The Incredible Shrinking Eye Care Sector

by: Stephen Simpson, CFA

Tuesday's announcement from Merck (NYSE: MRK) that it's acquiring Inspire Pharmaceuticals (Nasdaq: ISPH) is interesting on a couple of fronts. It's interesting for the multiple that Merck is paying and it is a good exit for Inspire shareholders. It is also interesting because it leaves so few publicly traded stocks in the eye care sector.

A Fair Deal For A Troubled Company

Merck is offering $5 in cash for each share of Inspire Pharmaceuticals, for a total deal value of $430 million. Although this price was a 26% premium to Monday's closing price, it was only half of where the stock was trading as recently as December, and that's a big part of why the company is taking the deal.

Inspire's shares got crushed when the company's drug candidate for cystic fibrosis (denufosol tetrasodium) failed in a Phase 3 study and the company abandoned the program. Add that failure to the prior Phase 3 failure of Prolacria in dry eye and the company was left with a very thin pipeline – a low-potential follow-on indication for AzaSite in blepharitis and some early-stage glaucoma compounds (likely at least six or seven years from marketability).

With this deal, Merck gets access to Inspire's drug AzaSite (a moderately successful drug for bacterial conjunctivitis) and royalty revenue streams for Restasis (a popular dry eye drug marketed by Allergan (NYSE: AGN) and another dry-eye drug on the market in Japan. Although Inspire is looking at lower royalties because the introduction of a generic competitor to Elestat, Merck is buying a relatively low-risk earnings stream with a good chance of a positive cash-on-cash return before AzaSite's patents roll off.

Slim Pickings

With Inspire off the market, there are very few plays on eye care left for investors. Pfizer (NYSE: PFE) and Johnson & Johnson (NYSE: JNJ) have significant eye-care businesses, but they are a relatively small percentage of the total pie for those companies. The same is true for Novartis (NYSE: NVS) – one of the biggest players in eye care already, and getting bigger with the acquisition of Alcon (NYSE: ACL).

Bausch & Lomb is buried within Warburg Pincus, and Meda AB is only a viable investment idea for those willing and able to invest on the Stockholm Stock Exchange. Likewise, while a handful of small private companies have eye care products, those are not viable investment options for most readers.

The Survivors

So what can an investor do?

Allergan (NYSE: AGN) gets close to half of its revenue from ophthalmology drugs (including drugs for dry eye, glaucoma, and inflammation) and though the stock is not notably cheap today, it would be worth a look on a pull-back. Perhaps ironically, Allergan may well get a lot of its future growth from its aesthetics and urology businesses as opposed to eye care.

For a pure play on the drug side, ISTA Pharmaceuticals (Nasdaq: ISTA) is about all that's left. ISTA has solid drug on the market for ocular pain and inflammation (and is transitioning customers to a new once-a-day version to avoid generic competition) and a promising new drug for conjunctivitis. The pipeline is also attractive, with compounds for dry eye, rhinitis, and inflammation all in the works (and with data expected in 2011). Although ISTA still holds a lot of promise and is not expensive, it has had quite a run already from 2009.

Same Story On The Device Side

Although investors have few options on the drug side, things aren't really any better on the device side. Abbott (NYSE: ABT) took Advanced Medical Optics off the market in 2009, and many of the large players on the device side are the same huge diversified healthcare companies that play on the drug side (JNJ, Bausch & Lomb, and Novartis). In fact, it is not uncommon to see companies like Luxottica (NYSE:LUX) or service providers like LCA-Vision (NASDAQ:LCAV) lumped into the group just to bulk up those conference attendee lists and make it seem worth the trip.

Cooper Companies (NYSE: COO) is a leading manufacturer of contact lenses (and a leader in toric lenses), but hasn't produced double-digit returns on assets since its 2005 acquisition of Occular Sciences. The company has carved out something of a niche in hard-to-make products like torics, but manufacturing issues have held the company back. Still, this may be a tipping point – this business good generate very solid growth (and good cash flow) with ongoing production and margin improvements, but after more than a 75% run in the stock over the past year, that story seems to be in the valuation.

Beyond that? Once again it is slim pickings, with Essilor (OTC:ESLOF) and its large market share in corrective lens being the only real remaining investment option. Essilor is a solid company with good margins, good returns on capital, and good growth prospects (a lot of the people in the world who need vision correction still do not have it), but it's not a screaming bargain.

The Bottom Line

The lack of ample eye care investment options is definitely a mixed blessing. It's certainly a good thing that there are relatively few eye diseases or conditions common enough to be blockbuster opportunities for med-tech companies. On the other hand, conditions like dry eye, glaucoma, rhinitis and conjunctivitis are worthwhile opportunities in their own right and can certainly generate ample returns for focused companies with compelling drugs.

Although there isn't much left in this space, investors should at least take a look at Allergan, ISTA, and Cooper – scarcity value alone may make these names interesting to bigger companies looking to add approved products to their own portfolios. Investors can also check out the prospects of Alimera Sciences (NASDAQ:ALIM) and pSivida (NASDAQ:PSDV), two small-cap biotechs focusing on ophthalmic therapies and technologies.

Disclosure: I am long ISTA.