Discovery Laboratories: Small Biotech Company With Multiple Prime Time Catalysts

This report is on (NASDAQ:DSCO), and also includes the following companies: Johnson & Johnson (NYSE:JNJ), Merck & Co. (NYSE:MRK), Pfizer (NYSE:PFE), Somaxon (NASDAQ:SOMX), Hemispherx (AMEX:HEB), AspenBio Pharma (NASDAQ:APPY), and AEterna Zentaris (NASDAQ:AEZS).

Without a doubt, this past year the biotech industry has been characterised by companies who’ve found ways to persevere past adversity, overcoming economic and financial downturns to bring in hefty profits for shareholders who took comfort in the saying, “patience is a virtue”. In order to understand this concept, we are going to highlight some of the companies we’ve profiled in the past in order to prove that being small does not translate to an inability to stand tall amongst the big boys. Yes ladies and gentlemen, comebacks do happen in the game of investments, and they are no different than your favourite sporting hero scoring a game winner.

Amidst buyout / partnership rumours from the top drug makers in the world, of the likes including Johnson & Johnson (NYSE:JNJ), Merck & Co. (NYSE:MRK) and Pfizer (NYSE:PFE), Discovery Laboratories is stepping up to the plate with some major upcoming company developments that could make this the next small cap home run play. Among the upcoming binary events: completion of BAT during May as the last step for FDA resubmission on its flagship product, phase 2 results for Acute Respiratory Failure in June, initiation of phase 2a trial for Cystic Fibrosis in 3Q10, and FDA submission of the flagship product, Surfaxin in the treatment of ARDS, during 1Q11. Make no mistake about it, there is serious room for growth as this 70M market cap company and Surfaxin is tapping into a $1.8 billion dollar market opportunity for Acute Respiratory Distress Syndrome, of which currently there are no drugs approved for treatment. What makes this story even more compelling is that Discovery has met and received response letters from the FDA a total of three times, all with minor requirements that have since been met and completed. As a well-capitalized company paired with strong fundamental and technical chart breakout potential, it is undeniable that its re-emergence as healthy NASDAQ listed company is right around the corner.

About Surfaxin

Discovery’s lead product is Surfaxin(TM) (formerly known as KL(4)-Surfactant), a novel, peptide-containing synthetic lung surfactant. Lung Surfactant is the substance that lines the lungs and helps to keep them expanded. Surfaxin(TM) was invented at The Scripps Research Institute and initially developed by J&J. The novel peptide, KL4, is a 21-amino acid peptide modeled by Scripps’ scientists after human surfactant protein B (SP-B). SP-B is considered to be the most important and functional protein of the human surfactant system.

Since licensing Surfaxin(TM) from J&J, the Discovery drug development team has added significant value to its existing proprietary base by developing a novel lavage technique. This technique can be best described as a “lung wash,” and is designed to remove inflammatory and infectious infiltrates from patients’ lungs, restoring their vital surfactant levels. In addition, Dr. Harry Brittain, Discovery’s AACP-honored VP of Chemical Development, has developed a simple way to improve the viscosity of the original J&J formulation, rendering it more efficacious and easier to deliver.

Indications for Surfaxin(TM)

There are three disease states that are characterized by a lack of surfactant:

1. Meconium Aspiration Syndrome affecting full-term babies;
   
2. Idiopathic Respiratory Distress Syndrome affecting premature
   infants; and
   
3. Acute Respiratory Distress Syndrome/Acute Lung Injury affecting
   children and adults.

ARDS/ALI afflicts approximately 220,000 patients annually. The company believes that it represents a $1.8 billion market opportunity in the US alone (with a market of similar size in Europe). There are currently no drugs
approved to treat ARDS/ALI, which has a mortality rate of approximately 50%. Discovery has the capability to produce Surfaxin(TM) in the commercial quantities required for the adult market.

FDA Response Letter Timeline:

1. Received FDA Approval letter April 2006. DSCO answered November 1, 2007
2. FDA Accepted complete respond from DSCO, November 16, 2007
   Set PDUFA date for May 1, 2008.
3. Received second FDA Approval letter, May 2008
4. Met with FDA to clarify, June 2008
5. Submits FDA complete response to second Approval letter, October 2008
6. FDA Accepted SECOND complete respond from DSCO November 7, 2008. Set PDUFA date for April 17, 2009
7. Received THIRD FDA Approval letter, April 2009
8. DSCO and FDA establish Path for potential SURFAXIN approval, September 2009
9. Submits Trial Protocol to FDA for potential SURFAXIN approval, November 2009
10. Receives FDA guidance for potential SURFAXIN approval, February 2010

You may view the detailed report by downloading the following file: DSCO_FDA_Timeline.pdf (373 KB).

Key Data Highlights:

• Treatment with Surfaxin significantly improved survival (p=0.05) through one-year of life compared with animal-derived surfactants, Survanta and Curosurf.
• Surfaxin significantly improved survival (p=0.04) through one-year of life when directly compared with Curosurf, the current market leader in Europe and current market growth driver in United States.
• Although treatment with Surfaxin improved survival in preterm children, no differences in neurologic outcomes through one-year of life were observed between treatment groups, however, Surfaxin demonstrated a statistically significant (p≤0.05) reduction in two important assessments of neurologic outcomes (reflex abnormality and gross tone) versus Survanta.

