Arena NOLs Will Come Into Play Soon

| About: Arena Pharmaceuticals, (ARNA)

It certainly did not take long for Arena (NASDAQ:ARNA) investors to note a little statement regarding a change of control made by company management at the Bank of America Merrill Lynch Conference last week. I had my email inbox fill up with great questions and some perhaps over zealous statements about a buyout from Big Pharma in the near future.

While a buyout would be nice, there is an oft overlooked "asset" that Arena has that investors will want to begin to think about as the anti-obesity drug Belviq launches and theoretical profitable quarters begin to take shape. Arena is carrying over $1 billion in Net Operating Losses (NOLs). Net Operating Losses are accumulated during the years when a company is starting out, and can be used by that company to offset profits, this taking away tax liability in the years when profits begin to materialize.

Currently, Arena has about $1.3 billion in NOLs. In simple terms, the company can make $1.3 billion in profits and not have to pay taxes. If you consider a corporate tax rate of 35%, the tax savings attributable to these NOLs is in the neighborhood of $450 million. That is not chump change, and is not something that the company should let go of easily.

Why is this so important? If there is a change of control it could carry a negative impact on the NOLs, or set up a three year test period where they are essentially frozen to a certain degree. As some readers know, I follow Sirius XM Satellite Radio (NASDAQ:SIRI) very closely. There are many more similarities and parallels between Sirius XM and Arena than many may realize. Several years ago when Sirius and XM merged the merger was structured in such a way as to preserve several billion dollars worth of NOLs. Shortly after the merger the company wound up in serious financial trouble. Liberty Media (LMCA) stepped in and provided a loan in exchange for 14.5% interest on the cash and a 40% stake in the company. The deal was quite complex, but one very important factor was that Liberty Media was forbidden to go over 49.9% ownership for 3 years. This kept the NOLs intact. Upon the three year anniversary of the deal, Liberty Media did take a controlling stake (over 50%) in Sirius XM.

As we contemplate a potential buyout of Arena we must remember this very large $1.3 billion dollar NOL asset that the company has. NOLs are very real, and once a company is making a profit, very beneficial. When NOLs exist any buyout deal can be pretty long and pretty complex. Sometimes a total buyout is not the course of action that is taken. This does not mean that we, as investors in Arena, should fear a buyout. It simply means that by being better informed as to the value of some things on the table, that the board, and if required we investors, need to give these NOLs their due consideration.

In the pharma sector the buyout is sometimes more about the pipeline and less about the cash flow of any current products. That may mean that a potential big pharma buyer may not care about the NOLs. That is where investors can stand up and express that not only do we care about them, but we know they are there and what they are worth.

While this article does oversimplify the process, it does give investors the key information that the NOLs are important, carry value, and will begin to come into play even without a buyout. Not having to pay tax means Arena can be very profitable until the NOLs are extinguished. In the longer term this is also important, because once they are all used, the company will need to pay taxes again. Stay tuned.

Disclosure: I am long ARNA, SIRI, LMCA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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