Eight Facts that Spell Trouble for Arena Pharmaceuticals’ Short Sellers

REZA is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors may be able to derive an interesting story from the following facts that would shed some insights into the price volatility of shares of Arena Pharmaceuticals (NASDAQ: ARNA).

1)    ARNA was added to the RegSHO list on November 15.

2)    Updated data from Nasdaq indicates an institutional ownership of 45.16% which is a significant jump from the pre-Adcomm level.

3)    Short interest in Arena is almost 51 million shares with the majority of the shares having been shorted under $4.70.

4)    ARNA has been wildly swinging, up and down, with daily fluctuations of up to around 10%.

5)    Arena is a few months away from launching Belviq (which I believe will be a global blockbuster).

6)    Arena’s partner, Eisai, is geared up to market Belviq through its established network which has previously marketed two blockbuster drugs.

7)    The prospects of receiving European and Swiss approvals within the next 6 months is very good.

8)    Arena is considering several partnerships across the globe, like the recent Korean one.

Facts 1 and 2 above are an explosive combination as they tell us there are two strong streams of demand for ARNA shares. This is assuming there are no such things as a short thesis. Shorts had a thesis back when the stock was under $2 and their thesis proved awfully flawed no matter how many journalists, analysts, and even paid doctors tried to help them.

Many retail investors did their due diligence, and were guided by scientists and medical doctors who were absolutely convinced the FDA would approve Belviq. Shorts’ thesis went up in smoke with an even stronger than expected FDA approval.

It's fair to assume that the institutional ownership jump to 45% came at a time when some investors (mostly retail) who'd been holding the stock for years took some profits by selling around 30 million shares after the FDA approval. Retail owners of the remaining 120 million shares who have held this long will likely not take profit at these levels knowing what lies ahead. Therefore, I believe institutions will have a harder time increasing their % holding to above 60% without an upward pressure on the stock.

After a strong approval with broad label parameters, the Arena short-sellers were left “holding the bag”, or rather, left in a hole, a very big black hole that could potentially cost them around a billion dollars in losses. That brings us to fact number 3.

Shorts decided it’s too painful to cover. The DEA review would give them some time to play their games. Shorts must be delighted that DEA has taken its sweet time – almost six months – to review the recommendation of FDA to schedule Belviq. This is an awfully long time and every day that goes by the healthcare system incurs hundreds of millions of dollars in obesity related costs (not to mention other conditions for which Belviq does wonders).

During this survival grace period, the shorts’ recovery strategy seems to have been to short more (thus, fact 3 above). Fact 4 seems to further confirm this: price rises due to institutional appetite (fact 2 above). More shares are shorted (fact 3) with hope of scooping up shares from retail investors who still own the majority stake in Arena. They also resort to naked shorting (fact 1) and are forced to deliver shares on settlement, combined with institutional buying, and price rallies over 10% in one day as we’ve seen, and the yoyo game continues.

The weakness in shares of Vivus (NASDAQ: VVUS) has negatively affected Arena’s shares simply because most Wall Street analysts still don’t understand the opportunities for Belviq. For example, Lee Kalowski of Credit Suisse had serious shortcomings (see appendix) in his analysts of Arena. Incidentally, in its latest filing CS indicated another increase in its ARNA position - this time through call options. Here's an interesting commentary on CS.

The same group of analysts who’ve been bullish on Vivus and bearish on Arena (and wrong in both cases) are bullish about Orexigen (NASDAQ: OREX). But we’ve seen OREX pull back from its recent rally after Credit Suisse and Bank of America helped them raise new funds. Bank of America has also been ludicrously wrong in its predictions of Arena.

Another side-noise in this yoyo game is the regular sell recommendations by Jim Cramer without any reason of substance. Curiously enough, several times when Cramer has made a sell recommendation, the stock has risen! His last sell recommendation corresponded with ARNA showing up on RegSHO and the next day rallying. In fact, one of the reasons I bought more shares under $3 was because TheStreet.com folks were saying sell. I could see through their flawed reasoning. Cramer’s latest reasoning for the sell signal was just “competition”. Given facts 1-3 above his disparaging comments are not surprising, nor do I take them seriously (except as a buy signal) because:

a)    the potential market is huge and there’s plenty of room for many competitors.

b)    in marketing science competition is viewed as positive as it confirms the market viability.

c)     Arena is miles ahead of competition – Orexigen’s Contrive is still not approved and Qsymia is not selling well (not surprising given its risks).

Facts 5 through 8 tell us this game can’t continue for much longer because Arena’s finances and prospects are continually improving. Belviq will be very successful commercially. Arena will probably be sold to a Big Pharma in excess of $6 billion ($25+ a share) sometime in 2013.

I just had an email about the short-sellers' games from a lawyer friend:

"The time and context of ARNA has changed from a developmental story to a growth story (remember this... it is an extremely effective investment strategy).  The shorts got trapped on that paradigm shift and it will eventually kill them. I will leave you with this:  the graveyards of history are full of dead short sellers. Be patient."

The views expressed above are NOT investment advice and are NOT medical advice. Please always do your own research. I am long ARNA and have no positions in the other stocks mentioned above. To find out more about my interests please visit www.rezamusic.com . If you like to join my private Arena-related mailing list send an email to (info -- at -- rezamusic -- dot -- com).

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