When looking at other companies who have faced similar circumstances, it becomes evidently clear what makes Discovery’s situation so special. Early last year, one company that stole the spotlight was Hemispherx (AMEX:HEB), whom had been working for decades on its main drug candidate. Despite not meet a positive response letter from the FDA on its PDUFA, the company its saw shares rise from $0.40 all the way to a high of $2.85 prior to any concrete developments, further proving that it is indeed the anticipation factor that drives this industry moreso than the news and outcome itself. Of course, there is no better comparison for Discovery Laboraties’ current situation than that of Somaxon (NASDAQ:SOMX), who followed in the footsteps of Hemispherx and rose from $0.95 per share to a high of $9.21 in a matter of three weeks as due to its highly anticipated flagship product FDA resubmission, as investors banked on the idea that this time they would gain approval, which they did. Initially receiving a negative response letter, they went on to discuss the items raised by the FDA in order to qualify and maximize chances of approval, perfectly matching that of Discovery Laboratories. The madness didn’t stop there however, as another company by the name of AspenBio Pharma (NASDAQ:APPY) stepped on the scene with their follow-up on the FDA required 800 patient stand alone pivotal, which was required as a change from the initial 600. The company saw shares rise from $2.30 to a high of $4.95 as a gap fill retracement took place from the initial drop on disappointment of the new FDA request, causing a delay in the final decision. Lastly, we saw AEterna Zentaris rise from $0.80 to a high of $1.96 in one month’s time, as investors realized its flagship product would soon hit the meet marketing requirements and hit a European market that resembled an equal size than that of North America.

Buyout / Partnership Candidate

Rumours are swirling that a buyout or major partnership is nearing for Discovery, especially with its current executives on hand. At the forefront is interim CEO, Mr. Thomas Amick, whom in 2004 retired from a distinguished 30-year career with Johnson & Johnson, having most recently serve as Vice President of Business Development. He also went on to manage the entire Johnson & Johnson portfolio for Canada. According to one CNN Money article, analysts say there’s no shortage of potential acquisitions by Johnson & Johnson. “There’s nothing too expensive for Johnson & Johnson,” said Robert Goldman, analyst for Keybanc Capital Markets. “They can buy anything they choose to buy in the medical products arena.”

This is not all that surprising, especially considering J&J spent $438 million on the purchase of Omrix Biopharmaceuticals Inc., a manufacturer of bleeding control products and a $1.07 billion acquisition of breast implant-maker Mentor Corp. Drugmakers Pfizer Inc., Merck & Co. and GlaxoSmithKline Plc also have said they’re interested in deals as prescription sales wither from generic competition.

Interestingly enough, and adding fuel to the fire was Discovery’s new statement in their latest 10-Q, “We now believe that it is in our best interest financially to seek to develop and commercialize our KL4 technology through strategic alliances or other collaboration arrangements, including in the United States.”

With regard to their current agreement, Discovery had this statement to say, “”The PharmaBio Agreement also provides that we and PharmaBio will negotiate in good faith to potentially enter into a strategic arrangement under which PharmaBio would provide funding for a research collaboration between Quintiles and us relating to the possible research and development, and commercialization of two of our drug product candidates, Surfaxin LS and Aerosurf, for the prevention and treatment of RDS in premature infants.”

Institutional and Mutual Fund Ownership Increasing

One of the most important metrics in determining whether the sentiment of the market is bullish or bearish on a given stock is institutional and mutual fund ownership. There is no two ways about it, stocks that have increases in this category more often than not beat analyst estimates and prove to be highly profitable investments with return on equity. According to Yahoo Finance, and MFFAIS, as of May, 9, 2010, 21 companies/funds/institutions reported holding shares of DSCO.

• 7 funds report no change
  
• 5 funds sold some or all for a total of 520,303 shares
  
• 9 funds added or took new positions for a total of 883,304 shares

Looking at the following reports, it is clear that the big boys are chasing shares in anticipation of a favourable FDA response on its flagship product.

Now that the history lesson is over, let’s get back to Discovery Laboratories and discuss the upcoming catalysts that should grant it the opportunity to become one of the most vivid companies on Wall Street.

Firstly, sometime during the end of May, given that the price per share continues to trade below $1.00, the company is expected to receive a NASDAQ delisting notice. At first glance, this might seem like a red light, however, once given some thought, you start to realize the potential at hand. When analyzing a long list of equities during the past decade, in almost every case, a company facing this situation has done everything in its power to meet the requirements and grant it consent for remaining on the major exchange. This means, a renewed inflow of press release distribution, increases in marketing and advertising expenditure, and company developments that should push the stock price higher. Taking a book right out of Mr. Buffet’s book, no company could better describe the quote, “Be fearful when others are greedy, and be greedy when others are fearful”. No better metric represents this fearfulness by Discovery investors than the lopsided short interest, totalling 13.14% of the float, or nearly 2,026,300 shares. By this point, seasoned technical and fundamental traders are most likely liking their chops at the opportunity to be a part of a major short squeeze, however there are always some doubters left behind, so lets move on.

