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Expert Financial Analysis and Reporting

Discovery Laboratories: New CEO and Update on Aerosurf (DSCO, $2.26)

Upcoming Key Events

There are two very important events in the next year. The first is reporting of results in a phase 2a trial of Aerosurf in younger babies of 26 to 28 weeks gestational age (GA). The key objective is to show safety. Encouraging results from this trial have already been reported for older babies of 29 to 34 weeks GA. An all-important phase 2b proof of concept trial is now underway that is initially enrolling older babies of 29 to 34 weeks GA. The results of the phase 2a trial in 26 to 28 weeks GA babies will likely be reported in 3Q, 2016 and if the results show that Aerosurf can be safely administered in this younger age group, patients of this GA will also be enrolled in phase 2b. This would be a significant positive for the Company. A negative or less than clear cut positive outcome could be a very serious issue depending on the reasons.

Assuming that the phase 2a trial allows the enrollment of babies of 26 to 28 weeks gestational age, management has guided that the phase 2b trial should report topline results in 1Q, 2017.The trial is a randomized trial of 240 babies and if successful might qualify as one of two well controlled trials necessary for registration. It should lead to a partnering deal in which DSCO would receive substantial milestone payments and the partner would pick up a significant amount of the development costs. A phase 3 trial would likely begin in late 2017 or early 2018, which if successful could lead to approval of Aerosurf in late 2019 or early 2020.

The results of the phase 2b are a critical binary event for DSCO. Later in this report I suggest that a clear success could lead to a $10 to $20 stock price in 2017 while failure could result in bankruptcy.

Everything Rests with Aerosurf

Aerosurf Is a Unique Product in Biotechnology

The investment case for Discovery Laboratories rests totally with Aerosurf which I believe to be one of the most unique and commercially promising product development opportunities in biotechnology. It potentially addresses a great unmet medical need in neonatal intensive care by allowing much easier and broader use of surfactant replacement therapy in premature babies with RDS. This could provide very meaningful survival and morbidity benefits in this fragile premature baby population.

Addressable Market is Large and No Competition is on the Horizon

Somewhere between 120,000 and 150,000 premature babies require respiratory support in the US annually to treat or prevent RDS. Roughly half of these are initially intubated, put on a mechanical ventilator and given surfactant. Treating babies who develop RDS costs about $55,000 and if they develop bronchopulmonary dysplasia it is even greater at $167,000. The primary population for Aerosurf is babies between 26 and 34 weeks who are started on nCPAP. This is a market of about 60,000 to 75,000 babies annually in the US.

Management has not given guidance on the potential price for Aerosurf, but the most frequent estimates of price by key opinion leaders has been about $8,000 per course of therapy. If so, the annual addressable US market for Aerosurf is $480 to $600 million. The European market is about the same as the US and the market in remaining parts of the world is about half of the US indicating a global addressable market of $1.2 to $1.5 billion. I am not aware of any viable competitive drugs in advanced development. Because of the great unmet medical need, the promise of a strong benefit to risk ratio and favorable pharmacoeconomics, I would expect Aerosurf to capture a large percentage of the addressable market.

Aerosurf has very unique and desirable characteristics for a pipeline product. In many other drug categories, most notably oncology, there are seemingly an endless number of new products in development. An investor has to be concerned not only that a product is safe and effective, but also has to make a decision on how it will fare against competitive products. With Aerosurf, the concern is only if it is safe and effective because of its uniqueness. The most impressive aspect of the product is that it can be lifesaving and result in the baby leading a normal life or prevent diseases which can have a lifelong negative effect on its lungs; the survival benefit can be a lifetime. Contrast this to oncology in which a 4 to 5 months increase in survival for a human at the end of their life is considered a major advance. This is why I view it as one of the most promising medical and commercial product development opportunities in biotechnology

For a much more detailed discussion of Aerosurf please refer to this report

Investment Overview

Discovery Laboratories announced the hiring of a new CEO and also updated the status of the Aerosurf phase 2 program. I think that the Board reached the conclusion that the Company needed to present a new face to the investment community as the last decade has been one of utter futility and disaster for investors. This began with the filing of an NDA for Surfaxin in April of 2004 which created much hope. However, the final approval was not received until March 0f 2012. In between, there were five Complete Response Letters (CRL). Surfaxin is the active ingredient in Aerosurf and clinical trials for Aerosurf were dependent on first gaining approval for Surfaxin. Hence, the Aerosurf program also was set back many years.

It is extremely important to understand that the FDA never questioned the safety and efficacy of Surfaxin. The esoteric issue delaying approval related to the validation of a quality assurance test. I won’t go into all of the details of this sad experience other than to say that if the FDA and the Company had worked together effectively that Surfaxin might well have been approved in 2005 or 2006. Instead, the company lurched from one CRL to the next. This resulted in a long stream of financings that were necessary to answer questions in the CRL to the detriment of advancing clinical programs. As a result, there were an endless number of financings that greatly diluted the share base without increasing the technology value of the Company. This is strikingly reflected in the share price which over the last ten years has declined from $102 (adjusted for reverse splits) to $2. Unsurprisingly as we sit here today, the Company has virtually no credibility with investors and analysts who have tossed it on the scrapheap of biotechnology failures.

