Description

At ~1x revenues, ISTA Pharmaceuticals (ISTA) is an attractive long candidate, giving you leverage to a rapidly growing top line (+37% Y/Y LTM  3Q10) in a company turning profitable. ISTA's equity value going forward will be driven by growing profitability, debt reduction, pipeline optionality and up to 35cts/share upside from a potential royalty obligation settlement. ISTA is a specialty pharmaceutical company focused on treatments for diseases and conditions of the eye in the United States. Its products treat ocular inflammation and pain, glaucoma, dry eye, and ocular and nasal allergies.

BRIEF HISTORY

Like many specialty pharmas subject to clinical risk, ISTA has its history of plummeting in value on the back of poor clinical development outcomes. Most recently in 2007 through 2009, the stock nose dived from the $10/share level down to below $1/share on the back the FDA denying approval of pipeline product T-Pred for ocular inflammation, negative data for its once daily Xibrom formulation and the subsequent Xibrom generic concerns (key intellectually property was then set to expire in January 2009). These pipeline & product setbacks happened while ISTA suffered from a high level of debt and was hemorrhaging cash, all amidst the bottom falling out of the market - perfect recipe for shareholder destruction.

What's changed? ISTA has come back from the dead and the Street hasn't recognized this. ISTA appointed a strategic advisor in 2008 that resulted in a recap of the company in the fall of 2008 by Deerfield Management, Sprout and Sanderling Ventures, all well-known healthcare investors. The $65mm financing alleviated the debt overhand and left ISTA well capitalized and positioned to execute on the business. Since then, ISTA has demonstrated robust sales growth from existing products, good cost control and achieved 2 key product approvals from the FDA.

PRODUCT SNAP SHOT

ISTA's 2 primary commercial products are Xibrom and Bepreve.

Xibrom : LTM sales $96.9mm, 27% Y/Y growth. Xibrom is indicated for the treatment of inflammation post cataract surgery and for the reduction of pain associated with cataract surgery. The drug was approved in March 2005.  Xibrom is an ophthalmic non-steroidal anti-inflammatory (NSAID), which is primarily given to patients who have undergone cataract surgery (2.5 million procedures are performed each year in the US). Xibrom continues to gain share here as ISTA's sales force ranks first in terms of face time with physicians (Xibrom has taken 11 share points YTD 2010). ISTA is aggressively competing with considerably larger competitors such as Allergan (market leader Acuvail/Acular franchise) and Alcon (Nevanac). ISTA's ability to consistently gain share is a good indication of the capability of the sales force and the quality and desirability of the product. (see below on path forward)

Bepreve: LTM sales of $11.1mm. Bepreve was approved earlier this year for the treatment of ocular itching associated with allergies. Allergic conjunctivitis is the most common type of ocular allergy, typically occurring during the spring and fall seasons. The ocular allergy market is dominated by Alcon's Patanol and Pataday with 69% share; the ocular allergy market is approximately $600mm in annual sales, growing 7% per annum. Bepreve is differentiated by its triple mechanisms of action from ACL's products: (1) a non-sedating selective H1 receptor antagonist (histamine); (2) mast cell stabilization; and (3) suppression of white blood cell migration into inflamed tissue. Expect product to grow to approximately $50-75mm in sales (it could do more).

Istalol: LTM sales of $20.8mm, 14% Y/Y growth. Beta-blocking agent for the treatment of glaucoma. This is an interesting situation as the key molecule, timolol, is generic (product is basically branded generic drug, protected only by formulation IP through 2017). As such it is the only actively marketed timolol brand and thus gets 100% of voice in the doctors' office. Product should continue to grow.

Vitrase: LTM sales of $10.8mm, 100% Y/Y growth. Ocular spreading agent (modifies the permeability of eye tissue, promoting diffusion of injected drugs, thus accelerating their absorption.) The growth is being driven by competing products exiting the market. This product has no patent protection. Expect sales to grow in the mid-to-high single digits going forward. ISTA recently was granted approval to manufacture the active pharmaceutical ingredient for Vitrase in-house, a step that will improve the margin for the product, but more importantly ensure adequate supply

BROMDAY, XIBROM 1X DAILY

ISTA's leading product Xibrom is used 2x/day and it no longer has patent protection. Indeed ACL has filed to sell a generic version of this product. ISTA's strategy is to migrate Xibrom to the newly approved 1x/day formulation, BromDay. So the primary concern with ISTA is whether or not they can successfully launch the 1x/day version of Xibrom prior to a generic Xibrom launch. Four things to consider here:

