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Expert Financial Analysis and Reporting

Discovery Laboratories: Disappointment with the Delay in the Surfaxin Launch Has Created a Buying Opportunity (DSCO, $2.24)


I had the opportunity to meet with the management of Discovery Laboratories (DSCO) recently and focused on several issues:

  • The problem with one of a number of tests used in quality assurance that was announced in October, 2012 and has delayed introduction from the planned launch of Surfaxin from November, 2012 to 2Q, 2013.
  • Progress in gaining formulary and national account acceptance for Surfaxin.
  • The launch strategy for Surfaxin.
  • A review of the clinical and pharmacoeconomic data that will be so important in Surfaxin’s launch.


Investment Thesis

I continue to recommend purchase of Discovery Laboratories. Biotechnology investing is a test of will. There are constant surprises on clinical trial outcomes, regulatory decisions, commercialization, patent challenges, capital raising and a host of lesser issues. It comes as no surprise that stock prices are extremely volatile as investors in Discovery can well attest. Investors have to constantly ask themselves why am I investing in this stock and when negative surprises occur (they always do), is that reason still valid.

In the case of Discovery, the reason underlying my owning and recommending the stock is that I believe that its KL4 surfactant technology potentially could lead to a paradigm shift in the practice on neonatology. The strategy is to start with a liquid instillate dosage form in Surfaxin and then introduce a lyophilized form called Surfaxin LS. The next and most important planned product is an aerosolized dosage of KL4 called Aerosurf which is, in my opinion, one of the most exciting drug candidates in biotechnology.

In regard to Surfaxin, data generated so far shows that it offers compelling advantages over the currently market animal surfactants. It statistically significantly reduces mortality and the need for reintubation and co-morbidities associated with reintubation relative to the animal surfactants. As importantly, pharmacoeconomic studies indicate that Surfaxin can significantly reduce hospital costs relative to the animal surfactants.

Surfaxin in its instillate dosage form is a meaningful improvement over the animal surfactants and its lyophilized form will offer further advantages. This is enough to own the stock. However, if Aerosurf, which is the aerosolized form, is successful in clinical trials, it has the potential to expand the usage and price point of surfactants. I see Surfaxin/Surfaxin LS as having peak sales potential of $100 million in the US. I see Aerosurf as having $500+ millions of potential peak sales in the US and the same amount in international markets.

Discovery is at the top of the list of companies that I follow in having produced negative surprises. Almost no one who has bought and held stock over the last eight years since it submitted the Surfaxin NDA in April of 2004 has a profit. There are two critical components of an NDA. The first is the clinical data needed to gain approval. The second relates to chemistry, manufacturing and control or CMC issues which are needed to assure that the product can be reproduced reliably lot after lot. There was never a question about the clinical efficacy of Surfaxin. However, CMC issues led to complete response letters and subsequent NDA resubmissions in February 2005, April 2006, May 2008 and April 2009.

Surfaxin was ultimately approved in March 2012 and management guided investors that the launch would begin in November 2012. On October 24th, the company once again shocked investors by announcing that it would need to optimize an analytical test and the launch would be delayed until 2Q. 2012. The stock moved steadily lower from $2.71 to a low of $1.80 and has since come back to $2.20. One knowledgeable investor whose opinion I respect and who follows my blogs e-mailed me the following comment: “Larry, my guess is you are beginning to see my previous points on the management of DSCO. As I have indicated, great product, lousy management.” He is not the only one who feels this way.

I must admit that I have in my darker moments contemplated walking away from following this company. However, my confidence in the commercial potential for Surfaxin has never wavered once the CMC challenges are surpassed. In this note, I go through the highlights of a recent meeting with the company. Management is very positive that the launch will proceed in 2Q, 2013. There is no way that an outsider can form an independent judgment on this so you can either take the company at its word or not. I do.

I focused a great deal in this meeting on preparations for the launch of the product and came away encouraged. The company appears to be dotting all the “i’s and crossing all the t’s”. I think it is well prepared. I am impressed by the quality of the clinical and pharmacoeconomic data that the company has created. The ability to put together an impressive amount of data and publish it in peer reviewed journals was probably the only good point of the eight year delay in gaining approval; it is a significant positive for the launch.