This dismal history has created skepticism that Discovery could do anything right, let alone developing a potentially paradigm changing drug like Aerosurf. If this prejudice can be shaken, one can see that Aerosurf has more than reasonable potential for successful clinical development. It starts with the major advantage that we already know that the active pharmaceutical ingredient in Aerosurf is safe and effective because it is Surfaxin which the FDA approved for RDS in 2012.

The next critical issue is whether Aerosurf can be delivered effectively to the lungs by the aerosol generator device component of Aerosurf. This delivery technology was licensed (paradoxically) to Discovery in 2005 by Phillip Morris which had spent over a decade and much money on finding a better nicotine delivery device. Since 2012, Battelle which is one of the leading developers of medical devices, has worked to perfect the device for commercialization of Aerosurf. (By the way, Battelle elected to receive some compensation for its work in the form of stock.) So the device component has undergone 20 years of development, much by sophisticated third parties. There is reason to hope that this device will deliver Aerosurf in the right amounts to the lungs. Indeed, animal studies have been successful in this regard.

Investment Issues

The Aerosurf program is now in phase 2 trials that are beginning to establish the clinical profile of the product. The primary objective of phase 2a is to show that Aerosurf is safe and to establish the effective dosage. Then phase 2b will establish proof of concept that the product is effective in RDS.

The first part of the phase 2a program has importantly established that the product is safe in infants of 29 to 34 weeks GA. Obviously, safety is of paramount importance in this fragile population of premature infants. The second part of the phase 2a is intended to show that Aerosurf is safe in even younger babies of 26 to 28 weeks GA. Topline results are expected in this 26 to 28 week age group in 3Q, 2016.

The phase 2b trial of Aerosurf in about 240 babies has already begun by enrolling babies of 29 to 34 weeks GA. If the phase 2a results in babies of 26 to 28 weeks are positive, babies of this age will then be enrolled in phase 2b. The Company is suggesting that topline results on this phase 2b trial could be available in 1Q, 2017.

To say that this is an important binary event is an understatement. Let’s look at two extreme possibilities. If the results are disappointing to the extent that there is no path forward, Discovery will go bankrupt. At the other extreme, if the results are very positive, it will provide proof of concept that Aerosurf works. This would very likely give investors great hope that a phase 3 trial could be executed that would replicate results from phase 2b and lead to approval in 2019. Success in phase 2b would also very likely lead to a partnering deal that would result in sharing of development expenses and milestone payments and of course validate the promise of the product. There are all sorts of in-between scenarios that I won’t attempt to go into.

The next point to consider is whether this tiny cash strapped company has the financial resources to finance operations through the completion of phase 2b and to the point of seeing results in 1Q, 2017. Later in this report, I show my analysis that the Company with a modest capital raise of around $7 million could end 1Q, 2017 with about $7 million of cash. There is no need for a much larger capital raise before then. With success in phase 2b capital should be available on much more shareholder friendly terms through partnering the product and/or financing at a higher share price.

Price Target Thinking

Let’s assume that the stock price remains unchanged at $2.26 between now and the reporting of topline results for the phase 2b trial in 1Q, 2017. Let’s also assume that the Company raises $7 million in an equity at about this price by selling a unit of one share and one warrant as was the case in the last offering. There would then be 24 million fully diluted shares outstanding and the market capitalization at the end of 1Q, 2017 would be $54 million (24 million shares times $2.26) and the Company would have roughly $7 million of cash.

In the best case scenario in which phase 2b results are quite encouraging, I would submit that DSCO might realize a market capitalization of $250 million to $500 million in 2017 or possibly much more based on looking at peer companies. This translates into $10 to $20 per share. This assumes highly successful results in the phase 2b trial that gives investors’ confidence that the phase 3 trial would have a high probability of success and approval in 2019. As I have previously commented, the addressable worldwide market is an impressive $1.2 to $1.6 billion for Aerosurf.

My thinking is that this is a highly asymmetric investment situation with an upside of $10 to $20 and a downside of $0. The next important event will be the reporting of phase 2a topline results for the 32 babies of 26 to 28 weeks GA. I am looking for confirmation of safety that will allow enrolling babies of this age in the phase 2b trial and perhaps we could see some signals of efficacy. If results are disappointing in this regard I will have to reassess my thinking.

Discovery Labs Announces Appointment of New Chief Executive Officer

Discovery announced that it has appointed Craig Fraser as its new CEO replacing John Cooper who had been with the Company for 14 years, the last three years as CEO. Mr. Fraser has over 25 years of experience in the biopharma industry. He was most recently COO at Aegerion Pharmaceuticals where he headed commercial, manufacturing and supply chain operations and also business development. Obviously, this suggests that his expertise is in commercialization of new products and this makes sense as DSCO is just starting a phase 2b proof of concept trial for Aerosurf that if successful could set the stage for commercialization sometime in 2019.

