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INSV > SEC Filings for INSV > Form 10-K on 26-Mar-2013All Recent SEC Filings

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Form 10-K for INSITE VISION INC


26-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the financial statements and notes thereto included in Item 8 of this Annual Report on Form 10-K.

Overview

We are an ophthalmic product development company advancing ophthalmic pharmaceutical products to address unmet eye care needs. Our current portfolio of products is based on our proprietary DuraSite ® sustained drug delivery technology.

Our DuraSite sustained drug delivery technology is a proven synthetic polymer-based formulation designed to extend the residence time of a drug relative to conventional topical therapies. It enables topical delivery of a drug as a solution, gel or suspension and can be customized for delivering a wide variety of drug candidates. We have focused our research and development and commercial support efforts on the following topical products formulated with our DuraSite drug delivery technology.

• AzaSite®(azithromycin ophthalmic solution) 1% is a DuraSite formulation of azithromycin, a broad spectrum ocular antibiotic approved by the U.S. Food and Drug Administration (FDA) in April 2007 to treat bacterial conjunctivitis (pink eye). It was commercialized in the United States by Inspire Pharmaceuticals, Inc. (Inspire) beginning in August 2007. The key advantages of AzaSite are a significantly reduced dosing regimen leading to better compliance and outcome, a trusted broad spectrum antibiotic, and a lowered probability of bacterial resistance based on high tissue concentration. In May 2011, Merck & Co. (Merck) acquired Inspire and Inspire became a wholly-owned subsidiary of Merck. Merck is now responsible for commercializing AzaSite in North America. We receive a 25% royalty on net sales of AzaSite in North America, plus minimum royalties if applicable.

• Besivance®(besifloxacin ophthalmic suspension) 0.6% is a DuraSite formulation of besifloxacin, a broad spectrum ocular antibiotic approved by the FDA in May 2009 to treat bacterial conjunctivitis (pink eye). An advantage of Besivance is a faster rate of resolution of the infection that may reduce the duration of the illness and reduce the chances of infecting others. Besivance was developed by Bausch + Lomb Incorporated (Bausch & Lomb) and launched in the United States in the second half of 2009. In 2011, Besivance was launched internationally in select countries. We receive a middle single-digit royalty on net sales of Besivance globally.

• AzaSite PlusTM (ISV-502) is a fixed combination of azithromycin and dexamethasone in DuraSite for the treatment of ocular inflammation and infection (blepharitis and/or blepharoconjunctivitis) for which there is no FDA approved indicated treatment. We completed a Phase 3 trial in November 2008 for the treatment of blepharoconjunctivitis and AzaSite Plus was very well tolerated. Although efficacious, the trial did not achieve its primary clinical endpoint as defined by the previous protocol. We discussed the results of this trial with the FDA and determined a new development plan for this product candidate. In May 2011, we reached an agreement with the FDA on a Special Protocol Assessment (SPA) for the design of a Phase 3 clinical trial of AzaSite Plus in patients with blepharitis. An SPA is a written agreement with the FDA that the study design and planned analysis of the sponsor's Phase 3 clinical trial adequately addresses the objectives necessary to support a regulatory submission. In November 2011, we initiated a new Phase 3 clinical trial for this product candidate in blepharitis and completed patient enrollment in the clinical trial in September 2012. This study enrolled more than 900 patients and we expect to receive top-line data in the second quarter of 2013.

• DexaSiteTM (ISV-305) is a DuraSite formulation of dexamethasone in development for the treatment of ocular inflammation. DexaSite is included in the Phase 3 clinical trial SPA for AzaSite Plus. In November 2011, we initiated a Phase 3 clinical trial for this product candidate in blepharitis and completed patient enrollment in the clinical trial in September 2012. This study enrolled more than 900 patients and we expect to receive top-line data in the second quarter of 2013.