Discovery can present data to the neonatology community and hospital formulary committees that show that for every 100 babies switched from the animal surfactants to Surfaxin, two lives can be saved. Surfaxin will likely be priced at a slight premium to the animal surfactants or roughly $1,000 per course of therapy. Pharmacoeconomic studies indicate that switching from animal surfactants to Surfaxin can produce savings on average of about $2,000 to $3,000 per infant. I think that the company can achieve its sales guidance of $8 million in the first full year of marketing, $40 to $50 million in the fourth year and $100 million in the seventh year; the latter assumes 65+% penetration of the market. Very importantly Surfaxin is the beachhead product that may lead to the acceptance of Aerosurf as the pre-eminent product used in the neonatology setting.

My focus on DSCO is on the long term, but I will try to address the question that traders will certainly pose. Where do you see the stock going in 2013? The stock was trading in the $3.00 to $3.50 range for a good deal of the time after it gained approval. I see the getting back to that level by 2Q, 2013 if the company is judged to be on track to launch in that quarter. If metrics and field checks related to the launch are favorable, I would see the stock moving steadily higher in 2H, 2013. A factor to watch is the potential for a partnering deal. The company was originally guiding to a partnering deal in 1Q, 2013. However, the September announcement slowed progress on these discussions as potential partners wanted to determine the extent of the problem. I now expect the partnering deal in 2H, 2013. The terms of this deal could have a very significant effect on the stock. My 2016 price target for the stock is $8 to $11 in 2016.

A major risk in owning the stock is that management has underestimated the difficulty of getting the test in question optimized and more time is required. This would obviously further delay the launch and the partnering deal. The stock would likely plummet and the company might have to do another equity deal at very low prices. I think we would see the stock below $1.00 in this negative scenario. I must also emphasize that my long term investment thesis is importantly based on Aerosurf, but that product has not yet shown proof of concept in clinical trials. Phase II trials will start in 2H, 2013 and the key phase IIb proof of concept trial will start in 1H, 2014, for which topline results may not be available until early 2015.


Chemistry, Manufacturing and Control Issues-CMC

In order to discuss the most recent delay, it is important to understand the importance of CMC. In analyzing products, investors focus on clinical trial data and pay scant attention to CMC issues that are integral to quality assurance even though both are critical to drug approval and commercialization. This is understandable as the CMC data is internal to the company and not readily available.

The FDA requires that a company demonstrates that its manufacturing process leads to the same final product with successive manufacturing lots. Tests have to demonstrate that the composition of the product is within specifications and its therapeutic effect is the same, lot after lot. Manufacturers also have to assure that their product is stable for a set period of time and sterile and free from pathogens. This is true for the final product and of course any active ingredients which are purchased from suppliers.

The FDA has a guiding process and is integrally involved in all CMC issues undertaken by a company. There are rules requirements and standard operating procedures. Through ongoing interactions with companies, the FDA provides a framework for CMC requirements. However, this is a guiding process and not a recipe. It is up to each company to interpret what will satisfy FDA requirements.

Companies have flexibility in their CMC approach; there is no one exact method for any product. Each company goes about designing particular tests that will satisfy the FDA on the quality of their product and these tests and their sequence of use are specific to the product. Consequently, Surfaxin quality assurance is based on tests specifically designed by Discovery and may differ from those used for the animal surfactants: Curosurf, Survanta and Infasurf.

There are three types of tests used with Surfaxin.

  • The first are biological tests such as the fetal rabbit assay. This tests the product in neonatal rabbit lungs to make sure that it is producing the desired therapeutic effect in this animal model.
  • The second are physical tests. An example is a test to assure that the drug lowers surface tension as it must in the lungs.
  • The third are chemical tests that deal with the four active pharmaceutical ingredients in the product. These assess that Surfaxin is within product specifications during the shelf life and somewhat beyond.

Regulatory agencies expect a specific protocol to be followed with each manufactured lot. If a test shows that something is out of specifications, the company has to determine if the result means that there is a problem with the product or if the test itself is giving inaccurate information. Is the test result true or not true? Discovery discovered during routine testing that there was an out of specifications condition with Surfaxin. The company immediately reported this to the FDA and began to formulate a course of action.

