Buy Discovery Labs Before March 6 PDUFA Date

| About: Windtree Therapeutics, (WINT)

Investment Thesis and Valuation

The transformation of a biotechnology company from development stage to commercial can be the catalyst for a sustained increase in stock price. Discovery Laboratories (DSCO) received regulatory approval for its first product, Afectair, on February 2, 2012 and I believe that there is a strong possibility for approval of a second product Surfaxin on its PDUFA data of March 6, 2012. These are the catalysts for my new buy recommendation. DSCO also has built a highly promising pipeline based on Surfaxin LS (the next generation Surfaxin) and Aerosurf, which I consider one of the most promising product concepts in biotechnology.

In valuing the stock, I look at DSCO in two ways. Though 2017, sales will be driven by Surfaxin, Surfaxin LS and Afectair which by then could have combined US sales of $98 million. Before considering the potential impact of Aerosurf, I would value the company in 2016 at 4 to 6 times these projected 2017 sales. This would result in a market capitalization of $392 to $588 million. Based on projected shares outstanding of 50 million, this results in a target price of $8 to $11 for 2016.

Aerosurf has the potential to make DSCO special and the valuation for DSCO that I just calculated doesn't take into account its effect on stock price. If Phase IIb clinical trial data that could be available in 2014 is positive, I think that it would have a very significant impact on valuation by 2016, over and above $8 to $11. I am projecting that Aerosurf could be introduced in 2017 and reach worldwide sales of $570 million by 2022. My worldwide sales projections for Discovery's products through 2022 are as follows:

Discovery Laboratories Worldwide Product Sales Projections

$ millions

2012

2013

2016

2017

2022

Surfaxin

$1.1

$8.0

$16.0

$5.2

$0.0

Surfaxin LS

0.0

0.0

20.0

49.2

196.9

Aerosurf

0.0

0.0

0.0

65.6

596.9

Afectair

0.4

8.0

33.8

43.3

68.9

Total

$1.5

$16.0

$69.8

$163.2

$862.7

Click to enlarge

I want to caution potential investors that while these numbers appear to have great precision, they really should be looked at as indications of trend and magnitude. Long term sales forecasts are subject to considerable forecasting error. Also, Aerosurf has not yet started Phase III trials and its successful development is far from assured. I want to strongly emphasize that this stock is only suitable for experienced biotechnology investors who understand and accept the reward and risk of investing in a biotechnology stock in front of a major binary event like the March 6 PDUFA date. If I am wrong and the FDA does not approve Surfaxin, my whole investment thesis goes out the window and the stock could slide to $1.00 or less. This is a big risk, but one that I am willing to take. I am all in before the PDUFA date.

With approval, investors will turn their attention to the need to raise significant amounts of cash to launch Surfaxin. The company plans on building a small sales team of 20 representatives to introduce Surfaxin in the US in 4Q 2012. I estimate that in order to carry out the launch plan and to have enough cash to fund operations through 2013, the company may have to bring $60 million of cash into the company.

At the time of the March 6th PDUFA date, I estimate that DSCO will have about $6 million of cash. I believe that the stock could have a good move with Surfaxin approval that could cause the exercise of 5 million warrants outstanding that expire in May and have a strike price of $2.94. This could bring in $15 million, and I think that the company might access the capital markets for another $30 million. With the validation of the KL4 technology that Surfaxin approval would bring, the company will probably partner Surfaxin LS and Aerosurf for foreign markets in late 2012 or early 2013. I think that the upfront payment on a partnering deal could be somewhere between $25 and $50 million. These factors have the potential to bring in $70 to $95 million of cash by the end of 2013.

Assuming a $30 million hypothetical equity offering at $4 per share in 2012 and exercise of the 5 million warrants, I estimate that shares outstanding at the end of 2013 could be roughly 37 million. I do not see profitability until 2016, so DSCO may have to raise additional capital in 2014 or 2015. My share count estimate for 2016 is 50 million. This increase in share count does not reduce the potential for a substantial increase in stock price if my product sales assumptions are achieved.

