Updated from 10:13 A.M. EDT

The Food and Drug Administration delivered a crushing blow to Neurocrine Biosciences ( NBIX) Tuesday, delaying final approval of one version of insomnia drug Indiplon and rejecting another version.

The FDA's ruling came as a surprise to Wall Street. Analysts had expected at least one version to get the agency's OK and provide stiff competition in a growing field. By early afternoon, Neurocrine shares had plunged 59% on 40 times its daily average trading volume.

"While we are disappointed in the FDA action, we will move forward expeditiously to address FDA's outstanding questions regarding the applications," said CEO Gary A. Lyons.

Lyons conducted a telephone conference call with analysts that lasted only a few minutes, in which he declined to answer questions or provide many details. Calling the FDA's decision "a surprise to us," he also said he believed the agency's action represented a "short-term setback."

Lyons added that he couldn't predict what impact the FDA's decision would have on financial guidance for the year. The company recently said it expected to break even during 2006 with revenue in the range of $165 million to $175 million, excluding royalty revenue from Pfizer ( PFE) based on Indiplon's sales.

"There is currently a significant lack of clarity on the immediate path forward for Indiplon," says Brett Holley, of CIBC World Markets, in a research report Tuesday. He told clients he is cutting his rating to sector perform from outperform, joining three other analysts who immediately dropped their ratings on Neurocrine Biosciences.

Pfizer, which signed a marketing agreement with Neurocrine Biosciences in 2002, had no immediate comment. Pfizer and Neurocrine Biosciences plan to co-promote Indiplon in the U.S., while Pfizer will handle the marketing in other countries.

"From Pfizer's perspective, the news is only a modest negative, with at best a negligible impact to earnings in the next few years," says Barbara Ryan, of Deutsche Bank, in a brief research note. Ryan maintains a buy recommendation, adding that she is "more enthusiastic" about upcoming Pfizer launches for the inhaled insulin Exubera and the anti-smoking drug Chantix. She doesn't own shares; her firm says its does and seeks to do business with companies mentioned in research reports.

Equity analysts have been predicting that Indiplon could be a $1 billion seller. Earlier this year, Standard & Poor's credit-rating unit put Indiplon on its Top Ten list of drugs that should achieve $1 billion or more in sales. "The commercial success -- or lack thereof -- of these Top Ten products may have credit-rating implications," S&P says.

The Indiplon announcement flattened Neurocrine's stock, sending shares down $32.26 to $22.37. Pfizer's stock was down 15 cents to $24.74.

Wall Street Reaction

Also swept up in the action was Dov Pharmaceutical ( DOVP) of Hackensack, N.J., which licenses Indiplon to Neurocrine Biosciences. Dov's stock slid $3.81, or 54%, to $3.24 on trading volume that was more than 10 times the average daily trade for the last three months. Two analysts cut their ratings, but S&P raised its rating to hold from strong sell due to the sharp drop in the stock.

The FDA granted conditional approval -- known in the agency terminology as an approvable letter -- for Indiplon capsules in strengths of 5 milligrams and 10 milligrams. Conditional approval can cause delays ranging from weeks to a few months depending on the questions that a company must answer.

If the conditions relate to discussions between the company and the agency on what a label will say, the delay shouldn't take very long. But if the agency wants more data, then the delay could take many months. Lyons provided no details Tuesday, saying he was "still trying to digest" the information from the FDA.

The agency also rejected the company's application for a 15-milligram extended release version of the drug. "The FDA indicated that they did not have an opportunity to review all of the information submitted during the application review cycles," Neurocrine said. The company added that it will talk to the agency "to clarify and determine the next steps required to move Indiplon towards full approval."

Analysts say the 15-milligram dose is the key to Indiplon's success. The FDA's rejection of this dose "raises questions regarding the viability of the Indiplon program for Pfizer, given that it was expected to be the better-performing product," says Albert L. Rauch, of A.G. Edwards, in a report to clients in which he maintains his hold rating on Pfizer.

If the extended-release tablet isn't approved, "Pfizer's incentive to remain in the relationship with Neurocrine on Indiplon is greatly diminished," he says. "We are therefore removing Indiplon from our estimates." Rauch doesn't own shares; his firm has had a noninvestment banking relationship with Pfizer.

CIBC analyst Holley says he talked with Neurocrine executives, who told him the FDA wants more information about preclinical trials and statistical analyses for the lower-dose, immediate-release versions of Indiplon that received conditional approval. "There were no specific requests for additional clinical trials," says Holley. Extra testing could add at least a year to regulatory review.

Holley also pointed out that Neurocrine Biosciences and Pfizer "do not plan to launch" the immediate-release sleeping pills without having secured FDA approval for the extended-release product.

Noting that the FDA hasn't reviewed crucial clinical data for the extended-release drug, Holley said "it is unclear" if more clinical trials will be needed. Although he says Neurocrine officials estimate that a mid-2007 launch is possible, he is betting on 2008. Holley doesn't own shares. His firm is a market maker and says it expects to receive or seek investment-banking compensation in the next three months.

The company's comments about regulatory delays prompted criticism from analyst Steve Brozak. "I'm no longer giving the FDA the benefit of the doubt," says Brozak, of WBB Securities, in Westfield, N.J.

The announcement that the FDA didn't have enough time to review the Indiplon application "is not an acceptable answer," says Brozak, who doesn't own shares of Neurocrine or Pfizer and who doesn't produce research reports on them. Brozak says the Indiplon delay reinforces his negative opinion of the FDA's review process, adding that all biotechnology investors lose when applications are stalled.

A Chain Reaction

The Indiplon announcement set off big trading in several companies that had feared competition from the drug and from Pfizer's marketing clout. Analysts had been predicting the medical-advertising equivalent of an arms race once Indiplon hit the market.

Based on their review of clinical trials, analysts had expected Indiplon to provide a strong challenge to a market now dominated by Ambien and a new extended-release version Ambien CR from Sanofi-Aventis ( SNY). Ambien loses U.S. patent protection in October.

In second place is Lunesta from Sepracor ( SEPR). Other players include an older drug, Sonata, from King Pharmaceuticals ( KG), and a newer drug, Rozerem, from Japan's Takeda Pharmaceuticals.

Stocks of the Indiplon competitors benefitted from the bad news. Sepracor was up $5.58, or 12.9%, to $50.60 on heavy trading; Sanofi-Aventis gained $1.43, or 3%, to $48.64; and King advanced 30 cents, or 1.7%, to $18.46.

The Indiplon news "is a benefit to Sepracor and its stock," says Adam Greene, of JP Morgan, in a Tuesday research report, as he maintained an overweight rating. "We believe the burden is now with Sepracor to drive share gains." He doesn't own shares; his firm is a market maker.

Sepracor recently added 450 sales representatives, and although some analysts say Sepracor would benefit from working with a deep-pockets partner, the company is still handling all the marketing work.

The Indiplon setback "will likely lead to upward revisions" in Sepracor's 2006 guidance for Lunesta, says Lawrence H. Neibor, of Robert W. Baird. He had been predicting an Indiplon launch later this year. Now, he says, the launch won't occur until "well into 2007." He has an outperform rating on Sepracor and a neutral rating on Neurocrine. He doesn't own shares, and his firm is a market maker for both stocks.

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