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The problem with coming up with a valuation on pre-revenue biotechs is that it is more of an art than a science. There are many variables an investor must consider such as market-size, competition, differentiation, penetration, growth, COGS, etc. It is a simple exercise to come up with just about any valuation you want by changing the variables. Until the newly approved drug is on the market for six months, you really can't forecast with any accuracy what the future value of that asset may be. Until then, it is all speculation and conjecture by both retail investors and professional Wall Street analysts. This week, Leerink Swann resumed coverage on Arena Pharmaceuticals (ARNA) with an Outperform and a $11-12 price target. Leerink Swann's reasons for the Outperform rating make sense but provide little insight into the actual value of the issue.

I consider myself a value-investor stock picker and not a trader. This is an important distinction and since I take a multi-year view of an investment, the questions I ask myself are different than a trader who is more concerned about trends and averages. Not that technical analysis isn't important, quite the contrary. I do believe in technical analysis as an important tool for determining tops and bottoms to guide buying and selling decisions but I always use technicals in conjunction with value-investing, fundamental analysis. With that in mind, let's analyze what Leerink Swann said this week and how that relates to a multi-year investment thesis for Arena.

Our due diligence points to a significant transformation occurring in the obesity space, similar in scope to smoking cessation a decade ago. The result should be a robust market expansion story advanced by: 1) novel more potent drugs; 2) increasing reimbursement; 3) significant sales & marketing efforts, and; 4) more approvals of effective therapies with co-morbid disease benefits. While the VVUS (OP) Qsymia launch has been slow, ARNA/Eisai's Belviq upcoming launch should work synergistically to broaden the market.

First, I agree with Leerink Swann's analyst that there is a fundamental shift under way to treat obesity as a disease, which hasn't historically been the case. So why a price target of $11-12? Certainly that aligns with the current technical chart but how does that equate to the fundamental value proposition if the obesity space is about to experience a "robust" expansion? How many scripts is Leerink Swann expecting in Years 1, 2 and 3? How do we know if BELVIQ is meeting expectations to justify a $11-12 price? What about European approval; does that double the opportunity or is it baked into their valuation?

Novel more potent drugs: Investors in this space should recognize that the only new novel drug that will be available for at least the next five years is Arena's BELVIQ. I'm not aware of any other novel medications for this indication that could reach the market in the next five years. Novel is the key here. As a novel, single agent, it opens up the opportunity to test with other compounds such as BELVIQ with generic phentermine. Vivus (VVUS) investors should watch the upcoming safety trials for this combination that could start in the 2nd half of 2013. If BELVIQ + phentermine can achieve a FenPhen-like 15% average weight loss at 12 weeks, it could make Qsymia even more irrelevant in the market than it already is. Given that obesity specialists regularly prescribe drugs both off-label and in combination to treat the disease, I believe it is likely they will do the same with BELVIQ.

  • 98% of obesity specialists prescribe weight loss drugs and 97% of those prescribe phentermine
  • 83% of obesity specialists write combo-therapies
  • 65% write unapproved combos
  • 56% will prescribe phentermine for long-term use against the label (only 32% prescribe orlistat long-term even though it is approved for long-term use.)
  • There were approx 6M scripts for phentermine in 2011 (that is probably 2-3M patients)

Increasing reimbursement: This is of course a key ingredient required to become a blockbuster. BELVIQ will have more insurance companies covering it at launch than Qsymia. According to Eisai, we know that 40% of commercial payers will cover BELVIQ in 2013, 50% in 2014 and 70% + government programs in 2015. Year three insurance coverage could be the difference between BELVIQ being a $500M drug or a $5B drug.

Significant sales and marketing efforts: What is significant in Leerink Swann's view? Eisai has just a few more reps than Vivus had at launch and 200 hundred isn't bad but it isn't 2,000. Eisai has not announced pricing, its market budget or Year One guidance. However, Eisai is expected to announce pricing at launch (March) and full year guidance on their Q4 earnings call in May.

More approvals of effective therapies with co-morbid disease benefits: This is BELVIQ's value proposition and how it will be marketed by Eisai. Obesity is a disease requiring chronic drug therapy for many, potentially millions of Americans. Like lipid-lowering therapies such as Lipitor or Crestor and diabetes blockbuster drugs like Januvia, BELVIQ should be taken on a chronic basis. It isn't just weight loss but therapy to address co-morbid conditions.

