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Expert Financial Analysis and Reporting

Discovery Laboratories (DSCO, $2.07): An Asymmetric Opportunity

Purpose of This Report

This is the first of a series of reports on Discovery Laboratories. Instead of publishing an extensive report (which I have actually written), I thought that I would publish smaller excerpts that may be easier to digest. I am starting with the most important part that goes through my thinking on why the stock has asymmetric upside potential if Aerosurf is successfully developed. However, if Aerosurf fails, I think that Surfaxin and the marketing team that it has assembled to market Surfaxin in the US gives the Company the platform and potential to acquire other neonatology products and succeed as a specialty pharmaceutical Company.

In future reports, I will provide an in-depth look at the issues that are important in understanding the Surfaxin launch. It is not just about putting a salesman in the field and knocking on the door or of a hospital. There are numerous other medical and reimbursement issues to deal with. I will also go through the market opportunity for Aerosurf and the clinical trial program that will hopefully allow the product to be marketed.

Keys to the Investment Thesis

The recent financing by Discovery Laboratories produced a decline in the stock, but also removed the financing overhang that was plaguing the stock. I consider this a key catalyst for a long period of appreciation of the stock from these levels. The Company should end the year with about $85 million of cash. This is enough cash to carry the Company through the first two years of the Surfaxin launch and to finish the important phase IIa and IIb trials of Aerosurf which will define the potential of that product. By my projections, DSCO would end 2015 with about $4 million of cash.

The Company will not allow the cash balance to decline to $4 million and will have to bring in new cash to the Company (probably in 2H, 2015). If the phase II trials of Aerosurf are successful, management should be able to raise the money on favorable terms at a significantly higher stock price. Also, success with Aerosurf could lead to a partnership for international rights (DSCO plans to market it in the US) that could significantly alleviate or reduce the need for cash to be raised from capital markets.

With the financing overhang removed, investors will focus on the launch of Surfaxin which begins a new era for Discovery. Surfaxin has meaningful, but. not huge potential; the product is just being introduced .The Company has given guidance of $8 to $10 million of sales in the first twelve months of the launch (essentially 2014), $40 million after four years (2017) and peak sales of $100 million. These projections seem achievable.

Aerosurf is beginning a phase IIa clinical trial in 4Q, 2013. This is an aerosolized dosage form of the active ingredients of Surfaxin, which is dosed as a liquid instillate. As I explain in later reports, I think that Aerosurf is one of the most novel and exciting new products in biotechnology. If phase II and III trials validate the product characteristics that Discovery believes this product will exhibit, I think that Aerosurf could be introduced in late 2017 and achieve US sales as follows; 2017 ($25 million), 2018 ($75 million), 2019 ($200 millions) and 2020 ($350 million). The product will be licensed internationally and has about the same potential internationally as in the US.

A very valuable and as yet unappreciated part of Discovery is the commercial team that it has put together over the last one to two years that comprises salesmen, medical liaison personnel and reimbursement specialists. This gives DSCO a very unique asset that addresses neonatology. They can follow the specialty pharmaceutical model of using the market reach of their sales force to obtain products through in-licensing or acquisition. This is a separate avenue of growth for DSCO and I would not be surprised to see sales from products that are not yet identified approach 50% or 100% of sales by 2017 or 2018 when Aerosurf may be launched. Later in this report, I estimate that Surfaxin alone supports the current valuation. The upside in the model comes from expanding the product offering through the specialty pharmaceutical model and the ultimate upside comes from Aerosurf.

Investment Risks

Discovery still languishes under the dark investment cloud that arose over the Company during the nearly nine year struggle to gain Surfaxin approval. This skepticism may make investors slower to react to positive news, let alone anticipate it. Investors may have to exercise some patience. However, the really important point is that the Company has the cash to get through the Surfaxin launch and important Aerosurf clinical trial data points without having to go back to the capital markets; the financial overhang has been removed.

From a fundamental side, a near term key risk will be how Wall Street judges the Surfaxin launch. Management has set expectations for a methodical launch that will result in sales (by my projections) of 1Q, 2014 ($0.75 million), 2Q, 2014 ($1.50 million), 3Q, 2014 ($2.50 million) and 4Q, 2014 ($3.75). Some skeptics may proclaim that these results are disappointing and suggest that the potential of Surfaxin is too limited to make Discovery a success story.

The first data readout on Aerosurf will be in mid-2014 from the phase IIa trial. This is primarily a trial to determine safety and dosage according to management and not designed to judge efficacy. However, the patients are pre-term (26 to 32 weeks gestational age) and have some degree of respiratory distress syndrome. In spite of management's caution, we might see some signals of efficacy. The key risk would be some negative safety issue and this would be a severe blow to the stock.

