InSite Vision: An Opthalmology Focused Company With A Broad Product Portfolio

| About: InSite Vision, (INSV)

Overview of InSite Vision

The core technology of InSite Vision (OTCQB:INSV) is its DuraSite delivery system that delivers drugs more effectively to the eye. The continual blinking of the eye can quickly wash out topical formulations and in order to retain effective drug levels in eye tissue, most drugs have to be given four to eight times per day. It is often difficult for patients to comply with this difficult schedule and missed doses can lead to reduced effectiveness or ineffectiveness of the drug. The pharmaceutical industry recognizes the importance of a simple dosing schedule and most current drugs are based on once or twice a day dosing, but this has been difficult to achieve with drugs used in ophthalmology. The important commercial differentiation of DuraSite is that it requires only one to two applications per day for proven ophthalmology drugs.

InSite has the key advantage that it is usually working with drugs that are known to be effective and safe. This speeds development time and has allowed InSite to develop and gain approval for two drugs: AzaSite and Besivance for bacterial conjunctivitis. It also has three products in phase 3 development that could gain regulatory approval in the 2014 to 2016 timeframe: AzaSite Plus and DexaSite for blepharitis and BromSite for relief of pain and inflammation after cataract surgery. InSite does not have the financial resources at present to build its own commercial infrastructure and will partner its three new products as it has done with AzaSite and Besivance. Almost all revenues arise from royalties on out-licensed drugs.

It is unusual to see such breadth of product opportunities in a small company, but this leads to great complexity in coming up with a sales and earnings model. Forecasting sales (and royalties) of each product requires numerous assumptions on such difficult to predict issues as clinical trial outcomes, regulatory approvals, partnering deals and the ultimate clinical role of the drug. The range of potential outcomes for the ultimate sales and royalties of each product is wide.

This Seeking Alpha report is a summary of a much more comprehensive report that can be accessed on my website. In that report are the detailed spreadsheets that I have used to project sales and earnings for InSite. It also gives much more explanations of InSite's products and the disease targets that they address. My sales model is based on what I believe is the most likely outcome for each product. I would frankly be shocked if I was right on any single product, let alone the company as a whole. Forecasting sales is an art and not a science and the purpose of this report is to provide a logical framework to follow InSite over time. As events unfold, they can be put in perspective and the sales model adjusted. While the numbers that I present in my report give the appearance of great precision, this is not actually the case. I am generally trying to capture magnitude, trend and time.

Investment Opinion

The model that I have developed projects that sales of InSite's five current products will reach $412 million of revenues in 2018. InSite has no plans to establish a commercial operation and will receive royalties from these products which are projected to be $54 million in 2018. The model projects EPS of $0.10 per share in 2018. If achieved, this earnings level in conjunction with a continual build in the pipeline based on DuraSite could lead to an above average price earnings ratio of 17 to 25 times giving a potential price target of $1.70 to $2.50 in 2018, which compares to the current price of $0.30. I would again emphasize that the precision implied by these numbers is deceiving, but I think that it does illustrate the considerable potential of InSite.

Given the uncertainties and errors inherent in long term forecasting, investors (me included) will initially be wary in accepting that InSite will achieve the sales and earnings that I have laid out. Investors need to establish a check list of the most important events that will validate or invalidate my assumptions and adjust my model accordingly. The single most important event on the horizon is topline data from the phase 3 DOUBle trial which will be reported in late 2012 or early 2013. I project that the results will be supportive of approval of AzaSite Plus, DexaSite and potentially AzaSite in blepharitis. However, I am projecting that the FDA will require a second confirmative phase 3 trial before granting approval for AzaSite Plus and DexaSite and that this will delay introduction until 2015 or 2016.

There are no approved drugs for blepharitis and AzaSite Plus and DexaSite have a clear first mover advantage. This along with their superior dosing schedule should lead to very high penetration in a market that is now treated with off label prescribing of drugs indicated for other disease conditions. AzaSite Plus is the key feature of the InSite Vision story and could be the primary driver of sales and earnings growth in the period beyond 2016 and I see it as having $150+ million of sales potential in the US five years after introduction. It has a supporting cast with BromSite, which could be approved in 2014, and DexaSite. I see these products as having $25 to $50 million of sales potential in the US five years after introduction. International sales for each product could approach 60% of US sales and are additive to the US numbers cited above.

I have listed below the critical events that will shape the investment scenario over the next few years. They are in chronological order as follows:

· I expect that the results of the DOUBle trial will be positive and reported out in late 2012 or early 2013. It is possible that the FDA could grant approval if the results are positive and result in a possible introduction of AzaSite Plus and DexaSite in 2014, but I believe that it is more likely that the FDA will request a second confirmatory trial so that ultimate approval will not come until late 2015 or early 2016.

· I think that the execution of a royalty deal on Besivance could be completed by yearend 2012 and raise on the order of $20 million of non-recourse debt. Investors will probably view this as non-dilutive capital that reduces the need for a future equity or at least the amount needed to be raised.

