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Expert Financial Analysis and Reporting

Discovery Laboratories: Still Another Delay in the Surfaxin Launch (DSCO, $2.00)


Discovery Laboratories just announced still another delay in the launch of Surfaxin. The Company received five Complete Response letters dating from 2004 before finally gaining approval of Surfaxin in March of 2012. Management then indicated that it planned to launch Surfaxin in November of 2012. However, in October it indicated that there was an issue to be resolved with an analytical chemistry method (quality assurance test) that would result in the launch being delayed until 2Q, 2013.

Most investors were expecting an announcement of the launch of Surfaxin, but were shocked by a press release on April 15, that indicates there will be still another delay. The FDA made four specific requests for new information. The Company indicated that it could reply to the FDA within two months and the FDA by regulation then has up to four months to respond which would delay the launch of Surfaxin until mid-October of 2013.


Specifics of the FDA Request

The FDA asked for specific information intended to clarify certain aspects of the updated product specifications on the revalidated analytical chemistry method that is in question. These are:

· Recommendations regarding how the product specifications should be documented and notated.

· A specific recommendation for the upper limit of a single product specification that Discovery Labs can readily accept.

· A request for two existing and readily available documents related to the improved analytical chemistry method.

· Request for supporting data using the recently improved and revalidated analytical chemistry method that is being generated from recent Surfaxin batches.

The first three requests can be readily handled. The first bullet point relates to just providing more historical information that is readily available. The second bullet point is a request that the upper specification on the test that indicates that the product is not in specifications be lowered; this is something that DSCO can agree to and requires no other work. The third bullet point is a request for more documentation on how the new specifications were arrived at. These three requests can be provided from existing documents in a matter of a few days.

The fourth bullet point is the gating factor that will require a little more time. It asks that the new specification should be tested in recent batches. The Company has decided to go a step further and prepare new batches for testing as well. This could take a few weeks and is the primary reason that it will take the Company as long as two months to respond.

Under existing regulations, the FDA has four months to respond and based on historical experience, it will probably take the full four months even though the actual time to review this information probably requires much less time. While it is possible that the FDA could act quicker than in four months given the nature of their requests, history suggests that they will use the full four months to review the resubmission.


Financial Consequences

The most serious implication of this delay is the effect on cash reserves. The Company ended the fourth quarter with $27 million of cash and had guided investors to an $11 million burn rate in the first quarter. In the first quarter, it announced an innovative debt deal with Deerfield that brought in $10 million immediately with the promise of an additional $20 million with the first commercial sale of Surfaxin.

I estimate that DSCO will end 1Q, 2013 with $28 million of cash. I estimate that the Company will burn about $10 million per quarter through the balance of 2013. Assuming no infusion of cash from any source, DSCO would have cash of $8 million at about the time of the new launch date for Surfaxin in October 2013.

The approval of Surfaxin would bring in the other $20 million from Deerfield and result in a year end cash position of about $18 million. The Company is in discussions on partnering Aerosurf and I had expected a deal in 2H, 2013. My expectation was that this would bring in $15 million of upfront cash and would reduce the burn rate as the partner shared research costs. I think this now could occur in 1H, 2014.

I expect that the burn rate for 2014 will be about $34 million. If the $20 million from Deerfield and the $15 million from the partnering deal are brought in, the Company would have just enough cash to see it through to the end of 2014. There will almost certainly be the need for a financing in late 2013 or early 2014. Any further delays in the Surfaxin launch that prevent cash inflows from Deerfield and the Aerosurf partnering could lead to a financial crisis.


What Could The Share Count Rise To?

It seems highly probably that Discovery will have to raise about $20 million or more in 2H, 2013 or 2H, 2014. It is possible that Deerfield might provide this, but it is more likely that the Company will be forced to do another equity financing. I think that a worst case scenario might be that the deal is done at $1.50 with 50% warrant coverage; this would increase the fully diluted share count by 13.3 million shares and 6.7 million warrants.

I estimate that the company currently has 43.7 million shares outstanding, 12.7 million warrants and 2.0 million options. It is probable that not all of the options and warrants will ultimately be exercised, but let's conservatively assume that they will be. Taking this into account and the 13.3 million shares and 6.7 million warrants in the hypothesized $20 million deal, DSCO in my worst case scenario could have around 78 million fully diluted shares outstanding by mid-2014.


What is DSCO Worth?

Management has guided that the launch of Surfaxin could create $8 to $10 million of sales in the first twelve months of the launch, $40 million after four years and peak sales of $100 million. To value Surfaxin alone, let's assume that the Company makes the decision to focus all of its resources on Surfaxin and to stop all spending on research for other products. This isn't going to happen, but it is a way of estimating the value of Surfaxin alone.

I estimate that at peak sales of $100 million that Surfaxin would contribute about $30 million of net profit in 2020. I further estimate that the market would value these earnings at about 15 times resulting in a market value of $450 million. Assuming 100 million shares outstanding in 2020 (this allows for more financings in the future that increases share count beyond 78 million), the value of Surfaxin alone would be about $4.50 in 2020.

Those of you who have followed my past writings on DSCO will understand that I believe that Aerosurf is one of the most promising pipeline products in biotechnology and I see its ultimate value as many times that of Surfaxin if it is ultimately approved and commercialized. I also think that if Surfaxin is commercialized with a proprietary sales force, the Company can acquire new products related to neonatology that would add shareholder value.


Investment Thesis

Like everyone else, I am extremely disappointed with this new and unexpected delay. I know that some investors will attribute this to management incompetence and certainly the many past disappointments make it difficult to refute such arguments. It is very hard to step back and try to evaluate this situation objectively and unemotionally. The first impulse is to throw in the towel and move on. While I sympathize with this view, I think it would be the wrong thing to do. I think that there remains great value in the company.

I am holding my current stock position. If I were only given the option to buy or sell the stock, I would buy it at current prices. However, I usually like to see the stock settle out after a disappointment like this and so I have no sense of urgency to buy more stock at the current price of $2.00.

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