Cephalon

(CEPH)

investors got a nasty shock Monday, but they might have seen it coming.

The West Chester, Pa., biotech company said a study showed that its only revenue-generating drug, Provigil, failed to outperform a placebo in treating attention-deficit hyperactivity disorder. That condition, known as ADHD, represented a major market that could have boosted Provigil annual sales by $100 million in coming years, analysts estimated. Sales of the drug were $18 million in the first quarter.

Cephalon shares fell 22 7/16, or 35.7%, to 40 5/16. Analysts say Wall Street's reaction illustrates the risk of betting on one-product stocks, particularly ones that have significant bearish followings. Meanwhile, some observers wondered if the plunge endangered Cephalon's merger with

Anesta

(NSTA)

, though the companies stood by the deal.

Downturn

The news came just two months after Cephalon announced that a Provigil study demonstrated "a statistically and clinically significant reduction" in symptoms of ADHD in a clinical trial of the drug. The study, which included only 22 patients, bolstered the view that Provigil could be approved for ADHD, a condition affecting up to 7 million school children.

But investors who read the fine print in Cephalon's most recent 10-Q filing with regulators may have noticed that Cephalon settled a class action lawsuit alleging the company misled investors about prospects for an earlier failed drug, called Myotrophin. That drug, which along with Provigil made up the main investment thesis for Cephalon, was dropped as a treatment for Lou Gehrig's disease after the company decided it would need to conduct additional studies in response to FDA concerns.

Into the Frying Pan
Cephalon before Monday's biotech blues

Source: BigCharts

Cephalon said in the 10-Q that the government was investigating "the use of certain lots of Myotrophin" used in clinical trials in 1994 to 1996. The company said it was cooperating with the investigation, although it said it "hasn't been identified as a target of the investigation."

The DOJ investigation focuses "on whether the drug met all manufacturing specifications in every instance. We believe it did," says Sheryl Williams, a company spokeswoman.

The Short Side

While it's not unusual for a company to face legal action over claims that it misled shareholders, investigations into clinical trials are unusual and can raise credibility questions. And Cephalon has accumulated a number of detractors: About 6.6 million Cephalon shares were marked as short positions as of July 10, meaning those investors were betting on the stock's decline.

And decline it did, a move that now threatens to put the brakes on Cephalon's plan to buy Anesta, another drug company, for $31.45 a share in stock. Anesta shares plunged in lockstep with Cephalon's Monday, dropping 10 3/4, or 36%, to 18 13/16.

"The deal could now be put into jeopardy," said David Saks, a fund manager with the

Gruntal MedSciences

fund. Saks, who doesn't own Cephalon, said if Cephalon shares don't bounce back, the deal will probably have to be recalculated. Shareholders have yet to vote on the deal, which had been valued at $444 million. Cephalon shares are now more than 50% below their highs, though they're well above their year-ago level of 14.

Frank Baldino Jr., Cephalon's hard-driving chief executive, expressed confidence that the Anesta purchase, aimed at diversifying Cephalon's product offerings, would be completed.

"We hope today is an overreaction," says Baldino in a conference call to investors today. "It should have no impact on the Anesta transaction."

Some investors said Cephalon's risk as a biotech company increased sharply when Myotrophin was pulled, even though the company is generating sales from Provigil, a major milestone for a biotech company. Approved by the

Food and Drug Administration

in December 1998, Provigil generated sales of $18.3 million in the first quarter, up from $4.2 million a year earlier.

"I have always thought Provigil for the ADHD indication is a risk I didn't want to take," says Peter Wen, fund manager with

Warburg Pincus Health Sciences

fund, which doesn't hold Cephalon. "This is an example of too much risk and expectation on a single product."