Clinical trials are expensive, and a big pharma collaboration is one of the best things that can happen to a fledgling biotech. That's why Arrowhead Pharmaceuticals, Inc. (NASDAQ:ARWR) shareholders have been scratching their heads since Johnson & Johnson (NYSE:JNJ) signed a potentially lucrative offer. 

Some think Arrowhead was too quick to hand over rights to a potential blockbuster for just $175 million upfront. Has the beating gone too far and created a bargain opportunity? Let's take a closer look.

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What brought Johnson & Johnson to the table

Hepatitis B virus (HBV) threatens the livers of around 1.2 million Americans, and there aren't any cures. In September, the stock soared after investigators showed us a few monthly doses of ARO-HBV led to big reductions in circulating signs of disease activity. 

In September, investigators presented early data from a study designed to find an effective dose that isn't toxic. Signs of virus activity were low enough from the first two groups to suggest the company has a winner. After receiving a few injections, one of eight patients treated with ARO-HBV showed a 99.99% reduction in signs of disease activity, and the minimum reduction was still an impressive 93%. 

What Johnson & Johnson brought to the table

Arrowhead hasn't reported any major safety signals with 100 mg and 200 mg dosages to suggest groups receiving 300 mg and 400 mg will have any problems. If raising the dose boosts efficacy without dangerous side effects, Johnson & Johnson, instead of Arrowhead's investors, will fund big pivotal studies the FDA needs to see before it reviews a new antiviral treatment. 

In return for rights to sell ARO-HBV around the world, Arrowhead received $175 million in cash upfront, and a $75 million equity stake for shares Johnson & Johnson purchased at a 56% premium to their previous day's closing price. The company is eligible to receive up to $1.6 billion in milestone payments as ARO-HBV crosses regulatory and commercial hurdles, and beginning a planned midstage trial will probably trigger a $50 million milestone payment in the near term. If J&J ever gets to launch ARO-HBV, Arrowhead will receive a tiered royalty percentage that tops out in the mid-teens.

There's a huge unmet need for a chronic HBV treatment, and meeting that demand could make ARO-HBV a megablockbuster. After preliminary data from just eight patients, though, there's still a lot that can go wrong. Shifting nearly all financial risk and future commercialization expenses to J&J in return for a combined $300 million in the near term was the right move for Arrowhead.  

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Image source: Getty Images.

Looking ahead

With Johnson & Johnson picking up the tab for ARO-HBV, Arrowhead can direct more resources toward candidates it still owns outright. Although Arrowhead has several preclinical stage candidates that could begin their first human studies soon, just two other candidates are in their first clinical trials right now, a wholly owned candidate for the treatment alpha-1 antitrypsin deficiency (AATD), and a cardiology drug partnered with Amgen (NASDAQ:AMGN).  

Investigators recently finished enrolling patients with AATD into a study to evaluate ARO-AAT, a candidate that could one day treat the rare genetic liver disease. While interim results from the first four patients were encouraging, it's important to note that this initial trial enrolled healthy volunteers who don't have the disease. 

Behind ARO-AAT, Arrowhead has just one other candidate in human-stage testing, AMG 890. Amgen and Arrowhead are attempting to prove that reducing apolipoprotein A with AMG 890 can also reduce the risk of heart attacks and strokes. That's a mighty tall order, especially considering we don't know if AMG 890 safely reduces reduce apolipoprotein A yet. Amgen began a placebo-controlled human proof-of-concept trial this July that will follow 88 patients for up to 225 days. It's going to be a long time before we see meaningful data from either of these two programs, and applying a significant value to either one before we do would be a bad idea.

A bargain buy on the dip?

Arrowhead shares are a lot more attractive following their recent dip, but it's probably a good idea to wait for a further pullback. The biotech's market cap is still up around $1.3 billion, which is still way too much, given how little we know about the drugs in its pipeline.

Arrowhead's valuation could seem perfectly reasonable if results from higher-dosage cohorts of the ongoing early stage study suggest ARO-HBV really can provide a functional cure. We'll know more in November, when the company presents more details at a medical conference. 

Editor's Note: The original version of this article incorrectly identified ARO-HBV as ARO-HPV. This has been corrected. The Fool apologizes for the error.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.