Thesis:

We believe a long position in ISPH offers an attractively priced, strategic asset with downside protection, several options for management to drive significant near-term upside (including selling the company), and a rational controlling shareholder in Warburg Pincus. 

Overview:

Prior to January 3, 2011, shares were a play on the company's late-stage Cystic Fibrosis therapy, denusofol.  However, on January 3rd the company announced the second and pivotal Phase III trial was unsuccessful and $400mm+ of market cap immediately evaporated as binary investors exited. 

 Unlike many busted biotechs, Inspire has other valuable assets including net cash, two royalties, a rapidly growing marketed drug, significant NOLs, commercial infrastructure including a ~92 person sales force, and a couple of pipeline compounds.  Finally, Inspire likely has strategic value to a variety of companies looking to establish a foothold or expand their ophthalmic presence because of the underutilized sales force and their relationships with doctors.  The company is currently undergoing a strategic review process and we expect a resolution in the next three to six months.    

Company Assets:

Below we describe and value each of the company's assets and provide an assessment of management's potential options for each of them.

1)  Net Cash

We give the company full credit for their cash despite guidance for a small cash burn because the strategic review is likely to be completed before much cash is burned, and because there is a rational, controlling shareholder limiting the risk of poor uses of capital.

2)  Restasis Royalty

The company receives royalties on sales of Restasis, the only FDA approved prescription dry eye treatment, which is marketed by Allergan.  In 2010 Restasis sales increased 19% y/y to $621mm driven by 4% script growth and price increases.  Allergan is guiding for 2011 Restasis sales to increase 12% to $695mm.  Inspire renegotiated the Restasis royalty agreement in August 2010 with the new agreement calling for a 4.4% to 3.7% royalty (scales down in out years), which is down from 7.3% under the old agreement.  However, the new arrangement covers any follow-on versions of Restasis, extends the term from 2014 to 2020, removes R&D funding requirements, and returns full clinical control of Proclaria, a follow-on dry eye therapy, to Inspire. 

The Restasis IP situation is a bit murky with the final patent expiring on May 2014.   However, Allergan management has grown increasingly bullish that generics will have a difficult time proving bioequivalency, a challenge with ophthalmic compounds given minimal absorption into the bloodstream as well as the need to prove bioequivalence for both the active ingredient and transporting agent. 

From March 8, 2011 Leerink Swann note:

"The threat of generic competition to Restasis was viewed as low since emulsion products would likely require clinical data to prove bioequivalence in a large trial. The cost of such an undertaking while facing the risk that Restasis X converts a significant percentage of the franchise prior to successful demonstration of efficacy by a generic offers additional comfort that generic competition may be limited."

From December 12, 2010 UBS note:

"Management was probably the most definitive that we can remember regarding the minimal likelihood of generic Restasis. This is due to the significant difficulty in running a successful non-inferiority study to Restasis and still outperform vehicle (i.e., the solution without drug). In fact, it is difficult to just take Cyclosporine and just beat vehicle. As far as it knows no company has even attempted this type of study.

The difficulty with moving its own Androgen Tears program out of Phase 2 (it has been there for like 5 years) also supports the significant challenges in running dry eye studies even for a company that knows dry eye pretty well."

Furthermore, Allergan is running Phase II trials on the Restasis follow-on, Restasis X, which may be ready to commercialize by 2013.  Assuming clinical success, Allergan will convert Restasis scripts to Restasis X, further insulating the franchise.  Street Allergan analysts expect Restasis out-year sales to range from continued growth to a 50% reduction.  Our base case assumes a 25% decline in 2015 and uses a 15% discount rate.

Our upside case (setting Restasis X aside) assumes Allergan is able to maintain market share and hold sales flat as a result of the difficulty generics will have as discussed above and uses a 10% discount rate. We use pre-tax cash flow because of the significant NOLs that should shield 100% of this income.

Inspire has three options for its Restasis royalty: do nothing, securitize it to raise cash, or sell the asset. We do not believe it would make sense to securitize the royalty because of the relatively high discount rate applied to royalty bonds (mid-teens), cash balance and limited cash burn, and limited ability to securitize post 2014 sales because of the IP overhang. On the other hand, selling the asset has real merit. As discussed above, Allergan is rather bullish on the drug's prospects, and Allergan pays the royalty out of the first dollar of sales, so this is a certain expense. At the valuations discussed above (and higher), buying in the royalty is meaningfully accretive and more attractive to Allergan than continuing to hold cash or buying back stock at 19x earnings (AGN NTM P/E). We believe this transaction would be fully shielded from taxes because of the significant NOLs (discussed below). 

