Merck Deal Provides Nice Upside For Depomed

This morning, Depomed (DEPO - Analyst Report) announced it has signed a non-exclusive licensing agreement with Merck (MRK - Analyst Report), whereby Merck will have access to the company's technology for extended release metformin.

We expect that Merck is seeking to co-formulate Depomed's metformin XR candidate with its DPP-IV agent, Januvia (sitagliptin). Merck already sells a fixed-dose combination sitagliptin-metformin as Janumet. However, Janumet must be taken twice daily because the formulation utilizes an immediate release metformin. Despite the dosing requirement, Janumet posted sales of $155 million in the second quarter 2009. We believe that Merck will look to quickly formulate Januvia with Depomed's metformin-XR product, thus allowing for once daily dosing with an improved side effect profile and tolerability over Janumet. Merck has guided total Januvia/Janumet sales in 2009 to between $2.4 and $2.7 billion.

In return, Merck paid Depomed an upfront payment of $10 million in cash. Depomed will also be eligible for a milestone payment (undisclosed) base Merck's filing for approved of any product that utilizes metformin-XR. Depomed will also be eligible for a modest royalty (undisclosed) on product sales.

We view this deal as a very nice incremental positive for Depomed. It provides $10 million in cash to an already well-funded company, along with the potential for additional milestone and royalties in the future. Plus, the deal with Merck is non-exclusive, meaning that other companies with DDP-IV inhibitors under developing, including Bristol-Myers (BMY - Analyst Report), Eli Lilly (LLY - Analyst Report), Novartis (NVS - Snapshot Report), Forest Labs (FRX - Analyst Report), and Amgen (AMGN - Analyst Report) among others, can also license the same technology from Depomed. And, given the significant dosing and tolerability advantage that Merck's sitagliptin + metformin-XR product will have over older generation molecules that utilized an immediate release metformin, other companies should fall into line quickly over the next few quarters.

We expect that Depomed will recognize the full $10 million milestone payment in the third quarter 2009. This should allow for the company to post its first positive income quarter since the second quarter of 2008. We are increasing our revenue and EPS forecasts for 2009 through 2013 based on expected similar deals in the future.

We initiated coverage of Depomed with a 'Buy' rating in June 2009. 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 2009. 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 2009.

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.

We believe at the current price of $3.32/share - a market capitalization of $170 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, and they just received $10 million from Merck in July 2009. Plus, 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 that utilizes AcuForm. For more information, please see our full initiation report issues in June 2009.

We are raising our price target to $6 per share. Our target is based on 20x our 2012 EPS estimate of $0.86, discounted back to present day at 25%.