I had the opportunity to speak with Mr. Fraser, but he had only been on the job for six hours at the time. It would have been a little bit unfair to expect him to give his detailed strategic plan. Based on this one brief telephone conversation, I found him to be straightforward and considering his brief exposure to the Company had a sound grasp of the issues.

Update on Aerosurf

Phase 2a Trial

The Company is completing a phase 2a program for Aerosurf that is being conducted in two parts. The first part involved a randomized group of 80 premature infants of 29 to 34 weeks GA for which data was reported in 4Q, 2015. The trial is primarily designed to demonstrate safety and determine dosage (remember that the concentration of Aerosurf delivered per minute remains the same and dosage is increased by giving the aerosol longer.) Aerosurf’s safety profile in this age group appears to be comparable to the control group which is a big positive when treating neonates.

This trial was not designed to establish efficacy but there were encouraging signals that suggest that Aerosurf may be reducing the incidence of nCPAP failure (the need for intubation and delayed surfactant therapy) by improving lung function. See my report "Discovery Laboratories: Results for Aerosurf in Phase 2a Trial are Encouraging; Why Then Did the Stock Crash?" for a detailed discussion of these results.

Discovery began the second part of the phase 2a trial in 4Q, 2015 that involves a randomized group of 32 younger premature babies of 26 to 28 weeks GA. This was also designed primarily to determine safety and dosage. In its February 2, 2016 press release, the Company said that start-up activities have taken longer than expected and as a result enrollment has been slower than expected. The previous guidance was that enrollment would complete in 1Q, 2016 and this has now been changed to 2Q, 2016; topline results are now expected in 3Q, 2016. This follows a long history of slower than expected enrollment in this phase 2a trial as results at one time were expected in early 2015.  Management has consistently underestimated the deliberativeness of institutions in enrolling premature infants in clinical trials. At last, DSCO is nearing the finish line for phase 2a.

Phase 2b Proof of Concept Trial for Aerosurf

In late December, the Company started its phase2b proof of concept trial; this is a randomized trial involving approximately 240 infants at up to 50 sites in the United States, Canada, Europe and Latin America. The trial is designed to evaluate Aerosurf administered in two dose groups (25 and 50 minutes and allows for infants to receive repeat doses. Aerosurf plus nCPAP will be compared to nCPAP alone which is standard of care.

The trial started by enrolling infants of 29 to 32 weeks GA and may begin enrolling infants of 26 to 28 weeks GA shortly after the results of this age group in the phase 2a trial are known. The Company anticipates completing enrollment for the phase 2b clinical trial by the end of 2016 and releasing top-line results in the first quarter of 2017. lists the primary outcomes measure of this trial as a combined endpoint of time to respiratory failure or death due to RDS over a 7 day time frame. Physiological parameters indicating the effectiveness of Aerosurf in lung function will also be measured.

The phase 2b trial will probably not be adequately powered to show statistical significance on the primary endpoint. However, it could show trends toward efficacy and further establish the safety profile of the drug. This could likely qualify as one of two trials required for a regulatory submission assuming success in all trials. The all-important phase 3 trial could begin in 1H, 2018. The one year or so delay from reporting topline results of phase 2b is the result of following babies beyond the endpoint of the trial to see a longer term effect, having an end of phase 2 meeting with FDA and finalizing design of the trial. Enrollment should be relatively rapid as it will use most of the sites used in the phase 2b trial. Initial results could be reported in late 2018 or early 2019.

Financial Issues

As of December 31, 2015, the Company had cash and cash equivalents of $38.7 million, an amount  the Company anticipates is sufficient to support the Aerosurf phase 2 clinical program and fund operations through the first quarter of 2017. The Company has been burning cash at about $8 million per quarter and at this rate the Company would have about $15 million of cash at the end of 3Q, 2016 when phase 2a results in babies of 26 to 28 GA are reported. The all-important phase 2b trial will report topline results in 1Q, 2017. Again assuming an $8 million quarterly burn rate, the Company could run out of cash just about the time results are reported.

It seems pretty clear that the Company will raise some cash before the end of 1Q, 2017 when the all-important phase 2b results are known. With positive phase 2b results, Discovery would have a very high likelihood of finding a corporate partner for Aerosurf that could take over some (most) of the development costs and could also receive substantial milestone payments. Although it might be possible to wait until phase 2b results are known before bringing in more cash, this would be pretty daring or reckless. The Company would want to have some reserve of cash as it negotiates with potential partners which I think might be on the order of $7 million. If so, I would anticipate that it will raise about $7 million sometime after topline results for the phase 2a trial in late 2016.

After the recent 1 for 14 reverse stock split, DSCO has 8.2 million shares, 2.7 million prefunded warrants from the last deal (these are essentially common stock), 5.8 million warrants and 1.0 million options. While GAAP accounting might come up with a lesser number, I include all of these in my fully diluted share count and come up with 17.7 million fully diluted shares. Assuming terms similar to the last equity raise which involved units of 1 share of stock and 1 warrant and assuming a 5% discount to the current price of $2.26 or $2.17, to raise $7 million.  This would require issuing 3.1 million new shares and 3.1 million new warrants. After the raise there would be 23.9 million fully diluted shares.

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