VIVUS Inc. (VVUS) and Arena Pharmaceutical (ARNA) are front runners in the development of weight-loss drugs. The rollercoaster rides for both stocks over the past two years demonstrate the volatility of small cap biotech stocks without commercial products. The FDA finally approved ARNA's Belviq (lorcaserin) on June 27, 2012. This makes Belviq the first weight-loss drug approved by the FDA in 13 years and reignites the enthusiasm for such drugs.

With the upcoming FDA decision on VVUS's Qnexa on July 17, 2012, there are a number of issues investors should consider: Will Qnexa receive FDA approval? What's the fair value for VVUS? What strategies can investors use to gain on the upside and protect against the downside?

Here we analyze Qnexa clinical trial data, the probability that Qnexa will receive FDA approval for treating obesity, market opportunities, and risk factors for Vivus. Our discounted cash flow model suggests a weighted target price for VVUS at $33-$34.

Clinical Trial Data

First, let's look at the phase 3 clinical trial data and benchmark Qnexa against the already-approved Belviq.

Arena conducted three phase 3 trials for Belviq (locaserin). The studies showed that, in both 1-year and 2-year studies, about 65% and 35% study subjects treated with Belviq achieved weight loss of >5% and >10%, respectively (ARNA 2011 10K filing). The percentage is lower for people with Type 2 diabetes.

By comparison, the three phase 3 trials conducted by Vivus showed that in 1-year studies, 84% of patients taking Qnexa achieved weight loss >5%. In 2-year studies, 79% of study subjects receiving Qnexa had weight loss >5%, whereas about 54% and 30% of patients achieved weight loss of >10% and >15%, respectively (VVUS 2011 10K filing; Qnexa phase 3 paper Dec2011; Qnexa phase 3 paper Nov 2011 ). Moreover, obese people taking high dose Qnexa showed average weight loss of 11-15%. Therefore, from an efficacy point of view, Qnexa appears to have greater and more sustainable weight loss benefits than Belviq.

The reason that the FDA held back approval for these two drugs in 2010 was primarily over safety concerns. Both drugs have their own issues. Belviq's most common adverse effects include headache, nausea, hypoglycemia, and upper respiratory tract infection. Qnexa's common adverse effects include skin sensation, nausea, dry mouth, constipation, dizziness, and insomnia. While these adverse effects are not serious, the FDA had concerns about other serious adverse effects, even though they were rare in these studies.

For Belviq, a major issue has been an association with increased incidences of mammary adenocarcinoma. Arena was able to address these issues by providing animal data showing that only high-dose locaserin increased mammary adenocarcinoma due to increased prolactin production (ARNA 2011 10K filing). Thereafter, the FDA Advisory committee voted 18 to 4 to recommend Belviq for the treatment of obesity, which was subsequently approved by the FDA on June 27, 2012.

For Qnexa, the FDA requested a comprehensive assessment of topiramate's (one of the two components in Qnexa) and Qnexa's teratogenic potential, including a detailed plan and strategy to evaluate and mitigate the potential teratogenic risks in women with childbearing potential taking the drug for the treatment of obesity.

In addition, the FDA asked Vivus to provide evidence that the elevation in heart rate associated with Qnexa does not increase the risk for major adverse cardiovascular events. From Vivus' 2011 10K filing, it appears that the company has engaged in discussions with the FDA and has provided the data that the FDA requested (VVUS 2011 10K filing).

Over the past year, the company has provided more data that shows that Qnexa does not increase the risk for major cardiovascular events or the observed increases in heart rate. In addition, the prevalence rate for teratogenic defects is very low (0.29%), which is comparable with the rates for infants of women who have previously taken antiepileptic drugs. On February 22, 2012, the FDA Endocrinologic and Metabolic Drugs Advisory Committee voted 20 to 2, recommending that Qnexa be granted marketing approval by the FDA for the treatment of obesity in adults.

In conclusion, based on a favorable weight loss efficacy of Qnexa over Belviq and that Vivus may have addressed the serious adverse effects raised by FDA, we believe that it is highly probable (>90%) that FDA will approve Qnexa for obesity treatment.

Market Size

According to the National Health and Nutrition Examination Survey conducted for 2007-2008, 68% of adults in the U.S. were classified as overweight, defined as a body mass index (BMI) greater than 25. The survey also found that 33.8% of adults were obese (BMI > 30). The percentage of American adults that are obese could climb as high as 43% over the next 10 years. Americans spend more than $30 billion annually on weight-loss products and services. Assuming 20-25% could be spent on weight loss prescription drugs, the market size is roughly $6B to $7.5B.

Currently approved anti-obesity drugs include Xenical (orlistat), marketed by Roche, its over-the-counter counterpart, Alli, marketed by GlaxoSmithKline, and phentermine, in several dosage forms and strengths that are available from several generic manufacturers. Thus, Belviq and Qnexa will compete with existing products as well as new products in the future. These numbers are incorporated into the valuation of the VVUS stock price (see below).

We have not overlooked another revenue generating drug from Vivus, Stendra (avanafil), which was approved by the FDA in April 2012 for the treatment of erectile dysfunction, or ED. ED was reported in 52% of men between the ages of 40 to 70 in the Massachusetts Male Aging Study, with the incidence increasing with age. Currently marketed drugs such as Viagra, Levitra, and Cialis all belong to the same class of inhibitors for phosphodiesterase type 5 (PDE5), which inhibit the breakdown of cyclic guanosine monophosphate. Vivus' Stendra is also a PDE5 inhibitor and thus will compete with such existing drugs.

