Image source: Aratana Therapeutics.

Aratana Therapeutics (PETX) is a biotech company developing next-generation medicine for pets. Rising spending on pet health should provide tailwinds to demand for pet medicine, but that doesn't necessarily mean that investors ought to rush out and buy Artana Therapeutics. Here are three things investors need to consider before adding this up-and-comer to their portfolios.

No. 1: No guarantees

Unlike larger pet companies such as Zoetis, Artana Therapeutics doesn't generate any meaningful product revenue and that means that its profit potential rests solely in its ability to develop drugs that pass muster with the FDA, veterinarians, and pet owners.

While companies do their best to de-risk drugs before spending heavily on R&D for them, medicines often fall shy of the mark during clinical trials and that means there's no guarantee that Artana Therapeutics will ever get into the black.

Investors were reminded painfully of the risk of clinical trials last fall when Aratana Therapeutics reported that a promising monoclonal antibody therapy for canine lymphoma failed. Share prices have rebounded since that shock, but they're still trading for less than half what they were a year ago.

PETX Chart

PETX data by YCharts.

No. 2: Revenue could be lumpy

Investors who look quickly at Aratana Therapeutics income statement may think that the company's $38 million in second quarter sales is indicative of what the company could earn in future quarters. Unfortunately, it isn't.

The vast majority of the revenue reported by Aratana Therapeutics last quarter is from an upfront payment made to by Eli Lilly & Co.'s (LLY -1.05%) animal health business, Elanco.  

Elanco paid Aratana Therapeutics a one-time upfront payment of $45 million in April to gain ex-U.S. commercialization rights to Galliprant and for co-promotion rights to Galliprant in the United States. Aratana Therapeutics recorded $38 million of that payment as collaboration revenue in Q2 and it designated the remaining $7 million to the balance sheet as a licensing and collaboration commitment.

Aratana Therapeutics could receive up to $83 million in future milestone payments, plus royalty payments and co-promotion fees, from Elanco in the future, but there's no guarantee that it will net the milestones and it only gets mid single digit to low double digit royalties on ex-U.S. sales. In the U.S., Aratana Therapeutics will receive 25% of the gross margin on sales prior to December 31, 2018 and then it will receive only a mid-single digit percentage of net sales between December 31, 2018 through 2028. 

No. 3: Flurry of activity

Eli Lilly's interest in Galliprant offers conviction, however, that Aratana Therapeutics' R&D program is on the right track. Elanco is the globe's third largest animal health company and that means that it has the resources to give Galliprant a good shot at commercial success. The deal may also indicate that other licensing agreements could happen in the future.

Among the drugs that could interest Elanco or another pet company are Entyce and Nocita. In May, the FDA approved Entyce as a therapy that can be used to stimulate appetites in dogs and in August, the FDA approved Nocita as a post-operative pain therapy. Entyce will begin generating revenue once it's launched in the first quarter of 2017 and Nocita is expected to launch before year end. 4 million dogs are treated for lack of appetite and 6 million dogs undergo painful surgery every year, according to Aratana Therapeutics' market research.

Looking ahead

Aratana Therapeutics' balance sheet boasts over $100 million in cash and that gives it some runway to establish its recently approved medications in the marketplace. If its medicines catch a foothold, then the pay-off could be big for investors. Owners are increasingly paying for human-like healthcare for their pets and last year $15.7 billion was spent on veterinary care alone. Given the markets dynamics, Aratana Therapeutics is undeniably an intriguing, albeit high-risk stock.