Discovery said that the test in question is not the fetal rabbit biological test, which contributed so importantly to the long string of complete response letters from the FDA. They stated that it was a chemistry test, but were not specific. I would speculate that the test might be used to determine whether the amount of one of the four ingredients in Surfaxin is too much or too little. I do not know if this was the case; but it is illustrative of the problem that was probably encountered.

After a careful review of the test results, Discovery concluded using other tests that the product was within specifications and that the test was giving a false positive. The company never considered a “hope it won’t happen again” approach. Management felt that the only reasonable course of action was to improve the quality of the test before launching Surfaxin. This led to the announcement in October that the launch would be delayed until 2Q, 2013.

The company is keeping FDA fully informed about the actions being taken as it goes through steps that validate the change in the test. They are also working with third party experts. Management has high confidence that the product will be launched in 2Q, 2013. The company sent out a letter to neonatologists indicating that Surfaxin would be available in early 2Q, 2013. There was no negative reaction from the neonatology community.


Formulary and Purchasing Group Acceptance

The process of gaining formulary acceptance after approval is a slow one. Discovery had cautioned that it would take about a half year to obtain most formulary approvals and to not expect noticeable sales until sometime thereafter. It takes time for formulary committees to decide to place Surfaxin on formulary and until then, it can’t be sold in the hospital. This means that the delay caused by the quality assurance issue which will push back the launch by about six months, will have not have the same delay on the launch ramp.

Hospital formulary approval is a formal process which can differ significantly from one institution to the next. It is usually based on the recommendation of a committee comprised of physicians, pharmacists and administrators; the mix varies from one hospital to another. This heterogeneity leads to different approaches to drug acceptance and utilization as each committee brings a different scope of skills and interests to the process.

The process almost always starts in the case of Surfaxin with a neonatologist and probably a pharmacist championing the product. Pharmacists then study the results of the clinical trials that were performed and present their findings to other committee members. They analyze the therapeutic and cost effectiveness of Surfaxin to the animal surfactant they are currently using. There will be physicians on the committee from other specialties who don’t understand the intricacies of the neonatology department and will need to be educated. Finally, there are the administrators who have to worry about the often competing issues of reimbursement, cost and quality of care.

The committee decides if the product would be beneficial to its patient population and cost effective for the hospital, if it is substituted for the current animal surfactant. If Surfaxin is placed on formulary, it will probably go through a trial period in which its use is restricted to a few babies, say 30 or so, to determine if it is performing as expected. If the trial experience is successful, Surfaxin will be made available without restrictions and will probably go on to be the only surfactant used in the hospital. Each surfactant has different characteristics for administration and this persuades many hospitals to use just one surfactant in order to avoid a potential dosing error.

Discovery’s initial objective is to gain formulary acceptance and for hospitals to order and use the product. Its goal is to have Surfaxin available in 100 of the top 300 hospital users of surfactants within one year of launch. It is estimated that 225 hospitals account for more than more 50% of surfactant vial usage.


Marketing Surfaxin

Discovery has a significant competitive advantage in that it is totally focused on the NICU. A common question asked by investors is how many sales reps are promoting Surfaxin based on the presumption that the sales rep is the principal marketing component of the launch, and if so, it follows that the more sales reps the more potential sales. This is not the case with Surfaxin. Its primary market is the neonatology units in a universe of 2000 hospitals that do not require an army of sales reps to cover. As was just noted, about 50% of surfactant units are purchased by less than 225 hospitals. However, this audience is very complex to deal with.

Discovery is using a team comprised of 40 people with three different responsibilities. About 20 sales reps are responsible for Surfaxin sales in an individual hospital and coordinating the work of two other groups that have a regional or national focus. A 10 person medical liaison group is comprised of people who have working experience in and in-depth knowledge of the neonatology unit. They can speak at a very high level on the science of Surfaxin, its clinical data and its potential role in an institution’s neonatology unit. One thing they may do is make customers aware of the life cycle plan of moving from Surfaxin to Surfaxin LS and ultimately Aerosurf.