1. In October, the FDA approved the 1x/day BromDay product. ISTA is launching the 1x/day product now and will be removing the 2x/day product from the market in the spring. The standard generic ANDA approval time frame is now in the 27-29 months time frame, putting a potential approval for ACL's generic product sometime in 2012. However, we fully expect that when generic Xibrom is approved by the FDA, the branded version will no longer be on the market (as noted being pulled this spring), severely impacting the generic's launch in 2012. Also as a comp for these types of situations, in ophthalmology this reformulation process works well. AGN recently did this with their Alphagan program where over five years the generic is only 15% of the Alphagan market post generic entry.
2. ISTA will also likely begin filing Citizens Petitions (CP) to prevent the generic product from ever coming to market. The CP rationale is that the FDA needs to request additional safety data for a generic filer as the product is an NSAID, a class which has known safety issues. This CP strategy has successfully delayed generic entrants in controversial product classes and may be effective in this case.
3. BromDay approval gives ISTA 3 years of 'data exclusivity' with the new 1x/day product. To launch a generic 1x/day product, a generic challenger now will be forced to reformulate the BromDay product and then file for ANDA approval. Given the lengthy lead time in getting ANDAs approved these days, BromDay may effectively have additional exclusivity beyond late 2013.
4. There is a potential issue for generic filers regarding the API (primary pharmaceutical ingredient) supply. There is only one FDA approved API source for Xibrom, and ISTA has it locked up in an exclusive arrangement. There are other drug master files at the FDA awaiting approval that will need to be approved prior to the FDA approving a generic Xibrom. Given that ACL filed their generic product, at least one of these sources is now likely ready for FDA inspection & approval. If this process does not go smoothly, the potential approval of ACL's generic XIbrom may be delayed beyond the 27-29 month ANDA approval wait time. Again, this will likely not be a relevant issue since Xibrom will be pulled from the market next year before ACL's product is approved.

2011 Xibrom/BromDay revenue growth will likely slow substantially as the product migration happens. ISTA's sales force has been spot on the last year so this switch may surprise everyone. We're taking a cautious approach here as speed bumps do occur in product shifts. We expect the product line likely to be flat in 2011 and then resume growing in the 20% range (still lower than the mid-40%s seen this year.)

SUMMER 2010 TECHNICAL PRESSURE ON THE STOCK

ISTA was removed from the Russell 3000 index over the summer, resulting in a substantial sell-off. During this time period Alcon also announced they had filed for approval to sell a generic version of ISTA's Xibrom (previously noted). The stock has since recovered to levels it traded in prior to these events.

PIPELINE

ISTA has a deep pipeline for a small company, and gets no value for it. There are two products that are worthy to note.

Bepotastine Nasal: this is a nasal formulation of the recently approved Bepreve ocular antihistamine. The nasal formulation is approved/sold in Japan by Mitsubishi Tanabe. ISTA notes that the allergic rhinitis market is approximately $2.2 billion in sales, with the nasal antihistamine component comprising about 12% of all prescriptions. In October ISTA reported positive phase 1/2 results from a Canadian trial, and is in the process of taking the drug into phase 2 in the US for the Texas spring Mountain Cedar pollen season. There is no question the drug works as (1) same drug/formulation is approved in Japan for allergic rhinitis and (2) in the Bepreve phase 3 trials, positive results were seen in nasal allergy signs and symptoms. The question is can they run trials to get the drug approved. Given that management has navigated & negotiated two product approvals in thr last 12 months, we believe the chances are much greater than 50/50 that this product gets approved. Sales potential is in the $50mm to hundreds of $mms.

Remura (lower concentration bromfenac) for Dry Eye: Bromfenac is the generic name for the active ingredient in Xibrom/BromDay. ISTA has formulated a lower concentration product that they recently took into phase 3 (final phase prior to filing for approval) under an SPA agreement. The SPA simply means the FDA thinks the trial design will result in clinical answers that if positive, it can use to approve the product (no guarantee however even if the data are positive). Dry Eye is the Holy Grail in ophthalmology as drug development in this area is littered with failures, and the only product approved is ACL's Restasis, which despite marginal efficacy should ring-in $600mm of sales in 2010. The two primary endpoints for the phase 3 program are the objective sign of conjunctival staining using the Lissamine Green test and subjective symptoms measured using the Ocular Surface Disease Index (OSDI). ISTA is optimistic these trials will work as in phase 2 studies, they achieved statistical significance on both the corneal staining and in the OSDI endpoints; they recently presented this data at the 6th International Conference on the Tear Film & Ocular Surface in September 2010. The sales potential for this product is $500mm+.

We don't give them any value for their pipeline as one doesn't need that to believe the stock is a bargain here. The pipeline does offer very nice upside. In the next 12 months there is little pipeline headline risk as well.

SENJU ARBITRATION POTENTIAL UPSIDE

ISTA inlicensed the technology for Xibrom, Istalol, Bepreve and several pipeline products not discussed herein from Senju Pharmaceuticals (Senju) of Japan. Senju is also the sole manufacturer for Bepreve. In April & June 2010, ISTA launched a lawsuit against Senju and AcSentient, respectively (ISTA acquired AcSentient in 2002; AcSentient was the original licensor with Senju) regarding Xibrom royalty obligations. The only US patent for Xibrom expired in January 2009. US case law clearly states that one does not have to pay royalties on a technology when its IP is expired. Also, per the terms of the AcSentient acquisition, ISTA also feels they do not have to pay these royalties. In September, Senju initiated an arbitration proceeding with the International Chamber of Commerce to settle this matter, of which the US courts want to see the outcome. If ISTA is unsatisfied with the outcome of the arbitration, it will still have the option of appealing in the US courts. The legal case seems clear per US case law precedent, but this situation remains unpredictable. ISTA continues to book the royalty obligations in its financials; as of 9/30/10, ITA had reserved $16.7mm for unpaid Xibrom royalties. This amount is approximately 1 year's royalties. If ISTA prevails, this will be approximately $0.35/share accretive annually. The arbitration will likely last a few quarters.

