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Expert Financial Analysis and Reporting

Discovery Laboratories Announces Changing of the Guard (DSCO, $2.21)

New Board and New CEO
There has been a significant leadership change at Discovery Laboratories (DSCO) which has appointed a new CEO. In addition, changes have also resulted in an almost entirely new five member Board of Directors. Tom Amick has resigned as CEO and has been replaced by John Cooper, who was previously CFO. Mr. Amick has also resigned as Chairman of the Board and was replaced by an outside director. Three of four outside directors on the board have joined within the last year and one half. The only inside director is John Cooper, who is also new to the board.

The new Chairman of the Board is John R. Leone who was elected to the board in November of 2012. In his pharmaceutical industry career, Mr. Leone was CEO of Cambrex Corporation, Chief Operating Officer of Aventis Pharmaceuticals, and General Manager at Rhone-Poulenc Rorer Pharmaceuticals. He is currently a Partner at Paul Capital Healthcare which invests in commercial-stage life science companies.

Joseph M. Mahady has just joined the board. He had a 30-year career with Wyeth Corporation and was President of Wyeth Pharmaceuticals, when it was acquired by Pfizer. He has broad international and domestic pharmaceutical experience and has had a direct leadership role in more than 30 product launches.

The third outside director is Bruce Peacock who joined the board in September 2010. Mr. Peacock began his career in biotechnology in 1982 as chief financial officer of Centocor. In 1992, he joined Cephalon as chief operating officer and as a member of the board. In 1999 he became CEO of Orthovita, a biomaterials company and from 2002 to 2005 was CEO and a director of Adolor. Most recently he has been CEO and a director of Alba Therapeutics. He also was a venture capitalist after leaving Adolor.

Implications for the Company
The three outside directors obviously have great experience and have had major leadership roles in successful biotechnology and pharmaceutical companies. Their experience in running life sciences companies and in launching new products should provide valuable guidance and insight to the Discovery management team. This is a seasoned and knowledgeable board and the decision of these three men to join Discovery’s board gives validation to the promise of its technology.

Mr. Cooper has been with Discovery for over 10 years as Chief Financial Officer. He was part of management that guided the company over the last eight years when it suffered setback after setback in its effort to get Surfaxin approved. He is the sole surviving manager of the group that was in place in 2004 when the company first submitted the NDA on Surfaxin in 2004; it was finally approved in March 2012 after going through five complete response letters.

The previous management has been excoriated for the delay in the Surfaxin approval and Mr. Cooper has been a target of criticism for these delays. He has also taken most all of the criticism for the series of financings that were done at ever lower valuations following the regulatory mishaps. I think that this criticism is overdone as he had no choice on timing. Moreover, had he not been successful in raising money in these stressful times, the company would have likely failed. He has to be given some credit for keeping the company afloat.

Mr. Cooper has never been CEO of a biotechnology company and there is no record to judge his leadership ability. However, he clearly gained the confidence of the three new directors who made the decision to choose him over potential outside candidates and as I have described previously, these three men come from highly experienced leadership positions in biotechnology and pharmaceuticals. Investors have to respect their judgment.

One very important member of the management team will be Tom Miller, the Chief Operating Officer of the company. He has played a pivotal role in planning for the all important upcoming launch of Surfaxin and has a deep understanding of neonatology and surfactant use. Along with Mr. Cooper, they will be the two pivotal players in orchestrating the commercialization of Surfaxin and potentially Surfaxin LS and Aerosurf.

Investment Opinion
I believe that the changes in the board and the CEO position are significant positives for the stock and I reiterate my Buy recommendation. My recommendation is driven by my enthusiasm for the commercial potential for Surfaxin, Surfaxin LS and Aerosurf as I have written extensively about in prior reports.

Following the announcement by management that there would be a delay in the launch of Surfaxin from November 2012 to 2Q, 2013 due to an issue with a quality assurance test, the stock has lost nearly a third of its value. The reaction of many investors was here we go again and there was concern that the problem that caused the delay and which was never fully described, might be more serious than management guided. It also gave rise to concerns about the company’s financial position. With its current burn rate, the company will run out of money in 3Q, 2013 and it clearly needs to raise money. It has two potential sources of capital, an equity deal and/or a partnering deal for Surfaxin, Surfaxin LS or Aerosurf. There is a very high probability that the company will issue more equity, probably after the commercial launch of Surfaxin in 2Q, 2013. Given the past history of its deals that were usually done under duress, many investors feel there will be a stock price decline, potentially sharp, when a deal is announced.

I received a fair share of criticism when I reiterated my Buy recommendation on December 17th as some investors feel that the upcoming equity offering will be dilutive and pressure the stock. Investors always worry about being diluted by equity offerings. However, Discovery has a significant burn rate that is needed to launch Surfaxin and conduct clinical trials on Surfaxin LS and Aerosurf. Raising money is not a bad thing for existing shareholders if it creates value and in the case of DSCO, this seems clearly to be the case. The future of the company is dependent on executing on the launch and the clinical studies and it needs money to do so.

I would prefer that the company not have to raise capital, but this is the only path forward to realize the promise of its technology. I think that a potential equity deal is well known and is significantly reflected in the current stock price. On the other hand, I do not think that a partnering deal is much reflected and this could cause a meaningful upside move if announced. Previously the company had hoped to complete a partnering deal early in 2013, but this has been delayed by the launch of Surfaxin being moved back into 2Q, 2013. Partners will probably want to wait until after the launch to conclude a deal. There is the potential for a partnering deal to occur concurrent with the announcement of an equity offering and if so, the widely anticipated decline of the stock upon the announcement of an equity offering might not occur. However, regardless of how the money is raised by the company and the near term effect on the stock, I feel investors taking a long term view will be well rewarded by buying the stock at current prices.

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