The objective of this analysis is to determine if Arena Pharmaceuticals (NASDAQ:ARNA) is currently trading at a fair valuation objectively and relatively to its peers.
On Oct. 15, an announcement was made that Esai, Inc., Arena's marketing partner for their flagship product, will be doubling their Belviq sales force to 400 representatives by December. This news was widely covered and Arena's stock has been trading 9% higher since that announcement. This does not reflect the company's increased value and it is not based on fundamentals, it's nothing more than a mediocre improvement in investor sentiment. Belviq's large sales force will be targeting 65,000 doctors. An added bonus is that these supplementary sales people are provided at Eisai's cost not at Arena's. This is great news for Arena since it doesn't require them to add anything to the existing royalty structure they have with Eisai, yet they get to reap the benefits of additional exposure and sales for their product.
The most similar peer company in this industry is Vivus (NASDAQ:VVUS); they are the only other company with a weight loss drug that is FDA approved. Their weight loss drug Qsymia is marketed by 150 sales representatives targeting 25,000 doctors. Arena definitely has the advantage here, and since both drugs are operating in the same market, this advantage will have serious repercussions on sales of both products. Why are these two companies still currently valued at the same level, about a billion dollars?
Both of these treatments are relatively expensive, yet Belviq costs $199.50 for a month's supply, almost 50% over the price for Qsymia. That is a big premium for a drug that yields lower results than its competition. With such high pricing and these drugs having to be refilled on an ongoing basis, price would play a big part in customer preference under normal circumstances. Though, at present, the circumstances are not normal. Not only will Arena's Belviq be marketed to over twice as many doctors as Vivus' Qsymia, but it will be marketed by Eisai sales reps. Even though Qsymia clearly has the advantage on pricing, the impact of this will be mitigated by Belviq's beefed up marketing strategy to the point that it should render this price difference totally insignificant.
Both are subject to a long list of safety disclosures, but this list varies for each drug. It is interesting to note that although Qsymia approval necessitated a mandatory risk evaluation and mitigation strategy (REMS) be developed by Vivus. The FDA did not deem that such a REMS was required for Arena's Belviq. Qsymia also has specific risks for pregnant women, namely birth defects. This is especially concerning since this risk is increased if Qsymia is taken in the first months of pregnancy, a period of time when women often do not know they are pregnant. Pre-menopausal women must therefore chose to use the less risky Belviq or employ very effective birth control techniques to ensure they will not become pregnant while taking Qsymia.
Some have stated that Qsymia is more effective than Belviq. Let's analyze the data closely and see if we come to the same conclusion. It is important to note that these two drugs have never been tested in a head-to-head clinical trial. The respective placebo controlled trials led to these results:
- Belviq provided an average weight loss that was 3% to 3.7% superior to the placebo.
- After one year of taking Belviq, 47% of patients that weren't diabetic lowered their weight by 5% or more.
- After one year of taking Qsymia, the average patient lowered their weight by 8.9%.
- 70% of patients taking Qsymia lowered their weight by 5% or more.
Even though it is admittedly hard to conclusively compare these two treatments since the clinical trials were designed differently, there does seem to be a trend of greater weight loss by a larger amount of people with Qsymia.
Arena's Product Pipeline
The first product in Arena's pipeline is known as APD811, the first treatment of Pulmonary Arterial Hypertension in the form of a pill. This is a very important development for this disease since the only alternative treatments are injections. If given the choice, the vast majority of people will pick an oral treatment over an injection. This simple fact will help APD811 dominate its market if it is approved.
The second product they are developing is known as APD334, a treatment for autoimmune disorders. The third and final product Arena has up their sleeve is a temanogrel that is set to capitalize on the billion dollar thrombotic disease market. Arena has also already secured a partner to develop this drug.
These promising products demonstrate a good diversification in both technology and target markets.
Vivus' Product Pipeline
Vivus has another FDA approved drug called STENDRA and/or Avanafil; it is used in the treatment of erectile dysfunction. This is a very crowded and competitive market, time will tell what share of this market Vivus is able to acquire. Vivus is also developing treatments for type 2 diabetes and obstructive sleep apnea. Qsymia, the drug they are using for weight loss is also the drug being trialed to treat these conditions.
This quick overview demonstrates concentration risk since all of Vivus' products, except for their ED treatment, is focused on Qsymia. If a Fen-Phen type of incident were to happen to Qsymia, Vivus would most likely go belly up.
Vivus Has a Weaker Moat
Qsymia is a combination of two chemicals, phentermine and topiramate, both of which are already individually approved by the FDA. Since these two components are widely commercially available as generics for much cheaper, it would be possible, although not necessarily probable that some physicians would prescribe the latter to patients who would have trouble affording the former. This weak moat issue will also be relevant for all of Vivus' upcoming products that utilize Qsymia.
For all these reasons coupled with the fact that Vivus is currently losing money at a much higher rate than Arena, how can Wall Street currently value both companies at the same level? Arena's recently doubled its sales force, and will profit from a much wider physician marketing network that will certainly be a game changer in the medium term as week-over-week scripts increase. These increasing prescription numbers will lead to increased earnings and analyst upgrades. The good news is that Arena's valuation hasn't fully caught up to this yet and it is still trading at about the same valuation as Vivus.
Arena is not properly valued at these levels. An increased sales force has reduced Arena's risk profile while simultaneously increasing the value of the company by about 40% (see below for calculations). This larger sales team will cut in half the time it will take for Arena to reach peak sales. The discounted cash flow method should be used to value Arena at this level of development. The shortened time frame to reach peak sales has an enormous impact on this valuation.
Using peak sales of $1 billion, a discount rate of 12%, a royalty rate of 31.5% of annual net sales, and applying the biotech industries average price to sales ratio of 6, the value of this company came to $4.39 per share before the announcement increasing the sales force:
- ($1 billion * 31.5% = $315,000,000) / (1 + 0.12)6 (years to peak sales)
- $159,588,803 * 6 = $957,532,819 (market cap)/218,253,685 (shares) =
- $4.39 per share
But doubling the sales force has brought the value to $6.16 per share:
- ($1 billion * 31.5% = $315,000,000) / (1 + 0.12)3 (years to peak sales)
- $224,210,778 * 6 = $1,345,264,668 (market cap)/218,253,685 (shares) =
- $6.16 per share
On Oct. 15, before the announcement was made, the stock price of Arena Pharmaceuticals was hovering around $4.35, a fair value at that time. Following the announcement, the stock is now trading in the $4.75 area. This means that even though Belviq's sales force will have gone up by 100% by the end of this year, the market only expects peak sales to be reached eight months earlier than they would have otherwise. Whether you agree or not that the time to peak sales will be cut in half, it is clear that it won't only go down by 11% (8.4 months/six years) as the market is currently priced.
The above analysis leads to the logical conclusions that Arena is currently undervalued, both objectively and in relation to Vivus. Since Belviq should now also experience a stronger, more abrupt growth curve than Vivus' Qsymia while simultaneously carrying less intrinsic risk, Arena is now a viable long-term investment.