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• BromSiteTM (ISV-303) is a DuraSite formulation of bromfenac in development for the treatment of post-operative inflammation and eye pain. We initiated a Phase 1/2 clinical trial for this product candidate in August 2010 and we received positive top-line results from this study in the first quarter of 2011, which demonstrated the efficacy and safety of BromSite. In the third quarter of 2011, we completed an additional Phase 2 clinical trial to investigate the pharmacokinetics (PK) of BromSite in humans. We received positive top-line results that showed that the mean concentration of bromfenac in the aqueous humor of patients using BromSite was more than double compared to the currently available bromfenac eye product. In July 2012, we initiated a Phase 3 clinical trial for this product candidate and completed patient enrollment in November 2012 with 268 patients enrolled. In March 2013, we received positive top-line results that demonstrated a reduction of inflammation and pain after cataract surgery at a lower drug concentration compared to the current market leader.

• DuraSite 2® is our next-generation enhanced drug delivery system, which is designed to provide a broad platform for developing superior ophthalmic therapeutics. DuraSite 2 is based on the original DuraSite technology, and incorporates a cationic polymer to achieve sustained and enhanced ocular delivery of drugs. DuraSite 2 is designed to increase the tissue penetration for topically delivered ocular drugs with the aim of improved efficacy and dosing convenience. We obtained preclinical data from a comparative study that demonstrated superior drug retention and tissue penetration compared to DuraSite. We plan to utilize the DuraSite 2 platform in future pipeline product candidates and expect that it will be available for license for our other drugs. A patent application for DuraSite 2 was submitted to the U.S. Patent and Trademark Office (USPTO) in 2009.

• ISV-101 is a DuraSite formulation with a low concentration of bromfenac for the treatment of dry eye disease. We filed an Investigational New Drug Application (IND) with the FDA for this product candidate in the first quarter of 2011. We plan to initiate a Phase 1/2 clinical trial for this product candidate, but no time period has been set.

Major Developments

Our recent major developments and events include:

• In July 2012, we initiated the BromSite Phase 3 clinical trial. We completed patient enrollment in November 2012 with 268 patients enrolled and received positive top-line results in March 2013;

• In August 2012, we amended the payment terms of the existing Merck License. On a quarterly basis, Merck will pay us the higher of the pro-rata annual minimum royalty or the earned royalty for 2012 and 2013. In addition, in August 2012, Merck paid us a $7.3 million catch-up payment for the difference between the earned royalties already paid for the fourth quarter of 2011 and the first and second quarters of 2012, and the pro-rata annual minimum royalties for those quarters;

• In September 2012, we completed patient enrollment for the AzaSite Plus and DexaSite Phase 3 clinical trial and enrolled more than 900 patients. We expect to have top-line data in the second quarter first half of 2013; and

• In September 2012, we introduced DuraSite 2, our next-generation enhanced drug delivery system and announced preclinical data from a study that demonstrated superior drug retention and tissue penetration compared to DuraSite.

Business Strategy

Our business strategy consists of the following:

1. Develop our pipeline of ocular product candidates. We seek to identify new product candidates from proven drugs that can be improved by formulation in DuraSite, which can substantially reduce the clinical risk involved in these product candidates. As appropriate, we plan to conduct preclinical and clinical testing of our product candidates.


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2. Partner our product candidates. When we deem it appropriate, we seek to partner with larger pharmaceutical companies to manufacture and market our products. Partnering agreements generally include upfront and milestone payments, as well as on-going royalty payments upon commercialization, payable to us.

Critical Accounting Policies and Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

We believe the following policies to be the most critical to an understanding of our financial condition and results of operations because they require us to make significant estimates, assumptions and judgments about matters that are uncertain:

Revenue Recognition. We recognize revenue when four basic criteria are met:
persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the fee is fixed or determinable; and collectability is reasonably assured. We have arrangements with multiple revenue-generating elements. We analyze our multiple element arrangements to determine whether the elements can be separated and accounted for individually as separate units of accounting. An item can generally be considered a separate unit of accounting if both of the following criteria are met: the delivered item(s) has value to the customer on a stand-alone basis and if the arrangement includes a general right of return and delivery or performance of the undelivered item(s) is considered probable and substantially in our control. Items that cannot be divided into separate units are combined with other units of accounting, as appropriate. Consideration received is allocated among the separate units based on the unit's estimated selling price and is recognized in full when the criteria are met. We deem service to be rendered if no continuing obligation exists on our part.

Our revenues are primarily related to royalties on product sales and licensing agreements, and such agreements may provide for various types of payments, including upfront payments, research funding and related fees during the terms of the agreements, milestone payments based on the achievement of established development objectives and licensing fees.