The Technology Platform

Discovery is focused on the development of products based on its KL4 synthetic surfactant technology for the treatment of respiratory distress syndrome (RDS) in pre-term infants. RDS is the result of a deficiency in human surfactant which is essential to reducing surface tension in the alveoli of the lungs and reducing the effort required to breathe. The lungs of many pre-mature infants are insufficiently developed and cannot produce sufficient amounts of surfactant. The most severely ill RDS babies cannot breathe by themselves and currently must be maintained by the use of mechanical ventilation and surfactants derived from the lungs of pigs and cattle.

There are three marketed products used to treat RDS that are surfactants sourced from animals: Abbott Laboratories' (NYSE:ABT) Survanta (harvested from cattle lungs), Cornerstone Therapeutics' (NASDAQ:CRTX) Curosurf (pigs' lungs) and Ony's Infasurf (calves' lungs). Surfaxin is a synthetic surfactant which incorporates the key protein and two essential lipids found in human surfactant. The history of the pharmaceutical industry has many examples of effective products sourced from animal tissues being replaced when humanized products become available. Recombinantly produced human insulin's replacement of animal insulin harvested from the pancreas of pigs and cattle is a classic example.

I think that over time Surfaxin and other KL4 based products will largely replace animal surfactants in the RDS market. However, the animal surfactants are life saving products. They are trusted by doctors who will not change to Surfaxin until they gain confidence through clinical experience that it has equal or better efficacy. This will not happen overnight.

Comparing Surfaxin and the Animal Surfactants

The pivotal Phase III SELECT trial compared Surfaxin to Exosurf, a synthetic agent that was the first surfactant product to be approved by the FDA. It was later withdrawn from the market by its manufacturer Glaxo (GLX) because it had come to be regarded as less effective than the animal surfactants and was an insignificant product for Glaxo. Surfaxin is markedly different from Exosurf in that it contains a critical human protein that is not included in Exosurf.

Survanta was included in the SELECT trial as a reference arm but the primary endpoints of the trial were based on comparisons of Surfaxin to Exosurf. Surfaxin was dramatically more effective than Exosurf in that trial and most numerical trends on endpoints showed Surfaxin as better than Survanta. However, there were not enough Survanta treated babies in the trial to establish statistical superiority. Surfaxin was also compared to Curosurf in a second supportive Phase III trial called STAR and found to be non-inferior. This trial was insufficiently powered to establish statistical superiority.

There is reason to believe that doctors will come to view Surfaxin as superior to the animal surfactants. In the SELECT and STAR trials, 1,546 babies were enrolled and investigators were able to track the progress of all but 29 of these babies. Physicians were able to compare the results after one year of treatment 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.

This favorable mortality data is obviously important, but a more powerful message to physicians stems from data on re-intubation. Surfaxin, Curosurf, Survanta and Infasurf are all given in conjunction with mechanical ventilation in which a breathing tube has to be inserted (intubation) through the windpipe. This is a traumatic procedure for infants that is only performed in life-threatening situations. If the baby relapses and has to be re-intubated, there are very serious clinical and cost ramifications. The same follow-up analysis showed that only 34.2% of babies given Surfaxin had to be re-intubated as opposed to 43.9% of patients given the animal surfactants. This was significant with a p-value of 0.005.

The data from the SELECT and STAR trial also resulted in very important data that 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 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 results of SELECT and STAR certainly support the hypothesis that Surfaxin is as effective as Curosurf and Survanta with comparable side effects. The post-study follow-up gives a strong indication that Surfaxin has a mortality benefit and through reducing the rate of re-intubation offers major clinical and cost advantages over the animal surfactants. However, these findings will probably not be included in the package label of Surfaxin because they were retrospective and not proscribed endpoints in the clinical trials. Nevertheless, the results have been published in peer-reviewed journals and neonatologists are well aware of the data and, of course, survival is the most indisputable of all end points even if the data is obtained retrospectively.