This is a difficult patient population to enroll. Imagine yourself the parent of a pre-mature infant asked to give permission to enroll your baby in this phase IIa trial. Management anticipates that about one in ten babies eligible for enrollment will actually enter the trial and has planned accordingly. However, enrollment could still be disappointing relative to management's expectations and this would likely put some pressure on the stock.

Valuing the Parts; Surfaxin, the Commercial and Medical Team and Aerosurf

Surfaxin

Surfaxin has moderate sales potential. However, I estimate that if the Company were to make the decision to focus all of its efforts on this product and to stop all research efforts, at peak sales of $100 million, it would contribute about $30 million of net profits or $0.40 of EPS in 2020. This provides a way of estimating the value of Surfaxin for shareholders. Putting a 15 multiple on Surfaxin peak EPS might result in a $6.00 to $7.50 stock price and this could occur in 2020 or so. Discounting this at a 15% rate leads to a net present value of $2.60 to $3.25. At a 20% discount rate the net present value of Surfaxin is about $2.15 to $2.50. By this calculation, Surfaxin supports the current stock price.

The Commercial and Medical Team

One of the under-appreciated assets of Discovery is the commercial and medical team that it has had in place for nearly a year to launch Surfaxin. Discovery has a unique focus and knowledge of neonatology that could prove of great value in attracting other critical care products for the neonatology market by in-licensing or acquiring products from other companies. While development of Aerosurf is the major investment appeal of the Company, I think that in the event that Aerosurf fails that there is the potential to employ a specialty pharmaceutical sales model that could still make this a very lucrative investment.

Aerosurf is the Elephant in the Investment Story

Aerosurf is the key to Discovery Laboratories being an exceptional stock; it represents a paradigm shift in the practice of neonatology. Let me give you a brief reason as to why I believe this is the case. The currently marketed animal surfactants and Surfaxin are given as liquid instillates that are administered by an endotracheal tube (intubation) directly into the lungs of a premature infant with respiratory distress syndrome or RDS. Through lessening surface tension in the lungs, surfactant makes it easier for a baby's lungs to expand and contract when used in conjunction with a mechanical ventilator. However, because of the considerable risks associated with intubation and mechanical ventilation, doctors will only give this treatment to babies with the most severe form of RDS.

There are 360,000 preterm babies born each year and the youngest (23 to 26 weeks gestation) are almost always intubated, given a surfactant and put on a mechanical ventilator. This is about 45,000 babies. However, there are another 110,000 generally older babies (26 to 32 weeks gestational age) who are at risk of RDS that doctors are reluctant to treat in this way because of the risks associated with intubation and mechanical ventilation. They are usually given nasal continuous airway pressure (nCPAP); I'll go into this in great detail in later reports. It essentially uses nose clips to administer air to the lungs and maintain positive pressure in the lungs to prevent them from collapsing during exhalation.

While nCPAP is much safer, it cannot deliver surfactant to the babies' lungs. This creates a dilemma for the neonatologist on whether to treat with intubation and mechanical ventilation or with nCPAP. This decision can affect life and death and long term morbidity for the baby. The "holy grail" for neonatologists would be to be able to give a surfactant along with nCPAP. This is the therapeutic target of Aerosurf

Aerosurf has the potential to make DSCO an exceptional company. In valuing Aerosurf, I think that one should look at the experience of MedImmune and its first key drug Synagis. Aerosurf and Synagis have a great deal in common. Both address disease populations of about 100,000 US babies. Synagis was priced at about $7,500 similar to my projection for Aerosurf. Synagis went on to reach about $1 billion of sales and was the major reason that Astra Zeneca (AZN) paid $15 billion to acquire Medimmune. I am estimating sales of Aerosurf also could reach the $1 billion level in the 2022 or beyond period. This example drives home the ultimate potential for DSCO if Aerosurf is successfully developed.

The development pathway for Aerosurf is long as for reasons explained in this report, I am estimating approval in late 2017 or 2018. However, I think that the promise of Aerosurf will add consistent value to the stock as the drug progresses through development to commercialization. Investors should keep in mind that the key active pharmaceutical ingredient in Aerosurf is the same as that in Surfaxin. Hence, we go into the phase II and III programs knowing that the drug contained in Aerosurf is safe and effective. The challenge is to show that it can be effectively and safely delivered in an aerosol form. It is more of an engineering challenge than a drug development challenge.

The results of this phase IIa trial will probably be available in 3Q, 2014. These should give an important insight into the safety of Aerosurf and could significantly de-risk the program in investors' minds. This would be followed by a phase IIb program that would seek to show efficacy signals; results could be available in 3Q, 2015 and would afford a major de-risking of the program. I think that each of these milestones could be an important inflection point for the stock.

Discovery intends to commercialize the product on its own in the US and to partner the product for markets outside the US, an event that is likely to occur until late 2014 or 2015. The Company is not in a hurry to conclude a partnering deal as favorable results in the phase IIa and phase IIb trials could greatly enhance the value of the deal.


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