We receive royalties from licensees based on third-party sales. The royalties are recorded as earned in accordance with the contract terms when third-party results are reliably measured and collectability is reasonably assured.

Revenue associated with non-refundable up-front license fees under arrangements where the license fees cannot be accounted for as separate units of accounting is deferred and recognized as revenue on a straight-line basis over the expected term of our continued involvement. Revenues from the achievement of milestones are recognized as revenue when the milestones are achieved and the milestone payments are due and collectible.

For the year ended December 31, 2011, we adopted amendments to the accounting standard related to multiple-deliverable revenue arrangements. The amendment requires entities to allocate revenue in multiple-deliverable revenue arrangements using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendment eliminated the residual method of revenue allocation and requires revenue to be allocated using the relative selling price method. The adoption of this amendment did not impact our consolidated financial position or results of operations since we did not enter into or materially modify revenue arrangements during the years ended December 31, 2012 and 2011. In addition, there have been no significant changes to the units of accounting, the allocation of consideration received to the various units of accounting, and the timing of revenue recognition based on this amendment. We do not expect the adoption of this amendment to have a material impact on future periods.

Income Taxes.We account for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax reporting bases of


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assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. Realization of deferred tax assets is dependent upon future earnings, the timing and amount of which are uncertain. We record a valuation allowance against deferred tax assets to reduce their carrying value to an amount that is more likely than not to be realized. When we establish or reduce the valuation allowance related to the deferred tax assets, our provision for income taxes will increase or decrease, respectively, in the period such determination is made.

We utilize a two-step approach to recognize and measure uncertain tax positions, if any. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained upon tax authority examination, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement.

Stock-Based Compensation. We granted stock-based awards to eligible employees and directors to purchase shares of our common stock under our stock compensation plan approved in 1994 (1994 Plan) and its successor the 2007 Performance Incentive Plan (2007 Plan). In addition, we have a qualified employee stock purchase plan (Purchase Plan) in which eligible employees may elect to withhold up to 15% of their compensation to purchase shares of our common stock on a quarterly basis at a discounted price equal to 85% of the lower of the employee's offering price or the closing price of the stock on the date of purchase. In August 2009, the Purchase Plan was suspended. The benefits provided by these plans qualify as stock-based compensation which requires us to recognize compensation expense based on their estimated fair values determined on the date of grant for all stock-based awards granted, modified or cancelled.

We estimate the fair value of share-based awards on the date of grant using the Black-Scholes option-pricing method (Black-Scholes method). The determination of fair value of share-based awards using an option-pricing model requires the use of certain estimates and assumptions that affect the reported amount of share-based compensation cost recognized in our Consolidated Statements of Income. These include estimates of the expected term of share-based awards, expected volatility of our stock price, expected dividends and the risk-free interest rate. These estimates and assumptions are highly subjective and may result in materially different amounts should circumstances change and we employ different assumptions in future periods.

For stock-based awards issued, we estimated the expected term by considering various factors including the vesting period of options granted and employees' historical exercise and post-employment termination behavior. Our estimated volatility was derived using our historical stock price volatility. We have never declared or paid any cash dividends on our common stock and currently do not anticipate paying such cash dividends. We currently anticipate that we will retain all of our future earnings for use in the development and expansion of our business and for general corporate purposes. Any determination to pay dividends in the future will be at the discretion of our Board of Directors and will depend upon our results of operations, financial condition, financial covenants, tax laws and other factors as the Board of Directors, in its discretion, deems relevant. The risk-free interest rate is based upon U.S. Treasury securities with remaining terms similar to the expected term of the stock-based awards.

Results of Operations

Revenues.

