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Expert Financial Analysis and Reporting

Discovery Laboratories: What the Marketing Approval of Surfaxin Could Mean to the Stock (DSCO, $2.72)

Surfaxin is Finally Cleared for Commercialization in the US
The long saga for Discovery Laboratories (DSCO) that began with the first filing of an NDA for Surfaxin in April of 2004 has finally come to an end as the FDA has cleared Surfaxin for marketing. The NDA was actually approved in March 0f 2012, but an issue with a quality control assay required an assessment to determine if the assay was validated for commercial manufacturing. This has been a long and painful experience for investors and I am sure that some investors will want to recount all of the problems that led to the delays and question the competency of management. However, at this point the focus should be on what this means to the Company in 2014, 2015 and 2016.

The acceptance of the quality control assay by the FDA means that the specifications for manufacturing the product have been finalized. Before Surfaxin can be sold, new commercial batches must be manufactured in accordance with those specifications. These batches should be completed and released by the FDA to be ready for commercialization in the Thanksgiving time frame. DSCO had previously hired and kept in place its sales and marketing team so that the company is ready to go to market immediately thereafter. The approval of Surfaxin also triggers a $20 million payment from Deerfield under the loan agreement; I estimate that year end cash will be about $30 to $35 million.

Sales in 4Q, 2013 will be minimal. Management has issued guidance that US sales in 2014 will be $8 to $10 million and has issued farther guidance of $40 to $50 million of sales in 2017. I estimate that if the Company were to only focus on selling Surfaxin, it could be profitable in 2016. However, the main focus of the Company is not Surfaxin, but Aerosurf, and R& D spending on Aerosurf will delay profitability until 2017 by my estimates.

Investors Will Focus on Aerosurf
The approval of Surfaxin is one of two critical events for the Company in 4Q, 2013. The other and potentially more critical issue is the beginning of the phase II program for Aerosurf, which had to await the approval of Surfaxin. Management has indicated that it will outline the clinical trial program in some detail in an upcoming conference call, perhaps the call on 3Q, 2013 results. At that time, they will discuss trial designs, number of patients, time lines and other issues related to the trials. See my comprehensive report on Aerosurf.

The phase IIa part of the program should begin shortly. Remember that Aerosurf uses a lyophilized form of Surfaxin that is delivered directly to a baby’s lungs through a proprietary capillary aerosol generator. It is the combination of drug and machine that makes this such a novel product with such great potential. The phase IIa program will determine if Aerosurf is safe for use in babies and the appropriate dosage. If phase IIa is successful, it will inform the Company on the design of a phase IIb program that will look for evidence of efficacy.

The results of the phase IIa program should be available in the 3Q, 2014 time frame. As I said, this will be primarily designed to determine if Aerosurf is safe and can be effectively deliver the product to the lungs. It is not designed to determine efficacy, but there is the potential that results could suggest that the product does have a therapeutic effect. The phase IIa will inform the Company on the design of the phase IIb trial which could produce evidence that Aerosurf is effective in mid-2015. If this is the case, it will be an enormous value driver for the Company.

Financing Needs
As I mentioned, the Company will end 2013 with about $30 to $35 million of cash. This is sufficient to fund the Company through 2014, but it will need further financing to get to the critical release of phase IIb Aerosurf data in med-2015. Management has several options available to it such as the public markets, an expansion of the Deerfield agreement or some other similar financial instrument and partnering.

Investment Thinking
There is an air of negativism that surrounds Discovery as it has been a very disappointing investment for so very long. It has taken nearly a decade to get Surfaxin approved as the NDA was first submitted in April of 2004 and investors have lost a lot of money in this time frame. Investors may approach DSCO with more skepticism than is usually the case when an NDA for a critical product is approved. The primary concerns of investors will be that Surfaxin has only modest sales potential of $40 to $50 million, the Company will need to bring in more cash in 2014 and that we are one year away from phase IIa data and two years away from phase IIb data.

However, investors need to focus on the true value creating asset that is Aerosurf, which is a paradigm changing drug for neonatology. If the phase IIb data indicates that Aerosurf can progress to phase III, I would expect a dramatic move in the stock. The market will pay up dramatically for drugs that have shown proof of concept in phase IIb trials and before phase III results are available. Let me give two examples.

Celldex (CLDX) sold at $2.60 at year end 2011 and had a market value of $117 million. Based primarily on phase II results in 2012, it began phase III trials for its cancer vaccine rindopepimut in glioblastoma and will soon begin a phase III trial of CDX-011 in triple negative, GNMPB positive breast cancer. The Company currently sells at $32.84 and has a market capitalization of $2.7 billion.

In the case of Pharmacyclics (PCYC) we have seen that the release of positive phase II data, a partnership with Johnson & Johnson (JNJ) and the filing and acceptance by the FDA of NDAs based on phase II results has had a dramatic effect on the stock. The stock prices at year end 2011, year end 2012 and at the current time have shown a staggering increase from $14.82 to $57.78 to $141.09. The corresponding market capitalizations in the same time frame have gone from $1 billion to $4 billion to $11 billion.

One can argue that Areosurf doesn’t have the potential of the Celldex or Pharmacyclics products. This may be splitting hairs as it has blockbuster potential if it is proven effective. The point of bringing up these two examples is that once the market becomes convinced that there is a good chance for success in phase III, market capitalizations of emerging biotechnology companies can go up ten to twenty fold.

DSCO with a current market capitalization of $143 million could potentially be valued in the $1 billion plus range if investors come to view the chances of success in phase III as significant. Even allowing for an increase in the fully diluted share count from 50 million to 65 million, the share price could climb to $15.

I think that in the event that Aerosurf fails, I don’t see a great deal of risk. If Surfaxin sales are viewed as reaching $45 million in 2017, I think that investors might value these sales at five times revenues and this could result in a market capitalization of $225 million and based on 65 million shares outstanding a stock price of $3.46. I would also point out that with its sales force in place; DSCO has the opportunity to bring in new products through licensing or acquisition that could enhance the value of the Company

One very important point to remember is that we know that Surfaxin is effective and that Aerosurf has the same active pharmaceutical ingredient as Surfaxin. The issue is whether Aerosurf can be delivered safely at therapeutic concentrations to the lungs of babies. The importance of this observation is that phase IIa results have the potential to convince investors that Aerosurf has a good chance for success. This is a catalyst that may be less than a year away. We may not have to wait for phase IIb results to see a big move in the stock.

The stock is up very sharply on the news of approval from $1.97 at last night’s close to a current price of $2.86. Given the historically bad experience with DSCO, there may be a wait and see attitude on the part of investors. The sales potential of Surfaxin is limited; the key phase II catalysts are one to two years away and the Company need to bring in more cash at some point in 2014.

My best judgment is that I think that the stock can hold the current stock level based on the Surfaxin approval and perhaps climb gradually through the point in time that we have a much better insight into whether phase II results justify a phase III trial. It is this event that will be the primary determinant of where the stock goes in the next two years. With positive data, per my Celldex and Pharmacyclics examples, I could see the stock going up five fold in a one or two year time frame. I would buy the stock at current levels in anticipation of this.

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