Obesity Drug May Be Goldmine For Arena

| About: Arena Pharmaceuticals, (ARNA)

Arena Pharmaceuticals (NASDAQ:ARNA) saw a jump of nearly 30 % in its stock price on the news that the Food and Drug Administration had approved its much-awaited obesity drug, lorcaserin, which Arena has branded Belviq. This is the first anti-obesity drug that the FDA has approved in almost 13 years, as many efforts in this direction by major pharmaceutical companies have been affected by side effects and issues concerning safety. The company CEO said that he believed that this represents a turning point for physicians in the treatment of overweight and obese patients. It is also a landmark for the company which has managed to survive for 15 years without launching a single new product in the market. The company was established in 1997 for the creation of drugs targeting G-protein coupled receptors, and it also has other drugs in development for treating pain, diabetes and other medical conditions. Obesity treatment is the jackpot for Arena.

Obesity has become a major global problem, prompting the CDC in Atlanta to call for it to be classified as a major disease. The Journal of the American Medical Association estimates that nearly 36% of adult Americans can be classified as medically obese, and the numbers are increasing. Obesity is becoming a major issue in Europe and many other parts of the world. This means that lorcaserin has every possibility of becoming a major blockbuster drug. Edward Tenthoff, an equity analyst with Piper Jaffray, has calculated that even a penetration of just over 1% could mean almost $2 billion in sales in the United States. All this money will not find its way into the pockets of Arena because of its partnership agreement with Japanese drug maker Eisai, who will take charge of marketing and share a large portion of the revenues. However, if everything works out according to the plan, Arena would be entitled to receive milestone payments that could amount to as much as $1.2 billion.

Arena had previous problems with the drug when the FDA rejected the initial application in 2010, but it would seem that the additional data supplied by the company has shown less risk than was previously thought. Estimates show that the US weight loss market is worth more than $60 billion and that the market for OTC diet pills and medication is expected to grow at more than 3% annually. This puts Arena in the position of being a company with a multibillion-dollar market cap if they are able to capitalize on the potential of the drug properly. And you should bear in mind that this is a market where Arena will have few competitors and where there is a high barrier to the entry for new medications.

We must not forget that Arena has had competitors hot on its heels who could win FDA approval in the near-term future. Both Vivus (NASDAQ:VVUS) and Orexigen Therapeutics (NASDAQ:OREX) have spent the last few years developing their diet pills needed to stem the epidemic of obesity in America. Vivus' diet pill, Qnexa, was backed by an FDA advisory panel in February, but the FDA has asked for more data and has delayed the approval until mid July. Orexigen is way behind in the approval process, but the company believes that it will be able to compete effectively even if it is beaten to market by Arena and Vivus.The FDA has moved cautiously in the approval of new weight-loss drugs after the withdrawal of previously approved drugs. Abbott Laboratories (NYSE:ABT) withdrew diet pill Meridia in 2010 from the market because of mounting concerns about the possibility of heart attack and strokes. The diet-drug combination fen phen was taken off the market in 1997 by American Home Products, now a part of Pfizer (NYSE:PFE), because of the risk of damage to heart valves.

When you have events with a known date such as an FDA drug approval, the price and volatility of the stock spike as investors take bets on the chances of approval. This can often lead to overvaluation of the stock concerned. Movements can often be 50% in either direction with a large downside if approval is held up for any reason. You only have to look at examples like Amylin Pharmaceuticals (AMLN), which lost half of its value when the FDA did not approve Bydureon as a potential diabetes drug and asked for more testing. Similarly, the FDA rejected the GTx (NASDAQ:GTXI) experimental drug to reduce fractures in men with prostate cancer asking for another study to be conducted. The stock subsequently took a beating. There has been plenty of action for Arena stock in anticipation of the FDA approval.

What happens next? When biotechnology companies see a sharp rally in the price following the receipt of an FDA approval, the next step is to make a secondary offering in the market to raise capital on favorable terms. Under the terms of its agreement with Eisai, Arena is required to manufacture and supply the drug from its facility in Switzerland for marketing and distribution in the United States. I think it is logical for Arena to raise more equity. It currently has about $90 million in cash and the same in debt, with total equity of about $45 million. It remains to be seen whether this cash will suffice for its requirements in the immediate future.

With this background, Arena is obviously a desirable stock for investment, and the question is whether it is a good buy now. I do not believe in timing the market and an investment must justify itself on the basis of fundamentals alone. Arena may be slightly overvalued at the moment, but I would still recommend buying this stock. While its competitors are on its heels and the potential of the anti-obesity drug treatment market yet to establish itself, I think now is the best time to get in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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