Heroes And Zeros: Arena Pharmaceuticals And Avanir Pharmaceuticals

by: Blue Corn Investments

This article will be the first in a series where I will be choosing two stocks and presenting a bull case for one stock (the Hero) and bear case for the other stock (the Zero). Today's bull case will be for Arena Pharmaceuticals (NASDAQ:ARNA) and the bear case will be for Avanir Pharmaceuticals (NASDAQ:AVNR).

Arena Pharmaceuticals - Bull Case

Arena Pharmaceuticals is a clinical stage biopharmaceutical company that has discovered, developed, and moved the first anti-obesity drug through FDA approval in the last 13 years in June of 2012. That drug is called lorcaserin and is being marketed as Belviq. Clinical trials showed lorcaserin to be a safe and effective medication. Lorcaserin was subsequently approved by the FDA without onerous prescribing restrictions, unlike its primary competitor Qsymia from Vivus Inc. (NASDAQ:VVUS). Belviq will be available at any pharmacy, unlike Qsymia, which will be available only through mail order pharmacies.

Below are eight reasons I am bullish on Arena:

1. Belviq is protected by composition of matter patents out to 2023, not including any patent term extensions or other exclusivity Arena may obtain. Belviq also has NCE (new chemical entity) status and was entered in the FDA "orange book" which offers it 5 years of marketing exclusivity.

2. The estimated target market for Belviq just in the U.S. is enormous. According to the Food Research and Action Center, two-thirds of U.S. adults are overweight or obese (approximately 151,000,000 people). Penetrating just 5% into this market would be 7,550,000 users of Belviq. At this time, Arena has not provided information on what the cost of Belviq would be, but in an interview on CNBC, Arena's Co-founder and CEO Jack Lief said the cost of Belviq would be about the same as a Starbucks Venti Latte in New York (about $4). The dosing is two pills per day. If Belviq is prescribed to 2.5% of the market or 3,775,000 million users who take two $2 pills per day that could mean revenues in the neighborhood of $5.5 billion - just in the United States!

3. Arena also conducted the Bloom DM (Behavior Modification and Lorcaserin for Obesity and Overweight Management in Diabetes Mellitus) trial. The results of this trial showed that lorcaserin, coupled with behavior modification, could lower blood sugar nearly as much as current second line treatments for T2 Diabetes (T2DM). That is another large potential market of over 25 Million people. Here is an excellent analysis outlining the use of lorcaserin vs current 2nd line T2DM treatments.

4. Arena has entered into a favorable marketing agreement with Eisai (OTC:ESALF) - a top 20 pharma - for all of North and South America with the rest of the world rights still belonging to Arena. Arena will get from 31.5% - 36.5% of Eisai's net sales with large milestones along the way. Eisai bears 90% of the post-approval development costs and all regulatory and marketing expenses. In addition, Arena will manufacture Belviq and sell it to Eisai at a profit as well.

5. There has been very little insider selling from Arena's executive team - in fact, CEO and Co-Founder Jack Lief has not sold one share of Arena. That speaks volumes to me. Contrast that to the mass selling of Vivus shares by insiders before and after FDA approval of Qsymia - the new anti-obesity drug from Vivus.

6. Institutional accumulation - Arena seems to have caught Wall Street off guard with the approval of Belviq. Wall Street did not believe Arena would get the drug approved and did not invest heavily in the stock. Now that Arena has been approved there seems to be all kinds of dirty tricks being employed by "Wall Street" to accumulate shares of Arena. This author on Motley Fool does an outstanding job of detailing the latest hypocritical actions by a large investment bank that, while downgrading Arena and tossing out a low ball price target, has actually been increasing its holdings in Arena stock.

7. Arena has no debt and approximately $143 million in cash on hand and is expected to rake in another $65 million milestone from Eisai when it receives DEA scheduling sometime in later fall of 2012. Once that scheduling is complete, then Eisai will hit the ground running and start marketing Belviq quite possibly before 2012 is over.

8. Arena is also expecting a decision on European approval in the first half of 2013. That opens up another market as large if not larger than the North American market.

I am expecting Arena's market cap to be in the $4 - $6 Billion range by the end of the first year after the launch of Belviq - that is, if it doesn't get bought out first by a "Big Pharma". That would put the share price based on the most recent close in the $18 - $27 range.

Avanir Pharmaceuticals - Bear Case

Avanir Pharmaceuticals is a small biopharma that is engaged primarily in marketing its FDA approved flagship drug Nuedexta for PBA (Pseudo-Bulbar Affect, also known as Pathological Laughing and Crying or PLC). Nuedexta is a patented combination of two generic drugs: dextromethorphan and quinidine. Avanir is also testing variations of this combination for other indications including MS neuropathic pain and agitation in Alzheimer's disease.

