Arena's Lorcaserin: What Now?

Sep.17.10 | About: Arena Pharmaceuticals, (ARNA)

What a brutal week for Arena Pharmaceuticals (NASDAQ:ARNA).

Lorcaserin began the week looking pretty; going into a panel with the lowest side effect profile, most thorough clinical trials, and efficacy meeting guidance (albeit by a ‘slim margin’).

Then came Tuesday.

Tuesday we learned that the FDA didn’t think very highly of lorcaserin’s efficacy, regardless of any guidelines it met. More troubling, however, was the FDA’s stance on reported cancer in rats. While Arena made the case that the cancer is not relevant to humans, the FDA insisted that they had not done enough to rule out the potential cancer threat.

On Thursday, the panel more or less agreed with the FDA’s concerns.

It appeared to me to be a close panel. Largely dominated by Proschan, Weide, and Kaul, the panel meticulously addressed all of the concerns as I thought they should. They asked the hard questions but it appeared Arena was ready in most cases with a response.

There were a few troubling moments during the panel, however:

1 - The two women’s groups coming out against the drug’s approval. To be sure, they really didn’t know if this would cause breast cancer in humans or not – at this point nobody knows – but I think the panelists got a view at just how the public could react if any cancer crept up after marketing the drug to world.

2 – The ‘I don’t know’ moment when discussing whether the cancer would be a concern. It appeared to me – and I don’t believe we have access to the transcript yet – that there was no one on the panel that could speak definitively on whether the cancer in rats was of concern to humans. One of the panelists (Weide?) pointed out that usually it’s only a concern when cancer appears in more than one species, but that appeared to be the most the panel could offer.

In the end I think the panelists opted for the conservative approach. Having heard no convincing argument to ignore the rat data other than from Arena’s own Dr. Williams, the panel voted 9-5 against approval. The potential risks outweighed the reported benefits.

Arena now has a tough go of things. Regardless of whether or not the rat cancer is of any concern to humans, the FDA has advertised their skepticism in the pages of the briefing documents to the panel. Arena will likely have to beef up their argument that lorcaserin will not cause cancer in humans before eventual approval. It would appear it will be years before the drug starts to generate any revenue for the company.

So the next question, then, is what is the appropriate price for the share at this point?

I wanted to point out a ballpark way in which you can determine what the stock price would be, rather than relying on the analyst recommendations. This is roughly what the equity research teams are doing anyways, so if you can master this you often times can figure out a target price before it’s reported.

The technique simply involves determining share prices at several different outcomes and taking the weighted average of share prices at those particular outcomes. For example, if there’s a 50% chance of an event to cause the share price to go to $8.00 and a 50% chance an event will cause the price to go to $4.00, the target price is $6.00. If the actual share price is $5.00 the investment may be a good trade.

Let’s take Arena’s possible outcomes and come up with a ballpark estimate. Please, change my numbers to reflect your own judgments.

I’m going to consider three scenarios.

1 – The FDA decides that the drug can go into the market in one way or another and is approved on the October PDUFA data. The FDA may stipulate that they have to get the additional animal data concurrently with public marketing of the drug or some other reason. If that’s the case I’ll assume the conservative scenario from my previous discounted cash flow valuations. I’ll give this a 5% chance and a potential share price (based on net present value) of $8.00.

2 – The FDA issues a complete response letter stating that Arena must address the cancer issue before the drug can be approved. Arena does the additional animal studies and is approved three years later than planned at which time its sales match the conservative scenario mentioned above. The drug gets eight years, as opposed to eleven, to market the drug before its patent runs out. I'm also gonna blow away $100 in market cap due to the cash burn associated with performing the trials, resubmitting, and simply staying in business until then. I’ll give this a 65% chance and a potential share price of $4.80 (approximately eight elevenths of $8.00 then subtracting the cash burn).

3 – The FDA issues a CRL and Arena/Eisai decide against even going forward with the drug. This could be because the FDA has requested more human trials or after doing additional trials the cancer issue rears its ugly head again. Arena is liquidated and Deerfield is given any residual value in the company; shareholders are left with nothing. I’ll give this a 30% chance and a share price of zero.

We then simply take a weighted average of the outcomes to give us our target share price.

0.05 x $8.00 + 0.65 x $4.80 + 0.3 x $0 = $3.52

Maybe I’m being too optimistic with this number – it most certainly flies in the face of what the market seems to believe at the moment. It’ll be interesting to see if any of the big banks will agree with me on this one. As I said, generate your own numbers based on your own due diligence. This was just an exercise.

Some Arena longs may ask “What about the pipeline?”. To that I would point out that only 15% of drugs in Phase 1 trials ultimately make it to market and all of Arena’s pipeline is in Phase 1 or earlier, but feel free to add that into your calculation.

I think you’ll find that just the exercise of approaching your investments in this manner will put you in a more objective frame of mind. Be careful, however, of the temptation to fudge the numbers to fit whatever preconceived notion you have about a stock.

I promise to move on to other stocks after this one. Happy trading!

Disclosure: Still long ARNA. I may start to average out early next week depending on market movements and my own due diligence.