The third component of the team is the national account group. They deal with group purchasing organizations or GPOS which have been formed to represent hundreds of individual hospitals. These are for profit organizations that buy in large quantities and thus realize volume related discounts that individual hospitals can’t. There are also institutional delivery networks or IDNs in which a group of hospitals, perhaps 5 to 20, band together to realize the benefits of group purchasing. Without the inclusion in group purchasing organizations, a product can’t be used by a hospital even if it has gained formulary acceptance. Discovery must also arrange for warehousing at central depositories and distribution as the purchasing organizations do not physically take delivery of product. One benefit of all the delays in gaining approval is that the company has had an extraordinary amount of time to plan and execute the launch and they seem to have been very thoughtful and thorough.


Background on the Role of Surfactants in Respiratory Distress Syndrome

Surfaxin addresses a breathing condition that is called respiratory distress syndrome or RDS. This results from insufficient surfactant production in the under-developed lungs of premature babies with the result that they are unable to absorb sufficient oxygen. RDS affects one out of four premature babies and is the most prevalent respiratory problem in the neonatology unit. It is the leading cause of death among preterm infants and often results in long term respiratory and developmental problems.

Surfaxin is based on KL4 surfactant technology which uses a synthetic, peptide containing surfactant that is structurally similar to human pulmonary surfactant. It will compete against animal surfactants which are extracted from the lungs of pigs and cattle; these are now widely used.

The current standard of care for managing preterm infants with respiratory distress syndrome usually requires intubation (insertion of a breathing tube into the infant’s airway) to allow for surfactant administration and respiratory support via mechanical ventilation. After successful treatment, the breathing tube is removed to allow the infant to breathe independently. However, about one third of infants have difficulty breathing independently after the breathing tube is removed and require reintubation.

Reintubation and extended exposure to mechanical ventilation are associated with an increased incidence of other complications such as bronchopulmonary dysplasia or BPD. This is a chronic lung condition that affects some preterm infants with respiratory distress syndrome or RDS who required mechanical ventilation. Scientific literature suggests that infants who require reintubation are three times more likely to develop BPD as compared to infants who are not reintubated. The cost of mechanical ventilation is up to $2,500 per day and the incremental in hospital cost of hospitalization for bronchopulmonary dysplasia diagnosis of about $80,000.

To be successful in the marketplace, Surfaxin must first show convincing clinical data that persuades the formulary committee that it provides a meaningful improvement to clinical care. It must also demonstrate that replacing animal surfactants with Surfaxin is cost effective for the hospital. Ultimate success depends on its actual use in the hospital validating the promise of the clinical and pharmacoeconomic data. Data produced before and after the introduction is critical to success in the marketplace

Hospitals are reimbursed under DRG’s which provide a set amount for a procedure such as respiratory distress syndrome. The reimbursement remains unchanged regardless of the cost of treatment and its outcome. To the extent that a hospital can reduce mortality and morbidity and the costs that come with it, savings generated become profit; revenues are fixed and costs are variable. For the more common complications of prematurity which include RDS, the DRG reimbursement is about $50,000 to $75,000.

The principal driver of cost under a DRG for respiratory distress syndrome is mechanical ventilation. Reducing the amount of time spent on mechanical ventilation produces major cost savings for the hospital. It also produces clear long term benefits for the infant and their quality of life. The average cost of a course of animal surfactants is about $800 or 1.6% of the reimbursement of the average DRG. Payors do not focus which surfactant is used; its cost is just part of the DRG.


The Importance of Clinical and Pharmacoeconomic Data

Clinical data is critical for the approval of a new drug, but this is only the start of ongoing data creation that broadens understanding. I think of drugs as software. Their value not based on the organic material that is the active ingredient, but rather on the information created through clinical trials that teach physicians how to most effectively use the drug. It is information on therapeutic efficacy in disease states, side effects, dosage, interaction with other drugs, etc. that defines the value of a drug. Think of how Microsoft Word has evolved and enhanced its value since its introduction in 1983 by increasing the applications of the program. The same holds true for a drug; usage starts with a limited amount of data and applicability, but as more data is created its value can expand dramatically.