3) Diquas Royalty

ISPH receives a high single-digit to low double-digit royalty on Asian sales of Diquas, a dry eye treatment that was recently approved in Japan.  Interestingly, in early 2009 the same compound failed in Phase III U.S. trials (Proclaria in U.S.), so Japanese approval could bode well for eventual U.S. approval.  Diquas sales will be minimal in 2011 and 2012, although Asian sales could eventually total $100mm.  Diquas has IP running until 2018.  We expect no specific action to be taken with the Diquas royalty because of the small size and immaturity of sales.

4) Azasite

The company markets Azasite, an eye drop approved for the treatment of bacterial conjunctivitis or "pink eye".  Azasite combines the antibiotic azithromycin, known to the masses from Pfizer's "Z-pak", with a technology that keeps the drug on the surface of the eye, thus requiring fewer drops.   Azasite's primary advantage is lower dosing, as only nine total drops are required per infection compared to 20 to 40 for competitive products, as well as widespread physician comfort with azithromycin.  Inspire markets Azasite to high prescribing eye care specialists through a 92 person sales force.   ISPH in-licensed the drug from InSite Vision in February 2007 and pays Insite a 25% royalty.   The drug has formulation and use patents, including IP licensed from Pfizer, through March 2019.     

Azasite received FDA approval in August 2007 and the launch ramp was a bit disappointing, although a new sales force compensation structure and better formulary access has led to robust 75% and 36% prescription growth in 2009 and 2010, respectively.  2009 and 2010 sales were $35mm and $43mm, respectively.  Management is implicitly guiding for 2011 sales to grow 30%+ to ~$55mm+. The drug's 4Q10 share of targeted, high-volume eye care specialists increased to 22% from 13% in 2009, demonstrating Azasite's differentiation as well as the sales force's efficacy.  The drug has a 12% share of the total ophthalmic market and a 5% share of the overall single-use, ocular antibiotic market.  Additionally the company implemented an 8% price increase in October 2009 and 2010. 

The bacterial conjunctivitis market is estimated at 17 million prescriptions annually, or ~$1bb at branded prices.  The market is growing 1% to 2%.  Alcon's Vigamox is the market leader with $224mm in 2010 sales.   60% of the category or ~10 million scripts are written by primary care physicians, pediatricians, and other non-eye care specialists.   We view potential sales to this segment of the market as a "hidden asset" as Inspire is not marketing to this channel and primary care physicians to whom we have spoken are unfamiliar with Azasite.   This "hidden asset" could be realized via a company sale to a larger pharma that has a primary care presence, or through a partnership. 

From the February , 2011 4Q10 Conference Call:

Irina Rivkind - Duncan-Williams - Analyst

"I was just wondering if there is any way to leverage the salesforce by potentially licensing AzaSite to other companies to co-promote perhaps in primary care or pediatrics a way to get it out and collect the revenue stream off of that?"

Adrian Adams - Inspire Pharmaceuticals - President & CEO

"Very good type of question. I think yes, we have been assessing whether or not there is the potential for broadening AzaSite into the primary care and pediatric community. We do believe that there is opportunity there. Clearly we do not have the wherewithal from a commercial point -- infrastructure point of view to leverage that internally ourselves. But obviously, as part of our broad corporate development and licensing activities, we have identified that as a potential opportunity, and it may provide an opportunity for strategic partnerships or other strategic opportunities."

In our base case, we value Azasite at 2.0x EV / Sales, which is in-line with the peer-group and balances the drug's rapid growth with the above-average outgoing royalty to Insite. In our upside case, we apply a 2.5x EV / Sales multiple to reflect a control premium and some strategic value for the underutilized sales force.

We believe this valuation is very reasonable because of the relatively untapped non-Ophthalmology market and potential indication for Blepharitis. We assume Azasite can garner 12% of the non-ophthalmic market, in-line with its share of the broad ophthalmic market but less than the 22% share of targeted prescribers.  This share translates to an incremental 1.2mm scripts and ~$80 million in sales.  We believe Vigamox's $224mm illustrates Azasite's potential upside if all market channel s are exploited.   

