zzlangerhans (99.78)

Arena Puts

September 07, 2010 – Comments (5) | RELATED TICKERS: ARNA

This is my latest effort to create a bidirectional trading strategy so as not to rely excessively on upward price movement in a sideways market. Shorting biotech is simply too dangerous for me – I can tolerate 50% or even 100% losses in a long investment but not 200% or 300% losses from a short gone bad. Psychologically I prefer to buy puts ahead of binary events – I know exactly how much money I’m placing at risk and almost exactly what I stand to gain. Win or lose, it’s over and I can move on.

My recent record with binary events has been abysmal. I lost $2000 betting against phase III data for Delcath and maintained green thumbs on Vivus and Jazz through negative FDA advisory panel votes. So follow me into this strategy at your own risk.

Background:

Arena (ARNA) has developed Lorqess (lorcaserin) serotonin receptor agonist to treat obesity. Lorcaserin was inspired by fenfluramine, a similar compound remembered for being the first half of the fen-phen drug that was recalled from the market due to an unacceptable incidence of heart valve damage. Lorcaserin was developed to bind selectively to the 5HT2C serotonin receptor rather than the 5HT2B receptor implicated in cardiac valvulopathy or the 5HT2A receptor responsible for certain psychiatric side effects that were also observed. The excitement for lorcaserin has always been predicated on the concept of fen-phen efficacy without adverse effects.

In 2007, when I started watching the stock, the share price hung out in the low teens with a market cap of nearly a billion dollars. The stub suffered the indignities of the financial meltdown poorly and fell below 3 even before any phase III data was released for lorcaserin. The share price was extremely volatile in advance of the results of the first phase III trial (BLOOM) and then rapidly degraded from 4.5 down to 2.3 after weakly positive data were released: 5.8% weight loss for lorcaserin vs 2.2% weight loss for placebo.

With the broad market rebound and optimism for the second phase III trial, the share price climbed back over 5 only to journey back under 3 yet again after results of the second phase III trial (BLOSSOM) were similar to BLOOM. In July of this year, the stock suddenly catapulted from 3 to as high as 8, a rise barely impacted by the negative FDA panel vote for Vivus’ Qnexa in mid-July. This classic Bottle Imp effect was nicely predicted by Donnernv in the Chimpconest while my own Bottle Imp candidate Biodel has languished thus far.

Now all the data is in and the foxholes have been dug. The FDA Advisory Panel is set to meet and vote on September 16, one day ahead of September options expiration, and the vote is almost certain to move the share price massively. I’m estimating a 60% likelihood of a negative vote based on limited efficacy, which will send the share price back below 3 and possibly below 2.

I’ve looked at the mindset of the Arena bulls, or Areniacs, and this is my impression. Most of them fall into two categories. One is long-term Arena bulls who are deep in the red thanks to a horrendous 2008 for the stock, and are locked into the "fen-phen with no side effects" mindset they had before the BLOOM and BLOSSOM data was released. The other is short-term momentum traders who were drawn in by the 100%+ jump in July and don’t have much experience with biotech and small pharma. One group wants their losses erased, the other is slavering for another short-term 100% gain.

The crux of the bull argument is that lorcaserin technically meets the FDA  efficacy standard for anti-obesity drugs as outlined here:

In general, a product can be considered effective for weight management if after 1 year of treatment either of the following occurs:
• The difference in mean weight loss between the active-product and placebo-treated groups is at least 5 percent and the difference is statistically significant
• The proportion of subjects who lose greater than or equal to 5 percent of baseline body weight in the active-product group is at least 35 percent, is approximately double the proportion in the placebo-treated group, and the difference between groups is statistically significant

Neither BLOOM nor BLOSSOM displayed lorcaserin efficacy that met the first criterion. However, the second criterion appears to have been met in that the 5% losers were 48% vs 20% in BLOOM and 47% vs 25% in BLOSSOM.

As far as the bulls are concerned, the standard of efficacy has been met and that side of the equation can be ignored. They would rather fight the battle on the safety side where lorcaserin appears to be on solid ground. The problem with this is that the FDA standard is a guideline, not legislation. If all approval decisions were made based on numerical guidelines then Advisory Panels would not be convened and approvals would be made by a computer. As long-time pharma groupies know, nothing could be further from the truth.

The Qnexa situation was obviously very different from lorcaserin. Qnexa showed stronger efficacy but also what turned out to be unacceptable side effects. The negative vote didn’t impact Arena’s rise because observers focused exclusively on the issue of adverse effects. My interpretation is that experts in the field are not desperate for an obesity drug and are not looking for ways to rationalize approval. Side effects are certainly one reason to dismiss a drug, but marginal efficacy is just as legitimate. 5% may be an FDA standard, but is a 300 pound guy going to 285 lbs after a year really a strong justification for a new drug when non-pharmacologic lifestyle modifications have been shown to be more effective?

I think the panel is going to want the pharma companies to go back to the drawing board a find a drug that really makes a strong, safe impact on obesity before they begin throwing out approvals for marginally effective compounds. A negative vote on Arena would likely request a new phase III trial of lorcaserin and would almost certainly kill the program. Lorcaserin simply is what it is, unless possibly they run a trial combining it with phentermine. Given that the entire market cap of Arena is enterprise value and the weakness of the remaining pipeline, a share price below 1 is conceivable with this outcome.

The other factor that gives me a pessimistic perspective on lorcaserin approval is the behavior of the share price over the last couple of years. Both phase III data releases were followed by steep declines. Was that a stampede of scared sheep misinterpreting positive data? Or was it the smart money headed for the exits? On the other hand, most of Arena’s current market cap can be attributed to the July price explosion which was not predicated on any new information. Does smart money suddenly pile into a stock ahead of a binary catalyst without any justification for a price change? Or was this a momentum-driven Bottle Imp effect?

I’ve spent a little time looking at the put prices for September expiration. The one I like right now is the 6 strike, with an ask of 1.55 at the close on Friday. The break-even price would be 4.45. If I buy $2000 worth, I’ll reap $1870 with a drop to 3 and $3160 with a drop to 2 (more likely). I’ll also have a little bit of insulation if a close vote doesn’t move the price as much as expected. By comparison, the 5 strike is at 1.15 with a break even of 3.85. $2000 worth of puts would render profits of $1480 with a drop to 3 and $3220 with a drop to 2.  I don’t want to be dependent on a drop below 2 to come out ahead.

If I’m right in my 60/40 assessment, the September 6 puts are a good deal. But I couldn’t have been more wrong about Jazz and Xyrem last month. The panelist remarks seemed to me like they were coming from another planet, and I had absolutely no clue about the outcome of that vote. So I think I’ll hold out a little longer, hoping for another upward surge in Arena’s share price before the vote (8 would be nice) and a drop in the put price to 1.4 or lower. Also, a last minute postponement of the panel would be a lousy reason to lose $2000.

OK, let the hate flow …