There was a time when clinical data alone drove the usage of a drug. Up until perhaps fifteen to twenty years ago there was limited emphasis on a drug’s cost effectiveness. Consequently, a drug company with a big sales force could create large selling drugs, even if they offered only marginal advantages over existing products. Those days have passed; a manufacturer must now demonstrate outcomes advantages over competing drugs and how their drugs will affect hospital and payor costs. The recent disappointing launch of Provenge is a case in point. The clinical data that led to its approval was exciting, but there was no additional data that could inform physicians on how best to use the product and most importantly there was no pharmacoeconomic data. The launch started nicely and then stalled.

As background, there are three currently approved animal surfactants: Survanta and Curosurf are the most widely used products and the third product is Infasurf. A synthetic surfactant called Exosurf was approved by the FDA, but the manufacturer withdrew the product from the market, because it was felt to be less effective than the animal products.


Clinical Data for Surfaxin Shows Superiority to Animal Surfactants

Discovery has some powerful clinical data, all of which has been presented in peer reviewed journals; this provides compelling reasons to switch from Curosurf and Survanta to Surfaxin. This springs directly from SELECT and STAR, the two phase III trials that were the basis for approval of Surfaxin. SELECT enrolled 1,294 patients with 524 treated with Surfaxin, 506 with Exosurf and 258 with Survanta. The primary endpoints for both trials were the incidence of RDS at 24 hours and RDS related mortality at 14 days for Surfaxin in comparison to Exosurf. Surfaxin was statistically significantly superior on both endpoints. STAR treated 119 patients with Surfaxin and 101 with Curosurf; Surfaxin was non-inferior to Curosurf. These results were published in 2005 in the Journal of Pediatrics, the premier medical journal for pediatric healthcare practitioners and this was the basis for FDA approval.

The next step was to use the data from STAR and SELECT to compare long term outcomes of Surfaxin with Survanta and Curosurf for mortality and re-intubation. In 2007, one-year follow-up results from the SELECT and STAR trial were published in the journal Pediatrics, The authors concluded that Surfaxin demonstrated a statistically significant survival advantage relative to Survanta and Curosurf based on analysis of the data in each trial and also pooled results for the two trials.

  • Using pooled results, treatment with Surfaxin significantly improved survival (p=0.05) through one-year of life compared with animal-derived surfactants, Survanta and Curosurf.
  • In the STAR trial, Surfaxin significantly improved survival (p=0.04) through one-year of life when directly compared with Curosurf, the current market leader in Europe and the United States.
  • Surfaxin demonstrated a statistically significant (p ≤ to 0.05) reduction in two important assessments of neurologic outcomes (reflex abnormality and gross tone) versus Survanta.

A third analysis of the clinical data on STAR and SELCT was published in 2011 in the Journal of Neonatal and Perinatal Medicine. This paper was then presented at the December 2 to 4, 2012 Hot Topics in Neonatology Annual Meeting in Washington D.C. Hot Topics is a prestigious and widely attended, international medical meeting dedicated to advancing the practice of neonatology. This study assessed the effect of reintubation on the risk of morbidity and mortality in preterm infants receiving surfactant therapy for the prevention of RDS, as well as the relative rates of reintubation between surfactant therapies. It was the first full description of the consequences of reintubation in preterm infants. This article and presentation drew the following conclusion.

  • Infants, who did not require reintubation, regardless of which surfactant was used, experienced a mortality rate of 0.5% as compared to 18% in those who did. This data was statistically significant and indicates that the risk of death increases 36 fold when a baby is re-intubated.
  • Infants who required reintubation had significantly higher rates of six major complications of prematurity, including BPD, necrotizing enterocolitis (a severe intestinal condition often requiring surgery and loss of bowel), sepsis, and intraventricular hemorrhage (bleeding into the brain).
  • Nearly 50% of the infants requiring reintubation developed BPD, whereas only 15% of infants developed BPD if they were not reintubated (p<0.05).
  • Infants treated with Surfaxin demonstrated a significantly lower reintubation rate compared with those infants treated with animal-derived surfactants Curosurf (33% vs. 47% respectively; p<0.05) and Survanta (35% vs. 43% respectively; p<0.05).
  • Infants treated with Surfaxin demonstrated a significantly higher combined outcome of survival without reintubation compared with those infants treated with animal-derived surfactants Curosurf (67% vs. 53% respectively; p<0.05) and Survanta (65% vs. 57% respectively; p<0.05).
  • Initial extubation rates were similar among surfactant treatments in both trials (80 to 84 %; p=ns)

This data showed that re-intubation is a significant risk factor for mortality and is also associated with time on mechanical ventilation and bronchopulmonary dysplasia.


