Sepracor (SEPR) shares surged up to 30% higher in early afternoon trading as news broke from the Nikkei of an approximately $2.71 billion offer from Dainippon Sumitomo.  Sepracor’s stock has been hammered over the last few years, and recently there have been some disappointing clinical trial results.  We wrote about one of these disappointing trials in early July (Study of Sepracor’s Depression Drug Has Investors Gloomy), on that day the stock was down nearly 20% after two trials had been less than impressive.  However, at that time we reiterated that this stock was simply too cheap, selling for just a 6.5x multiple of the most conservative analyst estimate.

Since we first wrote about Sepracor, analysts have become more positive on Sepracor’s ability to increase earnings.  Even though the price had come up somewhat since July, the stock was still selling for a lowly 6.5x the lowest analyst estimate for full year earnings.  We had upgraded SEPR to Greatly Undervalued from just Undervalued.  So, we were not surprised to see that Dainippon Sumitomo had seen an opportunity in Sepracor and their steady stream of revenue from Lunesta.

There is more than just valuation that appealed to Dainippon in this deal.  They are anxious to add to their pipeline of central nervous system drugs and Sepracor does have some exciting potential in the drugs currently in clinical trials.  Furthermore, Dainippon has an eye towards the established U.S. sales force of Sepracor, which is more than 1,000 strong.  The Japanese drug maker is seeking approval from the FDA for its lurasidone schizophrenia treatment, making its first major effort in the U.S. market.  If it is approved, sales of lurasidone should begin by 2011 and the drug has the potential to be a blockbuster.

Drug maker stocks can be volatile, as the results of trials often lead to huge swings in the stock’s price.  However, Sepracor was one drug stock that we through meet our criteria for a great value stock with potential for appreciation.  It was selling very cheaply and has been exceeding expectations for sales and earnings over the last two quarters.  In addition, it still has a steady stream of revenue coming from Lunesta, in addition to having great potential in their pipeline.  We are not surprised that Dainippon would bid for this company, and it seems to pave the way for a push into the U.S. market.

“Big percentage move on the down side out of Sepracor. It is down about 16% in the pre-market this morning… There’s Sepracor, $14.85 big drop as a depression drug that failed in a clinical trial. That’s why that stock is getting hammered ahead of the open.” Fox Business Network Money For Breakfast 7/2/2009

Drug maker Sepracor (SEPR) received some disappointing news today in regards to a clinical trial of a drug used to treat depression.  The preliminary study showed that 514 patients taking the drug, called SEP-225289, did not show any significant improvement in symptoms of depression after eight weeks of treatment, judging by the standards of the Hamilton Depression Rating Scale.  As if that disappointment was not bad enough, Sepracor received additional news about clinical trials of the pediatric Lunesta.  Lunesta is the company’s best selling drug, bringing in over $600 million or nearly 46% of the company’s revenue in 2008.  The FDA has placed a “clinical hold” on the trials due to non clinical issues that could effect the use of Lunesta on children.

The good news is that the clinical hold should have no effect on the use of the Lunesta among adults, otherwise Sepracor’s stock would be off even more than 18% with about half of their revenue in question.  If pediatric Lunesta is eventually approved it would serve to extend the patents for the drug and preserve that revenue stream for even longer.  However, as of right now the patents will not expire until 2012, so this set back does not effect our revenue or profit projections for the next few years. 

The set back in the depression drug trial certainly does hurt the pipeline of Sepracor, but these trials are still in early phases and that drug likely would not have been brought to market for years.  As our readers know, Ockham has a value investing philosophy at our core, and we see this drop as a potential opportunity.  The company has declined hugely over the last two years partially because growth in Lunesta has flattened.  Furthermore, company-wide sales are expected to drop only about 6% in 2009.  Even though sales are slumping, the stock has fallen much, much faster.  For example, SEPR over the past ten years has traded at 4.4x to 12x times sales per share, with the current metric only 1.2x it looks Undervalued in these terms.  While, today’s news is not good for the company’s future sales prospects, it appears to us that the stock has fallen too far in the past to ignore.  Sepracor has not rest all of its hopes in these two drugs; on the contrary, management is hopeful that Brovana will begin to live up to its blockbuster billing and that new drugs Alvesco and Omnaris could provide stable growth as well. 

Drug companies can be very risky, but with Sepracor trading only slightly above its 52-week low, the market has priced in a lot of bad news.  Coming into today, the most conservative of analysts’ estimates called for profit of $2.23 for 2009, the stock is only trading at a multiple of only 6.5.