If Leerink Swann really believes that there is a fundamental shift in the obesity space for disease management, then it is confirmatory of my belief as well. This market segment is much larger than the diabetes and lipid management market. Obesity is the root cause of many of the most costly diseases for which a majority of the best-selling drugs of all-time are indicated. With growing coverage by insurers and education to the medical community, the chances of BELVIQ's ability to sell more than $1B a year is far better today than it would have been even just five years ago. This belief is echoed by Eisai's CEO, Lonnel Coats, who stated in Eisai's Q2 earnings call that he believes BELVIQ will be Eisai's most important drug ever -- which indicates a multi-billion dollar a year product.

A Probability-Weighted Valuation Exercise

There is a heated debate between bulls and bears on whether or not BELVIQ will sell any better than the $600M Orlistat generated at its peak or better than the Qsymia has experienced so far. I've been of the opinion for many years that given BELVIQ's unique combination of efficacy, tolerability and safety - it will become the go-to, first line therapy in this market. Upcoming safety studies combining BELVIQ with phentermine and metformin will further enhance the market opportunities. With 70%+ insurance coverage in 2015, I think there is high-likelihood Eisai can make this a blockbuster as the CEO has indicated. However, we just won't know until it happens. Given the uncertainties, the best way for me to determine a future value for ARNA is to assign a probability to various sales scenarios. The first being comparatively poor and less than the side-effect ridden Orlistat, the second would be BELVIQ becoming a blockbuster and the third would be a more widely accepted drug as a result of its glycemic-lowering properties, good physician acceptance along with positive phentermine and metformin combination studies.

Valuation Assumptions

  • U.S.-Only Sales
  • Estimated target patient population: 100M Americans
  • 70% with insurance coverage: 70M Americans
  • BELVIQ retail value per chronic patient: $2,500 / year

(click to enlarge)

Investors should come up with their own estimates of each sales scenario, resulting revenue and their own probabilities for each. I have been an Arena bull for some time and believe that the probabilities are more weighted to the "Good" market acceptance scenario. As such, I come up with the following estimate for the value of ARNA in 2015:

My estimate: Scenario 1 of $4.15 (25% probability) * Scenario 2 of $60.50 (60% probability) * Scenario 3 of $141.18 (15% probability) = weighted PPS 2015 target of $58.52

If you are more bullish, you could adjust the percentages as follows: Scenario 1 of $4.15 (10% probability) * Scenario 2 of $60.50 (60% probability) * Scenario 3 of $141.18 (30% probability) = weighted PPS 2015 target of $79.07

The more bearish could adjust as follows: Scenario 1 of $4.15 (80% probability) * Scenario 2 of $60.50 (15% probability) * Scenario 3 of $141.18 (5% probability) = weighted PPS 2015 target of $19.45

Investors can use this simple method to adjust each scenario with your own estimates for what you think sales and profit will be for BELVIQ, assign your unique probabilities and come up with your personalized targets for the future value of Arena. Once we have guidance from Eisai in May, we will be able to more accurately adjust this probability model to account for meeting their sales expectations or not. Weekly script growth will show us the trend and by September, we will be in a better position to assign future price targets.

Of course there are additional variables to consider that are difficult to account for. The purchase price adjustments go away with BELVIQ annual sales of $2.5B and a total payout to Arena of $1.2B so you need to adjust for that. However, if BELVIQ is selling $2.5B a year in Eisai's territory then it is probably at least a $5B drug worldwide so the earnings will be much higher than in the scenarios listed above. It is always possible some unknown side effect comes out after launch which would hamper the ability to reach these sales figures.

Investors should always perform their own due diligence and prepare for Scenario 1 even if they assign a low-probability factor to it. Arena is likely to continue to be a very volatile investment as it shifts from speculative valuation to revenue-based valuation. We just don't know what will happen for sure until we can look in hindsight. Everyone has their own unique investing circumstance and is responsible for their own decisions. I believe Arena to continue to be an excellent risk / reward investment but there are a lot of variables in play to consider. However, I can say with some certainty that the future price of ARNA will be a direct reflection of actual sales, actual earnings and expected growth. We will just have to wait and see if that correlates with a stock price of $4 or $60.

Source: Arena's Recent Outperform Call And A Probability Weighted Valuation