Updated from 12:31 p.m. EST

Just a few weeks ago, Cephalon ( CEPH) looked like it was marching confidently toward the regulatory review of its drug for attention deficit hyperactivity disorder.

Now, the Frazer, Pa., company appears to have developed a bit of a limp, as a panel of medical experts prepares to meet on Thursday to discuss the experimental ADHD drug Sparlon, which Cephalon is proposing for the treatment of children ages 6 to 17.

On Wednesday, a day ahead of the panel meeting, the Food and Drug Administration posted on its Web site an analysis by a staff member who recommended that Cephalon's application be rejected. The risks are greater than the benefits "and preclude the safe use of this drug" for treating ADHD, the staff report, written last September, says.

Sparlon shouldn't be approved because it doesn't show a "clear, demonstrated advantage over existing" ADHD drugs, the report says.

The FDA staff reviewer adds that if additional analysis bears out the potential risks, the agency should discuss halting all clinical programs involving children that are currently underway with another Cephalon drug, the sleep-disorders treatment Provigil. The reviewer says the label for Provigil should be strengthened to warn about the risks it could pose for children.

Provigil and Sparlon both contain modafinil, although Sparlon would be given in doses of 345 milligrams to 420 milligrams vs. the recommended 200-milligram dose of Provigil. The FDA notes that Sparlon won't work as an ADHD treatment at the lower dose.

Two other FDA reviewers advocated that Sparlon receive conditional approval, subject to additional research on safety issues. "I need more information before passing final judgment," one reviewer says in comments posted on the FDA site.

Internal Debate

Documents released by the FDA illustrate the debate within the agency.

For example, one staff member cited three cases of severe skin rashes, including one instance of the potentially lethal Stevens-Johnson syndrome, as one reason for opposing Sparlon. But two other FDA reviewers said the matter could be addressed with a warning label and a determination of whether the problems were caused by Sparlon interacting with other drugs.

Those latter two reviewers made their comments in October, just a few days before the FDA granted conditional approval for Sparlon, saying Cephalon needed to resolve matters that neither the company nor the agency identified at that time.

However, one of the FDA documents released Wednesday is the letter of conditional approval, outlining the agency's questions, including the request for more information about the three cases of skin rash among 933 patients receiving Sparlon.

The letter asked Cephalon to clarify information about potential psychiatric side effects and to comment on proposed labeling and risk-management recommendations.

Publication of the FDA staff members' comments sent Cepahlon's stock down sharply early in the morning, but by the close it had rebounded to end higher by $1.45, or 2%, to $73.31. The stock dropped as low as $65.04 earlier.

Cephalon's trading volume of 22.5 million shares was more than seven times the daily average for the past three months.

Cephalon had little to add on the matter. "I do not plan on attempting to answer investor questions regarding the volumes of information contained in this briefing document," Chip Merritt, senior director for investor relations at Cephalon, said in a prepared statement. "All of the pertinent data will be discussed by our experts at the panel meeting on March 23rd."

The latest information adds to the nervousness investors and some analysts have had since an FDA report last week stated that there were four instances of suicidal "events," but no deaths, among 664 Sparlon users, compared with no events among 308 people receiving a placebo.

Last week's FDA analysis was based on a compilation of many clinical trials. The report didn't find a statistically significant link to Sparlon, and it added that its research had several limitations.

Investors bailed once the report was posted on the FDA Web site after the markets closed on March 14. Cephalon's stock dropped 9% during the next two days, one investment banking firm cut its rating and several others worried that Sparlon might be saddled with more restrictions than expected.

Label Danger

"We think, at a minimum, serious label warnings will be required," says Sagient Research Systems, a San Diego firm that tracks pharmaceutical developments, in a report issued last week. "Though the number of patients having events was small ... the overall patient exposure in the clinical trials was also small."

Sagient says it's possible that the FDA could require long-term studies, either before a formal review or after the drug reaches the market. Sagient Research, which has no financial relationship with Cephalon, expects Sparlon to ultimately be approved. The FDA granted conditional approval in October .

On Wednesday, another FDA advisory committee is examining existing ADHD drugs for their effects on children and for possible psychiatric side effects. Some ADHD drugs are prescribed for adults and children.

"The risk has gone up for a black-box warning for Cephalon ," says Marc Goodman of Morgan Stanley, referring to the toughest drug-label alert that the FDA can require. "We would rather err on the side of caution with respect to the equity," adds Goodman in a March 16 research report, in which he cut his rating to equal-weight from overweight. He reduced his Sparlon sales forecast to $500 million from $700 million for 2010.