Pharmacoeconomic Studies Show That Switching to Surfaxin from Animal Surfactants Saves Money.

SELECT and STAR collectively treated 1,514 infants with RDS and allowed comparisons with the two leading animal surfactants, Survanta and Curosurf. Survanta and Curosurf were approved based on studies which compared them to mechanical ventilation. There were no studies that pitted Survanta and Curosurf head to head for regulatory purposes and that appear in the labels. Neither product has done studies that followed infants to determine their long term outcomes.

SELECT and STAR allowed neonatologists to directly compare the patient outcomes for infants treated with Surfaxin, Survanta and Curosurf. As importantly, the wealth of data allowed neonatologists to ask and answer for the first time some important questions about the long term outcomes for infants treated for RDS. These trials provided a database for the first time that could be used to judge the effects on infants of reintubation. It also provided further insight into diseases that result from RDS such as bronchopulmonary dysplasia and broad range of other morbidities. It also allowed hospitals and payors to understand the costs of these issues. The SELECT and STAR trials are having an enormous impact on the ability of the neonatology community to understand surfactants as a class and to differentiate Surfaxin from Survanta and Curosurf.

Discovery next progressed to performing a pharmacoeconomic analysis of SELECT and STAR to determine the cost effectiveness of Surfaxin relative to the animal surfactants through reducing the need for re-intubation. The further analysis of the clinical data of STAR and SELECT that was presented in 2011 showed that Surfaxin has a lower rate of reintubation than Survanta and Curosurf. Reintubation leads to increased need for mechanical ventilation that costs about $2,500 per day and also can lead to increased mortality and additional morbidities such as bronchopulmonary dysplasia and air leak. Discovery undertook a pharmacoeconomic analysis of this data to determine the potential cost savings if a hospital were to switch to Surfaxin from the animal products.

The first analysis only considered cost reductions due to reduced time on mechanical ventilation; it did not take into account the additional cost of bronchopulmonary dysplasia and air leak. The analysis was presented at the 2012 Pediatric Academic Society Annual Meeting and is also expected to publish in peer-reviewed multidisciplinary journal shortly. The authors concluded that switching from animal surfactants to Surfaxin resulted in hospital cost savings of $160,000 to $252,000 per every 100 infants treated. Savings vary from patient to patient but on average this reduces costs per infant by $1,600 to $2,520.

Reintubated babies sometimes go on develop bronchopulmonary dysplasia; the incremental cost of treating BPD is about $85,000 per infant. In December 2012 Discovery reported on a second pharmacoeconomic analysis demonstrating that estimated the additional cost of BPD. The authors concluded that switching from animal surfactants would reduce hospital costs for treating BPD resulting from re-intubation by $389,247 per 100 patients treated by reducing the frequency of BPD. Costs vary widely from infant to infant but on average is $3,892 per infant. The analysis was also presented at the 2012 Hot Topics in Neonatology Annual Meeting and is expected to be published in a peer reviewed journal.

In both pharmacoeconomic studies, authors noted that additional analyses investigating potential reduction in other reintubation-associated morbidities are warranted. As such, Discovery Labs is conducting a third analysis of the potential pharmacoeconomic impact of these complications and expects to report the results in 2013.


Surfaxin’s Commercial Potential

IMS estimates that worldwide sales of surfactants in 2010 were $206 million and that sales by region were: US ($73 million), Europe ($61 million), Japan ($17 million) and rest of the world ($55 million). There are three marketed surfactants in the US: Curosurf, Survanta and Infasurf that are estimated as having sales of $34 million, $28 million and $11 million respectively. Outside the US, Curosurf is the leading product and may have worldwide sales of $125 million.

In the US, there are about 3.9 million births each year. About 350,000 babies are born before the 29th week of gestation and are at risk of RDS. DSCO estimates that 45,000 pre-term babies (the most severely ill) receive surfactants immediately after birth. There are another 120,000 babies with RDS that are first treated with nCPAP. This therapy is not as effective, but physicians want to avoid mechanical ventilation if at all possible. About 45,000 of these nCPAP treated babies within a few days go on to require surfactants and mechanical ventilation.

