Expert Financial Analysis and Reporting

Investment Summary

InSite Vision (INSV.OB) has an aggressive and capable management team that continues to impressively execute on its game plan, expand the business model and maximize outcomes for shareholders. I wrote a detailed report on the company on June 19, 2012, in which I estimated a price target range of $1.70 to $2.50 by2018. The stock has moved from $0.30at the time of the report to a current price of $0.40. This positive momentum stems from a number of positive developments that I describe in this noteas well as growing investor confidence in management. This note is a follow-up to the detailed initiation reportpublished on June 19, 2012 and investors should refer to that publication for details on sales and earnings projections as well as price target thinking.

The single most important event on the immediate horizon is topline data from the phase 3 DOUBle trial. The company just announced that enrollment has been completed and I think that topline data will most likely be reported in early 2013. The study's goal is to show that AzaSite Plus, DexaSite and potentially AzaSite are effective in blepharitis. I think there is a good chance for success in this trial, but it is probable that the FDA will require a second confirmative phase 3 trial before granting approval for AzaSite Plus and DexaSite and that this would result inintroductions in 2015 or 2016.

There are no approved drugs for blepharitis and AzaSite Plus and DexaSite have a clear first mover advantage, if approved. 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. I see it as having $150+ million of sales potential in the US five years after introduction. The potential for the rest of the world could also be $150+ million in that time frame. This product will probably be partnered after the DOUBle trial data is finalized, assuming success in the trial.

InSite has started the first of two phase 3 trials of BromSite, its new anti-inflammatory drug for treating cataract surgery patients. These trials should rapidly enroll and the company is guiding for topline data in 4Q, 2012 or 1Q, 2013 (I explain the reason for this rapid enrollment later) with a possible NDA filing in 1H, 2013. This product could be commercialized in the US through a partnering deal in 2014. I project US sales five years after marketing to reach $25 million to $50 million with similar potential abroad. This could be conservative if the company can show superiority of BromSite to Bausch & Lomb's market leading drug Bromday (actually a new formulation of Bromday that is expected by 2013).

The company also announced that its improved version of its DuraSite drug delivery system,which is called DuraSite 2, has shown superior pharmacokinetics to DuraSite in a recently reported pre-clinical trial. The DuraSite patent expired in 2009. A patent pending on DuraSite 2 could afford composition of matter protection through 2029. Management intends to aggressively license DuraSite 2 to other ophthalmic companies as well as to deliver new products, currently undisclosed, in its pipeline. Licensing is a new business strategy for InSite.

InSite management has induced Merck (MRK) to guarantee that it will pay minimum royalties on AzaSite, whose sales have been declining sharply and are at a current run rate of $21 million. Merck will pay $17 million for the year ending October 2012 and $19 million for the year ending October 2013. Merck has been ineffective in its commercialization of the product, but had not elected to return it to InSite. InSite executed a royalty deal on AzaSite in 2008 (I discuss this complex deal in greater detail later) and this created a situation in which InSite was close to default on the AzaSite note as royalties have dropped to a level at which interest payments are not covered. This scenario could have resulted in product rights to AzaSite being transferred to the bondholders. This Merck agreement has eliminated that chance in the near term.

I believe it is likely that Merck will decide to return the product to InSite on or before October 2013. InSite under its contract with bondholders will then have 90 days to find a new partner to take Merck's place, an unlikely proposition. In the event that no partner is found in that time frame, AzaSite rights will revert to InSite. As described later in this note, this could create a scenario in which AzaSite creates $10 million of annual earnings and cash flow for InSite. I give this scenario a 75% chance of occurrence.There remain, however, other scenarios in which InSite loses all rights to AzaSite.

Cash flow of $10 million per year for a cash constrained company like InSite is quite meaningful; under the current royalty deal, it receives no cash flow as all royalties flow to the note holders. The AzaSite situation combines with a plan to execute a royalty deal on Besivance, a product licensed to Bausch & Lomb; the goal is to raise $15 to $20 million by early next year. Success on these two fronts could allow InSite to escape financing at the current depressed stock price, which is obviously important to current shareholders. The company currently has $17 million of cash which covers about one year of cash burn.

Biotechnology investors know all too well that phase 3 trials which appear to have a high probability of success, like DOUBle, can sometimes disappoint. Because expected positive results in DOUBle are a principal driver of the stock, a trial failure would produce a sharp decline in the stock. However, the new development with AzaSite, the licensing and development opportunities afforded by DuraSite 2 and the potential for BromSite indicate that the company would still have promise even in the event that DOUBle fails. I am not predicting this, but it is important to be prepared for the possibility.

Update on the DOUBle Trial

Enrollment has been completed in the all-important DOUBle trial. Each patient is followed for six months or until recurrence. If the last patient enrolled goes six months without suffering a recurrence, the study would conclude in March of 2013. It would then take two months to process the data and reveal topline results so that topline data would be available in May of 2013. It is more likely that topline data will be available in 1Q, 2013.

