Expert Financial Analysis and Reporting

Price Target Thinking

In my initiation report of January 31, 2014, I argued for a 2018 price target of $20 to $27 under the assumption that DSC-127, their new drug for wound healing, fails in phase 3 and development is abandoned. In this event, the valuation of the Company would be based on its attractive and rapidly growing line of Advanced Wound Care Products, which I am projecting to reach sales of $45 million this year which is roughly 50% of the $92 million of total sales that is projected.

I further suggested that with success in the phase 3 trial that the stock could sell at $31 to $45 in 2018. Topline results for the trial should be released in early 2016. The reason that I focus on this somewhat distant year of 2018 is that by then we will know if DSC-127 is approved and commercially successful (or has failed) and the price will reflect whichever of these two outcomes emerges.

Another issue to consider is that DSCI would make an excellent acquisition for a larger company trying to establish a strong position in the treatment of diabetic foot ulcers, a large and rapidly growing market. There are few if any peer companies and none may be as attractive as DSCI.

Purpose of Report

I attended the Derma Sciences (DSCI) analyst day on June 17 and this report gives you my impressions of the meeting. This company has limited Wall Street analyst coverage and is not well understood. These are factors that I find attractive when I pick up coverage. I initiated coverage of the Company with a buy on January 27^th, 2014. That report and follow-up pieces can be found on my website at this link

http://smithonstocks.com/company-reports/?company=derma-sciences

My fundamental interest in the stock is importantly based on their growing portfolio of advanced wound healing products that are sold along with a broad line of wound dressings. The Company is focused on the treatment of difficult to heal wounds with a particular focus on diabetic foot ulcers. The epidemic in obesity has led to an epidemic in diabetes has led to an epidemic in diabetic foot ulcers. The pharmaceutical industry has paid a lot of attention to the treatment of diabetes and increasingly obesity, but has largely ignored diabetic foot ulcers, doubtless because numerous attempts at drug development have failed. DSCI is emerging as a leader in the treatment of diabetic foot ulcers.

AmnioExcel and AmnioMatrix Have Excellent Growth Prospects

DSCI’s portfolio of Advanced Wound Care products has been growing at 30% per year led by Medihoney and TCC-EZ. In January, 2014, Derma acquired marketing rights to the amnion based wound healing products AmnioMatrix and AmnioExcel. I think that these products will become the largest selling products in the Advanced Wound Care portfolio over the next five years and carry very high margins.

The key part of the analysts meeting was a panel of physicians and one nurse who specialize in treating very difficult wounds. They are just beginning to try the Amnio products and the number of patients that they had treated ranged from one to nine. These are anecdotal reports and in medicine it is sometimes dangerous to rely on anecdotes to reach conclusions and not randomized clinical trials. That said, their anecdotes were extremely impressive as they used the product on horrific, difficult to heal wounds and got very encouraging results. I was very heartened by the presentations and would urge current and potential owners of DSCI to listen to the webcast.

I think that DSCI has a clear winner in the Amnio product line, but it will take awhile for sales to build. The most important thing to watch is gaining reimbursement from eight Medicare administrative contractors in 2014 and 2015. This is absolutely critical to success. Derma has put in place a comprehensive plan to address each of the eight MACs and to secure reimbursement. MiMedx (MDXG) has been extremely successful in gaining reimbursement for their amnion products over the last two years and this provides a clear understanding of the pathway that can be followed to gain MAC reimbursement.

MiMedix has first mover advantage in the amnion space and should achieve $100 million of sales this year. The number two player is Osiris (OSIR) and should achieve sales of over $20 million. This year DSCI will have limited sales as it will get almost all sales from the VA system. It is estimating that sales will reach $2 million this year. The full product launch will probably occur in 2016 after the Company achieves coverage from all 8 MACS. Even though DSCI is a distant third at this point, this is a rapidly growing market and they should achieve a good piece of the market. The Company informally guides to peak sales of $50 million, but I think this could be low.

New Potential Indications for DSC-127

Another highlight of the meeting was a discussion of potential new indications for DSC-127 for wound healing. This is a new molecular entity that works by a novel mechanism of action that is hypothesized to attract stem cells to the wound.

There were presentations on pre-clinical studies of DSC-127 in scar reduction and radiation dermatitis. The latter results from use of radiation to treat cancer and may offer a market opportunity as large as wound healing. Possibly, one or more INDS could be filed in 2016. They are also working with BARDA on the use of DSC-127 to treat radiation exposure and resultant dermal burns resulting from a terrorist nuclear attack or nuclear accident. They are working with BARDA to determine if this program will move forward. This will hinge on success in the phase 3 trial.

DSC-127 Enrollment Guidance

The Company re-confirmed that it expects trial enrollment to be completed in mid-2015 with top line data read out in the first quarter of 2016. It is expected that the mid-point of the trial will be reached by the end of 2014. The current cost estimate for this program up to the filing of the new drug application continues to be between $55 million and $60 million of which about 50% has been spent.

Partnering of DSC-127

DSCI had thought of partnering DSC-127 in foreign markets, possibly in 2014. They did not stress this point at the meeting. I think that the equity offering that brought in $81 million earlier this year gives the Company the financial strength so that it does not need to rush into doing a deal.

Burns Are a New Opportunity for Medihoney

The final presentation was on the use of Medihoney in full thickness burns as an agent for debriding burns. It works through a different mechanism of action than enzyme debriding agents that are widely used today. Again there were two anecdotal reports from a physician in a burn center, but the results were very impressive. Treating burns is a big new initiative for DSCI.