Expert Financial Analysis and Reporting

• This agreement partners Discovery with a world class medical device developer and meaningfully de-risks development of Aerosurf.
• It also gives meaningful validation from a sophisticated third party of the revolutionary potential for Aerosurf in treating respiratory distress syndrome.
• The terms of the collaboration reduces capital needs for Discovery and Battelle only wins if Aerosurf is successfully developed.
• Phase 2a Aerosurf results will be reported in 4Q, 2014. These relate primarily to safety and may not have any efficacy signal. They may not affect the stock price.
• The phase 2b results should be available in 4Q, 2015 and will be a major inflection point for the Company; positive results could well double the stock price.

Collaboration with Battelle Announced

Discovery Laboratories (DSCO) has entered into a strategic collaboration with Battelle to develop Aerosurf, which is a combination of the surfactant drug lucinactant and a medical device used to deliver the drug. Discovery’s expertise is in drug development and it does not have the same degree of sophistication in medical device development. Battelle is one of world’s largest independent research and development organization with a highly developed capability for helping companies design and develop medical devices and to help bring the medical devices through ultimate FDA approval. It has 35 years of specific expertise in aerosol science.

The companies will work together to develop Discovery’s proprietary capillary aerosol generator (CAG) for use in the planned Aerosurf phase 3 clinical programs. Battelle will also provide the initial supplies of the medical device for commercialization if the phase 3 is successful. The CAG is currently being used in the phase 2 trials that are being conducted in respiratory distress syndrome in premature infants. Based on information gained in these phase 2 trials the final design will be determined for the CAG device that will be used in phase 3.

Battelle has great expertise in understanding the complex issues involved in gaining approval for a medical device. They understand from long experience the quality control, documentation and numerous other issues that FDA will raise. They know from long experience what to expect and this should help to avoid pitfalls that might result in the need to tweak the device after phase 3 trials are completed and before commercialization. Such tweaking can raise concerns with the FDA that the device has been altered and prompt the agency to ask for another phase 3 trial to confirm that the change in the device has not affected its therapeutic profile. You may recall that this happened to Mannkind (MNKD) and its inhaled insulin product.  With the Battelle agreement, Discovery has assured itself o the maximum extent possible that the device used in phase 3 will be acceptable to the FDA for commercialization.

Battelle Has Extensive Experience with Aerosurf

Battelle has already played a key role in preparing the CAG for use in the phase 2a and 2b Aerosurf programs. Discovery went to Battelle in 2011 for help in designing the current device so that they have intimate knowledge.  Discovery has paid Battelle $5.5 million for the work it has done so far. Moreover, Battelle has been involved with the clinical trial program and has visited clinical sites and interacted with physicians involved in the phase 2 a trial. Battelle knows this technology inside and out.

Financial Terms of the Agreement

Under the terms of the agreement, Battelle and Discovery Labs will co-invest in the development of an Aerosurf phase 3 clinic-ready aerosol device. I estimate that this will cost about $10 to $15 million and the companies have agreed to share the costs 50/50. Also, Battelle will assume the costs of any cost overruns. This reduces capital needs for Discovery by $5.0 to $7.5 million.

Battelle will receive warrants to purchase up to 1.5 million of shares of Discovery at $5.00 per share over a ten year period. One million of these warrants will be issued if milestones that determine commercial readiness are met. The other 500,000 warrants are contingent on meeting certain timelines. Finally, Battelle will receive a low double digit royalty on sales if Aerosurf is approved, but this royalty requirement expires after Battelle receives $25 million of cumulative royalties. Battelle only wins in this agreement if Aerosurf is successful in phase 3.

What is Battelle’s Motivation?

Battelle works with many medical device companies in a standard client vendor relationship. However, they occasionally do enter into a risk sharing model as is the case with Aerosurf. I understand that they do about one of these risk sharing deals every two years and usually with much larger companies. In the Discovery press release on this agreement, Battelle made the following comments that help to explain their motivation.

