Expert Financial Analysis and Reporting

• Phase 2a Aerosurf trial completion has been pushed back to 1Q, 2015 from 4Q, 2014.
• All important topline results from Aerosurf phase 2b proof of concept trial are likewise pushed back from 2H, 2015 to 1H, 2016.
• Management mention of pneumothoraxes seen in phase 2a startled investors, but is not likely to be an issue in completing phase 2a or conducting phase 2b trials.
• Surfaxin sales remain minimal at $106,000 in the quarter.
• The trial delays probably mean that the Company will have to raise capital and/or partner Aerosurf by mid-2015 before phase 2b results are available.
• I still believe in the potential of Aerosurf and Surfaxin. However, I am selling my stock to take a tax loss and intend to buy the stock back before phase 2a results are announced in 1Q, 2015.

First Quarter Conference Call Was Disappointing

Discovery Laboratories held a conference call on November 6, 2014 that was downbeat and has resulted in a further slide in the stock from $1.78 before the call to a current price of $1.53. The Company pushed back the timeline for releasing results from the phase 2a trial of Aerosurf and reported that the sales results for Surfaxin were only $106,000 in the third quarter and $176,000 for year to date.

The Company’s guidance at the beginning of the year was that the phase 2a trial would be completed in 3Q, 2014 and then was changed to 4Q, 2014. Now once again they have pushed it back to 1Q, 2015. Similarly, the original sales guidance for Surfaxin was that it would achieve $8 to $12 million in the first full year of marketing following its launch early this year. It now looks like $500,000 or so of sales could be realized. Adding a touch of alarm to the call, the Company pointed out that the incidence of pneumothoraxes in the phase 2a trial was greater in the Aerosurf treated babies than control. I discuss this in detail later in this note.

Investment Thesis

This delay is obviously a significant near term negative for the stock as it further delays the start of the phase 2 b trial. This proof of concept trial for Aerosurf is the key for a significant price inflection (assuming a positive outcome) as this would suggest a high probability of success for phase 3. This would be a major catalyst for the stock. Investors are now unlikely to see the phase 2b results until 1H, 2016. There might be some encouraging data reported from phase 2a in 1Q, 2015 suggesting benefit from Aerosurf administration. However, this is a trial aimed at determining safety and is enrolling only 42 babies. Hence, signals of efficacy would be suggestive rather than definitive.

This delay in the completion of phase 2a and the subsequent delay in the start and completion of phase 2b is a significant negative for the financial status of the Company. Discovery ended 3Q, 2014 with $55 million of cash and throughout the first three quarters of 2014 burned about $10 million of cash per quarter. At this rate, they would run out of cash somewhere in 1Q, 2016. The original hope was to complete the phase 2b trial in 2H, 2015 and with positive results, it would have been highly likely that they could have raised capital at a much higher price and/or bring in a partner to help finance the phase 3 trial. It now appears that they will have to rely on phase 2a data if they elect to raise capital and the price of the offering would be at a lower level. Originally, management wanted to wait for phase 2b data to enter into a partnering deal. They may now have to move sooner which would result in less lucrative upfront terms.

I still believe in the potential of Surfaxin and especially Aerosurf. I am very disappointed by the delay in the phase 2a and 2b trials as they were critical to my investment thesis for 2015. We are now in an information limbo until early 2015 when phase 2a results become available and possibly until 1H, 2016 when phase 2b topline results could be available. I think that the one case that I can make for a near term (within two years) move in the stock would be selling the Company. The Company currently has a market capitalization of about $132 million and assuming that they were to raise $25 million of equity this year that would bring the market capitalization to $157 million. Adding on the $30 million of debt owed to Deerfield Capital brings the enterprise value to $187 million in 2015. A 50% premium to the current price would be about $2.75 and a takeover price of $265 million. This seems pretty inexpensive for the potential value of Surfaxin and Aerosurf. However, I think that the chances for a sale of the Company are very small.

I do not see the stock going anywhere between now and reporting phase 2a Aerosurf data sometime in January to March of 2015. I anticipate that this will reveal some signals of efficacy although they will be suggestive rather than definitive. I also expect the Company to announce that they will begin the phase 2b trial. I would expect this to cause a modest bump in the stock. I am going to sell my stock and take a tax loss. My intention then is to buy the stock back in early 2015 before the phase 2a data is reported.

The Phase 2a Aerosurf Trial

The phase 2a trial of Aerosurf is the first trial in humans. It is a multicenter, randomized, open-label trial in which some babies are given standard of care which is nCPAP and others are given nCPAP plus Aerosurf. The enrollment criteria call for premature babies of 29 to 34 weeks gestational age who are at risk of respiratory distress syndrome to be enrolled within 21 hours of birth. The use of the aerosol generator with Aerosurf makes it more difficult to blind the trial.