Our revenues for the years ended December 31, 2012, 2011 and 2010 were, as
follows:



                                            Year Ended December 31,
                                          2012          2011       2010
                  AzaSite royalties     $   19.5       $ 13.9     $ 10.7
                  Besivance royalties        2.1          1.2        0.5
                  Other                       -           0.8        0.7

                  Total                 $   21.6       $ 15.9     $ 11.9


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For 2012, AzaSite royalties included $7.6 million of royalties based on net sales and an additional $11.9 million minimum royalty true-up payment by Merck. The increase in royalties was driven by an increase in the required minimum royalty to $17 million for the fiscal year ended September 30, 2012, the measurement period pursuant to the terms of the Merck License, and the pro-rata share of $19 million for the fiscal year ended September 30, 2013. Merck's obligation to make minimum royalty payments terminates in September 2013 and also may be suspended upon the occurrence of certain events, such as a requirement by the FDA or other governmental agency to suspend the marketing of AzaSite or withdraw it from the market in the United States. In addition, a decline in net sales of AzaSite by Merck further increased the minimum royalty true-up payment. Earned AzaSite royalties declined by 24% compared to the same period in 2011. The increase in Besivance royalties in 2012 was driven by an increase in net sales of Besivance by Bausch & Lomb.

For 2011, AzaSite royalties included $10.0 million of royalties based on net sales and an additional $3.9 million minimum royalty true-up payment by Merck. The increase in royalties was driven by an increase in the required minimum royalty to $15 million for the fiscal year ended September 30, 2011. In addition, a decline in net sales of AzaSite by Merck further increased the minimum royalty true-up payment. The increase was offset by a 6% decrease in AzaSite net sales. The increase in Besivance royalties was driven by an increase in net sales of Besivance. Revenues in 2011 also included $0.5 million from the sale of azithromycin to Merck and certain international partners under supply agreements and $0.3 million from the amortization and recognition of international license fee payments for AzaSite.

In 2010, revenues primarily consisted of $10.7 million of earned royalties from net sales of AzaSite by Merck. compared to $8.0 million in 2009. The $2.7 million increase in royalty revenues from the prior year was primarily due to a 22% increase of AzaSite net sales in the United States. In addition, the royalty rate for AzaSite increased from 20% to 25% in July 2009. 2010 revenues also included $0.5 million of royalties from net sales of Besivance by Bausch & Lomb, $0.5 million of grant income under the Therapeutic Discovery Program and $0.2 million from the sale of materials to Merck under the Supply Agreement.

Research and development.

Our research and development activities can be separated into two major segments, research and clinical development. Research includes activities involved in evaluating a potential product, related preclinical testing and manufacturing. Clinical development includes activities related to filings with the FDA and the related human clinical testing required to obtain marketing approval for a potential product. We estimate that the following represents the approximate cost of these activities for 2012, 2011 and 2010 (in thousands):

                                                 Year Ended December 31,
                                               2012        2011        2010
            Research                         $  5,047     $ 4,468     $ 3,137
            Clinical development               10,432       2,869       1,837

            Total research and development   $ 15,479     $ 7,337     $ 4,974

Our research and development expenses by program for 2012, 2011 and 2010 (in millions) were:

                   Program                   2012      2011      2010
                   AzaSite Plus/DexaSite    $  6.6     $ 1.6     $ 0.1
                   BromSite                    2.7       1.0       1.3
                   New products and other      0.4       0.7       0.7
                   Programs-non-specific       5.8       4.0       2.9

                   Total                    $ 15.5     $ 7.3     $ 5.0


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Research and development expenses were $15.5 million in 2012. In 2012, program expenses consisted of our AzaSite Plus/DexaSite program primarily related to costs for our Phase 3 clinical trial. We completed patient enrollment for the AzaSite Plus/DexaSite clinical trial in 2012 and enrolled more than 900 patients. Our BromSite program expenses primarily related to the costs for our Phase 3 clinical trial. We completed patient enrollment for the BromSite clinical trial in 2012 and enrolled more than 240 patients. Non-specific program costs, which comprised facility, internal personnel and stock-based compensation costs that are not allocated to a specific development program, increased primarily due to an increase in headcount as a direct result of the Phase 3 clinical trials. In addition, we continue to incur R&D expense to develop new product candidates.

Research and development expenses were $7.3 million in 2011. In 2011, program expenses primarily consisted of non-specific program costs which comprised facility, internal personnel and stock-based compensation costs that are not allocated to a specific development program. Our non-specific program costs increased in 2011 compared to 2010, primarily due to an increase in headcount. Our AzaSite Plus/DexaSite program expenses primarily related to costs for a new Phase 3 clinical trial that we initiated in the fourth quarter of 2011. Our BromSite program expenses primarily related to the Phase 1/2 clinical trial that concluded in the first quarter of 2011 and the Phase 2 PK Study performed in the third quarter of 2011.

