Don't worry, Arena Pharmaceuticals (Nasdaq: ARNA ) bulls. This isn't an article designed to bash your beloved obesity-drug maker. There's a more upbeat corollary to this article, "3 Reasons to Buy Arena Pharma," with all the positives about the stock.
But I do think if you're going to hold a stock through a binary event, such as the one Arena has with its upcoming Food and Drug Administration decision on loracaserin, you'd better know what the potential downfalls are.
Delay?
At the FDA advisory panel, some members of the committee expressed concerns about potential for the drug to cause problems with heart valves. Most weren't arguing that the drug shouldn't be approved -- the vote was 18-4 recommending approval -- but they did think the issue needed to be taken care of post-approval, probably in the form of a Risk Evaluation and Mitigation Strategy, or REMS, and/or a post marketing study. Additional paperwork required to establish those programs could push back the FDA decision.
If a delay does come, it's a little hard to know how the shares will trade. VIVUS (Nasdaq: VVUS ) is trading higher than where it was before the FDA delayed an approval decision on its obesity drug, Qnexa, to review the revamped REMS it submitted after its advisory panel. If the FDA had any other reason to reject the drug, it seems reasonable to assume it would have just issued a rejection rather than a delay. There's no need to look at a REMS that's used after approval if the approval isn't going to happen.
Arena is a little different because management has said that it doesn't see a need for a REMS. If the FDA comes back and says one is required, will investors worry that the company doesn't have a good sense of what the agency wants? If there's a misunderstanding about that -- it doesn't really matter whether it's the company's or the agency's fault -- what else isn't clear about the FDA's requirements?
Uncertain regulatory authority
While the advisory panel recommended approval, the FDA has the final say, and getting into the agency's head is difficult. An FDA chemist with inside knowledge even allegedly made initial bets in the wrong direction before approval decisions on drugs from Pozen and MannKind.
When the FDA initially turned down lorcaserin, Qnexa, and Orexigen Therapeutics' (Nasdaq: OREX ) Contrave, it was pretty clear the agency thought the drugs' risk-benefit analysis fell heavily on the risk side. Obesity isn't immediately life-threatening, and diet and exercise have few side effects beyond grumbling stomachs and sore muscles.
Lorcaserin's risks of side effects are clearer this time, and it seems as if the agency has lowered the bar, but there's no guarantee the drug will be approved. Ironically, if Qnexa had been approved on time, lorcaserin would have been second to market, but it would be easier to be confident that the agency has changed its hard-line stance. Being first in front of the firing squad has its drawbacks.
Valuation
Arena has quadrupled this year. The advisory panel was certainly a positive, and the company deserved a higher valuation, but the biotech has jumped another 27% since then. If you assume the post-approval valuation hasn't changed -- the market hasn't grown that much in the past month -- the increase since May has lowered the potential return if the FDA approves lorcaserin and increased the downside if the approval doesn't happen. If the FDA rejects Arena for something major, trading back under $2 per share is a real possibility.
Betting on the right side of an approval decision makes sense only if the returns justify the risks. And speaking of binary choices, the biggest one of all, the presidential election, is just around the corner. Find out how to profit depending on who's elected in the Fool's free report, "These Stocks Could Skyrocket After the 2012 Presidential Election." Get yours free.
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