One seemingly insignificant piece of news last week concerning one of healthcare's biggest players will probably be overlooked by most, but read between the lines and the fine-tuned investor will discern some interesting signals. Merck (MRK) has voluntarily reworked a royalty payment schedule with one of its partners, InSite Vision (INSV.OB), to the benefit of the latter.
Back in 2007, InSite developed an enhanced version of a previously available drug for conjunctivitis. The enhancement comes in the form of the drug's successful fusion with InSite's DuraSite technology, an additive the company engineered to make administering eye drops more efficient. InSite's enhanced pink-eye drops are marketed under the name AzaSite, manufactured and distributed by Merck.
According to InSite's own press release, Merck has voluntarily agreed to pay InSite the higher of the two following sums for AzaSite sales instead of the lower:
- The pro-rata minimum royalty payment with a baseline of 1%
- The earned royalty for 2012-2013.
Additionally, Merck voluntarily agreed to backdate that generosity and give InSite a catch up payment this month (August) of the difference between those rates during the last three quarters.
Considering that Merck's market cap is $132 billion, that royalty payments to InSite will clock in at a minimum $17 million for 2012, and that this new agreement is talking about the difference between $17 million and some number very close to that, this agreement amounts to a gift of something like one one-hundred-thirty-thousandth of Merck's market cap, give or take a few thousandths of a percent.
Far from belittling InSite, I am pointing out here that there is more behind this seemingly tiny royalty adjustment than immediately meets the eye, no pun intended. Whenever an outright gift like this is made in any industry, no matter how small it may seem, one must ask himself why.
Consider the following: InSite Vision's DuraSite technology can be theoretically applied to many existing FDA approved ophthalmic drugs. AzaSite is the company's first real success so far, but if Merck wants any more of its existing eyedrops to be DuraSite enhanced, then Merck has a vested interest in getting InSite up on its financial footing, that is if they think the company has a future.
On the FDA front, as of July 24, InSite's AzaSite Plus for ocular inflammation had 826 out of 900 planned patients enrolled in their Phase III clinical trial, which means that they are in the final stages of FDA approval for their next drug.
On the financial front, InSite has been making huge leaps specifically in the last three years. As per their income statement, in 2009 they had an operating loss of $4.12MM. In 2010, they reported an operating income of $655,000. 2011 saw an operating income of $1.02 million. But net losses have persisted through this growth because of one nagging problem: over $10 million of stubborn debt interest payments that have destroyed their profitability every year.
(Of course, if InSite were the federal government, they'd just call the last three years an economic boom and ignore the fact that their debt is eating them alive, but alas, InSite is a company with shareholders that can't print money, so the numbers actually matter.)
Enter Merck, and their backdated gift to restructure payments in InSite's favor gives the tiny company the chance to not only safely service its existing debt through Q3 2013, but more importantly to pay down nearly $5 million in principle. With total current liabilities at $67 million (see their balance sheet), that amounts to a 7.5% reduction in its principle debt. Modest, but not too shabby considering minimum royalty payments from Merck are estimated to increase 12% to $19 million for 2013.
Consider also the following hypothetical. Pfizer (PFE) and Allergan (AGN) both have drugs on the market for glaucoma. Pfizer's Xalatan is a once-a-day eye drop, versus Allergan's twice a day Combigan. If Allergan wants to one-up Pfizer in this market, they could enlist InSite to enhance Combigan. Merck knows this, and their generosity towards InSite shows it.
InSite has a long way to go to dig out of its debt hole and until they do, their negative equity makes their microcap stock speculative and significantly risky, especially considering the fact that AzaSite royalty payments from Merck will dry up in 2018. But seeing their growth, Merck has given them a leg up. In a manner of speaking, Merck has gone long INSV (without buying any shares, of course). Currently trading nearly 50% off its 52 week high, it will be interesting to see how their stock price develops as their balance sheet claws its way out of the red.