Below is back-of-the-envelope accretion math to an acquirer which possesses a large, primary care sales force. We conservatively assume Inspire's stand-alone sales force is currently break-even and 100% of profitability is derived from these incremental sales.  Furthermore, this analysis ignores that ISPH's sales force could be leveraged with a larger portfolio of assets. Note that this analysis roughly dovetails with our EV/sales based Azasite valuation of $2.68/share ($1.71 for current sales + $0.97 for the non-ophthalmic option).  

Alternatively, the company could execute a co-promotion agreement. We peg the value of an Azasite marketing partnership at $0.58 to $0.97 per share.  Such a deal could take the form of an upfront payment coupled with an ongoing royalty on sales or a 50/50 pre-tax profit split.  Assuming the latter, a fully-ramped, non-ophthalmic partnership could provide ISPH with an incremental ~$0.26 in annual FCF/share.  

4)      NOLs

To be conservative we have not valued the ~$320mm in Federal NOLS/R&D credits, which are potentially worth ~$1/ share, although we have also not taxed the royalty streams. 

5)      Pipeline

60% of recent R&D spend was focused on Denofusol, thus the company's pipeline is rather bare.   The pipeline is headlined by a Phase II trial testing Azasite in blepharitis, or inflammation of the eyelid, which is a potentially large indication with an estimated 34mm cases annually.  Additionally, Blepharitis treatment requires multiple bottles of Azasite, thus each script is more valuable than a pink eye script, which requires a single bottle.  There are no FDA approved therapies for Blepharitis and Azasite is currently used "off-label" to treat the condition.  In early 2010 an earlier Phase II blepharitis trial missed the primary endpoint, although secondary endpoints were achieved.  This Phase II trial showed substantial placebo effect and suffered from difficulties in measuring results, both common issues in ophthalmic trials. Management remains committed to the indication and the current Phase II trial began enrolling in late 2011 with data read-out expected in 2H11.  Ophthalmologists with whom we have spoken were positive on Azasite's utility in treating the condition.      

Strategic Review - why a sale makes sense:

The company held a strategic update call on February 17 announcing the shuttering of its Cystic Fibrosis program, which removed a worst-case downside scenario as a third trial would have cost ~$40mm and the company likely would have needed to raise capital.  Management also announced a 27% headcount reduction and expectations for modest $10 operational cash flow burn in 2011, or $17.5mm including one-time restructuring costs. 

On the call management noted it was reviewing its go-forward strategy and is exploring a variety of options including in-licensing marketed drugs, inking an Azasite primary care partnership, and strategic M&A.  We are confident the company will do something near-term, as a pharma sales force is a large, fixed cost expense that needs to be leveraged via multiple products.  The Street reacted positively to the update call and shares rallied to ~$4.50.  However, the stock subsequently retraced the entire move as the Street has interpreted management's somewhat opaque statements, as well as recent CEO appearances at sell-side conferences, to signal the company is not for sale. 

While management has multiple options to increase shareholder value, we believe a take-out is a distinct possibility given the following: 

1)      Large pharma conglomerates as well as smaller specialty players such as QLT and Ista have announced intentions to acquire ophthalmic assets.  A recent Les Echo article indicated Sanofi is looking to enter the U.S. ophthalmic market via a handful of acquisitions:

"Sanofi-Aventis SA plans to spend 1 billion euros over the next three years on acquisitions in ophthalmology, Les Echos reported, without saying where it got the information.  The company is currently studying "closely" four potential purchases, three of which are in the U.S. and the other in Israel, the French newspaper said. It didn't name the companies."

2)      Inspire holds substantial strategic value to an acquirer due to its rapidly growing core product, sales force and commercial infrastructure, and NOL.      

3)      The company has scarcity value as no more than a handful of stand-alone ophthalmic companies possess substantial commercial infrastructure as well as a rapidly growing marketed drug.  Sanofi has no U.S. ophthalmic presence and would likely place considerable value on the sales force.   

4)      Given the prior points, it appears unlikely management will find a cheap, marketed product to in-license.  Simply put it's a seller's market.      

5)      We believe Azasite is not well known by primary care physicians and pediatricians as Inspire does not market to these doctors, which account for 60% of total category scripts.   A buyer such as Sanofi that possesses a large primary care sales force could remedy this problem and potentially double sales in relatively short order, generating ~$40mm+ in incremental EBIT. 

