Alexza Remains Meaningfully Undervalued

In a recent Seeking Alpha article, PropThink argues that Alexza (ALXA) is overvalued. The case is made irrelevant of whether its lead product ADASUVE, for the treatment for agitation in patients with schizophrenia or bipolar mania, is approved by European and U.S. regulators in days to come. However, the valuation is flawed in the following respects:

1) High Weighted Average Cost of Capital (OTC:WACC). The use of an 18% WACC, the very high end of reasonable discount rates, is based on an inappropriate interpretation of the Company's 10-Q.

2) Cost burdens without matching future cash flows. By including costs related to ongoing investments but not risk adjusted future cash flows, the implication is that management will destroy future value. There are no arguments in support of such an assumption explicitly in the article.

3) Conservative revenue projections. While a reasonable case is made for ADASUVE's revenue projections, we find as an example, that Roth Capital's estimates in its December 4, 2012 initiation of coverage report are higher.

Unless otherwise stated I employ PropThink's projections throughout this article. Simply by correcting specific methodological issues with the valuation, I derive a value of \$7.50 to \$8.50 per ALXA share post-approval. Furthermore, without making heroic assumptions, I can support valuations of \$12.00 to \$16.00 per share.

High WACC

If one employs the Capital Asset Pricing Model (CAPM) to estimate the Company's WACC, a range of 12% to 15% is appropriate. Specifically, according to the CAPM model the Required Rate of Return of an asset (RR) is estimated by employing the following equation:

RR = Rf + Î² X (Rm-Rf)

Where:

Rf = Risk Free Rate

Î² = Volatility of an asset

Using the U.S. 30-year treasury bond for Rf at 2.8%; Alexza's Î² of 1.49 and a conservative Rm-Rf of 6% we derive:

RR = 2.8% + 1.49 X (6%) = 11.74%

Furthermore, if one were to value Alexza as an acquisition target (which I leave as an exercise for the imaginative reader), a pharma acquirer would likely employ a WACC of 8%. The table below shows the sensitivity of the valuation to WACC.

 WACC Market cap (\$mln) Value per share 12% 85.7 5.33 13% 80.1 5.03 14% 74.9 4.76 15% 70.1 4.51 16% 65.6 4.27 17% 61.4 4.05 18% 57.6 3.85

Cost burdens

It is inappropriate to load the Alexza valuation with R&D and G&A expenses that more properly relate to potential future cash flows from other projects. One should assume that spending on future projects generates the Company's required return and as such it should be added back to the valuation. The table below shows the net present value (NYSE:NPV) of future R&D expenses. When I add back the NPV of R&D to the base valuation above, I generate a value of \$7.47 to \$8.57 per share using a 12% to 15% WACC.

 WACC NPV of R&D (\$mln) R&D value per share 12% \$62.0 \$3.24 13% \$60.0 \$3.14 14% \$58.2 \$3.05 15% \$56.5 \$2.96 16% \$54.8 \$2.87 17% \$53.3 \$2.79 18% \$51.8 \$2.71

Further, there is a good argument that G&A expense also pertains to future projects. Pozen Inc.'s (NASDAQ:POZN) sale of Treximet U.S. royalties to Canada Pension Plan Investment Board (CPPIB) in November 2011illustrates the point. Pozen was a \$75mln market cap biotech that generated Treximet royalties of roughly \$16mln in 2011. With six and half years of patent life and a legal overhang, Pozen received \$75mln plus a tail royalty of 20% starting in 2018. The deal was seen as unlocking value otherwise ignored by investors. I would make the following observations:

1. IRR. The implied rate of return to CPPIB was 8.6% assuming flat revenue, and 12.3% assuming 5% revenue growth. Actual Treximet sales growth was flat in 2011. This supports my argument above that an 18% WACC on pharmaceutical royalty-based sales models is far too high.

2. Tax loss benefit. Pozen treated the royalty as revenue and employed its tax losses to offset the income. In other words, Pozen was able to accelerate the benefit of its tax losses. If Alexza were able to use its \$324mln of losses tomorrow, those alone would be worth \$130mln (or \$7.62 per share) assuming a tax rate of 40%.

3. Limited future obligations. Subsequent to the royalty sale, Pozen's Treximet related expenses were limited to developing the product in Europe. If investors did not believe that Pozen's subsequent activities would generate adequate returns, they could ask for the cash and shut down the company.

Discounting milestones and net manufacturing revenues with a WACC of 12% (similar to the Pozen deal), I obtain a value of \$207mln or \$11.67 per share. I would note that a royalty sale would easily be offset by Alexza's existing losses, so no taxes would be payable. Further, if I use royalty projections from the recent Roth initiation and assume that revenues remain flat from 2016 to 2022 (not included in Roth's model), I obtain \$15.94 per share.

Conservative revenue projections

Finally, using Roth Capital's recent initiation of coverage report we find ADASUVE sales projections that are somewhat more optimistic, as illustrated in the table below:

 PropThink Roth Capital Peak US sales (\$mln) 161 207 Peak OUS sales (\$mln) 144 104 Peak US year 2022 2016 Peak OUS year 2022 2016

Valuing Roth's free cash flows without the R&D burden (attributable to future projects) generates a value of \$10.14 per share with a 12% WACC (which compares to the \$8.57 valuation using PropThink's forecast).

Putting it all together

Assuming ADASUVE is approved in Europe and the U.S., based on a more appropriate valuation of PropThink's own forecast I obtain a valuation of \$8.57 per share. Alternatively, substituting Roth Capital's forecasts, I obtain a valuation of \$10.14. Finally, if Alexza were able to sell its ADASUVE royalties, those would be worth \$11.67 and \$15.94 based on PropThink and Roth forecasts respectively.

Disclosure: I am long ALXA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.