Contrary to the expectations and hopes of many, prevailing circumstances strongly suggest that speculators hanging their hats on a buyout of Arena Pharmaceuticals (NASDAQ: ARNA) will be sorely disappointed. Moreover, a fundamental assessment of the small biotechnology concern's prospects seems to indicate that even very optimistic revenue projections for its only FDA (Food & Drug Administration)-approved product won't support attractive capital appreciation over the long haul, as least not on a risk-adjusted basis. This means that a buyout, in the unlikely event that it did occur, would not fetch a compelling premium over the current price. As such, the stock's primary appeal seems to be as a trading vehicle, an investment strategy that has a debatable track record and one that we don't advocate for retail investors.
The Odds of a Buyout Could Be Spelled E I S A I
Speaking with the perspective of an analyst and editor who's published, read, and edited literally thousands of research reports, I think it's safe to say that Wall Street analysts tend to be overly optimistic and prefer to recommend a stock, than otherwise. A typical throwaway line in a report when the numbers don't support a "buy" recommendation might go as follows: This stock offers below-average price appreciation potential but our numbers could prove low because they don't include acquisitions; Or, our price target doesn't take into consideration the possibility that the company could be acquired. Unfortunately, these statements ignore the reality that most acquisitions tend to be dilutive and the probability of a specific corporation being acquired is very small. So, absent a compelling argument in favor of an extraordinary transaction, like the one I believe I made in my Seeking Alpha article 'Pricing a Highly Probable Takeover of MannKind' (MNKD), the prospect of a buyout should be a minor consideration in purchasing a stock. (Note: This article was triggered by an article by a fellow contributor to Seeking Alpha entitled: 'Arena Buyout More 'Highly Probable' Than MannKind.')
In assessing the appeal of Arena stock as an investment, the always-attractive notion of a corporate buyout can probably be discarded very quickly for the following reasons: Arena has a marketing and supply agreement with Japan-based Eisai Inc. (OTCPK:ESALY) that covers most of North and South America, including the critically important United States market. As noted in the company's filings with the Securities and Exchange Commission, Arena "will manufacture and sell Belviq to Eisai for marketing and distribution in the United States and, subject to applicable regulatory approval, in the additional territories under our agreement for a purchase price starting at 31.5% and 30.75%, respectively, of Eisai's aggregate annual net sales (which are the gross invoiced sales less certain deductions described in the Eisai Agreement, including for certain taxes, credits, allowances, discounts, rebates, chargebacks and other items) in all of such territories on an aggregate basis." The price could be adjusted as high as 36.5%, depending on the sales achieved, and there are some "one-time" incentives. It's also important to note that the agreement includes a stand-still provision limiting Eisai's ability to acquire its partner's securities and assets. Clearly, the two companies could amend their agreement in the future, allowing for a merger, but Eisai probably has little incentive since it already has the marketing rights to the Belviq in the largest (by far) market. In the meantime, though, the agreement will undoubtedly serve as a substantial deterrent to other potential suitors. An acquirer could purchase the marketing rights to the Americas back from Eisai and/or market the product in other parts of the world, but this adds many layers of complexities. Moreover, Belviq's sales potential in Asia, Africa, and probably Europe, is probably rather modest. Absent a deal with Eisai, the acquirer would essentially be the partner's manufacturing arm.
The Facts and Realities on the Ground
Once the 'takeover' angle (or speculation) is removed in assessing a stock, the investor is left with an evaluation based purely on fundamentals. With few exceptions, the valuation measures to consider are dividend yields, cash flow, market price to book value ratios, and price-earnings ratios, taking growth prospects into account. In Arena's case, as with most money-losing biotechs, the first three metrics are meaningless, leaving only the company's earnings prospects. With that in mind, we'll first detail some of the facts relevant to developing an earnings model and then discuss two potential scenarios that derive, however tentatively, from the facts.
- Vivus' (VVUS) obesity drug Qsymia was approved by the U.S. Food & Drug Administration last summer and launched soon thereafter. Sales thus far have been underwhelming and discounting has started. Its application to market Qsymia in the European Union (EU) was rejected.
