Initiating DepoMed with a Buy

We are initiating coverage of DepoMed (DEPO - Analyst Report) with a Buy rating and $5 price target. We are excited about the potential for Serada, and enhanced formulation of gabapentin that utilizes the company’s proprietary AcuForm technology, for the treatment of hot flashes / vasomotor symptoms (VMS) in menopausal women.

Serada is currently in two phase III trials with data expected in the fourth quarter of 2009. Gabapentin is a molecule that has been well studied in hot flashes / VMS, and meta analysis shows it is the superior non-HRT efficacy option out there. Unfortunately, the dosing requirements and side-effect profile of the drug dramatically limits prescriptions in this market.

With Serada, DepoMed is a significant opportunity in our view. We see the drug as a potential $500 million or more opportunity.

DepoMed is also developing its AcuForm-enhanced gabapentin molecule for the treatment of neuropathic pain, more specifically post-hepatic neuralgia (PHN). For this candidate, DM-1796, the company is collaborating with Solvay. DM-1796 is currently in a phase III program with data expected in the fourth quarter of 2009.

PHN represents an attractive market opportunity for Solvay considering gabapentin’s already entrenched market position. DepoMed’s formulation offers improved dosing and tolerability over the generic immediate-release molecule.

With Serada, DepoMed is looking to transform its business operations into a fully-integrated specialty pharmaceutical company focused on women’s health. The company’s goal is to build a specialty sales force and promote women’s health products to the Ob/Gyn market.

DepoMed has two early-stage molecules:  DM-3458, a controlled release formulation of omeprazole therapeutic that may specifically address nocturnal acid breakthrough (NAB) associated with gastroesophageal reflux disease (GERD) and DM-1992, a novel gastric retention formulation of Levodopa/Carbidopa for the treatment of Parkinson’s disease (PD). Both molecules utilize the company’s AcuForm technology.

We believe management will look to monetize these non-core assets, just as the company did with its extended-release metformin product, Glumetza, for the treatment of type-2 diabetes, so that it can acquire or build the necessary infrastructure to address the women’s health market.

We believe at the current price of $2.63/share – a market capitalization of $133 million – the shares are significantly undervalued. Breakeven operations are achievable if either Serada or DM-1796 makes it to the market in 2011, with strong profitability if the company can see both drugs approved and on the market.

Additionally, DepoMed’s current financial position is solid. The company exited the first quarter 2009 with $94.1 million in cash and investments – approximately 67% of the current market capitalization. Management has several potential non-dilutive ways to raise cash in 2010 through upfront collaborative payments on Serada, out-licensing either of the two earlier-stage candidates, or signing a research collaboration with another company around AcuForm.

We believe the shares can trade up to $5 per share in anticipation of positive phase III data on Serada in hot flashes / VMS or from DM-1796 in PHN. Our $5 target is based on a 20x multiple on our 2013 EPS fully-taxed forecast of $1.02, discounted back to present day at the aggressive rate of 25%. This corresponds to a market capitalization of $260 million.  We believe this is fair considering the company as two potential $500 million candidate in phase III trials.