The Obesity Race: Update, Part 1

 |  About: Arena Pharmaceuticals, Inc. (ARNA), Includes: OREX, VVUS
by: Psych Analyst

Arena Pharmaceuticals' (NASDAQ:ARNA) Locaserin had an 18-4 positive advisory committee recommendation, and the price per share has doubled. Some are warning that FDA-approval (decision on June 27) is not in the bag. Vivus Pharmaceuticals' (NASDAQ:VVUS) Qnexa had a 20-2 advisory committee positive vote, but VVUS has a 2 billion market cap, and people are saying that the price now includes all the good news including FDA-approval, and now is the time to sell. Orexigen (NASDAQ:OREX) was asked to do a large pre-approval study, and that request has not yet been withdrawn, but the price per share has been rising. What's an investor to do?

The indications for approval on Lorcaserin are quite compelling. Besides the positive advisory committee vote, the head of the FDA, Margaret Hamburg, for the first time gave a speech calling obesity a disease. The FDA's briefing documents for the advisory committee were clearly positive, and in the advisory committee itself the FDA advisors were universally supportive of Lorcaserin.

Most of the investment journalists who previously had been saying Lorcaserin would never get an FDA recommendation are now saying approval looks likely, but they are suggesting big delays, restrictive REMS, disappointing post-approval sales, etc. Restrictive REMS and big delays are unlikely for reasons summarized here. What I want to talk about today is post-approval initial sales, what a share is worth today, and if it is too late to get in.

Predicting initial launch results

From BMI estimates, 36% of the country is now obese. Predictions are for 42% by 2050. The best evidence is that BMI underestimates the true obesity crisis. Another 33% of the US is overweight. Put simply, the average American has a weight problem, and the rest of the world is quickly catching up.

Dieting and exercise, the standard advice for the last 40 years, is obviously not working. Current prescription meds have market penetrations of less than 1%, because there are none that are reasonably safe for long-term use without very unpleasant side effects (unless excess flatulence and sudden anal leakage is no problem for you, in which case, skip my next party). The current world-wide obesity market is probably the biggest untapped market for a med that we will see in our lifetime.

Sales history of obesity medications

1996--Redux, in its first year on the market, 132 million in sales, and fen-phen had 48 million=180 million.

1997--Meridia hits the market, sells 60 million, and 240 million outside the US=300 million peak annual sales.

1999--Xenical hits the market. Annual sales peaked at 600 million.

With each new drug to hit the market, world-wide sales grew 60-100%. There has been a 13-year-gap since then, which would suggest a lot of pent-up demand for initial launch. To project forward from this, you have to account for an increasing population, and an increasing percent of obesity in that population. For example, in the US, obesity increased from 19.4% in 1997 to 36% in 2010. By 2013 that number will be higher. Of 116.5 million obese people in the US alone, 78 million will be 16-65 years old, prime ages for meds.

You have to account for a much greater knowledge of the negative health effects of excess weight among physicians and the general population. Also, for greater safety investigations, reassuring results, and fewer unpleasant side effects among the newer meds than the old ones, making MDs more comfortable prescribing them and more patients interested in trying them.

Reasoning from sales history like this suggests to me annual sales within the first few years of $2-4 billion.

Possible transfers of dollars from current products

Prescriptions: In 2009 the patented anti-obesity drugs Xenical, Alli, and Meridia each had worldwide sales of $300M to $350M. The withdrawal of Meridia from international markets puts $300M or so up for grabs. $300M-$600M go to generic products including phentermine, amphetamines, and sibutramine. Thus, 2009 worldwide spending was about $1.5 billion. It's probably $2 billion by 2013.

Non-prescription: More than 50 individual dietary supplements and 125 proprietary products are listed in the Natural Medicines Comprehensive Database as commonly used for weight loss. There are natural ingredients like ephedra, bitter orange, chromium, that get a few billion. There are those hawked on late-night TV, every weight-loss promise that you spray near your nose, sprinkle on your food, or rub into your belly. If you add all the different types of weight loss remedies plus Weight Watchers, Jenny Craig, Slim-fast, Medifast, etc., sales have been estimated at $50 billion in the US alone. The new obesity meds won't capture all these dollars, but with any customer interest at all, at least several billion of them should be easily available.

New products tend to increase spending in a category, so not all of the obesity meds' sales must come from pre-existing products. Reasoning from current sales like this suggests to me annual sales of several billion.

Meds with several billion in sales are not that unusual. In 2011, 14 meds had sales of over $5 billion, and for the first time a medicine reached one billion in sales within a year of launch. If any category of med should be able to do that, this should.

Initial penetration rates: The big question

No matter how many sales dollars are available, it boils down to how acceptable to MDs and sought-out by the public these pills will be. Predictions of initial penetration rates by brilliant and highly qualified observers after significant research seem to be varying from 2-7%.

Michael Murphy, well-known investment guru and best-selling investment author, is predicting about $3.5 billion world-wide sales revenue for Lorcaserin alone by 2015, assuming an initial 7% market penetration which then grows.

John Tucker, Ph.D. in chemistry, MBA, and consultant in biomedical technology, is predicting $.8-1 billion in peak worldwide sales for Lorcaserin, which he thinks will then drop. He seems to be at about 2% initial market penetration.

