Two Ways To Speculate On Arena Pharmaceuticals Phase III Results

I’m not an advocate of short-term trading for serious investors, but sometimes a situation comes along that is just irresistible. At the end of this month Arena Pharmaceuticals (ARNA) will reveal top-line data from the first of two pivotal Phase III trials of its weight-loss drug, lorcaserin. This is essentially phen-fen reformulated to avoid the negative side-effects that combination drug had on heart valves. Phen-fen was very effective for losing weight, but the unexpected side effects got it pulled from the market. Lorcaserin targets the exact same, well-validated weight-loss receptor. All of Arena’s Phase II data indicate that the people using the drug will lose significantly more weight than those on the placebo, so the only question in my mind is what the Phase III heart impact data looks like.

This first Phase III trial, named BLOOM, is a large randomized and controlled trial, enrolling 3,181 patients over two years, which incorporates a moderate diet and exercise program. Other moderate diet and exercise programs in other studies have shown a relatively small amount of weight loss in the placebo group, around 1.5% to 2.5%.

BLOOM has already undergone a planned review by an independent Echocardiographic Safety Monitoring Board, or ESMB, of unblinded echocardiographic data performed after patients completed 12 months of dosing in the trial. The review confirmed that differences, if any, in the rates of FDA-defined valvulopathy in patients treated with lorcaserin and in the control group did not meet the ESMB’s predetermined stopping criteria. I am sure the stopping criteria was set very low after the phen-fen disaster, so the odds are high that there will be no meaningful impact on heart valves reported at the end of March.

However, this is a speculation because if there is a problem, the stock will go to $1 and then to $0 as the company runs out of money. In the December fourth quarter, ARNA reported a $62.5 million loss, or 84 cents a share, of which $53.3 million was spent on R&D – primarily the clinical trials. For all of 2008, they lost $239.5 million, and they only have $110 million left. They say they will only burn $60 million in 2009.

The burn rate will come down now that BLOOM has completed enrollment and preliminary analysis, but they still have BLOSSOM, the second Phase III trial underway, with just enough cash to finish it if BLOOM is a bust. BLOSSOM is a 4,000-patient, one-year trial that completed enrollment last June, and is now in the follow-up stage. The plan is to see top-line data from BLOSSOM in September, followed by a NDA (New Drug Application) filing before the end of the year. But if BLOOM is not a statistical success with very low or no side-effects, Arena will run out of money next year.

Management is betting the company on the BLOOM results coming in less than two weeks, and they need a clear win to generate interest from prospective partners who can infuse some cash to cover the ongoing losses and strengthen the balance sheet.

Frankly, I was going to let this one pass and just not talk about, even though I think the odds of a successful trial are high. But yesterday the analyst at Canaccord Adams downgraded the stock from Hold to Sell, set a new target price of $2.50, and knocked ARNA from $5.09 on Friday to $3.99 yesterday. It is not bouncing back today. His reason for the downgrade: The BLOOM trial results will draw intense scrutiny from the FDA for the safety side effects. Such a penetrating insight!

Without accusing anybody of anything, in the past I have seen analysts who aren’t bullish anyway (his previous recommendation was a hold) downgrade a stock for a non-reason in advance of an event. Their firm then provides a market for the stock because they have a big buyer: A hedge fund that is short and needs to cover at a low price just before they might get blown out of the water by some good news. As I say, I’m not accusing anyone of anything, it’s just something to think about.

As you can imagine, ARNA stock has been very volatile, as this is one of the most-watched biotech events so far this year. It ran to $7 in mid-February, fell back under $4 in early March, got back to $5.50 last week and then was ambushed by the Canaccord Adams downgrade back under $4.

So should you buy the stock? No! It is a rank speculation with a very short time to decision day, and therefore a perfect options candidate. There are two ways to participate:

1. Buy the April $5 call option (UGG DA) for around $1.15, or buy the April $7.50 call (UGG DU) for just over 50 cents. With 17% of the float (12.5 million shares) sold short, I expect the stock to shoot to $10 or $12 on good news. It could even do a Dendreon-like run into the $20s. Just assuming it hits $11, the April $5 call will go to at least $6, a 400% return on your investment. The April $7.50 call will go to at least $3.50, about a 550% return on investment. The downside to both of these contracts is a loss of ALL of your money.

2. Do a call spread. To do this, you buy the April $5 call (UGG DA) for $1.15 and sell the April $7.50 call for about 50 cents. Your net cost for this will be $1.15 minus 50 cents, or 65 cents. You could also do this with the July contracts, buying the July $5 call (UGG GA) for $1.75 and selling the July $7.50 call (UGG GU) for 90 cents. In that case, your net cost is $1.75 minus 90 cents, or 85 cents.

If the BLOOM data is bad, you will lose ALL of your 65 cents or 85 cents at risk. But if it is good, you will sell the $5 call, buy back the $7.50 call, and book the $2.50 difference as profit. You’ll make 285% on the April contracts, or 195% on the July contract.

Personally, after you guys are done buying I probably will just buy the April $7.50 call and shoot for the moon, since the downside is 100% no matter how you do it. So my formal recommendation is buy the Arena Pharmaceuticals April $7.50 call (UGG DU) under 60 cents, and DO NOT use any money you cannot afford to lose.

As always, you can comment on the website. I’ll bet we have some MD subscribers with an opinion on phen-fen.

“Why not go out on a limb? That’s where the fruit is.”

– Will Rogers