Tired of your stocks fluctuating wildly on the whims of sentiment relating to the credit crisis and commodity prices? Why not diversify into a stock that fluctuates wildly to a different drummer -- the U.S. Food and Drug Administration (FDA)?

Discovery Laboratories ( DSCO) is a high-risk biotech prospect for sure. But then, based on recent volatility metrics, so are many supposedly defensive stocks. You might as well consider a volatile stock that at least has identifiable catalysts to provide high returns -- catalysts that may start playing out as soon as this Friday, Oct. 31.

Discovery expects to hear back from the FDA on that date about whether its latest response supporting its long-pending application to market Surfaxin will be given Class 1 or Class 2 status. If the former, then Discovery can expect to get a ruling on its Surfaxin application within 60 days. If it is designated Class 2, a six-month vigil will be necessary.

Surfaxin is the brand name for Discovery's KL4 compound, a synthetic peptide that mimics the properties of lung surfactants that allow proper breathing. Surfaxin shows promise for treating prematurely born infants suffering from respiratory distress syndrome (RDS). Discovery is also developing a version of the drug in aerosol form called Aerosurf.

For years, Discovery Labs' shares have risen and fallen on the promise and -- so far -- the disappointment of pronouncements from the FDA regarding the marketability of Surfaxin. Although the FDA appears satisfied with the clinical trials that show Surfaxin as beneficial for the treatment of premature infants suffering from RDS, Discovery Labs ran into manufacturing and labeling issues years ago that continue to impede Surfaxin's commercial launch.

Bullish Insiders

Insiders have been persistent accumulators of Discovery's shares through its travails. You have to go back to June 2005 to see the last insider sales of shares. The buying started in March 2007 and has continued through this month. In all, eight executives and directors have slowly but surely purchased nearly $1 million worth of DSCO at an average price of $2.07, and at specific prices ranging from $1.60 to $2.54 a share.

While hardly the largest dollar volume of purchases among the filings I monitor, I take them in context. These insiders do not pull down seven-figure salaries, or have a ready stippled picture awaiting their next appearance in a Wall Street Journal column. However, their persistence has resulted in all the buying insiders increasing their holdings significantly since 2007 began, keeping DSCO's insider profile bullish by my rating system.

Insiders obviously expect KL4 to generate revenue at some point. And their bets look to be coming to a head now. If Friday brings a Class 1 designation, I would expect DSCO to catch a bid as investors start to position themselves for an FDA decision that would be just 60 days away -- imminent in FDA time.

If Class 2 is all the Surfaxin application musters, expect short-term weakness as investors already in the stock roll their eyes collectively at yet another obstacle this drug seems to encounter at every turn from the FDA. But then expect the stock to gain strength as the six-month deadline (around April 2009) approaches and investors once again position themselves for the FDA pronouncement.

Umpteenth Time the Charm?

Whether you get in now, betting on Class 1 status this Friday, or wait for the Class 2 disappointment for more short-term weakness, the real payoff -- or plunge -- in DSCO will come around Dec. 31 of this year or April 30th of next year.

On the upside, I believe DSCO has the potential to more than double if the FDA finally gives approval. The stock traded up to $3.75 in May 2007 just before the FDA put investors back in the waiting room with yet another approvable letter. The weight of past disappointment may stop the shares from getting back to that level if bullish anticipation once again boosts DSCO prior to the FDA's next decision date. But if actual approval is given, it seems logical that that past bullish level could easily be hit again.

True, the potential revenue from Surfaxin alone do not justify a $3.75 share price for Discovery. The worldwide market for treating infants with RDS is only estimated to be $200 million or so per year. But approval for Surfaxin would pave the way for future approval of the aerosolized version of KL4, which has much broader market potential to treat adult respiratory problems. Adult applications could eventually increase the revenue potential of KL4 to more than $1 billion annually.

Indeed, it is the anticipation of KL4 being used in larger indications that Discovery's management points to as a reason the FDA has been so careful in its approval procedures for this first KL4-based product.

Just so much spin? Could be. But you have to give credit to insiders for putting their money where their spin is. More supportive to this point than insiders' bullishness, however, is the announcement on Sept. 3 that the aerosolized version of Discovery's KL4 surfactant will be used in a Phase IIa clinical trial for cystic fibrosis patients.

This is not a trial run by Discovery Labs. It is an investigator-initiated study at the University of North Carolina, and is funded largely by the Cystic Fibrosis Foundation. These two organizations approached Discovery for the trial -- an important distinction that appears to support Discovery's assertions that the company should be viewed as a biotech with a promising technology platform, not just a single product.

This view of Discovery is important to feel better about the downside risk to DSCO if the FDA nixes Surfaxin, or issues another approvable letter asking for yet more information. The major (and not undeserved) knock against the company has been management's inability to get a clean decision from the FDA. But importantly, the FDA has not been rejecting the clinical data showing the efficacy of KL4 vs. the animal-derived surfactants now on the market. It has stopped the launch because of manufacturing and other nonclinical issues.

Real Risks, Real Rewards

If Discovery fails this time around, DSCO will tank -- no doubt. But any innate value in the technology platform should stop the stock from going to zero; there would be the potential for a deeper-pocketed or (critics would quickly offer) better-run biotech firm to take over the platform.

So, with my calculation of the upside of Discovery's shares as greater than 100%, and my downside calculation of less than 100%, it comes down the odds of the upside playing out vs. the downside to decide whether this high-risk/high-return stock makes sense to bet on.

Reasonable minds can differ on this matter. But for all the disappointments, it seems that Surfaxin has at least been inching toward approval with each approvable letter from the FDA. The independent interest shown by the Cystic Fibrosis Foundation also tells me that Discovery is onto something with its technology. Add in insiders' persistent buying, and I believe it's at least a 50-50 chance that the FDA finally gives investors in DSCO something to cheer about come decision time.

That's a hairy calculus for sure, but that's what a high-risk/high-reward play looks like. And for investors interested in such play, shares of Discovery Labs look as good as any -- especially because the catalysts for winning or losing are clear, and not so far away.


This article was written by Jonathan Moreland, whose newsletter, "TheStreet.com InsiderInsights," parses mounds of data on insider trades to find investable ideas.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider Discovery Laboratories to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Moreland was long DSCO, although holdings can change at any time. Jonathan Moreland is director of research and publisher of the weekly publication InsiderInsights, founder of the Web site InsiderInsights.com and the director of research at Insider Asset Management LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, Moreland appreciates your feedback; click here to send him an email.

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