Wall Street has doled out significant punishment to Vanda Pharmaceuticals (NASDAQ:VNDA) this year, but the pain could get much worse.

The pharmaceutical company failed to convince the U.S. Food and Drug Administration to change its mind over a partial clinical hold for an important drug candidate. Despite the reaction from analysts, the spat didn't really seem like a big deal in the grand scheme of things. After all, the business has two promising products on the market that are growing sales and enabling profitable operations.

Well, the drug franchises were growing. First-quarter operating results showed that combined revenue from Hetlioz and Fanapt declined 10% from Q4 of last year. While Vanda reiterated its full-year 2019 revenue guidance, the surprising slowdown might sow doubt among investors regarding its ability to deliver. It also has the potential to undermine the key argument that Wall Street was overreacting to ongoing regulatory uncertainty. Should investors be worried now?

An hourglass.

Image source: Getty Images.

By the numbers

Vanda Pharmaceuticals reported modest revenue growth compared to the year-ago period, but a sizable jump in operating expenses outpaced the increase in sales. That led to an operating loss for the business in the most recent quarter. That's surely a disappointment for shareholders who thought red ink was behind the company. 

Metric

Q1 2019

Q1 2018

Change (YOY)

Hetlioz net revenue

$28.9 million

$25.4 million

14%

Fanapt net revenue

$18.7 million

$18.2 million

3%

Total revenue

$47.7 million

$43.6 million

9%

Operating expenses

$49.8 million

$41.2 million

21%

Operating income

($2.1 million)

$2.4 million

N/A

Data source: Press release. YOY = year over year.

The results look even worse when compared to the strong performance delivered in the fourth quarter of 2018: 

Metric

Q1 2019

Q4 2018

Change (QOQ)

Hetlioz net revenue

$28.9 million

$32.4 million

(11%)

Fanapt net revenue

$18.7 million

$20.6 million

(9%)

Total revenue

$47.7 million

$53.0 million

(10%)

Operating expenses

$49.8 million

$43.9 million

13%

Operating income

($2.1 million)

$9.2 million

N/A

Data source: Press release. QOQ = quarter over quarter.

So what the heck is going on? CFO Jim Kelly explained on the quarterly earnings conference call that the quarter-over-quarter decline was "fully accounted for by inventory changes" between the two most recent quarters. In other words, customers stocked their inventory with Hetlioz and Fanapt at the end of 2018, then reduced their purchases by a nearly equal amount in the first quarter of 2019. They were likely trying to get ahead of a planned price increase that went into effect in January 2019.

That apparently appeased Wall Street analysts, as no one on the 49-minute call asked about the product revenue slump during the Q&A session. (Then again, product revenue growth and operating income haven't been a focus of analysts in recent quarters anyway.) Almost all of the questions were about the lawsuit with the FDA over tradipitant.

Long story short, the FDA is insisting that Vanda runs a nine-month nonrodent toxicology study to collect additional safety data. The drug candidate cannot be tested in humans for longer than 12 weeks until then. The soon-to-be-initiated phase 3 trial in gastroparesis will need to be run for longer than that, which explains the anxiety on Wall Street over the impasse. It doesn't help that analysts estimate peak annual sales of $900 million if the drug receives marketing approval.

A scientist in a lab with a disappointed look on his face.

Image source: Getty Images.

The company announced that it intends to start the phase 3 trial in Q2, but it has to meet with the FDA before then and attempt to work out a resolution. A lawsuit against the regulator has gone nowhere so far, with the District Court for the District of Columbia issuing a stay and siding with the FDA's legal authority. Vanda still thinks the requirement for additional safety trials is illegal. How it will all shake out remains a bit uncertain, but investors should learn of an update in the coming days or weeks.

Remain vigilant, but don't panic yet

Management reaffirmed its full-year 2019 revenue guidance calling for a midpoint of $220 million in net product sales. Investors will want to keep a close eye on sales in Q2 to ensure the issue really does come down to inventory decisions. Vanda expects to end the year with over $260 million in cash, so it can comfortably endure a choppy quarter here and there in addition to increasing sales and marketing expenses. Therefore, investors shouldn't panic over the recent revenue slump, but it can't hurt to keep recent developments in the back of your mind.