I think these two make the best arguments for the high and the low and I will try to compare and contrast them. Dr. Tucker is primarily using past results from obesity medications like Xenical to predict Lorcaserin's impact, allowing for some improvement. But it's hard to predict just how many people would try Lorcaserin that were put off by Xenical's anal leakage.

Also, Tucker concluded from his analysis that an obesity med providing 10% loss of body weight with few side-effects would be a blockbuster. But he calculated Lorcaserin's efficacy using the placebo-adjusted results of 4%, rather than the 7-8% that would be more accurate for the real world. Lorcaserin is actually closer to his predicted blockbuster profile, suggesting higher initial penetration rates.

Finally, Tucker did not have available the surprisingly excellent glycemic control results for Lorcaserin from the Bloom-DM trial with diabetics. Prevention of type-II diabetes is another factor that might impel higher penetration rates.

Mr. Murphy's 7% market penetration estimate may be too high given that no previous obesity medication achieved 1%. He also does not take into account the competition between Lorcaserin and Qnexa, assuming Lorcaserin will be tried first in every case.

Let's be conservative. We'll lean toward Tucker and assume only a 3.25% market penetration for Lorcaserin. Mr. Murphy offers detailed revenue calculations in his latest forecast, including the deal with Eisai, Arena's partner on Lorcaserin. He comes to a per share value for Arena of $20. Rather than redo the calculations, let's just use his results as a starting point. Although Arena's milestone payments from partner Eisai might be off, he is also using only six times revenue to calculate share value, which could be higher. Thus, we'll start by taking Mr. Murphy's per share value and more than halve it=$9.3 per share.

There has been a 10% dilution since his article=$8.4 per share.

Mr. Murphy is predicting obesity at only 30%. By 2013 it should be 37%=$10.6 per share.

Mr. Murphy left out prescriptions for the overweight but not obese, many of whom will ask their MD for these drugs. Knowing the negative effects of excess weight, I don't see any compelling reason for doctors to deny their patients a med that will improve their health. When no FDA-approved med is available for a condition, and a med has approval for a closely-related condition, that med is often prescribed off-label. If the same number of overweight as obese take Lorcaserin, it would double ARNA's value, but let's be conservative and add only ¼, to $13.3.

Mr. Murphy is counting the US and Europe but is not counting the rest of the world. The US is currently the biggest single market for weight loss drugs, followed by Europe. However, China, Russia, and India could soon begin to eclipse Western countries for obese populations. China alone is predicted to reach 665-670 million in overweight and obese by 2015 (vs. perhaps 240 million US). China alone could more than double ARNA's value. Although far from definite this vast possibility has to be worth something, but since there are no applications pending let's be very conservative and add 1/10. $14.6.

ARNA just concluded an expanded marketing agreement with Eisai to include Brazil, Mexico, and Canada. That should bring it up to $15.25.

This is, in my view, the floor estimate of the value of a share of Lorcaserin right now. If I try to estimate costs and all the values from start to finish myself, I get a higher number. I get $15.25 with a penetration rate of only 2.2%, or by leaving out the overweight and the rest of the world. Even if we use a confidence interval and say I am wrong by 30%, Arena is currently undervalued by almost half.

Is that realistic and practical?

Reimbursement issues: Many are concerned about whether insurance will cover these prescriptions because it is an unknown. Unknowns always cause anxiety. I think insurers may cover these meds because it will save them money in the long-run, but I don't think this is a big concern even if they don't. The huge amount of money being spent on things that don't work as well suggests that people will part with a few bucks a day to stay slimmer.

This would be an expense that would appeal not only to the sober, logical side of people trying to reduce their risk of future bad things happening (a difficulty that Lipitor had to overcome), but also to the vanity of people wanting to look better and be sexier. I don't think this will be a hard sell.

Manufacturing capacity: Arena currently has the capacity to manufacture 1 billion Lorcaserin tablets per year in their facility in Switzerland. Arena owns the top two floors and the exclusive right to purchase the bottom two floors, basement, and another small building until 2018. The purchase was completed in 2011. In the last shareholder's meeting, the CEO revealed that the company plans to ramp up after approval to be able to produce 5 billion pills/year. At maybe $2 per pill, that is enough capacity for blockbuster sales. As a wise poster said, this suggests what future sales forecasts Arena is thinking about.

Investment Considerations: Short-Term Horizon

Those who listened to my other two recommendations in Seeking Alpha about this company are now up as much as 300 percent, depending on when they got in. Perhaps that gives me a little credibility.

As of this writing, ARNA is selling for around $6.50/share. This is a chance for retail investors to get in ahead of the big institutions, which seem to be waiting for the FDA decision. On June 27, I believe the FDA will give final approval and ARNA will go to around $10/share for a 50% return, and quite possibly more.

Even if there is a delay of 3-6 months on the decision, so what? How much less is money really worth in a few months than now, 5%? So instead of a 50% quick return, you get the equivalent of 45%? Does that make it a bad trade?

I will follow with a second article later about why institutions have held back, what I think the company is worth long-term and how long I would consider holding it. This 10-bagger still has a ways to run, and if you missed out on the first four bags, it is not too late.

Although I was long ARNA for the Advisory Committee vote, I purchased more since, because at this time of life I am more interested in big bets on near-certain 50% returns than probable 100% returns but with a real chance to lose my stake.

Disclosure: I am long ARNA.