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Edited by Kate Boehme

Last week had been a good one for Arena (NASDAQ:ARNA) investors. The stock gained about 12 percent in the last week while healthcare stocks stayed flat on average. The stock is still trading about 40 percent lower than its 52-week high, but I remain confident that it will bounce back soon. In the meantime, I have developed a detailed valuation model for Arena. According to my valuations, Arena stock is worth at least $21.30 based on domestic revenues. Arena hit the bull's eye by winning a ten-year tax holiday for its manufacturing plant in Switzerland. A tax holiday for manufacturing will allow Arena to keep costs low.

The US obesity market is currently worth $1.2 billion and will likely continue to grow at a rate of 20 percent annually. Arena has already handed marketing rights for the domestic obesity market to Eisai Inc. As part of this deal, Arena will get 31.5 percent of net sales from Eisai and an additional 36.5 percent of any sales above $750 million. To gain a clear picture of Arena's revenues, it is necessary to calculate revenues for Eisai and then sift out Arena revenues according to these agreed upon percentages. Arena will also get milestone payments of $60 million from Eisai depending on a decision from DEA and drug supply levels. However, since there is currently no concrete timing for the next milestone payment, I have opted to ignore them for the purposes of this valuation. The primary concern of this exercise is to determine the value of the stock based only on the future potential of the drug in the domestic market.

Arena was able to acquire new chemical entity [NCE] status for Belviq, which gives the company exclusive marketing rights over the drug for the next five years. Since Arena will not be forced to think about competition from the generic producers for at least five years, it will be able to concentrate solely on competing with Vivus Inc. (NASDAQ:VVUS). Furthermore, in its trials Arena found that Belviq was also effective for Type 2 diabetes patients. Eisai Inc is therefore also planning to market Belviq to diabetic patients, and I have consequently considered these efforts in the revenue estimates laid out here. At present, there is no official price announced for Belviq, but Arena's chief executive, Jack Lief, recently said that the drug would cost about the same as a Starbucks Venti Latte. So, considering this projection, the price can be assumed to stand around $3.75 for a daily dosage. Meanwhile, Arena will manufacture the drug in Switzerland and deliver it to Eisa; the manufacturing costs ought to stand at around 20 percent of the price at which it is sold to Eisai. The CEO of Eisai, Haruo Naito, said that the company was trying to make it possible for customers to get coverage from the insurance companies, but doubts still remain as to the actual level of coverage from insurance companies.

Arena has been carrying tax losses for some years, which makes its current effective tax rate incredibly low, while earnings could be inflated. To normalize the tax rate for this valuation, I have assumed an overall 35 percent rate for Arena. The company plans to employ 190 medical reps at the start, and then slowly increase the number, though a final number has not yet been decided. I have also assumed a discount rate of 13 percent for Arena's valuation. While the discount rate is a little high when compared with general market yields, I believe it is justified due to the increased risk.

Revenue assumptions have been divided into two parts. The first part includes full year customers, or rather, subscribers who find the drug effective and so use a full year subscription. The second part considers users who do not find the drug effective and so leave after the initial three-month period. Manufacturing and administrative expenses will rise as the company increases production and covers a larger portion of the market.

2013

2014

2015

2016

2017

Obesity Market

$1,440,000,000

$1,728,000,000

$2,073,600,000

$2,488,320,000

$2,985,984,000

Patients prescribed full year dose

700,000

875,000

1,093,750

1,367,188

1,708,984

Patients prescribed three months dose

250,000

262,500

275,625

289,406

303,877

cost of one year subscription @ $3.75 a pill, 300 pills a year

$1,125

$1,181

$1,240

$1,302

$1,367

Revenues for full year subscription

$787,500,000

$1,033,593,750

$1,356,591,797

$1,780,526,733

$2,336,941,338

Revenues for 3 months dose subscription

84,375,000

88,593,750

93,023,438

97,674,609

102,558,340

Total Revenues for Eisai

$871,875,000

$1,122,187,500

$1,449,615,234

$1,878,201,343

$2,439,499,677

Proportion of revenues for Arena from sales below $750m (31.5%)

$236,250,000

$236,250,000

$236,250,000

$236,250,000

$236,250,000

Proportion of revenues above $750 million (36.5%)

$44,484,375

$135,848,438

$255,359,561

$411,793,490

$555,642,499

Total Arena Revenues

$280,734,375

$372,098,438

$491,609,561

$648,043,490

$791,892,499

Purchase Price Adjustments

$70,000,000

$73,500,000

$77,175,000

$81,033,750

$85,085,438

Total gross revenue for Arena

$350,734,375

$445,598,438

$568,784,561

$729,077,240

$876,977,937

Manufacturing costs

$70,146,875

$89,119,688

$113,756,912

$145,815,448

$175,395,587

Gross Profit

$280,587,500

$356,478,750

$455,027,648

$583,261,792

$701,582,349

Operating Expenses

$35,000,000

$40,250,000

$46,287,500

$53,230,625

$61,215,219

Net income before Taxes

$245,587,500

$316,228,750

$408,740,148

$530,031,167

$640,367,130

Tax Rate

35%

35%

35%

35%

35%

Tax Expenses

$85,955,625

$110,680,063

$143,059,052

$185,510,908

$224,128,496

Net Income

$159,631,875

$205,548,688

$265,681,096

$344,520,259

$416,238,635

Net Profit Margin

45.51%

46.13%

46.71%

47.25%

47.46%

Shares outstanding

182,500,000

182,500,000

182,500,000

182,500,000

182,500,000

Diluted Shares outstanding

230,000,000

230,000,000

230,000,000

230,000,000

230,000,000

EPS

$0.87

$1.13

$1.46

$1.89

$2.28

Diluted

$0.69

$0.89

$1.16

$1.50

$1.81

As is clear from the model, revenues for Eisai will approach $2.5 billion in the year 2017. Of this amount, a significant portion will go to Arena. In fact, according to my estimates, Arena will have an EPS of $2.28 in 2017 based on domestic operations. The net profit margin for the company will be especially healthy due to these lower manufacturing and administrative expenses.

Valuation

Valuation

2013

2014

2015

2016

2017

Earnings

$0.87

$1.13

$1.46

$1.89

$2.28

Discount rate

13.00%

13.00%

13.00%

13.00%

13.00%

Present Value Factors

0.88

0.78

0.69

0.61

0.54

Discounted Earnings

$0.77

$0.88

$1.01

$1.16

$1.24

Terminal year Value @5% constant growth

$29.93

Discounted Terminal Value

$16.24

True Value

$21.30

Summary

Belviq has massive potential to become the market's biggest weight loss drug. This drug could be particularly beneficial for its manufacturer, Arena, as it is applicable to not just the obesity market, but the diabetes market as well. At present, close to $50 billion is spent on diabetes products worldwide, with close to 37 percent of this number coming from the US. The diabetes market represents another area where the company can generate significant revenues. There are rumors about a potential company takeover by Pfizer (NYSE:PFE), but Eisai should also be considered. Eisai may want to take advantage of the existing partnership and put in a takeover bid. I believe Arena stock is primed to go up, regardless of any takeover that might occur. Arena investors can expect to reap enormous rewards for their patience. My fair value estimate suggests a target price of about $21 for the stock. Based on the current price of $8, the stock has almost 160 percent upside potential.

Source: Arena: Significant Upside Potential