Below are five reasons I am bearish on Avanir:

1. Avanir's flagship drug Nuedexta was approved by the FDA at the end of October in 2010 and subsequently launched by Avanir in February of 2011. It is now 19 months post-launch and sales of Nuedexta, although increasing, are still well below current and expected cash burn. According to the CEO in the most recent quarterly conference call (Q3 2012 on August 8), Avanir's weekly prescriptions were at 2232 with an annualized gross run rate of $52 million while operating expenses were revised upward to $94 - $96 million for the year. Avanir had approximately $84 million in cash, cash equivalents, and restricted investments in marketable securities.

2. It would appear the treatable market may not be as large as expected or the drug is having trouble gaining traction or expenses have increased or some combination of all three. Consider that company raised approximately $88 million with a 20 million share stock offering in November of 2010 for commercializing Nuedexta and then, on May 7, 2012, secured a $30 million term loan at a minimum per annum interest rate of 8.95%. This loan also has a warrant provision that allows the lender to purchase $1.365 million worth of stock at a potentially reduced price prior to closing the loan. On August 8, 2012, Avanir filed an S-3 shelf registration to sell up to an additional $100 million worth of stock (dilution). This is an updated shelf replacing an old one that was set to expire in September of 2012. The company of course disclosed this in a regulatory filing and the CFO said this in the CC on August 8th: "Importantly, we continue to believe that based on our current NEUDEXTA revenue and expense plan, we do not anticipate a need for any significant dilutive financing in the future."

However, $25 million of that $100 million is set up as an ATM (at the market) facility with Cowen and Company. The $25 million ATM facility makes it very easy and convenient to sell additional shares in to the market at any time and at any price up to the $25 million limit, and investors will not know until the next quarterly report. The ATM portion of the shelf and the above quote leads me to believe Avanir could sell those $25 million worth of ATM shares and still stay within the intended spirit of the above quote (yes, I know - call me a cynic).

3. There have been repeated insider sales since FDA approval, with the latest being a 190,125 share sale by the CEO on June 25, 2012. There were 3 small purchases by insiders (including the CEO) on March 7, 2012 totaling 18,000 shares between the 3 purchasers - those are the only open market purchases I could find since FDA approval in 2010.

4. SSRIs (Selective Serotonin Reuptake Inhibitors) are safe, well tolerated, effective, and cheaper alternative off-label treatments for PBA (also known as PLC). See this medical abstract titled "Treatment Of Pathological Laughing And Crying" authored in 2007 that ends with this opinion statement from the 3 medical doctors who authored it: "Selective Serotonin Reuptake Inhibitors (SSRIs) are efficacious, safe, and well-tolerated treatments for PLC and are recommended as first-line treatments for this condition. Tricyclic antidepressants, dextromethorphan/quinidine, or dopaminergic agents may be useful alternative treatments in patients in whom SSRIs are ineffective or poorly tolerated." Dextromethorphan and quinidine are the same ingredients used in Nuedexta. Generic SSRIs are a fraction of the cost of Nuedexta, plus neurologists have seen decades of safe use and are generally more conservative in their approach to prescribing new drugs - especially if there is a viable alternative treatment. Avanir's CEO even mentioned conservative physicians as one possible hurdle for getting more prescriptions written in the Feb 2012 conference call.

5. Patents Challenged By Generics - Avanir has patented Nuedexta with "method of use" patents since it is comprised of two well known generic drugs that have been in use separately for decades - quinidine as an antiarrhythmic and dextromethorphan as a cough suppressant. While "method of use" patents can certainly be defended, "composition of matter" patents are generally regarded as more difficult to invalidate by generic manufacturers - "A patentable new drug compound (a composition of matter invention) is usually the Holy Grail". Avanir's "method of use" patents are currently being challenged by five separate generic manufacturers. Avanir had only 36 months of marketing exclusivity because it is not a new chemical entity (NCE) and so does not enjoy the 5 years of marketing exclusivity that NCE status offers. The clock is ticking. This does not mean that Avanir will not be able to defend its patents.

In my opinion, Avanir is slightly over-valued right now and would expect the market cap to remain in the $350 - $500 million dollar range. While I think possible future indications (years off) could take Avanir to the $500 million to $1 billion market cap level, I have not seen evidence of any significant off-label traction for, what are most likely, much larger indications than PBA. For now, I will pass on Avanir and continue searching for other stocks that have, what I believe, is a greater potential to appreciate over the next 6 - 12 months.

In summary both Arena and Avanir have high short interest and passionate investors. If you are an Arena bear or an Avanir bull - I hope this article gets you to think about the other side of your investment. I believe one must carefully and dispassionately analyze their investments from every angle.

Disclosure: I am long ARNA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is informational and intended to spur thought and discussion. This article is NOT a substitute for your own extensive due diligence and does NOT qualify as investment advice. DO NOT BUY OR SELL STOCKS BASED ON THIS ARTICLE. I do not short stocks nor do I invest in options.