A Clear View of InSite Vision's Bullish Prospects

| About: InSite Vision, (INSV)

Investors and analysts seem to be ignoring shares of InSite Vision (ISV) since FDA approval for AzaSite in late April and plans for a late third quarter domestic product launch by its partner Inspire Pharmaceuticals (NASDAQ:ISPH), who licensed the product back in February. Since Inspire seems to be attracting the attention of Wall Street analysts, I will present my own conservative financial model which yields a present value for InSite of at least $3 per share; and which provides a solid rationale for an acquisition by Inspire of its smaller drug development partner.

First, I will cover some recent developments at InSite since FDA approval of AzaSite, including net institutional selling of shares, a golden parachute SEC filing for the CEO, and quarterly earnings. Some of the recent weakness in the share price of InSite back to the $1.50 level where it began the year could be attributable to 4.2 million shares of stock sold by Balyasny Asset Management as of March 31, leaving them with a remaining stake of about 2.6 million shares. Other notable institutional transactions in the first quarter included the following: Wellington (added over 1 million shares), Global Capital (sold roughly 0.5 million shares), JMG Capital (added over 0.3 million shares), and Pacific Assets (added over 0.3 million shares). The net impact of these major transactions was a total of about 3 million shares sold during the first quarter in a stock that only averages about 350,000 shares traded on a daily basis, providing significant headwinds for a share price that has been struggling to escape the $1.50 - $1.60 range in recent trading.

On May 8, InSite announced an 8-K SEC filing detailing a change in control agreement to provide severance benefits for current Chairman, CEO, and CFO Kumar Chandrasekaran, who has been with the company since 1987. The agreement covers termination due to a potential change in control at the company, termination by the company without cause, voluntary resignation by Kumar for good reason, and termination in the event of death or disability of Kumar. The agreement has fueled speculation among investors about a potential acquisition or possible management changes at the company, especially in light of the long tenure of Kumar at InSite, which was founded in 1983.

Earlier this month, InSite also reported uneventful first quarter financial results highlighted by a current cash and investment position of just over $4 million and a net loss of $2.6 million. Further strengthening the company's balance sheet subsequent to the end of the first quarter was a $19 million milestone payment received from Inspire in response to FDA approval for AzaSite. Other useful information from the company’s 10-K SEC filing from the quarter includes a fully diluted common stock share count of 116.6 million shares versus a current tally of just below 94 million shares. Outstanding warrants from previous private placements account for 16.7 million potential shares at an average exercise price of $0.76 per share. Also, outstanding employee benefit stock options add up to 6.5 million potential shares at an average exercise price of $1.19 per share.

Now, getting to the financial model that I was talking about earlier, a good place to start is an overview of the market for AzaSite and the follow-on antibiotic/steroid combination product AzaSite Plus. The annual domestic ocular antibiotic market based on IMS data for 2006 is approximately $360 million for the single-entity market (AzaSite) and approximately $245 million in the combination products (AzaSite Plus), as described in Inspire's most recent 10-Q SEC filing. The total number of prescriptions written for this market in 2006 was about 15 million, representing a healthy 7% growth rate from the previous year. The advantage for both AzaSite products over existing competitors is two-fold -- a total dosing regimen that requires 60-75% fewer drops in the eye and a novel mode of antibiotic action to reduce chances of bacterial resistance.

Next, it is useful to examine the marketing and clinical development estimates for both products. AzaSite is expected to launch in the late third quarter this year and Inspire has provided full-year 2008 sales guidance of $30-$45 million. My peak domestic sales estimate for AzaSite is $100 million in 2010 or roughly 25% share of what should be a $417 million market, assuming just 5% compounded growth.

AzaSite Plus is about two years behind in its clinical development, putting its product launch some time in late 2009 with peak sales of about $65 million likely in 2013, reflecting the smaller market for combination products. The follow-on product to AzaSite is expected to bypass Phase 2 studies and begin a Phase 3 trial later this year based on CEO comments last week. Also, investors should keep in mind that Inspire has the first option at licensing the combination product and it seems like a logical choice for them in order to leverage the cost of their sales force
I have modeled the following royalty stream through 2010 for InSite: $9 million in 2008 for an EPS of $0.08, $12 million in 2009 for an EPS of $0.10, and $31 million in 2010 for an EPS of $26 million. Royalties are based on 20% for the first two years and 25% thereafter for domestic AzaSite sales as previously agreed to with Inspire and are also applied here as an estimate for AzaSite Plus, since that deal is still pending, but will likely have similar terms. I estimate increasing AzaSite sales for the three year period of $45 million, $60 million, and $100 million; with the first year of sales ($30 million) for AzaSite Plus occurring in 2010.

Next, I applied a 20 multiple to InSite's EPS estimate of $0.26 in 2010 to arrive at a future price target of $5.20 during the first year in which both products are estimated to be on the market. I then discounted the 2010 price target back three years by 20% annually to arrive at a fair present value of InSite at $3 per share. I used the high estimate of Inspire's conservative sales figures for AzaSite in 2008 and assumed rapid market share growth for the drug because of its advantages and familiarity among physicians. For AzaSite Plus, I made my assumptions based on a market that has two-thirds the sales potential of AzaSite and a product launch by 2010.

My assumption of a 20 multiple to 2010 earnings is based on sustainable, future earnings growth for InSite of at least 20% once both products are on the market and other sources of revenue begin to contribute meaningfully -- such as AzaSite Otic and international royalties from sales of both eye drop products. The CEO has guided for multiple international deals in the coming year, likely including a package deal for both AzaSite and AzaSite Plus. The deals will focus on the two largest, concentrated ocular anti-infective markets in Western Europe and Japan, which represent about $320 million in total sales for this category. The 20% discount rate is about twice the rate of return of the stock market over the long-term to reflect the increased risk of owning a micro-cap biotech stock.

However, InSite's pipeline actually carries a very low risk of clinical development based on its proven ability to achieve FDA approval with AzaSite and the well known attributes of the drugs that are in its product formulations. Also, InSite announced in February that it entered a patent agreement with Pfizer (NYSE:PFE) that allows it to market and license the rights to AzaSite and AzaSite Plus. My financial model is intentionally conservative, with major upside possible from pending international royalties and sales agreements, AzaSite Otic, and other applications of the company's DuraSite delivery technology. The bottom line for investors is that InSite Vision may not be around for long at the $1.50 per share level, and now may be a good time to buy some shares before Inspire makes the same realization.

Disclosure: Author has long position in ISV

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