An Eye-Opening Potential Acquisition

As a pharmacist, I know that the easier a drug is for patients to take, the more likely a doctor will prescribe it -- and the greater its chances of financial success. That trend seems to bode well for the latest offering from Inspire (NASDAQ:ISPH). In fact, it might even make sense for the company to acquire its new drug's developer.

A visionary new drug
Late Friday, the FDA approved the antibiotic eyedrop AzaSite, developed by InSite Vision (AMEX:ISV) and recently licensed to Inspire for commercialization in the U.S. and Canada. AzaSite is a topical formulation of the popular antibiotic azithromycin -- widely familiar as a five day Z-PAK, originally made by Pfizer (NYSE:PFE). Its less complex treatment regimen could help it capture leading market share for treating pink eye and other eye infections.

Thanks to InSite's proprietary DuraSite technology, AzaSite requires fewer doses than rival products, creating a viscous solution that is better retained in the eyes to eradicate infections more efficiently. According to InSite, the market for these treatments consists largely of children and busy adults -- patients who'll most likely demand convenient dosing from doctors. In addition, AzaSite belongs to the macrolide class of antibiotics; leading competitors Vigamox, from Alcon (NYSE:ACL), and Zymar, from Allergan (NYSE:AGN), are both fluoroquinolones, whose widespread use has reduced their effectiveness amid growing bacterial resistance. Vigamox and Zymar collectively generate roughly $260 million in annual sales.

AzaSite may also have a leg up on Alcon's Tobradex, a $170 million annual seller that combines antibiotics and steroids to soothe eye infections accompanied by inflammation. AzaSite Plus, a similar combination of medicines currently in clinical trials, would offer the same benefits but require less frequent dosing. AzaSite already reported phase 1 safety data earlier this year, and its combination of previously approved drugs improves its chances for a thumbs-up from the FDA.

Following the money
InSite cleared one of the biggest non-regulatory hurdles for its new drug in mid-February. In exchange for agreeing to pay Pfizer a low-single-digit cut of net sales, the company gained exclusive worldwide rights under the patent family "Method of Treating Eye Infections with Azithromycin." The deal includes AzaSite Plus, and InSite can sublicense it to Inspire as well.

With that issue resolved, InSite wasted no time teaming with Inspire to start selling AzaSite later this year. In exchange, Inspire paid InSite a $13 million upfront license fee, a $19 million milestone payment due upon FDA approval, and a 20% royalty rate for the first two years on the market, with 25% thereafter.

Let's do the math
After watching Wall Street basically ignore InSite's shares, even after AzaSite's approval, I believe that a buyout by Inspire could create a combined company much stronger than the sum of its parts. Inspire ended fiscal 2006 with about $100 million in cash and an additional $20 million under an existing loan facility (already earmarked for the $19 million milestone payment Inspire now owes InSite). As $7.25 per share as of Tuesday's closing bell, Inspire's market cap is just over $300 million.

Currently, InSite has about 93.5 million shares of common stock outstanding, plus warrants outstanding to purchase 16.7 million shares of common stock at a weighted average exercise price of $0.76 per share. That gives it a fully diluted share count of just more than 110 million, based on an S-3 recently filed with the SEC. The company used $7.3 million of Inspire's $13 million up-front fee fully pay back all outstanding debts, leaving it with about $4 million in cash and zero debt after regular quarterly expenses. Based on its closing price of $1.55 on Tuesday, InSite's market cap stands at roughly $170 million -- almost identical to where it started the year, before any of its drugs had been approved!

If Inspire bought InSite for about $2.70 per share (roughly $300 million on a fully diluted basis), using $100 million of its available cash and approximately 27.5 million common-stock shares for the remainder, I believe that the resulting company would enjoy a premium market cap greater than the firms' combined current $470 million.

I'm guessing that market would value the combined company in the $7-to-$8-per-share range, where Inspire currently trades. With 70 million shares outstanding, that would add up to a $500 million market cap. Currently, Alcon trades at 8.4 times trailing annual sales, while Allergan receives a trailing price-to-sales ratio of approximately 6. Given Inspire's current revenue projections, and the following conservative sales estimates for AzaSite:

... the combined company's price-to-sales ratio would shrink from a high of 6 in 2008, to 4 in 2009, to less than 3 in 2010.

A healthy outlook
I think that's conservative, actually. I'm only accounting for roughly $150 million in peak sales of AzaSite in 2010, without any additional licensing revenues or royalties from international sales. I'm also excluding any sales or out-licensing agreements of either AzaSite Plus or fellow spinoff AzaSite Otic, which lend considerable upside for the combined company. Inspire would also acquire the rights to the valuable DuraSite technology, which could be applied to existing or new drug candidates in the future.

In conclusion, if Inspire wants to boost revenues, populate its pipeline, increase its market cap, and become profitable, I believe that the company should look toward InSite, with an eye for acquisition.

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Fool contributor Mike Havrilla, R.Ph., B.S., Pharm.D., is a pharmacist who lives and works in the small Pennsylvania town of Portage. He owns shares of InSite Vision, but has no position in any other stock mentioned. He invites your comments and feedback at [email protected]. Pfizer is an Inside Value pick. The Fool has a disclosure policy.