6)      Allergan, which is the Restasis royalty payor, has a low cost of capital and as previously discussed appears to have grown increasingly bullish on the product's tail, thus likely places considerable value on the asset.  Shares of AGN currently trade at ~19x NTM EPS, so buying-in the stream at a high-single digit IRR is a much better use of capital than share repurchases.  We actually believe the ideal outcome is for Allergan to buy the Restasis royalty with another party purchasing Azasite and the commercial infrastructure.    

7)       Warburg Pincus own 28% of the company and is likely driving the strategic review process.  It purchased the stake via a preferred share transaction in July 2007 at a cost of $5.25/share.  The investment is held in Warburg Pincus IX, which closed with $8bb in August 2005.  We view Warburg as a rational decision maker and wonder if it wants to spend several years in-licensing assets or risking further clinical trial disappointments when it could harvest the investment now.      

8)      Warburg also owns ophthalmic pure-play Bausch & Lomb, thus is intimately familiar with the eye care market.  Bausch's ocular antibiotic, Besivance, has been a disappointment and the company might be interested in Azasite.  

9)      CEO Adrianne Adams sold his prior two companies, Kos Pharma and Sepracor, to large pharma.   

10)   The Chairman of the Board, Ken Lee, was also on the Board of CV Therapeutics, a specialty pharma company sold to Gilead.  CV's assets consisted of a very marginal, marketed drug, a royalty, and substantial commercial infrastructure including a 170 rep specialty CV sales force.  Gilead purchased CV primarily for its commercial infrastructure and cardiologist contacts, which it hoped would drive adoption of cardiovascular pipeline asset Darusentan.  Of note, Gilead topped an initial bid from Astellas by paying a lofty ~7x NTM revenue and was widely viewed to have overpaid, so the sell process was well run.  The Gilead/CV transaction provides a blueprint for how Inspire could be marketed.  Lee was also on the Board of OSI Therapeutics, which was sold to Astellas.   

Given the strong case for selling the company, we have debated why management has not publically displayed the for-sale sign.  While the tactic would cause shares to pop and potentially lead to a higher eventual price, recent take-unders as well as for-sale companies not finding buyers (e.g. Savient Pharmaceuticals) demonstrate that the move can back fire.  Additionally, Inspire likely has several possible options, thus can maintain negotiating leverage and garner a higher price by earnestly pursuing all paths.   Finally, Warburg needs liquidity and not a short-term stock pop and is likely cognizant of the risk of a Savient type outcome.     

What Are Management's Other Options?

Assuming ISPH operates as a stand-alone entity, we estimate the company would be modestly cash flow positive by 2013 before factoring in any other transactions. If this is the path the company takes, we expect it to leverage its sales force by in-licensing additional compounds and out-license Azasite to a marketing partner. 

The sales force currently pays for itself but is largely a fixed expense. Thus, layering-in additional 75% to 85% gross margin sales will drive significant incremental cash flow.  

We estimate the combination of in-licensing a new product and an Azasite partnership could drive $0.50+ in FCF by 2013, which supports a ~$5+ stock price.  Clearly our estimates are dependent on myriad assumptions and our analysis is not meant to divert attention from the primary thesis that the company is a potential acquisition target.  The analysis does illustrate downside protection if a deal does not occur and highlights the variety of options available to management to drive shareholder value.  Additionally, the slate of options gives management leverage in any strategic negotiation. 

Other Reasons for Mispricing

1)      50%+ of current value is derived from royalties, which are often mispriced in public markets.  Many investors look at specialty pharma companies on an EV/sales basis, but the metric can be deceiving if a substantial portion of the underlying corporate value is derived from royalty streams.  We believe royalty buyers currently demand a mid-teens IRR, although Allergan could accretively buy-in the Restasis stream at a high-single digit IRR.   

2)      2011 financials will look significantly different than 2010. 16% of 2010 revenue comes from the Elestat royalty, which will expire in 2011 due to generic competition.  Additionally, the Restasis royalty rate drops from 7.4% to 4.4%.  These two issues will drive a ~10%+ decline in 2011 revenue.   Finally, the company's G&A, R&D, and cash flow burn will decrease substantially from 2010.  These changes are in the company's 2011 guidance, although could confuse quantitative screens.

Key Risks

Clearly the key near-term risk is a dilutive transaction.  The Street may also be disappointed if the company purchase a pre-revenue asset.  We believe Warburg's presence reduced the odds of a value destructive transaction.