We have added Arena Pharmaceuticals to our evaluated coverage list and created a 5 and 10-year pipeline valuation model.

Arena currently has two fully owned drugs in clinical development, APD356 for obesity and APD125 for insomnia. In addition, Arena has two drugs in collaborative development with Merck and Johnson & Johnson (J&J). Merck began phase I testing in the third quarter of 2005 with a GPCR niacin agonist for the treatment of atherosclerosis and related disorders. J&J began a phase I clinical trial in February 2006 for APD668 in type II diabetes.

ADP356 for obesity is Arena’s most advanced program, having reported positive phase II data in December of 2005. Arena plans on initiating a phase III trial for ADP356 in the second half of 2006 and we are currently projecting U.S. approval in the first half of 2010. Our current peak U.S. revenue for ADP356 is $655.2 million in 2016. Please see our Obesity Indication Report for more information on ADP356.

APD125 for insomnia is a novel and selective 5-HT2A receptor inverse agonist that recently began a phase II clinical trial. The trial will enroll about 125 patients with primary chronic insomnia and evaluate two active doses against placebo in a cross-over design. The company expects top-line data from the trial to be released in the third quarter of 2006. Arena hopes ADP125 will offer an advantage over the current GABA-A receptor insomnia treatments, as it has a different mechanism of action which may lead a better side-effect profile. The company also hopes the drug will not be classified as a controlled substance by the DEA, as the GABA-A receptors are. We are currently projecting U.S. approval in 2011 and peak U.S. revenue of $775.1 million in 2016. While the insomnia market will have many players by 2016, Arena’s novel approach may give it a marketing advantage and future positive data may lead us to raise our market share forecasts.

We feel Arena will need to partner both its obesity and insomnia drug with a pharmaceutical company in order to maximize their potential. We have currently modeled for a 50/50 revenue split in the U.S. and 20% royalty to Arena outside the U.S. for both drugs. We have modeled a partnership agreement for ADP356 to be reached in 2008 and Arena to receive $150 million in upfront and regulatory milestone payments. We have not yet modeled for milestone payments related to ADP125 and will wait until the drug shows further progress in phase II testing. Arena’s collaborative revenue is expected to reach $34-38 million in 2006 and we have modeled for 10% growth in collaborative revenue until 2007 when both Merck and J&J can decide whether to extend their agreements. After this time we have modeled for a steady $30 million inflow (growing 2.5% annually) of collaborative revenue.

Based on this model, we value Arena’s 10-year pipeline at $7.41/share. Our model projects that Arena will need to raise a significant amount of additional capital before having a drug on the market. While we currently find Arena to be Overvalued, both of Arena’s wholly owned drugs are being studied in potentially large markets and positive data could fuel share appreciation. Arena’s platform also addresses large markets, so the company may be an attractive takeover candidate, but at this point its other programs are too early in development for us to assign value to them.

Because both of Arena’s modeled drugs are in phase II, the potential revenue is still heavily adjusted downward. If and when Arena moves ADP356 into phase III testing (expected 2H 2006), we would value its 10-year pipeline at just over $14.00/share, still leaving it Overvalued at its current price. Despite the potential for positive news flow, we feel Arena is priced to perfection and any negative news could significantly reduce its share price.