Expert Financial Analysis and Reporting

Purpose of Report

Discovery Laboratories (DSCO) held a quarterly conference call on May 3 to update investors on the pending launch of Surfaxin and Afectair. This followed an important press release the day earlier that discussed a paper presented at the 2012 Pediatric Academies Society Annual Conference in Boston. This report highlights the key points of the two communications.

Investment Summary

Discovery Laboratories has two products approved for U.S. marketing with Surfaxin and Afectair and controls worldwide rights to these products with the exception of Surfaxin in Spain and Portugal. It also has a highly promising pipeline. Surfaxin LS is a meaningful improvement over Surfaxin and Aerosurf is conceptually one of the most intriguing biotechnology products in development with worldwide sales potential of $750 million to $1 billion by my estimates. Due to a lengthy delay in gaining approval of Surfaxin, the company is not well followed or understood and has a current market capitalization (based on fully diluted shares) of $157 million, which seems modest for a company with its fundamentals.

I continue to recommend purchase of DSCO. After the approval of Surfaxin, the stock soared to a high of $4.08. However, the company then completed an equity financing at $2.80 which took all of the wind out of the sails of the stock. This offering raised $43 million and was critically necessary to give the company the financial resources necessary to launch Surfaxin and Afectair. However, the execution of the deal was painful for existing shareholders. In the aftermath of the deal, the stock drifted down to $2.39, perhaps due to disillusionment with the financing.

Investors are focused on the launch of Surfaxin and Afectair in 4Q, 2012. While success of the launches is critical to the company's future, it will be sometime in 1H, 2013 before we begin to get a good read. One of the most important catalysts in the meantime is likely to be increased analyst coverage. The approval of Surfaxin has caused considerable interest in the stock. DSCO has had little or no coverage over the past several years due to the well documented problems in gaining regulatory approval for Surfaxin. With this behind the company, analysts can focus on the intriguing potential for Surfaxin, Surfaxin-LS and Aerosurf rather than fretting about whether Surfaxin will be approved. This could stimulate demand for the stock.

Perhaps the most important catalyst for the balance of the year could be the consummation of a partnering deal for Surfaxin, Surfaxin-LS and Aerosurf. This is likely to be for rights outside of the U.S. as DSCO wants to commercialize these products on its own in the U.S. However, the company is open to any deal that maximizes shareholder value. A partnering deal would be the added touch of validation that might cause the company to light up on institutional investors' radar screens. The company has expressed confidence that a deal can be consummated by 1Q, 2013 and more likely by the end of 2012.

Press Release of May 2nd

The Phase III Surfaxin trials conducted by DSCO enrolled 1,546 patients of whom only 29 were lost to follow-up. These were the largest trials by far ever conducted for surfactant therapy. There is a rich trove of information that can be mined from these trials which provides direct comparisons of Surfaxin to the animal surfactants, Curosurf and Survanta, which now dominate the market. This data in my opinion provides compelling reasons for formularies to adopt Surfaxin.

The study at PAS was a retrospective analysis of the Phase III trial data relating to re-intubation of premature infants treated with Surfaxin, Survanta and Curosurf. Infants with respiratory distress syndrome or RDS are treated by intubation in which a breathing tube is inserted into the airway to allow for surfactant administration and respiratory support via mechanical ventilation. The first intubation is a highly invasive procedure that while critically necessary, can damage a baby's lungs and if re-intubation is required, the damage is compounded.

The data presented at PAS showed how important it is to avoid re-intubation. In those two trials, 779 babies were not re-intubated and 493 were. The mortality rate in re-intubated babies was 18.0% versus 0.5% in babies who were not re-intubated. Re-intubated babies spent a total of 22 days on mechanical ventilators versus 8 days for those not intubated. Long term use of mechanical ventilation can lead to lung damage that can last a life time and whose treatment is very expensive, costing about $2,500 per day. A common complication of mechanical ventilation is bronchopulmonary dysplasia (BPD), which causes serious lung damage and can cost $100,000 to treat. Re-intubated babies had an incidence of BPD of 49% versus 15% for babies who weren't re-intubated. The marked advantage of Surfaxin over the animal surfactants as a consequence of reducing the need for re-intubation is a highly meaningful differentiation.

The analysis presented at PAS showed that Surfaxin treated infants had a re-intubation rate of 34% which compares to 47% for Curosurf and 43% for Survanta. This was statistically significant in favor of Surfaxin with a p value of less than 0.05. The analysis went on to conclude that the use of Surfaxin as opposed to Curosurf and Survanta spread across the 90,000 patients treated annually with surfactants could potentially result in an average saving for a hospital of $160,000 to $252,000 for every 100 patients treated. This amounts to $1,600 to $2,250 reduction in the average cost of treatment per baby. This compares to a current drug cost of surfactant therapy of about $700 per baby treated. This saving suggests that Surfaxin priced at a premium to the animal surfactants could still save hospitals significant amounts of money before accounting for improved treatment outcomes.