There are other points to consider that favor Surfaxin over the animal surfactants. A major advantage of KL4 surfactants is that they are produced through synthesis, which allows consistency of the manufactured product and production of unlimited quantities. The harvesting and processing required for animal surfactants obtained from slaughtered animals can result in significant lot to lot variation of active ingredients. As a consequence efficacy can vary with the result that some babies may receive sub-therapeutic doses. This may account for the mortality and re-intubation benefits shown with Surfaxin

There is a theoretical risk that the use of an animal surfactant can result in the transmission of an animal disease caused by a virus or bacteria to a human although I am not aware of any case in which this has occurred. There are also subtler issues such as animal rights activists who would be alarmed by the ongoing slaughter of animals if a synthetic product like Surfaxin were available. And there are also certain religions such as Islam, Hinduism and Judaism that have taboos associated with consuming and presumably inhaling cattle or pig derived products.

Surfaxin LS

Discovery is already working on a second generation Surfaxin, a lyophized product called Surfaxin LS. Surfaxin and the animal surfactants are manufactured as liquids, which must be kept cool throughout their product life; this presents handling and storage problems. Surfaxin LS is freeze dried and stored as a powder until it is needed. It is then reconstituted with distilled water. This is a major advantage over Surfaxin and the animal surfactants.

There is also another important aspect to Surfaxin LS. Europe requires head to head trials for a new product entering a market in which there is effective therapy and as was just discusses, the Surfaxin SELECT trial did not directly compare Surfaxin to an animal surfactant. Surfaxin LS will probably need to be compared in a clinical trial to Curosurf, the leading surfactant in Europe. DSCO will begin European marketing with Surfaxin LS. Assuming success in its clinical trials, Surfaxin LS could reach world markets in 2016.

Aerosurf

A major disadvantage of Surfaxin and the animal surfactants is that they are delivered through an endotracheal tube inserted through the windpipe. The physician inserts a catheter into the tube and uses a syringe to deliver the surfactant. He then turns and manipulates the baby to try to distribute the surfactant throughout the lungs. The "holy grail" for neonatologists would be an effective product that can be delivered without intubation. Discovery's third surfactant product, Aerosurf, is aimed at providing a solution to this unmet medical need.

Aerosurf is engineered to be used in conjunction with a procedure called nasal continuous positive airway pressure (nCPAP). This procedure is already used extensively by neonatologists to treat milder cases of RDS. Using a tight fitting mask, a tube asserts positive pressure through the nasal passages into the windpipe and into the lungs to prevent the alveoli from collapsing when air is exhaled. This is a much less intrusive approach than mechanical ventilation, but also less effective.

With Aerosurf, Discovery has developed a system that delivers KL4 surfactant as an aerosol to the deep reaches of the lung. It can be delivered through nasal clips used in nCPAP without the need of an endotracheal tube. This requires sophisticated medical device engineering in addition to drug development skills. DSCO in-licensed a novel aerosol generator called a capillary aerosol generator for which it has exclusive rights for use in neonatology. This is the key element of the device part of the system. It then had to engineer a KL4 product having precisely controlled particle size that could be aerosolized and delivered to the deep lungs. In addition to these two primary technical requirements for Aerosurf, there was much additional, sophisticated device engineering required.

A pilot trial in humans of Aerosurf using a prototype device was conducted in 2007 and results suggested that it was as effective as Surfaxin in treating RDS. For approval, the FDA requires that when a medical device is used in conjunction with a drug that all device and drug elements used in clinical trials be identical to the product for which marketing approval is sought. DSCO has spent the last four years finalizing the design of the device and preparing for clinical trials.