The worldwide sales in 2011 of PDE5 inhibitor products for the treatment of ED were approximately $4.2 billion. Viagra ad Cialis each have about 45% market share ($2.0 billion for Viagra, $1.9 billion for Cialis), whereas Levitra has about 7% market share ($300 million). While the market for PDE5 inhibitors will continue to represent a sizable market opportunity for Vivus, we shall factor in the competition the company will face as well as how fast and aggressive Vivus is able to market its product.

Finally, another important point to make is that most of Vivus' patent portfolios for Qnexa and Stendra (disclosed in 10K) only cover the U.S. and Canada. This suggests that the major sales and revenue source for Vivus products will be from North America. This was factored into our stock valuation.

Risk

A number of risk factors could affect VVUS' stock price estimate:

(1) FDA approval status. A delayed approval or even a rejection (a remote possibility) could make the stock price decline.

(2) Marketing and commercialization strategy. With 38 employees, Vivus must seek pharmaceutical partners for commercialization and marketing of its products. It has not disclosed any partnership agreement with any pharmaceutical companies yet in its annual report; however this could change in the next few months after the FDA decision on Qnexa.

(3) Patent position and barrier to entry. Vivus is the exclusive licensee of 31 patents and 13 published patent applications, mostly in the U.S. and Canada. Thus, the marketing rights are primarily in North America. Unless Vivus also applies for patent protection in other developed or emerging markets, it will not be able to defend its products worldwide.

(4) Competition. As described in the market information section, the anti-obesity and erectile dysfunction markets have multiple competing products. The opportunities for Vivus to expand market share depends on its products' superior features or competitive advantages as well as its marketing strategies. Qnexa appears to have better efficacy than Belviq and other anti-obesity products. Once approved, it should have a better value proposition than other products.

(5) Business risks. At present, Vivus has secured the commercialization right for Stendra. However, it has limited revenue potential due to competition in the ED market. Thus, the company's valuation is largely hinged on Qnexa approval. Furthermore, with few staff, Vivus must seek commercialization partners to expedite its sales. Alternatively, Vivus may strategically seek acquisition and merger partners.

Valuation

We used the FCFE valuation as the primary model for estimating VVUS stock price. We used median gross profit margin and net profit margin from comparable companies, e.g. Human Genome Sciences (HGSI), Seattle Genetics (SGEN), Dendreon (DNDN), Vertex (VRTX), Regeneron (RGEN), or Bristol-Myers Scribb (BMY), as a guide to estimate revenue growth, gross profit, net income, and free cash to equity for a five-year period (2013 to 2017). Based on FEFE model with 15% discount rate, the estimated stock price is $33.5, $42.5, and $9, respectively, for three scenarios (baseline, optimistic, pessimistic). The weighted fair value of the stock is $33-$34, after assigning probabilities to each scenario.

Baseline Scenario: This assumes that FDA approves Qnexa for obesity treatment in July 2012 and the company is able to launch the product in Q4 2012 with a pharmaceutical partner(s). Our estimate of Qnexa revenue is the following.

The estimated market for weight loss prescription drugs is ~$7B, as described above. We can also derive the market size by other method. Assuming the cost for weight loss drug is $2-4/day and each person is on the regime for average 150 days, it amounts to average $450/yr/person. Assuming 20% of obese people (16M Americans) use prescription drugs, the total market size for weight loss drugs is $7.2B.

Due to competition from Belviq and other existing anti-obesity drugs (Xenical, alli, phentermine), our assumption for maximal market share of Qnexa (if approved by FDA) is 20% ($1.44B) over next few years. Thus, our estimate for Qnexa sales is $25M (2012), $100M (2013), $220M (2014), $440M (2015), $750M (2016), and $1.12B (2017). This represents a gradual increasing in market penetration rate of ~1.4%, 3.1%, 6.1%, 10.4%, and 15.6%, respectively from 2013 to 2017.

As for Stendra, due to keen competition, we assume the lowest estimate of maximal sales of $380M by 2017, equivalent of ~9% market share of $4.2B. Our estimate for Stendra sales is $20M (2012), $40M (2013), $70M (2014), $130M (2015), $230M (2016), and $380M (2017).

Combined both revenue numbers and assume a linear decline of revenue growth from high growth stage to a normalized 8% over a 4-year time after 2017, our estimated stock price for VVUS is $33.5 by the end of 2012.

Optimistic Scenario: Build upon the baseline scenario assumption, the company could potentially grab larger market share for both products. Assuming an extra 10% increase in sales, this will boost company valuation to an estimated stock price of $42.5.

Alternatively, the company may be acquired by other pharmaceutical company. This may represent the best scenario as the merger and acquisition will expedite the commercialization of its products and maximize shareholder value.

Pessimistic Scenario: This represents the worst outcome if FDA rejects Qnexa approval or issues another CRL. Under this scenario, the revenue is mainly from Stendra. An estimated stock price is $9.

If we assign probability for each scenario, 60% for Baseline, 30% for Optimistic, and 10% for Pessimistic, then the weighted stock price is ~$33-$34.

Disclosure

We have no position in the stocks mentioned, but may initiate a long position on VVUS over the next 72 hours. We are independent analysts. We receive no compensation to write about any specific stock mentioned in the article.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VVUS over the next 72 hours.