As many investors know, Arena Pharmaceuticals (NASDAQ:ARNA) and Eisai (OTCPK:ESALY) launched the anti-obesity drug Belviq in June of this year. So far, sales have been decent, but have not set any records. One thing that investors seem most confused about is the methodology by which Arena earns revenue on sales of Belviq.
Perhaps the easiest way to understand this in very simple terms is that Arena receives a "royalty" of sorts on the net sales of the product. The deal between Arena and Eisai gives Arena an agreed upon percentage of NET sales. At the moment that percentage is 31.5%.
In the second quarter Arena recognized $1.3 million in revenue when the product had only been on the market for a few weeks, and sales were less than 5,000 prescriptions. How is it that Arena recognized so much revenue in a short period of time?
The answer is that Arena is recognizing revenue at the point of purchase rather than the point of sale. Simply stated, the company got paid for the sale of Belviq to wholesalers. Thus, in Q2 the sales of Belviq were 50,000 bottles at a wholesale price of $199.50. That meant that there was roughly $10 million in GROSS sales. The NET sales came in at about $4.3 million. Arena recognized 31.5% of the NET sales as revenue. That is the methodology of how Arena is booking the "royalty." See the simplified breakdown of how this works below:
- Eisai estimates NET sales for any given quarter and places an order of Belviq from Arena. In this case, Eisai paid Arena about $10 million for 50,000 bottles.
- These bottles were sent by Eisai to various warehouses across the country.
- Pharmacies, in preparation for the launch, placed orders to the warehouses.
- Consumer buys the product from the pharmacy.
- When the warehouse begins to get low in stock, they order more Belviq.
- Eisai gauges the warehouse inventory level and will place another large order with Arena.
- Eisai will pay Arena for the additional stock (let's assume another 50,000 order)
- Eisai will pay Arena an estimated NET fee.
- At the end of a contracted period of time, the companies will assess the sales from warehouse to pharmacy, and from pharmacy to consumer. Shipping, discounts, etc. will be deducted and they will arrive at a NET sales figure.
- Once that figure is determined, Arena and Eisai will adjust accordingly.
- Any difference from the estimate will generate a check to be paid to the appropriate party. If Eisai paid too much, Arena will cut a check to Eisai. If Eisai did not estimate enough, Eisai will cut a check to Arena.
- The process continues.
The bottom line here is that the initial revenue we saw Arena book in Q2 was derived mostly from the "stocking of shelves" at the warehouse level. There should be a point in time in Q3 when these warehouses need more inventory. If we look at a 30% adjusted IMS sales number, we can note that about 28,500 scripts have flowed down through to consumers since launch. That would imply that warehouses have about 22,500 bottles of Belviq left from the initial order. If 4,000 scripts are sold each week, there are about 4 weeks left in supply. Essentially another order should be placed soon, if not already.
If the third quarter the order is another 50,000 bottles, it will generate another $10 million order in GROSS sales to Eisai. The sales through the period, less shipping, discounts, etc. will determine a new NET sales number, and Arena will recognize 31.5% of NET sales as revenue in Q3.
So why track weekly sales if that is not the revenue that Arena is recognizing? The answer is that sales to consumers are the mechanism that creates pharmacy orders, which in turn creates depletion of warehouse inventory, and subsequently another order of Belviq at the wholesale level. Simply stated, retail sales still drive the revenue pipeline. In addition, the final accounting of the NET sales cannot be determined until the consumer purchases (inclusive of discounts) happens.
What we are looking for in weekly sales is that they get to a volume that necessitates a quarterly order of more than 50,000 bottles of Belviq at the warehousing level. We are looking for traction that creates 75,000 bottle orders, or 100,000 bottle orders. What we want to see is traction at retail that translates to greater traction at wholesale.
Essentially, in the first quarter we saw the benefit of stocking the shelves. Going forward we want to understand when we will see that benefit again, and to what degree. Thus far the pace through 9 weeks has been about 3,166 scripts a week. That pace equates to a 15-week supply, or 2 weeks longer than a quarter. As sales increase, the number of warehoused bottles will as well. In my opinion a Q3 order of 75,000 to 100,000 bottles is not out of the question. In fact, I would lean toward the 100,000 bottle level. This would imply $20 million in gross sales for Q3. In theory that could translate to $3.1 million in revenue for Arena. This is why tracking the metrics we can track is important. By tracking things like this investors can be ahead of the curve on what a quarter will deliver.
Taking things a step further, weekly tracking begins to paint a picture of how many patients are getting refills, and thus remaining on the treatment. Refills give investors and doctors alike a sense of the percentage of patients that are likely to have success with the drug. This type of data points toward analyzing the discounts currently being offered and how to improve the pricing model to maximize revenue and minimize rebates. This will take more weeks to get a good feel, but it is the progression that savvy investors will take to better understand the fundamental picture of Arena in applying a proper valuation.
The Arena story is still unfolding. Investors have several tools to assess the company and how it is tracking. Learning to read the data is the best strategy for successful investing. Stay tuned.
Additional disclosure: I have no position in Eisai