What's Really Moving Arena Pharmaceutical And What You Should Pay For It Right Now

| About: Arena Pharmaceuticals, (ARNA)

As you know, Arena Pharmaceuticals (NASDAQ:ARNA) has taken the financial news by storm this past week, and rightfully so, considering the stock price has run up from $2 to touching $12 since May. Early last week, Jim Cramer, on Squawk on The Street, declared that Arena was the number one stock he is watching right now, and expected the price to keep rising. It did, until Friday, when the stock dropped off by 15%. Of course, the reason for this recent price appreciation is the anticipation of the June 27th FDA decision on Arena's pending obesity drug, Lorcaserin. This is going to be a make or break decision for Arena, at least in the short-term. The purpose of this article is to examine what really moves this stock, what will happen if Lorcaserin is approved, and how much an investor should be willing to spend right now.

Friday morning, a Seeking Alpha article was published arguing that shares should be sold because approval has already been priced at its then current level, $12. A better argument would be that this play is too risky for some retail investors, but as discussed below, approval is not priced at this point. Bloomberg proclaimed that this article was the root cause of the 15% slide. While this is great news for the Seeking Alpha community in terms of exposure and reach, it seems a bit farfetched. The Wall Street Journal decided it was due to options traders taking gains. Technical analysts would likely agree, in that 2 weeks' worth of daily gains has to knock off at some point, since all good things must end. And yes, it can be argued that the options traders were making their trades based on the article, but I feel that this discredits the amount of institutional ownership at play. As of the end of March, the top ten institutional holders of Arena held 20% of the float (Blackrock was 3 of those 10), and in total, institutions and mutual funds controlled about 29%. Given this, and the amount of prop firms that would key in on a stock like Arena because of its volatility makes it unlikely that at-home investors played a significant role in Friday's decline. There was also a reshuffling of the Russell 2000 on Friday, for which Arena is a member and is currently its highest performer.

As mentioned, Arena is shoving all-in on lorcaserin. The company has dumped an incredible amount of money into their Phase I-III clinical trials, and currently, the company carries a lot of debt. This article from Forbes about how Phase-III costs may be weeding out helpful drugs provides a good discussion on Arena and its gamble on obesity pharmaceuticals. It has been costly and terribly unprofitable up to this point, and this is reflected in its books. Luckily, there are probably few investors who see Arena as a long-term, value play, which is good, because its financials throw up more flags than a NFL referee. Between January and April, Arena was injected with about $30 million in cash, which took the company out of its nearly insolvent state, but debt still exceeds cash, and it is dropping about $30 million each quarter on what is essentially just R&D.

In 2010, the initial New Drug Application for Lorcaserin was rejected by the FDA because of the possible link to a heart valve disease and cancer found in lab rats (but not in humans). This link offers a look into the approval process and a timeline on the Lorcaserin pill. Arena has had 2 years to conduct more convincing trials, and it now seems likely that the drug will be approved. This statement is based on the fact that Arena is working off of a previous rejection, so it has guidance on the particular issues that need to be addressed, and the JPMorgan report is linked in the aforementioned Seeking Alpha article. This report also stated that it is now extremely unlikely for the approval to be delayed, based on a precedent set by the FDA on Vivus Inc, wherein a delay was ordered 8 days before the decision was scheduled. With only a matter of days before the Lorcaserin decision, a delay is presently unlikely. Additionally, in May, a group of medical advisors to the FDA voted 18-4 for Lorcaserin's approval.

The JPMorgan analyst also stated that he feels that there is about a 70% chance of ultimate approval. While I certainly question the basis of this figure (since the FDA does not make such disclosures), it can be used to help determine how much an investor should be willing to pay for shares of Arena going into Wednesday's results from the FDA.

Obesity is an important issue in America, with nearly a third of adults tipping the scales. This means that the potential client base for Lorcaserin will be much larger than for the average prescription drug. This list from CNBC of the top selling pharmaceuticals provides a look at the type of sales figures Arena could hit if the obesity drug is approved and widely marketed to a large number of people.

Hypothetically, let's say that Lorcaserin, if approved, will become an equivalent to Crestor (used to treat high cholesterol) by AstraZeneca (NYSE:AZN), with sales at about $4 billion. This would be a conservative figure, since Crestor has strong competitors, mainly Lipitor (NYSE:PFE), and various generics. Lorcaserin would have much higher profit margins, since there are no generics yet, but may also be facing competition, from Vivus's Qnexa, if approved in July. And all four of these drugs face competition from the alternative of diet and exercise.

In any case, a large chunk of that $4 billion would be going to Lorcaserin's distributor, Eisai Co, and of course, for production costs. That, along with other related costs, and paying down debt, could leave Arena with a conservative estimate of $1 billion. This number over the 181 million shares would yield earnings of $5.5 per share. The amount could be around $5 due to other costs, like an infusion of capital into its other drugs in the pipeline.

Next, Big Pharma companies trade around 15-20 times earnings. Here's the difference between Big Pharma and Arena; one has a diversified catalog of products with more on the way, and the other has an obesity pill. Arena's current pipeline is bleak. So if we were going to attach a predicted P/E to Arena, it would have to be very low, like 5-8x. Of course, this would result in a huge jump in price, to $25-$40 per share.

Now if one were to use JPMorgan's 70% likeliness of approval, basic statistics would say you'd be willing to pay $17.5-$28 per share right now. I would not personally pay anywhere near that price, but I feel that below $12 is worthy of rolling the dice.

Lastly, it is important to remember that the Supreme Court will soon be ruling on the Health Care Reform Bill. While this is a massive issue with discussion best left for another place at another time, it should at least be mentioned. If it were to pass (though it will not, given the current justices on the Court) more potential clients would be available, because of the mandated health insurance. If it does not pass, there is the likelihood that the costs of health insurance will remain relatively stable (less demand and stable supply), and this is the type of drug that doctors would be willing to prescribe to their patients, because weight loss leads to lower cholesterol, lower chance of diabetes, lower blood pressure, etc. This pill has the potential to alter the landscape of prescription pharmaceuticals (because it could result in lower sales of the pills for the aforementioned ailments), and Arena has the opportunity to grab the biggest piece of the pie, pending Wednesday's decision.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in (ARNA) over the next 72 hours.