While not a subject of this press release, DSCO has previously issued data that compares mortality for 651 babies treated with Surfaxin and 386 babies treated with Survanta and Curosurf. One year after treatment, 26.7% of Surfaxin babies were alive as compared to 24.6% for those treated with animal surfactants. This was statistically significant with a p value of 0.05. This means that for every 100 babies treated with Surfaxin instead of animal surfactants, the lives of 2 babies were saved.

The company in my opinion will price Surfaxin at a modest premium to the animal surfactants in an effort to maximize unit market share. The implication of the PAS report is more important to future dosage forms of Surfaxin. The next dosage form to be introduced will be Surfaxin-LS which could offer meaningful administration and stability advantages that can significantly reduce hospital costs. This product will replace Surfaxin usage. After Surfaxin-LS comes Aerosurf. I think that Surfaxin LS could be priced at $1,400 and Aerosurf at potentially $5,000. What does this mean? It means that the current U.S. surfactant market that has about $70 million of sales would have a value of $140 million at Surfaxin-LS prices and $450 million at Aerosurf prices because of the higher price points. The resulting market opportunity is much more compelling.

Cash Position

DSCO ended 1Q, 2012 with $55 million of cash. The company burned about $6 million in the 1Q which is representative of the intrinsic burn rate exclusive of the costs associated with the introduction of Surfaxin and Afectair in 4Q, 2012. The company gave guidance for a burn rate of $9 million in 2Q, 2012 but none for 3Q and 4Q.

The company has provided guidance that the all-in costs for marketing Surfaxin and Afectair will amount to $14 million on an annualized basis or $3.5 million per quarter. If this amount is added to the intrinsic burn rate of $6 million, it suggests a burn of $10 million in 4Q, 2012 and perhaps $9 million in 3Q, 2012. Assuming no cash inflows, the company would end the year with $27 million.

The company continues to give guidance that it will complete a partnering deal by 1Q, 2013 and most likely by the end of this year. I think that this deal could bring in $20 million or more as an upfront payment. If so, this would lift the year end cash position to $47 million. It is also probable that the partner would pick up some of the R&D costs for the pipeline products Surfaxin-LS and Aerosurf which would reduce the burn rate going forward.

There are 2.8 million warrants outstanding that are exercisable at $2.95 and expire at the end of May. If exercised, they would bring in $6.4 million of cash. The company also has an ATM in place that could bring in $13 million at current price levels and the remaining drawdown amounts under the CEFF could bring in another $1 million.

Shares Outstanding

Shares outstanding at the end of the quarter were 43.4 million shares. There are about 10.0 million warrants outstanding that have a reasonable chance of being exercised and an additional 2.4 million options. This brings the potential share count to 55.8 million.

Pipeline Updates

The manufacturing preparations for Surfaxin-LS are near completion and the company will soon talk with US and European regulators about the design of the Phase III trials. I would look for these to begin in 2013.

The final design of the critical components of the Aerosurf delivery device is about completed. It is critical that the key elements involved in aerosolizing and delivering the drug during the clinical trials be identical to the device that will be used in commercialization. The FDA is very rigid on this point and if changes are made to the device used in clinical trials, it could likely lead to a Complete Response Letter. The company discussed this issue on the call. They said that they had been very careful and methodical in designing the device they are using in clinical trials so that it can be nearly identical to the one that will be used in commercialization. The Phase IIb proof of concept trial for Aerosurf is likely to begin in 2013.

Partnering Discussions

The company reported that it is in talks with a number of potential partners covering the gamut from multinational firms with strong hospital marketing expertise throughout the world to small regional players in smaller markets outside of the developed countries. The company reiterated that it hopes to complete a partnering deal by no later than 1Q, 2013 and possibly by the end of 2012.

Disclosure: The author of this article owned shares of Discovery Laboratories at the time this note was written. This should be taken into account as it may introduce bias into the conclusions and interpretations that are made. In reading this note, you acknowledge that you have not used it as the sole basis of your decision making and that all investment decisions are based on your own analysis. An investment in Discovery Laboratories carries substantial risk and investors could potentially much of their investment. The reader acknowledges that he/she has carefully read the Investment Approach, Terms/Conditions and Disclosures sections in the About Us section of the website. The reader acknowledges that he/she will not hold SmithOnStocks accountable for any investment loss that may be incurred if a decision is made to invest in Discovery Laboratories.