Should Investors Wager On Weight Loss With Arena Pharmaceuticals?

| About: Arena Pharmaceuticals, (ARNA)

Arena Pharmaceuticals (NASDAQ:ARNA) has had a rough time in 2013. In the year-to-date, the stock has lost 11%, trailing the return on the S&P 500 by a sizable 21% in the same period. That's a far cry from how Arena performed in 2012, when its stock gained 382%.

The fortunes of Arena can be traced to six letters: B-E-L-V-I-Q.

For those who are not familiar with the pharmaceutical space, Belviq is Arena's obesity treatment and is a direct competitor of Vivus Inc.'s (NASDAQ:VVUS) Qysmia. The U.S. Centers for Disease Control reckon that obesity affects 36% of Americans. Concurrently, the rate of obesity has risen in OECD countries by 8% in the past two decades. Given these factors and the success of Pfizer's (NYSE:PFE) Lipitor, which had peak annual sales of $11 Billion, the financial stakes are high for companies that can introduce weight-loss drugs.

Belviq's main selling point has always been that it treats obesity with limited side-effects - in Phase III trials, Belviq was determined to have the same tolerability as a placebo and, while the drug produced some side-effects such as headaches, nausea, nasopharyngitis, upper respiratory tract infections and sinusitis among trial participants, these were determined to be of mild and transient severity - in some cases the incidence of the side effect was just 5% more than in cases where a placebo was used. This is in sharp contrast to other weight loss treatments over the years whose side effects ranged from heightened risk of heart failure and stroke to heightened flatulence.

In June 2012, Arena received FDA approval for Belviq. The anticipation and receipt of the approval helped the company rise as much as 722% to a high of $13.50.

However, the stock has floundered since then and is at just 59% of its peak price as it awaits its scheduling designation from the U.S. Drug Enforcement Agency (NYSE:DEA). That means that while Belviq may soon become available in developing countries such as Mexico, it is still awaiting entry into the world's largest drug market.

In the meantime, news has emerged that Belviq has entered Phase 1 trials as a treatment for autoimmune diseases, which could allow it to challenge multiple-sclerosis treatments such as Novartis' (NYSE:NOV) Gilenya.

Given all this, is now the time to take a punt on Belviq? We take a look at 3 areas:

1. Where to, Belviq? The fate of Arena ultimately depends on Belviq. DEA scheduling public comments were closed on January 18th, and it typically takes 200 days - roughly 7 months - for a scheduling designation to be assigned. That means that the reasonable time to expect Belviq to receive its scheduling designation is August.

That's a lot of time in which short-sellers can crater the stock. However, it is also an opportunity for Arena - while this is happening, it has been proactive in making inroads in other markets, as its foray into Mexico has demonstrated. It also allows Arena to focus on trials for alternative uses for the drug, thereby expanding its market beyond just obesity treatment?

Why is the latter important? Simply put, no drug has been able to generate the sales of Lipitor. For instance, Abbot Laboratories' (NYSE:ABT) Meridia was launched in 1997 but was pulled in 2010 after trial data emerged that increased the likelihood of heart attack and stroke among users. At its peak, Meridia sold just around $300 million - a small fraction of the $11 billion in sales generated by Lipitor. Another example was Roche's (OTCQX:RHHBY) Xenical, which peaked with $600 million in sales but lost momentum owing to its embarrassing side-effects.

More recently, Qysmia's sales have disappointed judging from the action of insiders - despite the fact that some analysts had predicted it to generate $1 billion in annual revenues. That could be worrisome for Arena even after it receives its sheduling designation: Qysmia and Belviq were frequently mentioned side-by-side in these analyses.

That said, it's worth mentioning that Belviq has one major advantage over Qysmia - unless its scheduling designation drastically changes, Belviq is likely to be sold over-the-counter. Owing to concerns regarding its side effects, Qysmia can be sold only through mail-order, hampering its sales.

Assuming that Belviq is able to generate $300 million annually in sales to begin would not be an unmitigated disaster. By our calculation, this would allow Belviq to generate approximately 12-cents per share, which would represent a sharp turnaround from the 4-cent per share loss analysts expect this year.

The point here is not to provide an EPS estimate but rather to demonstrate that expectations for outsized sales are negatively impacting the perception of the stocks.

2. Not going under anytime soon. Fortunately for shareholders, Arena can survive quite a bit longer without Belviq sales thanks to a solid balance sheet. To wit, its Quick Ratio is at 5.4 - more than double the 2.5 ratio among its peers - this is the result of Arena's raising its cash by approximately $100 million (+170%) in 2012 through a combination of debt and equity financing.

With sufficient cash to cover its operating requirements as well as to fund its ongoing development work, Arena is not in any danger of having to kite its operations against expected future sales.

At the same time, Arena's debt is manageable with a Total Debt-to-Equity ratio of just 0.75 - making it roughly in-line with its peers. This is deceiving, however, as Arena's term loans were structured notes that carried warrants on equity shares. In short, Arena's debt level is much lower than its peers - it's in no danger of missing critical payments, enabling management to concentrate of bringing Belviq to market.

3. Valuation: heart of the unknown. While Belviq certainly holds promise, the tepid history of weight loss drugs since Lipitor makes it difficult to determine what valuation to assign to Arena. Assuming a 12-cent per share EPS going forward would give it a P/E of 66x - 7/10th that of its peers (though that would still give it a P/E of 3.7x that of the S&P 500).

Taking that into reverse, what would Arena's EPS need to be for it to trade at just 40x earnings? The answer is approximately 20-cents per share. By our estimate, to get to that level, Belviq would have to generate approximately $400 million in sales.

Given the $1 billion revenue estimate, that doesn't seem unlikely but what matters isn't so much whether Arena can make that much off of Belviq, but when that will happen. If that point is still well into the future then the impetus to buy Arena shares lacks urgency.

Time to Decide

Given the balance of risks, we believe that Arena merits a Hold at this time: DEA scheduling is still half a year away and the subsequent time it will take to ramp-up revenues offsets the attractiveness of Arena owing to the potential of Belviq.

In our view, the best time to get into Arena would be during the middle part of the summer, when the market has typically consolidated, perhaps resulting in an attractive erosion in Arena's share price. Doing so would enable investors to take positions in Arena with ample lead time to participate in any rally associated with an imminent DEA scheduling.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Black Coral Research is a team of writers who provide unique perspective to help inspire investors. This article was written Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Black Coral Research is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.