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One of the benefits for investors who focus in specific sectors is that new opportunities can come from research. While researching Theravance (NASDAQ:THRX) and Valeant (NYSE:VRX) over the last few quarters, Arena Pharmaceuticals (NASDAQ:ARNA) came up recently. A number of readers bought Arena when shares traded below $6. This leaves investors noticing shares at the current price paying two-fold or more.

Theravance and its partner GlaxoSmithKline PLC (NYSE:GSK) reported positive results from four Phase III tests for the treatment of chronic obstructive pulmonary disease ("COPD"). Theravance and GSK are testing LAMA/LABA, which is a mix of two molecules, in four 24-week long studies. LAMA/LABA are two molecules that dilate the bronchial passages.

Theravance rose from $18 to $29.49 in recent weeks, up over 60%. Theravance runs the risk of dropping as investors lock gains. The company is worth another look if Theravance files for a regulatory filing for COPD treatment in late-2012. By comparison, Arena is up 8-fold from its 52-week low: should investors new to Arena be initiating a position in the company?

As readers will already be aware, the Food and Drug Administration approved Arena's obesity drug, Belviq, the first weight-loss drug in 13 years. Belviq is known chemically as lorcaserin. Two other firms are trying to gain approval for the same kind of drug: Vivus Inc. (NASDAQ:VVUS) and Orexigen Therapeutics (NASDAQ:OREX).

There are six reasons why Arena is a company to consider buying:

1) Wall Street Wants Arena to Fall

When Arena gained approval, shares opened at $13.50, but ended the day slightly above $11, a gain of nearly 30%. Shares did not rally because 25% of the shares are institution-owned and 75% retail-owned. By comparison, VVUS is 68% institution-owned, which means Wall Street would favor VVUS over Arena. In addition, short-interest was 46 million shares as of June 29 2012.

A bias for negative news will give new investors an opportunity to start a position in the company at a discount.

2) Takeover Candidate

Arena filed for marketing approval in Switzerland on July 11, which means the company will need an European partner for distribution. A larger pharmaceutical company might want to buy Arena before the company finds a partner to share marketing and distribution costs. As Arena continues to establish global distribution, the value of the company will keep going up.

3) Threat of Qnexa Exaggerated

Qnexa is still awaiting further reviews due to safety concerns.

Qnexa is a combination of phentermine and topiramate. Topiramate, an appetite surpressor, is known to cause birth defects. Phentermine works by increasing metabolism, but is only for short-term use. The onset of tolerance may be followed by a rebound in weight gain.

The results of the FORTRESS (Fetal Outcome Retrospective Topiramte Exposure Study) is still interim, since VVUS did not perform data validation on the results.

4) Arena Insiders Are More Bullish than VVUS Insiders

In 2012, VVUS insiders sold 1.7 million shares for a cumulative market total of $37.4 million as of June 27 2012:

Cumulative Total of VVUS Insider Sales:

(click to enlarge)

(Data Source: insidertrade.net)

By comparison, Arena insiders sold just 177,495 shares valued at just $1.7 million.

5) Skepticism for Belviq Exaggerated

In the BLOSSOM ((Behavioral modification and Lorcaserin Second Study for Obesity Management) study, 63% of the participants who completed the trial lost at least 5% of their body weight. 35% lost at least 10% of their body weight. The long-term benefit was clear: patients lost an average of 17.0 pounds, or 7.9% of their body weight.

6) High Revenue Potential

There are a number of assumptions that need to be made to determine a range of values for Arena. Assuming Belviq will sell for between $2 and $4 per day, and taken twice daily, the revenue per patient per year is:

Revenue Per Patient / Year

Low

High

$2,920

$5,840

There are 78 million Americans who are considered obese, which investors might incorrectly think is be the sales size for the drug. The revenue range for Belviq is enormously wide, at between $228 million and $228 billion:

% Obesity Market (U.S.)

# Receiving Treatment

Market Size (Low-end)

Market Size (High-end)

100%

78,000,000

$227,760,000,000

$455,520,000,000

75%

58,500,000

$170,820,000,000

$341,640,000,000

50%

39,000,000

$113,880,000,000

$227,760,000,000

25%

19,500,000

$56,940,000,000

$113,880,000,000

10%

7,800,000

$22,776,000,000

$45,552,000,000

5%

3,900,000

$11,388,000,000

$22,776,000,000

4%

3,120,000

$9,110,400,000

$18,220,800,000

3%

2,340,000

$6,832,800,000

$13,665,600,000

2%

1,560,000

$4,555,200,000

$9,110,400,000

1%

780,000

$2,277,600,000

$4,555,200,000

0.50%

390,000

$1,138,800,000

$2,277,600,000

0.25%

195,000

$569,400,000

$1,138,800,000

0.10%

78,000

$227,760,000

$455,520,000

Investors should assume worst case scenarios for Arena: no more than 5% (4 million) seek treatment for obesity, with 10% choosing Belviq. After 12-weeks of usage, assume only 33% continue treatment.

The resultant revenue would be between $387 - $774 million:

% Obesity Market (U.S.)

# Receiving Treatment

Revenue (Low-end) $

Revenue (High-end) $

0.20%

156,000

455,520,000

911,040,000

0.17%

132,600

387,192,000

774,384,000

0.15%

117,000

341,640,000

683,280,000

0.10%

78,000

227,760,000

455,520,000

The resulting earnings and forward P/E at a 25% margin for Arena would be:

% Obesity Market (U.S.)

EPS at 25% Margin (NYSE:LOW)

EPS at 25% Margin (High)

P/E (High)

P/E

0.25%

0.58

1.16

19.36

9.68

0.25%

0.49

0.98

22.77

11.39

0.25%

0.43

0.87

25.81

12.9

0.10%

0.29

0.58

38.71

19.36

Arena's partner, Eisai, will pay Arena between $40 and $60 million. The conservative payment amount from Eisai should temper investor expectations on the initial sales strength for Belviq and the valuation for Arena.

From its 10k filing on May 2012:

If lorcaserin is approved for US marketing, and upon the delivery of product supply for launch, we will also receive a milestone payment from Eisai of $40.0 million or $60.0 million, depending on the approved drug label.

Conclusion:

There is no doubt that Arena's obesity drug will be successful. The recent surge in shares makes Arena a riskier play than when shares traded below $6. Still, Arena has a product that is safe, and sales will grow as Arena and Eisai market and distribute the product. A share pull-back is likely to be minimal, but the long-term upside is enormous. More importantly, investors who want to start a position in Arena are paying an estimated forward-P/E of between 11.4 and 22.8.

Source: The Time To Buy Arena Pharmaceuticals Is Now