BromSite Starts Phase III

BromSite uses DuraSite to deliver the non-steroidal anti-inflammatory agent, bromfenac. It is intended to be an improved version of ISTA Pharmaceuticals' (now part of Bausch & Lomb) very successful product Bromday (also uses bromfenac as the active ingredient). BromDay is indicated for the treatment of ocular inflammation and pain after cataract surgery. Since 2000, it is estimated that Bromday and its predecessor product Xibrom have been prescribed over 20 million times globally. It is generally used for 14 days after cataract surgery and can usually be the only anti-inflammatory drug needed, eliminating the need for steroids.

Bromday recorded sales of $85 million in the US in 2011. It was approved in October 2010 as a follow-up to the ISTA's earlier twice a day formulation Xibrom. Under Waxman-Hatch, it was granted three years of marketing exclusivity through October of 2013. Bromday is the leading product in the topical ophthalmic non-steroidal anti-inflammatory market which has sales of approximately $370 million stemming from total prescriptions of three million annually. The patent on Xibrom expired in January 2009 and in May of 2011; the FDA approved a generic version of Xibrom. Currently, only one ANDA is approved, but other approvals are likely. Bromday has exclusivity until October 2013.

There are competitive anti-inflammatory agents and corticosteroids available, but it is felt that bromfenac has significant tissue penetration that allows it to get to the back of the eye. Many experts believe that this provides protection against cystoidal macular edema or CME that occurs in only a small percentage of cataract patients, but potentially can lead to blindness. Bromday is viewed by some ophthalmologists as reducing the risk of CME in addition to its anti-inflammatory effects affording significant differentiation from competitive drugs.

In October of 2011, InSite announced positive top-line results from a Phase 2 head-to-head pharmacokinetic study of BromSite versus Bromday. Although BromSite has a 25% lower concentration of bromfenac than Bromday, it still achieved more than twice the tissue penetration in the eye as compared to Bromday. This enhanced tissue penetration could lead to additional back-of-the-eye uses and new indications for BromSite beyond the initial post-cataract surgery indication. InSite believes that BromSite is a superior drug and that it has potential exclusivity until 2029.

InSite has reached agreement with the FDA in regard to conducting two 240 patients each Phase 3 studies of BromSite versus the DuraSite vehicle. The first of these trials has started and InSite believes that the trials will enroll rapidly. As a generality, an ophthalmologist will set aside at least one day a week for doing cataract surgeries and can do as many as 20 in a day. With 15 sites enrolling, it should be easy to enroll these trials. The company is guiding to topline results in Q4, 2012 or early 2013. If successful, an NDA for BromSite could be filed in 2013.

Bausch & Lomb is developing a product using a lower formulation of bromfenac that is intended to replace Bromday prior to the patent expiration in October 2013. When this third generation product is approved, InSite intends to do a head to head pharmacokinetic study that it hopes will show superior tissue penetration for BromSite. If this study shows little differentiation, I would expect BromSite to capture 30% of the Bromday market and achieve sales of $25+ million of sales within three years of introduction. If it shows markedly enhanced tissue penetration it might capture more that 50% of the market and achieve sales of $50 million within three years of introduction.

DuraSite 2

The composition of matter patent on DuraSite expired in 2009. InSite has developed a new improved version on which it has filed a patent that may issue in the next year. This would afford composition of matter patent protection through 2029.

The company recently reported on a pharmacokinetic study that compared DuraSite 2 containing the anti-inflammatory drug ketorolacto a second arm with DuraSite containing ketorolac, and a third arm with ketorolac used alone. This demonstrated that DuraSite 2 containing ketorolac produced 4 times the tissue penetration of ketorolac alone and 2 times the tissue penetration of DuraSite containing ketorolac. This greater potency should produce greater efficacy for drugs that DuraSite 2 is used to deliver.

This composition of matter patent protection is very important to ophthalmic companies who could use DuraSite 2 as a tool to increase product life cycles as well as to deliver new products. InSite has never employed a strategy of licensing its drug delivery technology to other companies. Management believes that they can build an interesting portfolio of licensing opportunities with DuraSite 2. It will also be used in the development of new drugs in the InSite pipeline that have not been publicly disclosed.

New Developments on AzaSite

Background

InSite originally licensed AzaSite to InSpire Pharmaceuticals, which was subsequently acquired by Merck in 2011. The agreement with InSpire called for a royalty rate of 25% of sales. Under InSpire, the product reached $18 million of sales in 2008, $35 million of sales in 2009, $43 million in 2010 and $40 million in 2011. The terms of the agreement (transferring from InSpire) allow Merck to give the product back to InSite upon six-month notice. If Merck chooses to retain rights, itis required to pay a minimum royalty of $17 million for the year ended October 2012 and $19 million for the year ended October 2013.

In 2008, InSite executed a royalty deal with financial investors that raised $60 million of non-recourse debt capital at a 16% rate of interest. The agreement called for the external AzaSite royalties to Pfizer and the interest payments to be paid out of the AzaSite royalty stream. If net royalties exceeded interest expense, the principal would be repaid and if net royalty payments were not sufficient to cover interest payments, this would be added to the principal. In 2011, the royalty payment was $10 million which covered the interest requirement of $8 million, allowing for the principal to be paid down. In 2012, the royalties could come in around $5 million which is not enough to cover interest expense of $8 million.

