The wait for regulatory approval of Arena Pharmaceutical's (ARNA) diet drug has left investors in an anxious state. Although the U.S. Federal Drug Administration (FDA) approved Arena's compound lorcaserin in June 2012, the FDA classified it as a Schedule IV controlled drug, making it subject to additional controls by the Drug Enforcement Administration (DEA). Ever since, Arena has been waiting for the DEA to complete a review and provide a final classification for lorcaserin, which Arena plans to market under the brand name Belviq. A process that was originally supposed to require four to six months has now taken eight months and counting.
In early 2012, Arena had also submitted an application to the European Union for approval of Belviq in that market. Investors were nonplussed as Arena responded to the usual set of questions from the European Medicines Agency (EMA). However, a second notice of outstanding issues coming by letter from the EMA in January 2013, has challenged the resolve of even the most patient shareholders. Issues raised by the EMA committee, such as tumors in rats and psychiatric events, sent a chill across trading in ARNA.
Six weeks after the EMA notice, a sizeable "short" position has developed in Arena Pharmaceutical shares. To be clear, 55.3 million shares have been sold short by investors expecting the worst for Belviq. This development is no surprise. It has been accompanied by a series of negative or less than supportive commentary from sell-side analysts.
The question is whether the bear-case view is a bit overdone. The short interest in ARNA represents 26% of the flotation (total shares outstanding less shares held by insiders). That in itself means something. More importantly, consider that as deep and swift as trading has become in ARNA, it would take almost seven days of trading to clear all the short interest in the stock. Called the Days-to-Cover Ratio (Total Shares Sold Short divided by Average Daily Trading Volume), the measure is a good barometer for stocks under a cloud of controversy. Compare the ARNA ratio to the average Days-to-Cover for all stocks sold short on the Nasdaq - 3.22 days. Stocks sold short on the New York Stock Exchange could be mopped up before noon as indicated by an average Days-to-Cover of 0.39 days for NYSE stocks.
With such a build-up in short interest, even the slightest good news for Arena could trigger a so-called "short squeeze." A shift to bullish sentiment would likely drive the bid high enough to cause short-sellers to "buy-in" and close short-positions. Eye-balling historic trading patterns in ARNA suggests the majority of the short interest in the stock was built up at prices between $6.00 and $12.00. A 25% shift higher in stock price would leave the majority of short interest well in the negative.
What is the likelihood of positive news for Arena's Belviq? Well, pretty high!
While approval in Europe appears to be a long way off or even a non-starter, Belviq is more likely than not to be sold in the U.S. - perhaps the largest market for diet drugs. Granted during the wait for the DEA to finalize a classification for Belviq, a competing diet drug has been approved and launched. Vivus, Inc. (VVUS) is already selling its Qsymia drug in the U.S. for chronic weight control. For many drugs, arriving in second to the market would be a serious letdown. However, both Arena's Belviq and Vivus' Qsymia are intended for the chronically obese as well as those who may be less hefty, but have a risk factor such as diabetes or heart disease. That means as many as two out of three Americans could be candidates for prescription diet therapies. That is arguably one of the largest drug markets in the world. Even second place in such a large market will be lucrative.
The hitch for Arena has been the extra step required for classification as a Schedule IV drug by the DEA. Vivus' Qsymia is the brand name for an extended release formulation of phentermine and topiaramate. Phentermine is an appetite suppressant and topiramate is a seizure medication. Arena's Belviq is composed of lorcaserin, which decreases activity within the appetite centers of the brain. Apparently the FDA decided Belviq was too vulnerable to abuse to let it go to the market without added oversight. Even with DEA involvement in the process, it is still more a matter of when and not if, Belviq will get a berth on the U.S. pharmacy shelves.
This brings us back to that measure of short interest 55.32 million shares. Is it wise to sit in a short position with such a large crowd when there is impending positive news?
It appears to me that investors have already factored a U.S. launch into Arena's future. However, the value attributed to that opportunity has been muted by news of Vivus' head start. Arena's case has not been helped by the news that Vivus has already resorted to discounting after experiencing a tepid response to its Qsymia price tag. Hence ARNA hovers near the $8.50 price level, about 37% below its 52-week high price.
A final clearance for take-off in the U.S. market for Arena's Belviq would likely be accompanied by renewed discussion of milestone payments and royalties. Arena is expected to receive $5.0 million from its marketing partner upon receiving a DEA designation and another $60 million upon Belviq's launch. Then royalties begin. Arena's CFO at one point suggested the first $1.0 billion in total sales could trigger royalties in excess of $300 million.
Chatter about payments and cash flows along with the enthusiastic re-calculation of future revenue and profits are likely to generate a dramatic shift in sentiment, turning up the volume on Arena valuation and stock price. If that happens, it might be ARNA bears who are nibbling on their digits.
Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.