Goodman also predicts the agency will probably require stricter labels on other ADHD drugs for cardiovascular risks, knocking the growth rate of all ADHD drugs down to 5% from 7% between 2006 and 2010.

"The bottom line is that the FDA has gotten stricter on safety," says Goodman, who doesn't own shares but whose firm has had an investment-banking relationship with Cephalon. "The FDA clearly wants to make material changes to the labeling for the ADHD class of drugs."

Seeking an Edge

Among existing and experimental ADHD drugs, the FDA found more suicidal events with Sparlon and with Eli Lilly's ( LLY) Strattera when all drugs were compared against a placebo, but not to the point that the events were considered statistically significant.

Strattera, available since 2003, already has a black-box warning that describes the risks of suicidal thinking among children and adolescents and a strong warning for potential liver problems. If Sparlon gets a black box, it would lose a potential marketing advantage against Strattera.

Cephalon has been hoping to secure another advantage for Sparlon based, in part, on what another FDA advisory committee said last month. The panel voted 8 to 7, with one abstention, to recommend a black-box warning on most ADHD drugs for potential cardiovascular problems. The FDA doesn't have to follow its advisors' recommendations, and the close vote suggests there's plenty of room for debate. Sparlon wasn't reviewed by this committee.

If the agency agrees, the tougher warning would affect drugs such as Ritalin, from Novartis ( NVS), and generic versions of the drug. Also affected would be Adderall and Adderall XR from Shire ( SHPGY) and Concerta from Johnson & Johnson ( JNJ).

The Shire drugs already have a black-box warning about abusing amphetamines, which can lead to heart damage or sudden death.

The panel only targeted stimulants, a group that doesn't include Strattera or Sparlon. Cephalon has been pointing to company-sponsored trials showing that Sparlon didn't cause problems with blood pressure, heart rates or heart-rhythm measurements, but the tests lasted only nine weeks.

Some analysts say that because Sparlon contains modafinil, the same ingredient in Provigil, and because Provigil has a generally mild side-effects profile, Sparlon will likely be approved by the FDA.

"Provigil has been on the market for seven years with relatively few reports of very serious neuropsychiatric issues such as suicidal thoughts," says Lawrence Neibor of Robert W. Baird & Co. in a recent report to clients.

Because modafinil "has shown relatively few problems in an adult population" for Provigil, Neibor doubts the FDA will impose a black-box warning on Sparlon. Neibor, who has an outperform rating on Cephalon, doesn't own shares. His firm doesn't have an investment-banking relationship.

A Delicate Balance

The big issue for Cephalon and Sparlon is how the FDA should act when scientific studies are contested or are ambiguous. Last month, some supporters of a black box warning for cardiovascular risk said the label could be removed if subsequent long-term tests showed there was no link to ADHD drugs. Opponents of the strictest warning said the FDA should demand more conclusive evidence.

There might be a replay of this debate involving psychiatric side effects. The FDA's staff analyzed data from roughly 90 clinical trials, looking for three types of side effects -- psychosis and mania, suicidal events and aggression.

Many trials "were of very short duration" and many tested small numbers of patients, the FDA says. Plus, because different test sponsors had different guidelines, there was a "potential lack of consistency" in identifying side effects, the agency says.

The FDA adds that if companies continue to rely on short-term testing, there will be "limitations for defining the safety profile of the drug." Until the FDA offers clear guidance, Cephalon investors will receive mixed messages from Wall Street.

The FDA report "shouldn't affect the approvability of Sparlon, and we remain comfortable with our current projections," says Megan Murphy of Lazard Capital Markets in a research note published last week.

Murphy, who has a buy rating, predicts Sparlon could reach peak yearly sales of $430 million four years after it goes on sale. She bases her optimism on the many research limitations cited by the FDA and the lack of statistical significance in the reports of psychiatric side effects linked to Sparlon. She doesn't own shares, and her firm doesn't have an investment-banking relationship.

However, though David Windley still has a buy rating on Cepahlon, the Jefferies & Co. analyst says in a research report last week that the FDA might require stronger-than-expected language on Sparlon's label. He doesn't own shares of Cephalon.

"Sparlon may not get a label that offers distinctive advantages over stimulants, which could have assisted in rapid adoption," he says.