Research and development expenses were $5.0 million in 2010. In 2010, our program expenses primarily consisted of non-specific program costs which comprised facility, internal personnel and stock-based compensation costs that are not allocated to a specific development program. The non-specific costs decreased in 2010 compared to 2009, primarily due to savings resulting from our corporate restructuring in March 2009. Our BromSite program expenses primarily related to preclinical experiments and the Phase 1/2 clinical trial that was initiated in August 2010.

Our future research and development expenses will depend on the results and magnitude or scope of our clinical, preclinical and research activities and requirements imposed by regulatory agencies. Accordingly, our research and development expenses may fluctuate significantly from period to period. In addition, if we in-license or out-license rights to product candidates, our research and development expenses may fluctuate significantly.

General and administrative.

General and administrative expenses increased to $5.8 million in 2012 from $5.6 million in 2011. In 2012, we incurred slightly higher costs related to financial reporting services and investor relations.

General and administrative expenses increased to $5.6 million in 2011 from $4.5 million in 2010. In 2011, we incurred higher personnel-related costs due to an increase in headcount and higher legal expenses pertaining to patent litigation with the Regents of the University and Sandoz.

Cost of revenues.

Our cost of revenues were $1.1 million, $1.9 million and $1.7 million for 2012, 2011 and 2010, respectively. Cost of revenues were primarily comprised of royalties accrued for third parties, including Pfizer, based on AzaSite net sales by Merck. In 2011 and 2010, cost of revenues also included the cost of the azithromycin supplied to Merck and international partners under supply agreements.

Interest expense and other, net.

Interest expense and other, net, was an expense of $9.5 million, $10.2 million and $10.2 million for 2012, 2011 and 2010, respectively. Interest expense was primarily due to the interest expense on the non-recourse AzaSite Notes issued in February 2008 and related amortization of the debt issuance costs incurred from our issuance of the AzaSite Notes. Interest expense decreased in 2012 as a result of pay downs of principal on the AzaSite Notes.


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Change in fair value of warrant liability.

Change in fair value of warrant liability was income of $1.9 million and $2.2 million for 2012 and 2011, respectively. The income resulted from a decrease in the fair value of our warrant liability that was initially valued as of July 18, 2011 and revalued as of December 31, 2012 and 2011. The decrease in fair value was primarily driven by a decrease in our stock price.

Liquidity and Capital Resources

In recent years, we have financed our operations primarily through private placements of equity securities, debt financings and payments from corporate collaborations. At December 31, 2012 and 2011, our cash, cash equivalents and short-term investments were $9.3 million and $26.4 million, respectively. It is our policy to invest our cash and cash equivalents in highly liquid securities, such as interest-bearing money market funds, treasury and federal agency notes. The current uncertain credit markets may affect the liquidity of such money market funds or other cash investments.

We have incurred significant losses since inception, including net losses of approximately $8.3 million, $6.9 million and $9.6 million for the years ended December 31, 2012, 2011 and 2010, respectively. As of December 31, 2012, our accumulated deficit was $207.8 million.

We believe we have available funds to enable us to meet our obligations for approximately the next 12 months. Our ability to fund our operations is dependent primarily upon our ability to execute on our business plan, including generating sufficient cash inflows from operating activities and obtaining additional funding.

We will need to raise additional funding to support our operating activities. Adequate funding may not be available on acceptable terms, or at all. The failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations and financial condition. The accompanying financial statements do not include any adjustments that might result from the outcome of these uncertainties.

Cash used in operating activities was $10.3 million, $8.9 million and $8.1 million for 2012, 2011 and 2010, respectively. The increase in 2012 compared to 2011 was primarily due to our Phase 3 clinical trials related to AzaSite Plus/DexaSite and BromSite. This cost increase was offset by an $11.9 million AzaSite minimum royalty true-up payment received from Merck. The increase in 2011 compared to 2010 was primarily due to higher personnel costs related to an increase in headcount and costs incurred to prepare for clinical trials related . . .

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