerosurf babies have higher oxygen saturations in their blood and less carbon dioxide in their lungs; these are both indicators of improved lung function. They also report that the delivery device is working well according to investigators.

Even with stopping of spending on Surfaxin, the Company is in a tight financial bind. It says that its $45 million of cash at the beginning of 2015 is enough cash to last through 1Q, 2016; this is at about the time or shortly before phase 2b results are expected. It seems highly probable that the Company will have to raise about $20 million in the next quarter or two to see itself through the reporting of phase 2b results. This will likely be done at a sharp discount to the market with heavy warrant coverage.

The reporting of phase 2b results in 2Q, 2016 is an extremely critical event for the Company. If the results are equivocal or just bad, the Company will almost certainly have to liquidate. Hence the downside risk on the stock is $0.00 in this event. If they are encouraging, investors could come to believe that Aerosurf has a very high probability of being successfully commercialized. I have previously written that I believe that a safe and effective Aerosurf would result in a paradigm shift in the treatment of premature babies with RDS. I believe that it could be one of the most promising products in biotechnology with the potential for $1 billion of US sales.

Success in the phase 2b trial would in most probability give rise to a several fold increase in share price and make financing the Company on favorable terms for shareholders an easy matter. It would almost certainly lead to a lucrative partnering deal for international rights to Aerosurf. The Company could probably do one phase 3 trial and use this in combination with the phase 2b to seek regulatory approval. The product might come to market in late 2018 or 2019. The current market capitalization is about $125 million; I think that clear cut, unequivocally positive results in phase 2b could increase market capitalization to $500 million to $1 billion. This is a five to tenfold increase in price,

There are two critical questions to consider. Will the phase 2b results be positive and can the Company meet the timeline for completing the trials in 2Q, 2016? On the latter point, Discovery has a pretty dismal record going back over a decade in meeting timelines. In the most recent phase 2a trial, it originally gave guidance that results would be released in 3Q, 2014 and the current guidance is 2Q, 2015. This is not encouraging.

In judging the probabilities of success, I am encouraged by what the Company has said about interim results in the phase 2a trial. Based on their comments, Aerosurf plus nCPAP appears to be as safe as nCPAP alone. Also there is evidence that babies given Aerosurf are achieving higher oxygen saturation in the blood and lower levels of carbon dioxide in the lungs. These are strong surrogate markers of efficacy in RDS. I think this suggests there is a good probability for success in the phase 2b trial.

I recommended selling the stock at the end of 2014 and taking a tax loss with the thought that I would probably recommend buying the position back in early 2015. This is still my intention and I am encouraged by the data reported on the phase 2a trial although it is anecdotal. However, I think that I will wait to see the final data on the phase 2a trial and possibly wait for some announcement from the Company on its financing plans. I have found that buying a stock immediately after a key financing that takes away the financing overhang can be very profitable for investors. Stay tuned.

Discovery is Seeking a Partner for Surfaxin

In 2014, Discovery spent about $19 million on the introduction of Surfaxin and recorded only $312,000 of revenues. Clearly the launch has been a failure and the Company has to make a hard decision. With only $45 million in cash, it cannot spend another $19 million of the commercialization of Surfaxin in 2015 and carry on the phase 2 development program for Aerosurf.

The Company is biting the bullet on Surfaxin. It is now seeking a partner with a Company that has expertise in the hospital and the financial resources to give Surfaxin the support that it needs. Management states that they are in advanced stages of discussions to form a strategic alliance with Surfaxin and the goal is to bring this very quickly to a close. If they cannot form a strategic alliance or collaborative arrangement, the most likely scenario would be to cease the commercialization of Surfaxin and put all resources behind the theme of aerosolized Aerosurf.

Financial Issues

Approximately $4.5 million of operating expenses in 4Q, 2014 were expenditures to support manufacturing, quality, medical affairs and commercial efforts to support Surfaxin. Under the strategic alternatives currently being considered regarding Surfaxin, they expect such expenses could be greatly reduced if not completely eliminated.

The Company ended 2014 with $44.7 million. They are now forecasting that this cash is sufficient to fund operations through the first quarter of 2016. I think that Discovery needs to raise about $20 million of cash to carry the Company past the reporting of topline results for the phase 2b trial.

Discovery has $30 million outstanding under a secured loan facility with Deerfield with repayment due in three equal annual installments of $10 million beginning in February of 2017. The 2017 and 2018 installments may be deferred if they achieve certain financial milestones. This is a financial overhang.

Aerosurf Phase 2 a Design

The phase 2a study was a multicenter, dose- escalating study that evaluated three doses of increasing amounts of aerosolized KL4 (the active ingredient). The increased amount was achieved by lengthening the time of administration as opposed to increasing the concentration. The KL-4 was combined with nasal CPAP and compared to a controlled group of nasal CPAP alone.

There are eight active (KL-4 plus nCPAP) and eight control (nCPAP alone) babies per dose group. Babies receive a single dose and are then followed as they progress through neonatal intensive care. The study is in babies of 29 to 34 weeks gestational age having respiratory distress syndrome that requires treatment with nCPAP. To be included in the study, babies must have a significant oxygen requirement.

The trial will enroll 48 babies with half on nCPAP and half on KL-4 plus nCPAP. The trial size was increased last year by about a third to increase the number of control babies so that the number of control babies will match the number in the active arm. This makes the study more robust and better able to assess safety and tolerability as well as detect signals of efficacy.

Aerosurf Phase 2a Trial Enrollment Was Slow

Discovery again acknowledged that enrollment in the phase 2a trial of Aerosurf has been slow and frustrating. At one point they had hoped to see final data in 3Q, 2014 and this was then revised to 4Q, 2014. Based on the recent rates of enrollment, they are now projecting completion late in 1Q, 2015 or early 2Q, 2015.