When it comes to its financial position, the company is breathing easy. As per its balance sheet ending December 31st, 2009 the company’s total assets stood at $21.40 million with current assets having the highest proportion standing at $15.97 million. Further the most promising financial aspect of Discover Laboratories is that cash and cash equivalents happen to have the proportion of more than 98 percent in total figure of current assets which depicts the company’s high liquidity positions and its ability to lay off its current liabilities any time. The company has no long term debt at all whereas its long term capital lease obligations stand at $0.43 million ending up in total liabilities of $16.92 million.

FDA Update on Surfaxin

On 2/16/10, DSCO announced that in response to written guidance recently received from FDA, it will now focus on a pathway that would entail solely performing additional preclinical work, instead of conducting a limited clinical trial to potentially gain FDA marketing approval for Surfaxin (lucinactant) for the prevention of Respiratory Distress Syndrome (RDS) in premature infants. Based on prior guidance received from the FDA, DSCO expected that a limited, pharmaco-dynamic (PD) based on study in preterm infants would be required to address the sole remaining Chemistry, Manufacturing & Control (CMC) issue regarding the final validation of a fetal rabbit Biological Activity Test (BAT, an important quality control release and stability test) necessary for Surfaxin approval. DSCO believes a Complete Response could be submitted to the FDA during 1Q11. DSCO stated that the safety and efficacy of Surfaxin for RDS has previously been demonstrated in a comprehensive phase 3 clinical program and consistent with previous communications from the FDA there continues to be no questions regarding clinical trial data and no indication that the FDA has any concerns related to other quality assurance tests or the manufacturing process for Surfaxin.

Other Key Pipeline Programs:

• Discovery Labs is conducting a Phase 2 clinical trial to determine whether Surfaxin improves lung function and reduces the duration and related risk-exposure of mechanical ventilation in children up to two years of age diagnosed with Acute Respiratory Failure (ARF). ARF is a severe respiratory disorder associated with lung injury, often entailing surfactant dysfunction. ARF occurs after patients have been exposed to serious respiratory infections, such as influenza (including the type A serotype referred to as H1N1) or respiratory syncytial virus (RSV). Hospitalization following influenza or other viral infection is associated with high morbidity and significant healthcare costs. Enrollment is now completed and top-line results are expected to be available in June 2010.
• Surfaxin LS(TM) (lyophilized dry powder formulation of KL4 surfactant) and Aerosurf(R) (aerosolized formulation of KL4 surfactant) have the potential to greatly improve the management of RDS and represent the opportunity, over time, to expand the current RDS estimated worldwide annual market of $200 million to a $1 billion opportunity. Surfaxin LS is intended to improve product ease of use for healthcare practitioners, eliminate the need for cold-chain storage, and potentially further improve product clinical performance. Aerosurf holds the promise to significantly expand the use of surfactant therapy in pediatric respiratory medicine by providing neonatologists with a means of delivering KL4 surfactant while potentially avoiding the risks associated with invasive endotracheal intubation and mechanical ventilation.
  The Company is currently conducting important preclinical activities for both Surfaxin LS and Aerosurf as well as advancing development of its capillary aerosolization device to support regulatory requirements for its planned clinical programs. The Company is preparing to further engage the FDA and international regulatory agencies with respect to its planned Phase 3 clinical program for Surfaxin LS and Phase 2 clinical program for Aerosurf. The Company intends to initiate these clinical programs upon determining final regulatory strategy and after securing appropriate strategic alliances and necessary capital.
• Aerosolized KL4 surfactant is being evaluated in an investigator-initiated Phase 2a clinical trial in Cystic Fibrosis (CF) patients. The trial is being conducted at a leading research center, The University of North Carolina, and is further supported by the Cystic Fibrosis Foundation. The trial has been designed to assess the safety, tolerability and short-term effectiveness (via improvement in mucociliary clearance) of aerosolized KL4 surfactant in CF patients. Enrollment is approximately 70% complete and top-line results are now expected in the third quarter of 2010.

Technical Chart Analysis

From current levels, the downside remains very small as appose to the upside. The stock is currently trading well below its 50-day moving average and 200-day moving average, usually a strong sign that a reversal is imminent given that the company has pending developments. As Discovery marches closer to key catalysts, expect it to reach a minimum price per share of $0.78, with a possible test of the strong resistance at $1.25. The stock was trading at current levels back in August of 2009, when it shot up well above 100% in a matter of days.

Relative Strength Index (RSI) shows a highly oversold stock, of which generally sees a rebound as those with short positions get out with buy market orders. Look for new investors and day traders to also increase the volume as they begin trading based on the technical chart analysis. Full Stochastics remains highly undervalued at the current 6.29 mark, whereby it should move back to its original 50 mark as seen in previous trading sessions. MACD divergence is currently laying flat awaiting a rebound, and this is usually an indicator of a stock poised for a major run up.

Disclosure: Long DSCO