The study design calls for the administration of sequentially larger single doses of Aerosurf in three dosing cohorts and just nCPAP in a fourth. The increased dosage of Aerosurf is achieved by running the generator longer as opposed to changing the concentration of the aerosol. The plan is to enroll 42 babies in the trial. There have been no details given, but I would guess that there will be about 10 to 11 babies in each of the three dosage arms and likewise in a control group given nCPAP.

The primary objective of the study is determination of safety and tolerability. Babies are assessed by recording adverse reactions, oxygen saturation levels, serum electrolytes, complications of prematurity and signs of worsening respiratory distress as evidenced by nCPAP failure leading to the need for intubation, mechanical ventilation and rescue surfactant administration. While the primary endpoint is safety and tolerability, the other measures could allow some assessment of potential therapeutic effects. The Company has reported that it sees babies “pinking up” and this is suggestive that Aerosurf is leading to increased oxygen uptake which is the therapeutic goal. However, this is a small sample size and it is highly unlikely that any efficacy signal would be statistically significant.

The phase 2a study was initially planned to enroll 36 babies of 29 to 32 weeks gestational age; full term is 38 weeks from conception.  Last summer this was changed to babies of 29 to 34 weeks gestational age and the enrollment was increased to 42 babies. At the time, the Company changed guidance for completion of the study from 3Q, 2014 to 4Q, 2014. Now they have once again pushed the timeline to 1Q, 2015. They have also increased the number of centers enrolling from 4 to 8.

I asked management if the delay in enrollment was due to difficulty in gaining parental consent or physician concern about pneumothoraxes. They said that neither of these were factors. The delay was attributed to logistical issues. There is a brief window of opportunity for enrolling the babies (21 hours) and logistical issues sometimes prevented bringing together all of the personnel and equipment needed to treat a baby. In retrospect, they wish that they had started with 8 centers.

Pneumothoraxes in Phase 2a; Is This a Problem?

During the conference call, the Company made a point that the incidence of pneumothoraxes in Aerosurf treated babies was greater than in those given just nCPAP. They said that the incidence of pneumothoraxes in both arms was within published ‘normal’ ranges. I will discuss this in more detail shortly.

A pneumothorax is a collapsed lung which occurs when a small hole in the lung allows air to leak into the space between the lungs and chest wall. This air then pushes on the outside of the lung and causes it to collapse; in most cases, only a portion of the lung collapses. This is a common complication of respiratory distress syndrome or RDS in which the lack of surfactant requires more force to open the lung, whether this is from the baby breathing on his own or being assisted by mechanical ventilation. A small, uncomplicated pneumothorax may heal on its own. When the pneumothorax is larger, doctors insert a catheter or needle between the ribs to remove the excess air. This releases the built up air and the lung then expands to fill the space. This is not a complex procedure, but in premature infants any procedure is potentially dangerous.

Of course, the key question is whether Aerosurf is causing the pneumothoraxes or is this just RDS rearing its ugly head. While I cannot be absolutely certain, I think that this is probably related to RDS and not the administration of Aerosurf. Probably the key reason to believe that the pneumothoraxes were not due to Aerosurf is that they occurred 20 to 30 hours after the Aerosurf was given as a single dose. It is beleived that Aerosurf and other surfactants cycle out of the lungs within ten hours or so and are gone. This would mean that at the time that they occurred there was no Aerosurf in the lungs. Because the babies were not producing sufficient amounts of surfactant, the baby’s efforts to breathe were forced and could have resulted in a hole.

Pneumothoraxes are integrally tied to RDS. In the pre-surfactant era when premature babies were put on mechanical ventilation, the incidence was somewhere in the 20% to 40% range, with even higher incidence rates in infants that were re-intubated. With the use of exogenous surfactants, the incidence dropped into single digits. According to the package insert for Surfaxin, the incidence of pneumothoraxes seen in the two trials that were the basis for Surfaxin’s approval were: Surfaxin, 3% to 4%; Exosurf 4%; Survanta 2% and Curosurf 1%. However, this is not applicable to the Aerosurf trial because of the differences in ages of the babies. Surfaxin treated babies were of gestational age of 26 to 32 weeks and the Aerosurf group was 29 to 34. (Full term is 38 weeks from conception). Older babies are more susceptible to pneumothoraxes because they have more control over lung function; they can close the glottis and grunt or cough in an effort to expand the lungs while younger babies may not. This results in more potential for pneumothoraxes in the age group treated by Aerosurf than that treated by Surfaxin and the animal surfactants. Another factor to consider is that Aerosurf goes preferentially to areas of the lungs that are more open. In this single dose study, it may be the case that the more closed areas did not get surfactant. Hopefully, in clinical practice the surfactant would be given for a longer time period and open the closed areas as well.