Merck Fails to Perform on AzaSite

The expectation was that under Merck, AzaSite sales would grow dramatically as Merck trained its powerful marketing force on the product. However, it turned out that a lot of the sales of AzaSite were coming from off-label prescribing toophthalmologists for blepharitis instead of the approved indication of bacterial conjunctivitis. Amazingly, it seems that Merck did not factor this in when they acquired Inspire for $430 million. Like most big pharmaceutical firms, Merck has been burned by off-label promotion lawsuits and immediately ceased promotion for blepharitis. Sales began to drop for AzaSite, slowly at first and then precipitously as promotion ceased. In 2010 sales were $43 million and in 2011 came in at $40 million. The current run rate is about $21 million.

Details on Royalty Deal

Insite is obligated to pay noteholders a 16% interest rate on outstanding principal, which currently stands at around $50 million to be paid out of the AzaSite royalty stream.

Obviously, royalties of $5 million (25% royalty rate multiplied by $21 million of sales) does not meet interest expense of $7.5 million (16% interest rate multiplied by $50 million of debt) and adds to the principal due.

InSite was in the position that it would have to make up the difference or be in default on the debt, in which case the rights to AzaSite would revert to noteholders. There is a timing difference in that InSite receives royalties during any quarter at 25% of sales. For the period ending October 2012, Merck is required to make up the difference between the royalty rate of 25% times sales and $17 million. However, in the individual quarters, if this does not cover interest due to noteholders, InSite has to make up the difference or be in default. This was the case in the last quarter. If InSite defaulted, it could lose ownership of AzaSite to the noteholders.

Merck has not been effectively commercializing AzaSite. This is not surprising as AzaSite sales of $21 million comparedto Merck's corporate sales of $48 billion. They are relatively meaningless and nowhere close to being on the radar screen of top management. Merck seemed inclined to do nothing.

InSite management proactively approached Merck to try to motivate Merck to actively promote the product. These attempts don't appear to have had any success, but they do appear to have motivated Merck to try to make the situation as right as possible. The leverage that InSite had was that if Merck failed to take any action, it could have left a blemish on how Merck dealt with other marketing partners.

What Will Merck Do Now?

Merck had the option of: (1) issuing a six-month notice and giving the product back, (2) aggressively promoting the product for bacterial conjunctivitis or (3) maintain status quo.Merck has apparently opted for status quo. Merck is now obligated to pay the guaranteed royalty of $17 million for this year and about half of the $19 million for next year at this point. Merck does not give any evidence that it will aggressively promote the product. As I suggested earlier, this appears to be an effort to do what is right. Merck could have walked away from any obligation upon the issuance of a six-month notice. This means that the notes will not go into default in the near term, in which case, the product rights would have reverted to the bondholders.

The question is what Merck will do at the end of the October 2013 period. My feel is that Merck has no intention of promoting the product and will give the product back to InSite at that time. What does this mean for InSite? If Merck gives the product back, InSite under the contract with noteholders has a 90 day period in which it is required to use its best efforts to find another marketing partner for AzaSite. If this effort is unsuccessful, the product then can be commercialized by InSite.

The chances of finding a new partner on the deal terms with Merck are probably nil. The 25% royalty on sales for a product that has declined from peak revenues of $43 million to a current run rate of $21 million is just not doable. It is possible that a deal could be done at a lower rate of say 15%. This would create $3 million of royalties that would not be able to meet the $7.5 million of interest payment on the debt. InSite would default on the notes and product rights would revert to the bondholders. This is the worst case.

Best Case Scenario is Major Positive for InSite

The best case scenario is that InSite will not be able, using its best efforts, to find a new partner within the 90 day time period as called for in the contract. Contacting the likely partners and having them do due diligence in 90 days is a very aggressive time table just to get term sheets. Actually consummating the deal in less than 9 months would be heroic.

There is a very high probability that no deal will be done. This creates the best case scenario in which the rights for AzaSitecommercialization revert to InSite. InSite would be required to pay the bondholders 25% of sales which are achieved with AzaSite. Merck has indicated to InSite that it believes that the $21 million current run rate is largely achieved from prescribing of AzaSite by pediatricians and general practitioners for the approved indication of bacterial conjunctivitis. The off label prescribing of ophthalmologists for blepharitis has largely gone away.

The implication is that the current sales run rate of $21 million is probably the nadir of sales that is achieved without active promotion of the drug. InSite believes that it can maintain or even boost the sales of AzaSite with internet detailing and that total costs of doing this might only be $5 million or so. Here's how the numbers might work. InSite would record sales of $21 million and pay 25% of those sales or 5.3 million, to the noteholders. Subtracting this and costs of $5 million would results in $10 million of annual cash flow to InSite.

The best case scenario for InSite is not a great one for the noteholders, but it may be the only one. The royalty payments would not meet required interest payments and the principal would continue to grow. They would likely have to write down the debt value on their books. However, the noteholders will have received interest payments and principal repayments in excess of the $60 million of debt that was issued to InSite.