- Arena's Belviq also received FDA approval last summer but delays in getting DEA (Drug Enforcement Administration) clearance pushed back its market introduction to earlier this month. Facing likely rejection, the company withdrew its application to market Belviq in the EU earlier this month.
- Orexigen Therapeutics Inc. (OREX) is conducting late-stage studies of its obesity drug Contrave and may well have clearance to launch the product next year in both the United States and the European Union.
- The market for obesity drugs is potentially huge but the weight loss landscape is littered with once-hot prospects that fizzled.
- The problem of obesity is getting worse worldwide but the sales potential overseas of expensive weight-loss drugs is probably relatively small.
- The presence of three competing products will limit the pricing power of all three companies.
- Belviq's long-term revenue potential is obscured by three similar products likely hitting the market essentially around the same time; a number of potential rivals under development; the uncertain dynamics of the market; and the question of how insurers will ultimately embrace these drugs, in terms of reimbursements. The extremely low visibility is underscored by Wall Street's wide ranging estimates for both revenues and earnings. In 2014, for example, the mean revenue estimate for Arena is $95 million, consisting of 11 data points that have a high of $175 million and a low of $51 million. In 2017, the fifth year post-launch, the mean revenue figure is $320 million, with a high and low of $551 million and $206 million, respectively. The earnings estimates for next year range from a low of a $0.39-a-share deficit to a profit of 14 cents, with a mean of minus 18 cents. In 2017, the mean is $0.68, consisting of a low of $0.13 and a high of $1.65.
One Optimistic Scenario
The wide range detailed above highlights the difficulty in forecasting the performance of a particular drug. That said, for our initial scenario, we'll use the most aggressive $551 million revenue projection of 2017, which translates into drug sales of roughly $1.6 billion and is considerably above the figure implied in Eisai's expectation of reaching $1 billion by 2020. The high-end $1.65 earnings estimate isn't reasonable, though, in our view, because it implies ridiculously low COGS (cost of goods sold) and SG&A (sales, general, and administrative) expenses. Assuming a still optimistic gross margin of 85% and bare-bones other expenses, the $551 million in revenues is unlikely to support earnings of more than $1.25 a share. Using a premium price/earnings multiple of 18 and a discount rate of 10%, this scenario gives us a present value of around $13.
An Even More Aggressive Revenue Projection
In the second scenario, we begin with the mean revenue estimate for 2014 of $95 million, consisting of 11 data points and a high of $175 million and a low of $51 million. Then, projecting greater growth than all of the analysts in the data base, we have revenues doubling annually for the subsequent three years, resulting in a total of $760 million in 2017, which translates into drug sales to Eisai of about $2.2 billion. Assuming gross margins on drug sales of 80%, a very optimistic operating margin of 42%, a tax rate of 20%, and a diluted share base of 230 million shares, the second scenario would have Arena earning about $1.10 a share in 2017. Applying an 18 multiple would give us a stock price in the $20 neighborhood, which, discounted back to the present at a 10% rate, equates to a stock price of around $11.80.
Arena Pharmaceuticals has a decent balance sheet and an FDA-approved drug. The company also has other prospects in the R&D program, but they are still very deep in the pipeline and far from commercial viability. The existence of a marketing partner suggests that the drug Belviq could gain traction reasonably quickly, but the outlook is somewhat cloudy and even optimistic revenue projections seem to indicate that much of the possible good news is already discounted in the stock price. As well, the agreement with the marketing partner significantly diminishes Arena's appeal as a potential takeover target. Events such as Belviq's rapidly approaching market launch, the subsequent announcements of prescription data, and the release of quarterly sales figures will most likely drive stock-price movements and serve as fuel for traders, but investing or speculating on this basis is essentially tantamount to gambling. All in all, the upside potential offered by these shares doesn't compensate investors adequately relative to the risk being taken. It's certainly sufficient, however, to preclude recommending a bearish position.
Disclosure: We (as in 3Dimensional Research) recommended Arena stock purely as an "event driven special situation" last May leading up to the FDA decision on Belviq. We don't have a position in the stock now and have no intentions to take one.