Arena Pharmaceuticals Inc. (NASDAQ: ARNA) engages in the clinical development of biotechnology products, primarily focused on the therapeutic areas of cardiovascular, central nervous system, inflammatory, and metabolic diseases. Arena has generated massive buzz as of late with the much-publicized FDA approval of obesity drug lorcaserin (Belviq). While the results of clinical trials have demonstrated a modest 5% reduction in weight compared to placebo controls, the continued obesity epidemic in the United States has created a massive consumer base that is actively looking for an answer. While this answer may be Belviq, it will need stronger data before the drug receives backing from insurers. With an estimated 42 percent of the U.S. population facing obesity by 2030, the announcement of Belviq’s FDA approval helped catalyze an intraday appreciation of as much as 53 percent during Wednesday last week, only to be followed by a 10% cool down the following day. Nevertheless, Arena’s move to commercialize this potentially lucrative product has undoubtedly gained the attention of competitors Vivus (VVUS) and Orexigen Therapeutics (OREX).
At the end of the 1st quarter of this financial year, there were a total of 9 hedge funds invested in Arena Pharmaceutials, with a modest net investment of $13.8 million of its $1.87 billion total market capitalization. This compares to $597.8 million of hedge fund activity within Vivus ($2.84 billion market cap) and $38.2 million of capital invested in Orexigen ($399.88 million market cap). The holders of Arena’s stock includes Daniel Gold, DE Shaw, Israel Englander, Glenn Russell Dubin and quant guru Jim Simons, among others. While the FDA’s approval is a positive sign for ARNA’s strategy going forward, this endorsement may have already been priced into the market, as the stock has risen over 450% in the last three months. How the company translates the government’s authorization into a commercial success is yet to be seen. In 2010, Arena made a deal with Japan's Eisai company for Belviq. Arena will receive an upfront payment of $50 million from Japan's Eisai company and up to another $90 million in milestone payments for U.S. approval and delivery of the product for sale. Also under agreement, Arena will receive 31.5% on the net sale from Eisai and 36.5% on the portion that exceeds $ 750 million. As Arena reported a first quarter loss of $ 29.4 million and has 4 drugs in the first stage of development, the regulatory success of Belviq was of critical importance to the future of Arena Pharmaceuticals.
Last week witnessed another regulatory development with regard to the passage of President Obama’s Affordable Care Act. The Supreme Court’s decision to uphold the highly controversial individual mandate and the legislation’s collective components are expected to have a negligible impact on the pharmaceutical industry. S&P Equity Research has projected a 2%-3% increase in revenues stemming from extending health insurance coverage to 32 million presently uninsured Americans, which would roughly offset the already-agreed-to Medicare Part D price discounts, higher Medicaid rebates, and new fees.
Belviq’s FDA approval has also led to positive sentiment surrounding VVUS and OREX shares, as the likelihood that their weight loss drugs Qnexa and Contrave, respectively, will be approved has increased as well. OREX has seen an appreciation of over 70% in the last 30 days, and VVUS stock has appreciated nearly 10% in the last 5 days. The negative earnings of these three companies are reflected in their negative PEG ratios; ARNA at -1.14, VVUS at -1.63, and OREX at -0.34 over a 5 year projected horizon. ARNA has a gross margin of 0.41 compared to -2.80 for OREX, which reflects that ARNA is retaining more on each dollar of sales relative to servicing its other costs and obligations. Free cash flow yields for ARNA, OREX, and VVUS are -4.30%, -6.26% and -1.57% respectively. Five-year growth projections for ARNA are at 25%, and should be looked at cautiously given the anticipated passage of weight loss drugs from its competitors. In addition, ARNA has displayed a strong degree of positive correlation with the ‘VIX’ index over the last 60 days, indicating that the stock has generally outperformed the market when uncertainty has spiked. The potential market size of obesity drugs is extraordinary, with only a 1.2% penetration of the market producing a possible $1.8 billion dollars in US sales by 2018. Nonetheless, the sheer dependency that large pharmaceutical companies have on a core portfolio of drugs, and in this case, a single drug, makes us hesitant to commit fully to Arena Pharmaceuticals. Assuming an earnings per share of $0.79 in 2017, and discounted at a 20% growth rate with a Price-to Earnings multiple of 25, the intrinsic value of ARNA is approximately $10/share. Given the recent rally among ARNA and its competitors, one would be wise to wait until further clinical trials have reinforced the efficacy of this potentially blockbuster drug. Until then, the landscape of this industry makes Arena’s Belviq product highly vulnerable to competition.
Note: This article is written by Mohsen Ghazi.