In 2011, DSCO announced the results of a study in pre-term lambs that indicated that Aerosurf showed comparable efficacy to Surfaxin in treating RDS. The pre-term lamb model is accepted as an excellent predictor of efficacy in humans. If the aerosol product that is Aerosurf can be effectively delivered to pre-term lamb lungs, there is good reason to believe that it can be delivered effectively to human lungs.

DSCO is working with the FDA and EMA on a Phase II trial design that could begin in 2013 and establish proof of concept in 2014 leading to pivotal Phase III trials that set the stage for possible approval in late 2016 or 2017.

Regulatory Review Process Has Been a Nightmare

Surfaxin's road to potential regulatory approval has been a long and torturous one. Following the very successful Phase III trial, an NDA was filed on May 13, 2004. Over the ensuing eight years, the company has gone through a frustrating experience. In trying to gain approval it has received four complete response letters. The March 6, 2012 PDUFA is based on the fifth re-submission of the NDA.

Over this period of time, the FDA has never questioned the safety and efficacy results shown in SELECT. The delay has been the result of manufacturing issues and most importantly not validating in the SELECT trial a quality control test called the fetal rabbit biological assay test or frBAT. This is a test used to determine stability of Surfaxin during stages of the manufacturing process and when it is held in inventory. In this assay, pre-term rabbits are divided into one group that is given Surfaxin and another that is given no drug. The difference in lung function between the groups over time is an indication as to whether Surfaxin has remained stable and active.

The saga and frustration in trying to satisfy the FDA is a long and complex story. A good part of the blame for the delay can be attributed to DSCO moving too rapidly in its anxiousness to get the product approved. The FDA was also culpable in not giving clear indications of what it considered necessary to validate frBAT. Both sides stepped back after the last CRL and took a more measured approach and for the first time the FDA laid out in writing what it considered to be the essential steps needed.

DSCO has worked very carefully to meet the requirements presented in the written instructions from the FDA. In recent corporate presentations, DSCO has discussed the issues that the FDA needs to resolve and has shown the painstaking detail that the company has used to try to meet these requirements. The data that has been generated appears to be what the FDA is looking for and I think that there is a high probability that the FDA will consider the frBAT as having been validated and grant marketing approval to Surfaxin.

Afectair

The company has just received approval for a medical device called Afectair that adds a new and meaningful component to the company's outlook. In its work on Aerosurf, the company found that the delivery of aerosol medications through nCPAP was remarkably inefficient with as little as 1% of the dose ultimately finding its way into the human lung. DSCO came up with a proprietary, patented solution to the problem in Afectair. It simplifies and improves the efficiency of the ventilator circuit connection and allows more of the drug being dosed to be delivered to the lungs.

While it was specifically invented to deliver KL4 surfactant, Affectair is applicable to most other aerosolized drugs. It can potentially be of benefit to all of the 1.4 million patients now receiving aerosol medications through nCPAP. The selling point of Afectair is not improving the efficacy of the drug, but sharply reducing the waste of expensive drugs. Based on third party research, DSCO has indicated that peak sales of Afectair could reach $50 to $75 million and is independent of the success or failure of the KL4 technology.

Overview of Use of Surfactants to Treat RDS

IMS estimates that worldwide sales of surfactants in 2010 were $206 million and that sales by region were: US ($73 million), Europe ($61 million), Japan ($17 million) and rest of the world ($55 million). There are three marketed surfactants in the US: Curosurf, Survanta and Infasurf are estimated as having sales of $34 million, $28 million and $11 million respectively. Outside the US, Curosurf is the leading product and may have worldwide sales of $125 million.

In the US, there are about 3.9 million births each year. About 350,000 babies are born before the 29th week of gestation and are at risk of RDS. DSCO estimates that 45,000 pre-term babies (the most severely ill) receive surfactants immediately after birth. There are another 120,000 babies with RDS that are first treated with nCPAP. This therapy is not as effective, but physicians want to avoid mechanical ventilation if at all possible. About 45,000 of these nCPAP treated babies within a few days go on to require surfactants and mechanical ventilation.