The Company stated that the Data Safety Monitoring Board and Steering Committee members (all thought leading neonatologists) were not surprised to see pneumothoraxes and this was not a factor in the slower enrollment. They won’t comment on where they are in enrollment other than to say that they are over halfway through the enrollment goal of 42 babies which implies that 22 or more have been enrolled. The Company also would not comment on the absolute number of pneumothoraxes seen in the dosage groups or the control group. However, the small numbers in the trial suggests one or two in the dosage groups and one in the control group. This is a guess on my part.

Phase 2b Trial

Once phase 2a shows safety and tolerability, the Company can advance to phase 2b in which they expect to demonstrate both physiologic and clinical evidence of a beneficial effect in infants ranging from 29 to 34-week gestation infants. Success in phase 2b should allow DSCO to properly design the Phase 3 study that will demonstrate efficacy and safety.

The phase 2b program could start in 1H, 2015 and complete in 2H, 2016. This trial will compare Aerosurf plus nCPAP to nCPAP alone. The CEO of Discovery Laboratories, John Cooper, stated on the last conference call that based on the data they have seen this far in phase 2a that they would begin the phase 2b trial. Dosing of Aerosurf is a function of time and is not volumetric based so there will be no standard dose for a baby in phase 2b. The judgment of the neonatologist based on the particular circumstances of the baby being treated will likely be the determinant of how long the aerosol will be administered.

Surfaxin Launch

Management clearly underestimated the difficulty in launching Surfaxin as early this year they were guiding to first year sales of $8 to $10 million and it looks like they may come in around $500,000. Let’s consider some of the reasons for this.

It is hard to launch any product in the hospital that does not immediately fill a great unmet medical need. There are two laborious paths which Surfaxin must take to gain access and be used in a hospital. The traditional one is to gain a recommendation from the Pharmacy and Therapeutics (P&T) committee to add it to the hospital formulary, which includes a list of products that can be prescribed at the discretion of NICU physicians practicing in the hospital. An alternative approach is to gain restricted use, non-formulary allowance in which the institution evaluates the product for a period of time during which usage is usually limited to a few doctors who may only use the product in accordance with a specific protocol.

Most hospitals in the US carry only one of the three animal surfactants. This is primarily because each product requires different preparations and dosages. Having more than one product adds to the risk of improper preparation and dosage. The ultimate goal of the Surfaxin launch is to be exclusive at each institution, but this is not possible in most institutions in the near term.  Hence the initial goal is to get the medical staff to understand the data behind Surfaxin which shows mortality and morbidity benefits. In this regard, it has a huge advantage over the animal surfactants that have almost no clinical data. Once this is achieved, the aim is to gain acceptance as a second surfactant in the hospital with a long term goal of being exclusive.

Neonatologist interest in Surfaxin is high, but the gating factor has been getting before the P&T committees and gaining formulary approval or restricted access. The challenge has been getting in front of the committees. The absence of one individual can sometimes push the decision to the next meeting which can be a month or a quarter later depending on the institution.  The Company mentioned that nearly 50% of planned P&T meetings presentations have been rescheduled and some multiple times. This is the harsh reality of introducing a new hospital product. However, once P&T meetings take place, management states that in the overwhelming majority of cases they have gained formulary or restricted access approval.

I do not think that management has made any major mistakes in the launch other than perhaps underestimating the difficulty of gaining access to P&T committees. I think that they did not appreciate that more was needed than just the buy-in of the neonatologist who was looking at the clinical results which other members of the P&T committee were not aware of or not particularly interested in.

A key part of the launch strategy is to focus on a universe of hospitals with a special focus on 30 centers of influence and related hospital systems. These thought leading institutions will then influence surrounding hospitals to follow. The Company is trying very hard to educate institutions.  In addition to sales reps, it has a medical affairs team that converses at a very high intellectual level with neonatology physicians and professionals.

Management has said that the selling cycle for a given institution is 9 to 12 months. In regard to an inflection point for sales, they point to Curosurf which showed an inflection two years after the launch. This would suggest a sales inflection in early 2016. Management is giving no guidance on sales, but Street estimates for 2015 are somewhere around $2 million.