“One of our missions is to support what we believe to be transformational medical advances. Based on our work to date and our assessment of the opportunity, we believe that Aerosurf addresses a significant unmet medical need, and represents a potential revolution in the management of infants with respiratory distress syndrome. We are excited to combine our expertise in aerosol drug delivery device development with Discovery Labs’ expertise in synthetic surfactant technology and neonatal RDS.”

Implications for Phase 2b Trial and Phase 3

This agreement does not signal problems with the phase 2a trial nor changes in the timelines for the phase 2b and phase 3 trials. The phase 2a results, which relate mainly to safety, should be announced in 4Q, 2014. Assuming goals of that trial are met which seems highly probable; the Company will roll seamlessly into the phase 2b proof of concept study which should establish if the drug device combination is effective and safe. This critically important information should be reported in 4Q, 2015 in accordance with previous announcements. This is an extremely important inflection point for the Company and the stock. The current market capitalization is only $140 million and I think that positive phase 2b results could double the stock.

Assuming success in the phase 2b trial, there will be an end of phase 2 meeting with the FDA so that the phase 3 could start in mid-2016. Discovery is not giving any guidance on this trial at this time. However, the successful phase 3 study of Surfaxin enrolled 1100 patients in two years and the Aerosurf study will probably require less than half of this number. Remember that we know that the active ingredient in Aerosurf is the same as Surfaxin so that there is not a question of efficacy. The major issue to be resolved is if the medical device can deliver therapeutically effective levels of the drug to the various regions of the lungs. Hence, it may be possible to enroll 500 or so patients so that the trial could take one and one-half years or less a complete. If so, phase 3 results could be reported in late 2017 and Aerosurf might be approved in 2H, 2018.

Outlook for the Stock

Investors have been disappointed so far in the introductory sales of Discovery’s first product Surfaxin. This has had a weakening impact on the stock this year so that investors are hoping that clinical trial results on Aerosurf will help the stock. This was discussed in a recent article that I wrote on Seeking Alpha.  Continuing disappointment with the launch could cause further pressure on the stock and could even cause investors to write off  Surfaxin  which would shift all investor focus to Aerosurf.

The phase 2a trial of Aerosurf is intended to demonstrate safety. The Company has indicated that there haven’t been any safety issues observed in this open label trial so it is likely that the trial will reach its safety endpoints and the company will roll into phase 2b. However, if there is a negative signal on safety, I would expect a sharp drop in the stock. Conversely, if there were some meaningful signals of efficacy, it would have a positive effect although I doubt it would be dramatic.

The phase 2b results for Aerosurf will be extremely important. Negative results that would discourage further development of the drug would have a devastating effect on the stock. Conversely and what we are all hoping for, is a clear signal of efficacy that would lead to a phase 3 trial. So what are the chances for that? Studies of Aerosurf in pig and lamb lung models, which are accepted pre-clinical models for surfactants, have been encouraging. Still, results in neonates is the only unequivocal way to determine the effect of the drug in humans.

Aerosurf has blockbuster potential. I have estimated that sales could reach $1 billion in 2022 if the product is approved. The thinking behind this is outlined in this report. I know that 2022 is a long way off and it is hard to look that far out. However, if Aerosurf were to reach $1 billion of sales in 2022, a comparison to other biotechnology companies suggests that the stock would sell at five times sales which would lead to a $5 billion market capitalization. This compares to the current $150 million market capitalization.

There will be a big reward for investors if the optimistic scenario for 2022 comes about. The stock in the near term will respond to events that make investors come to believe that this is more or less likely or not at all likely. In the next year, the results of the phase 2b trial will be the primary determinant shaping investors’ views. If results are encouraging, I would expect a very sharp upward move in the stock. Judging what the magnitude of this move might be is extremely difficult, but given that the current market capitalization is only $150 million, it could be dramatic. Small biotechnology companies that move products into phase 3 based on positive phase 2b results can sell at market capitalizations of $300 million to $1 billion with each case being unique. My best judgment is that the trial will be successful and we will see a dramatic move in the stock.