Altogether, 90,000 babies are treated each year in the US with surfactants. I estimate that this number of surfactant treated babies will be roughly stable over the next five years based on the assumptions that the number of overall births will remain unchanged that the occurrence of RDS and surfactant penetration of the RDS market remain unchanged.

The benefit to cost ratio for animal surfactant therapy is extremely favorable. The benefit is that they are life-saving and allow many babies to survive and live a full life. The price of therapy is only about $1,000 per treatment. The manufacturers of these drugs have not made an effective effort to persuade payors of the benefits of therapy and did not do follow-on clinical trials to differentiate their products. As a result, they have been essentially sold as commodities on a price basis. This pricing strategy was influenced by Abbott for whom Survanta is a small product in terms of sales. They have used Survanta as a loss leader marketing tool to allow their salesmen access to hospitals to promote their much more important infant formula products.

If the surfactants were first being introduced today, the prices would be appreciably higher. New cancer drugs, for example, are generally priced at over $50,000 or more even though survival benefits are generally measured in months or years as opposed to possibly a lifetime for a surfactant treated baby. If surfactants were priced comparably to cancer drugs, the US market would be $4.6 billion instead of $73 million.

The role of Aerosurf in the treatment of RDS is still not certain as the Phase III trials that will define its role have not yet started. There are some important parameters to look at. There are about 120,000 pre-term babies with RDS in the in the US who are initially treated with nCPAP alone because doctors want to avoid intubation and mechanical ventilation. Of these, 120,000 about 45,000 will need to be intubated and placed on mechanical ventilation. Unfortunately, physicians do not know which babies will progress to mechanical ventilation. This suggests that the addressable market for Aerosurf is the 120,000 patients now treated with nCPAP.

Aerosurf is highly differentiated from Surfaxin and the animal surfactants. It may provide equivalent therapeutic outcomes in a sub-group of less severely ill patients and at the same time could save hospital the expense incurred with intubation and mechanical ventilation. I think that a premium price of $7,500 per course of treatment could be justified if Aerosurf can prevent intubation and mechanical ventilation. The potential addressable market could be judged to be the 120,000 nCPAP babies who go on to intubation and mechanical ventilation. This represents a US addressable market of $9 billion.

There is potential for Aerosurf to be used in respiratory conditions beyond just RDS in pre-term babies. These include disease such as cystic fibrosis, acute lung injury and chronic obstructive pulmonary disease. It may also have potential for delivering other drugs to the lungs. However, this is in the future and for the present I think that investor should focus on the use of Aerosurf in babies at risk of RDS.

Key Assumptions Used in Sales Projections

In building a sales model for DSCO, there are many assumptions to make. The most far-reaching is that all of the products will be successfully developed. I am building my model on the basis that DSCO markets its surfactant products in the US and partners them in international markets. Afectair will be sold worldwide through distributors.

I assume that Surfaxin and Afectair will be introduced in the US market in 4Q, 2012 and that Afectair will be introduced in Europe in 1H,2013. I assume that Surfaxin LS will be introduced in the US and Europe in 2016 and will quickly replace all of Surfaxin usage in the US and lead to the first commercial sales in Europe. Remember that Surfaxin will not be sold in Europe. I assume that Aerosurf will be introduced in world markets in 2017.

The key pricing assumption for Surfaxin and Surfaxin LS is that they will initially be priced at modest premiums to the animal surfactants. I further assume that they will capture about 45% of the US surfactant market by 2016 and 75% by 2020. Following the introduction of Surfaxin LS in international markets I am estimating similar pricing and market penetration rates. As Surfaxin builds to a larger market share and undertakes studies which show favorable cost to benefit outcomes, I think there is the potential for significant pricing flexibility. For example, in some European markets in which Curosurf has a dominant market share, its price is two to three times higher than the US. I could see the price of Surfaxin LS in the US in 2022 being two to three times the introductory price of Surfaxin in 2012.

Disclosure: I am long DSCO.