Altogether, 90,000 babies are treated each year in the US with surfactants. I estimate that this number of surfactant treated babies will be roughly stable over the next five years based on the assumptions that the number of overall births will remain unchanged that the occurrence of RDS and surfactant penetration of the RDS market remain unchanged.

The benefit to cost ratio for animal surfactant therapy is extremely favorable. The benefit is that they are life-saving and allow many babies to survive and live a full life. The price of therapy is only about $800 per treatment. This is based on the history with the animal surfactants. Survanta was the first product that came to the market followed by Infasurf. Because there was no data to differentiate one from the other, Infasurf was priced at 15% price discount. Curosurf then entered the market, again with undifferentiated data, and was priced at a 30% discount to Survanta.

The manufacturers of these drugs have not made an effective effort to persuade payors of the benefits of therapy and did not do follow-on clinical trials to differentiate their products. As a result, they have been essentially sold as commodities on a price basis. This pricing strategy was influenced by Abbott for whom Survanta is a small product in terms of sales. They have used Survanta as a loss leader marketing tool to allow their salesmen access to hospitals to promote their much more important infant formula products.

If the surfactants were first being introduced today, the prices would be appreciably higher. New cancer drugs, for example, are generally priced at over $50,000 or more even though survival benefits are generally measured in months or years as opposed to possibly a lifetime for a surfactant treated baby. If surfactants were priced comparably to cancer drugs, the US market would be $4.6 billion instead of $73 million.

Over time, through word of mouth as opposed to clinical data, the neonatology field has come to view Curosurf as the best of the three animal surfactants. Beginning in 2005, the manufacturer was able to realize price increases. Following these price increase, the market share of Curosurf has continued to climb and is now at 50%. This suggests that a perceived superior product like Surfaxin has some pricing flexibility.

Management has given guidance that Surfaxin will reach $8 to $10 million of US sales in its first twelve months of marketing. By year 4 it projects $40 to $50 million of revenues and by year seven $100 million based on becoming the standard of care and obtaining a 65% market share.


The Future Lies with Surfaxin LS and Especially Aerosurf

Surfaxin should be able to command a premium over the animal surfactants, but not something that would reflect the real value of the product. Over time Surfaxin, Surfaxin LS and Aerosurf have the potential to drive the animal products from the market. Surfaxin LS is an easier to use lyophilized form of Surfaxin and Aerosurf is an aerosolized version. These products have the potential to replace Surfaxin and the animal surfactants and this will allow the price point to move up. I think that Aerosurf could have a price point of $10,000 per treatment as opposed to perhaps $1,000 for Surfaxin. This is the real promise of Discovery Laboratories.

The role of Aerosurf in the treatment of RDS is still not certain as the phase IIb and III trials that will define its role have not yet started. Phase II trials are planned to start in 2H, 2013 and the phase IIb trial which will define the product could start in 1H, 2014. There are some important parameters to look at. There are about 120,000 pre-term babies with RDS in the in the US who are initially treated with nCPAP alone because doctors want to avoid intubation and mechanical ventilation. Of these, 120,000, about 45,000 will need to be intubated and placed on mechanical ventilation. Unfortunately, physicians do not know which babies will progress to mechanical ventilation. This suggests that the addressable market for Aerosurf is the 120,000 patients now treated with nCPAP.

Aerosurf is highly differentiated from Surfaxin and the animal surfactants. It may provide equivalent therapeutic outcomes in a sub-group of less severely ill patients and at the same time could save hospital the expense incurred with intubation and mechanical ventilation. I think that a premium price of $10,000 per course of treatment could be justified if Aerosurf can prevent intubation and mechanical ventilation. The potential addressable market could be judged to be the 120,000 nCPAP babies who go on to intubation and mechanical ventilation. This represents a US addressable market of $1.2 billion.

There is potential for Aerosurf to be used in respiratory conditions beyond just RDS in pre-term babies. These include disease such as cystic fibrosis, acute lung injury and chronic obstructive pulmonary disease. It may also have potential for delivering other drugs to the lungs. However, this is in the future and for the present I think that investor should focus on the use of Aerosurf in babies at risk of RDS.

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