VALUATION

2010 is the year that ISTA turns profitable. Excluding a potential Senju settlement, the Street has ISTA reporting $0.47/share in 2011, and $0.62/share in 2012. A DCF is probably the best way to look at valuation here as you shouldn't simply capitalize earnings in these spec pharma situations - the evolving nature of patents must be factored into the analysis.

Our model tempers growth going forward, taking sales growth down from 39% in 2010 to 12% in 2011 (BromDay switch), 20% in 2012, 18% in 2013, ultimately leading to top line declines in 2017. We are below the Street in our numbers. ISTA also had approximately $195mm of NOLs at YE 2009. Using a zero long term growth rate terminal assumption, we get to a DCF value in the low-mid $6s/share, using a 13.4% WACC.

The table below summarizes the projections:

ISTA will start cash flowing approximately $20mm/yr and growing starting in 2011, and this cash flow will pay down debt. When pro forma'ing the forward revenue multiple for the debt reduction, ISTA is really trading 0.9x 2011 EV/sales and 0.7 2012 EV/sales.

The profitable spec pharma universe currently trades at 1.8-2x forward sales/EV and 9.5-10x forward P/E.  If you apply the low-end of the sales multiple range to 2011 sales, the math points to a mid $5s/share stock price. Note that ISTA's top line is growing at more than twice the sector, which arguably should result in using the multiple from the higher end of the range. On the P/E side, typically in these situations I look at the second year of profitability. Applying 9.5x 2012's EPS yields mid $5s/share.

There is an argument to be made that one should factor in the potential of the Senju settlement, and include some value for the pipeline as it certainly can more than double the company's sales in the next 5 to 7 years. We view these items as additional margin of safety and will look to evaluate them as time progresses. Lastly, despite ISTA being the only independent specialty ophthalmology company remaining, we haven't applied any strategic asset premium.

Regarding the value of the pipeline, a potential way to value them is to consider the programs as a pre-commercial, late stage small cap biotech company. In the comp universe we use (27 companies with phase 2 and phase 3 assets), the median EV is $57mm, implying the pipeline could be worth approximately $1/share. One can also do product level, risk adjusted DCFs on the pipeline products individually; we have not done this analysis.

A note on the shares here: ISTA has 33.5mm primary shares outstanding and 15mm warrants from the debt recap struck at $1.50. From our analysis we use treasury method FD shares of 43.21mm. There are also 7mm options struck at $5.50 not included in our share count.

VARIANCE TO THE STREET

ISTA is not well followed and only SunTrust publishes regularly on the name. SunTrust recently increased their price target to $9/share.

MANAGEMENT OWNERSHIP AND COMPENSATION

Management owns approximately 12.6% of the stock here, lead by the CEO who has 5%. 80% of this ownership is via options. The CEO does own 411k shares of stock. The BOD has a standard 3 tier staggered set-up, and there is currently one vacancy. The BOD seems to be well composed with a drug IP expert, asset manager, large shareholder, former Alcon biz dev, and other relevant industry experience. The annual comp per BOD member is probably a little high at ~$115k/year, but over half of that is options.

Management comp is targeted to be at the 50^th percentile of the peer group, with the annual cash bonus at 75^th percentile for superior performance, and annual long-term incentive grants targeted at the 50^th percentile. The CEO's 2009 comp package was 44% base salary and 56% incentive. Comp is weighted toward long-term incentives (options and restricted stock).

WHAT COULD GO WRONG

• BromDay switch fails - would be a bad outcome. Given though that Xibrom is being removed from the market this risk should be largely mitigated
• Xibrom generic launches prior to Xibrom being pulled from the market - highly unlikely ACL will get product approved before 2012, well after Xibrom is pulled. Still a risk.
• Senju royalty is resolved against the company, enforcing the royalty liability as long as the product remains on the market (how we model ISTA)
• Senju arbitration prevents ISTA from further in-licensing additional Senju products (not sure how much this affects them going forward)
• Pipeline fails - stock not pricing in much competition here

DISCLOSURE: We and our affiliates are long ISTA, and may long additional shares or sell some or all of our shares, at any time. We have no obligation to inform anybody of any changes in our views of ISTA. This is not a recommendation to buy or sell shares.

Catalyst

• Earnings and continued positive script trends
• Successful Xibrom/BromDay switch
• Senju settlement
• Pipeline progress