In discussing the slow enrollment, the first issue that the Company touched on was inclusion and exclusion criteria for enrollment. This was tightly restricted in order to select the most appropriate patients for the trial. They are currently studying babies of 29 to 34 weeks gestational age suffering from RDS. The study requires that babies be surfactant deficient and receiving oxygen. They found that many babies in this age group are less surfactant deficient than younger babies and they don’t have a supplemental oxygen requirement. As a result, many babies in this age group did not qualify for the study.

Key Objectives of the Aerosurf Phase 2a Trial

The key objective is to determine if the drug is making its way into the lungs of premature babies with RDS at adequate levels to be effective and with no significant safety issues. The phase 3 trial of Surfaxin clearly showed that when the product is delivered in adequate amounts that it is safe and effective. The issue in the phase 2a Aerosurf trial is to determine if adequate amounts of KL-4 can be delivered safely to babies’ lungs.

The primary objective of this first trial is an assessment of safety and tolerability for the single dose of aerosolized KL4 surfactant. They can move on to the next phase 2b proof of concept trial as long as the study shows adequate safety and tolerability of Aerosurf plus nCPAP as compared to nCPAP alone. With only a small number of babies yet to enroll, they are confident in that the safety and tolerability profile of Aerosurf arm continues to be similar to the nasal CPAP arm.

A secondary objective of this study is to obtain biological evidence that Aerosurf is getting to the lungs of these infants and doing what it needs to do. Evidence of the drug is getting into the lungs comes from how much oxygen the babies required which is determined by the FiO2 measurement and how effective the lungs get rid of carbon dioxide.

The third objective is to gain experience with the aerosol device and evaluate its performance. The device performance is being assessed by internal device controls as well as investigator reports. They are also looking at treatment failures, adverse events, serious adverse events, complications of pre-maturity.

Aerosurf Phase 2a Results

This is an open label trial which means that the Company can see most of the data as it is generated. The Company said that what they have seen is encouraging. In the interest of being transparent they have provided some details in advance of the full data release. There have been two successful reviews by the Independent Safety Review Committee. These followed the completion of each of the first two 16 patient dosing cohorts. The third cohort is now nearing completion of enrollment. The side effect profile for Aerosurf plus nCPAP appears similar to that of nCPAP.

On the third quarter conference call last year, the Company informed investors about the occurrence of pneumothoraxes (air leaks from the lungs) in the trial. At the time there were numerically more events in the Aerosurf arm than the nCPAP arm. Since that time, there have been additional pneumothoraxes, but all occurred in the nCPAP arm. As a result, at this point in time there is no difference in rates of occurrences of pneumothoraxes between Aerosurf plus nCPAP versus nCPAP alone. This is extremely reassuring.

There is physiological evidence of delivery of drug into the lungs of these babies. The FiO2 or fraction of inspired oxygen is one of the measurements used to assess how well the lung is functioning in bringing oxygen to the blood. Blood oxygen saturations in the protocol require maintaining it between 88% and 95%. Babies with healthy lungs can achieve this breathing room air. Babies with RDS require supplemental oxygen to maintain their blood oxygen levels in the desired range. The babies in this trial required at least 25% oxygen which compares to 21% oxygen in the air that we breathe.

The supplemental oxygen can cause unwanted side effects, so care providers try to decrease the amount of supplemental oxygen these babies breathe as quickly as possible. In Aerosurf babies, the Company says that investigators are describing babies as pinking up and breathing easier after treatment. They are seeing that the amount of oxygen these babies require is less as well and this is an important sign of clinical improvement.

RDS babies frequently have increased values of carbon dioxide because the lungs don’t work well. The Company reports that they are seeing decreases in carbon dioxide values in Aerosurf treated babies, another sign that the lungs are working better to get gases in and out of the blood. These effects happen quickly after treatment begins.

Another major objective of the trial is to show that the device itself is working as expected and the investigators utilizing the device are having a very good experience with it. The Company is satisfied that the delivery device is working well.

Next Phase 2b Trial

Management has already made the decision to advance to the phase 2b trial. Before that, they will perform a safety study in younger babies of 26 to 28 weeks gestational age. This will be started upon completion of this third dosing group. They have already begun startup activities for phase 2b, including additional sites selection and investment in devices and trial infrastructure to prepare for the planned phase 2b study. Enrollment will be expanded to include babies of 26 to 32 weeks gestational age as compared to 29 to 32 weeks in the phase 2a study. They expect the phase 2b trial to conclude in the first half of 2016.

Given the disappointment in time for enrollment in phase 2a, investors are asking whether the Company can hit this timeline in the phase 2b. The Company’s response is that they have a better estimate of the number of sites that will be needed based on the clinical trial experience to-date. They plan to have approximately 30 sites in the U.S. for the 2b study and half of those will be already be up and running due to participation in other parts of the phase 2 program. Startup times will be greatly diminished. The 2b study also will include sites outside the U.S.

They have modeled enrollment based on the pace that was seen in the phase 2a trial, but this could be conservative. The phase 2b trial will be enrolling younger babies in the 26 to 28 weeks gestational age group who are more likely to meet the inclusion criteria for enrollment. This should significantly expand the potential pool of babies for the study. Some of the inclusion criteria required in the first study may be modified in ways to facilitate enrollment. They also believe that the data from the phase 2a program is compelling and will generate excitement in the neonatal community that will boost enrollment.

Partnering Aerosurf

The Company will be open to partnering Aerosurf outside the US over the next 12 months. They have had conversations with a number of companies that have an interest in Aerosurf. The question is whether any company would offer acceptable terms prior to the completion of the phase 2b trial. The Company did not encourage investors to think that a partnership might happen in the next 12 months.