Xenoport (NASDAQ:XNPT): Ouch - now this is going to hurt a bit!

Xenoport (NASDAQ:XNPT) is going to be in the casualty list today after the FDA issued a Complete Response Letter (CRL) for Horizant (XP'512) for treating RLS.

In the CRL, the FDA stated that “a preclinical find of pancreatic acinar cell tumors in rats was of sufficient concern to preclude approval of Horizant at this time." XenoPort and partner GSK will be in contact with the FDA to determine possible next steps.

- Deutsche Bank is downgrading XNPT to Hold from Buy noting they had had previously ascribed a high probability of approval given that the active ingredient of Horizant is a prodrug of gabapentin (Pfizer's Neurontin), an efficacious molecule that has been widely used for over 16 years, in addition to positive Phase 3 data. Hence, the firm is surprised by the FDA decision. In the CRL, the agency acknowledged that they had approved gapabentin even though there were similar carcinogenic findings associated with this compound. However, at that time, the FDA believed that the seriousness and severity of Neurontin's indication (refractory epilepsy) at the time justified the potential risks.

Deutsche believes that the probability is high that the FDA will require additional trials for approval, likely delaying potential product launch by a year or more. Given the FDA's extremely intractable stance concerning product safety, they think the odds are low that the product could be approved in the nearterm. And, there is a reasonable chance that Horizant could never be approved. Hence, given this surprising development, they are downgrading XNPT share.

- RBC Capital is lowering their XNPT target to $12 (prev. $30) while curiously maintaining their Outperform rating on the stock.

Firm notes they are surprised given the FDA previously only requested a REMS which is discussed in the late stages of approval, and think this is an irrational decision by the FDA. We note that the label for gabapentin discusses higher preclinical risk of pancreatic adenocarcinoma in male (but not female) rats at doses 10x higher than human doses, but it did not affect survival, and did not metastasize. Also, more than 2085 years of exposure with gabapentin showed no human cases in their clinical studies (nor XNPT's clinical studies). Thus we think based on available data, the findings are inconclusive and should not block approval.

RBC thinks 6-12 month delay and slim chance of approval but it can't be completely ruled out. They acknowledge the highest likelihood is that any approval of Horizant is unlikely particularly because the FDA seems concerned about the risk/benefit in RLS (as opposed to acknowledging giving approval to Pfizer in epilepsy). Some possible options may include 1) agreement on running additional preclinical studies showing inconclusive link to cancer; 2) examining full databases of gabapentin to determine any higher rate vs. background rate in normal populations; and 3) running post-marketing surveillance to monitor risks (such as Novo's liraglutide for diabetes that got approval after the FDA's perceived risk of thyroid cancer). The main concern is that epilepsy and diabetes may be seen as more serious medical concerns than RLS by the FDA.

RBC estimates XNPT has $135M in cash at YE09 or $4/share ($2 at YE10). If chances of approval are 25-30% and upside is $20-22, then risk/reward seems most favorable in single digits around $6-8 where Horizant would have $3-5/share or $150M EV, appropriate given the current risks and overhang.

Notablecalls: This is going to hurt, I suspect. XNPT was an analyst battleground with sponsors like Morgan Stanley constantly reiterating their Overweight rating with $44 target and firms like Lazard saying valuation was full around the $20 level (HOLD, $19 fair value estimate).

I guess the first warning sign was when GSK announced that it may cease research in depression and pain couple of weeks ago.

Now we have RBC saying they would consider $6-8 level as attractive on valuation basis (XNPT has $6/share in cash), which means the stock is likely to trade in the $12-$14 level today and drift lower towards the $10 level after that. The stock could drift way lower from there over the coming months.

So, if you can gets shorts in the $13-14 level...you should be able to cover lower later on.