· AzaSite (not AzaSite Plus) was licensed to InSpire Pharmaceuticals and under that company achieved strong sales of $43 million in 2010. However, much of this was achieved for the off-label indication of blepharitis and not the approved indication of bacterial conjunctivitis. When Merck acquired InSpire in 2011, it ceased off-label promotion in blepharitis and sales are now at a $25 million run rate. Merck has said that it views AzaSite as an important product for the company and if it chooses to aggressively promote AzaSite for bacterial conjunctivitis, I think that AzaSite could return to a rapid sales growth trajectory. I am waiting for a sign that will indicate what Merck intends to do.

· The BromSite phase 3 trials should report results in late 2012 or early 2013. I expect that will be successful and lead to approval and a licensing deal in 2014. BromSite does not have the large opportunity of AzaSite Plus is but it has reasonable potential and the upfront payment from a licensing deal could further reduce the need for an equity offering.

· I am projecting an equity offering of $15 million in 2014 to top off the cash balance. I consider this to be conservative as it is possible that partnering deals could obviate the need for an offering.

· If a second phase 3 trial is required to confirm DOUBle, its results could be available in late 2014 and lead to approval of AzaSite Plus, DexaSite and potentially AzaSite for blepharitis in late 2015 or early 2016. This would be a major plus for the stock.

· Approval or anticipation of approval of AzaSite Plus and DexaSite in 2015 could lead to licensing deals with upfront payments that could put InSite into a strong cash position and eliminate the need for equity offerings.

One of the deterrents to purchasing small capitalization companies like InSite is that they usually have to undertake large stock offerings in proportion to their market capitalization to fund clinical development and this can result in significant dilution. At first glance, InSite seems to be fall in this category as it ended 1Q, 2012 with $22 million of cash. I am projecting a cash burn of $13 million for the balance of 2012 so that without new sources of cash, the company would end the year with $9 million of cash. However, InSite has the potential to execute a deal to monetize the royalties of Besivance that I think could bring in $20 million of non-recourse debt in 2012 or 2013 and in 2014, I think that upfront payments in conjunction with partnering of BromSite could bring in another $7 million or so. It is possible that InSite will not have to raise more equity, but my model suggests that they could raise a moderate $15 million or so in 2014 to top off their cash position.

Investors have come to understand that successful clinical trials don't always lead to quick and predictable approvals. The FDA has issued a large number of complete response letters over the last few years relating to chemistry, manufacturing and control issues. These usually result in one to two year delays in approval. I think that the experience that FDA has had with the DuraSite drug delivery system and the fact that they are dealing with drugs that have a long history of clinical use and that the DuraSite delivery system has been validated by prior approvals of AzaSite and Besivance sharply reduces this risk for AzaSite Plus, DexaSite and BromSite.

I want to point out that there are significant risks in the InSite story. I think that the DOUBle trial and the BromSite trials will be successful, but clinical trials are by their nature high risk undertakings. Failure in the DOUBle trial would be a critical blow to my scenario and lead to a sharp drop in the stock price. The outcome of the BromSite phase 3 trials is less important. My biggest concern with the DOUBle trial is that the endpoint of time to recurrence that is critical to showing superiority of AzaSite Plus to DexaSite has not been validated in a phase 2 trial and is untested.

Assuming that all of my projections come to pass, I can see a steady appreciation in the stock price through the end of 2014 followed by a significant jump in late 2014 or early 2015 with favorable results in the confirmatory phase 3 trial to DOUBle followed by another strong jump with approval in 2016. Thereafter, the transition of the company to an earnings driven story could lead to very strong stock price appreciation.

There is the potential that InSite might be a potential takeover candidate. There is growing interest in big pharma in acquiring assets that may lead to several hundreds of millions in sales as opposed to their traditional strategy of going for blockbusters with several billions of sales potential. This stems from the growing difficulty in coming up with blockbusters. With AzaSite Plus, DexaSite and BromSite, InSite could be viewed as a compelling building block on which to build a meaningful ophthalmology business. However, I can only see this happening if the results in DOUBle are very positive.

The acquisition of InSpire by Merck (NYSE:MRK) for $430 million in May of 2011 and ISTA Pharmaceuticals by Bausch & Lomb for $500 million in June of 2012 gives credence to this viewpoint. At the time of acquisition, InSpire had product sales of about $43 million and co-promotion and royalty revenues of $63 million and ISTA had about $160 million of net product sales. Both had an established commercial infrastructure and sales forces, which InSite lacks. However, InSite's pipeline potential is much greater. How this might balance out in the mind of a potential acquiror depends on the company. However, I could see a potential offer for InSite to get AzaSite Plus, DexaSite and BromSite and the pipeline beyond. The later in the product development process, the higher the likely bid, but I could see a bid of perhaps $150 million ($0.62 per share) in 2014 and perhaps $300 million ($1.23 per share) in 2015. Please note that these numbers are based on a share count that includes a projected equity offering of $15 million in 2014.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.