I just posted a research report video on YouTube that includes my five-year revenue forecast for Arena Pharmaceuticals (NASDAQ:ARNA). For the reasons listed in the video, I believe Arena's Lorqess and Vivus' Qnexa will both be approved by the FDA this time around. Orexigen's Contrave also is likely to get approval if their pre-approval cardiac impact trial is successful. Obesity doctors need new drugs to treat the worldwide obesity epidemic, with about two-thirds of U.S. adults now classified as overweight or obese.
Here's my revenue model for Arena, assuming Lorqess is approved on June 27. The great thing about a formal model is that you can easily change it to adjust for your assumptions on market share, pricing and other variables. It gives investors a solid framework to analyze and discuss the company.
Line 1: I start with the U.S. population, which is projected to grow at a little less than 1% per year.
Line 2: I assume that only the 67% between 15 and 64 are prospective patients.
Line 3: Obesity estimates for this age group vary from 26.4% to 34.5%, depending on how obesity is defined. The percentage of overweight people is as least as large, but the labels for both Lorqess and Qnexa will be only for the clinically obese. Of course, it will be used extensively off-label, but let's ignore that to be conservative. I used 30% as an estimate of the obese people, which also is conservative.
Line 4: Last year, about 4.4 million people sought obesity treatment, or 7% of the calculated prospective patient group. I made what I think is a cautious assumption that this will grow by 1% a year for the next five years as word spreads about the availability of Lorqess and Qnexa.
Line 5: Line 3 times line 4 gives us the number of obese that will seek treatment each year.
Line 6: The FDA has two different standards for obesity drugs, and a new drug only has to reach statistical significance on one of them to be approved. That's because all diet drugs seem to work very well for some people and not at all for others. The two standards are in place to allow a drug that works well for a sub-population to get approval, even if its overall numbers are weak.
Within 30 days of starting treatment with Lorqess, doctors know who the high-responders are. (Qnexa has to be titrated, so it takes longer to identify a clinical response.) In Arena's clinical trials, that cohort was about 35% of those taking the drug. In actual practice, I expect Lorqess to continue to be used for a much higher percentage of patients, at least for a while, but to be conservative let's not count that first month of sales or any continuation sales except for the high-responders. That gives us the number treated and helped by lorcaserin - the revenue-generating patients.
Line 7: Next I have assumed that Lorqess is priced at only $1 a pill wholesale, with two pills a day. I recall one early conference call where the company said that was the low end of the reasonable range. After approval, I can easily change this spreadsheet to reflect the real pricing. But to be conservative again, let's assume just $2 a day per patient. That times the number of patients on line 6 gives us the annual revenues to their U.S. marketing partner, Eisai Pharmaceuticals.
In 2012, the drug will not be approved until midyear, and it will take another three months to get to market. So for 2012 I have divided the annual revenue calculation by four to get to the $281 million in sales by Eisai. To be conservative, I also divided the 2013 sales by two to account for rollout and stocking issues, reducing Eisai's revenues from lorcaserin to $648 million. That probably is overly conservative.
Line 8: Under the terms of their deal with Eisai, Arena will manufacture the product in Switzerland and sell it to Eisai for a purchase price starting at 31.5% of Eisai's annual net product sales. The purchase price will increase on a tiered basis to as high as 36.5% on the portion of annual net product sales exceeding $750 million. I assumed there is no increase until the $750 million level is hit, which is again conservative.
That gives us the revenues to Arena from Eisai, assuming lorcaserin does not hit full stride until 2014. As I explained above, "full stride" is itself a conservative number.
Line 9: I then assumed the same path for revenue growth in Europe, with a one-year lag. Arena filed for approval in Europe on March 2, and already is in discussions with potential marketing partners. Line 9 assumes European introduction is delayed to the fourth quarter of 2013. That's also very conservative.
On Line 10, in addition to their share of the sales of lorcaserin, Arena gets up to an additional $60 million in milestone payments upon regulatory approval and the delivery of product supply for the launch. I show that as revenue in 2012. There's another $70 million in regulatory and development milestone payments that I split evenly between 2013 and 2014.
On Line 11 there's $1.16 billion in one-time purchase price adjustment payments based on annual sales levels of lorcaserin. I don't have any idea what that schedule of payments is. I assumed it added 10 percentage points to Arena's share of the revenues starting in 2014, although it would take many years to add up to $1.16 billion. The actual schedule may be faster or slower.
Adding the revenue sources up on Line 12, Arena does roughly $150 million this year, a little over $325 million next year, almost $850 million in 2014 as Europe kicks in, and over $1.3 billion two years later. If these numbers seem outrageous to you, fine - do your own spreadsheet. You can make even more conservative assumptions if you wish. But I could make an equally strong case for higher pricing, a higher percentage of the obese seeking treatment, and faster purchase price adjustments.
The big question is: What's it worth? Any drug that has blockbuster status is worth at least 6 times revenues, and usually more. On Line 13, using 6 times revenues, Arena has a value of nearly $900 million this year, followed by almost $2 billion in 2013, $5 billion in 2014, and so on.
On Line 14, after a March financing the company has 160 million shares outstanding. The calculated price per share on Line 15 is $6 this year, $12 next year, $32 in 2014, and so on.
Wall Street values companies by discounting their expected future prices. Once lorcaserin is approved, spreadsheet models like this will be everywhere. Some will use more aggressive assumptions, and some will use less aggressive assumptions. Although Wall Street usually discounts future earnings and prices at a 10% rate, maybe 15%, I have used a more stringent 20% discount rate. On Line 16 you can see that $52 price in 2016 is worth $25 today.
A word of caution about cash. At year-end, the company had $57.6 million in cash. They picked up $27.9 million more in a January private financing, and $24.7 million in an early March private placement. They are using about $23 million a quarter, so at the end of the March quarter they should have about $87 million in cash. They can easily get to the June 27 approval date, but realistically they must get approval or this stock could go to zero.
Approval would bring in the milestone payment and possibly an up-front payment from a European marketing partner (and maybe others in other jurisdictions). Although Arena does have a promising pipeline of other products, if lorcaserin is turned down or delayed, the debt holders will get the company and the pipeline, not us shareholders. Arena has about $116 million in debt.
With that caution in mind, at the current stock price level ARNA looks like an excellent risk/reward opportunity that should pay off in less than four months.
Disclosure: I am long ARNA.