It was just a week when I wrote that Teva Pharmaceutical (NYSE:TEVA) seemed undervalued on the basis of its probable free cash flow (FCF) trajectory, but that a host of uncertainties (including its strategic direction/priorities) made it a tough stock to love. Wednesday's announcement of a U.S. marketing partnership with Alexza (Nasdaq:ALXA) for the controversial inhaled acute agitation therapy Adusave is a good case-in-point. While Teva may see a diamond in the rough here, a lot of investors and analysts are going to look at this as a sign that the company is flailing around in search of a new direction and embracing longshots as a strategy.

The Deal
Both companies jointly announced Wednesday morning that they'd reached agreement on a partnership covering the U.S. marketing and further development of Adasuve. Adasuve is an interesting drug – essentially an inhaled version of an old drug (loxapine), but one that has been shown to be quite effective in treating acute agitation in patients with schizophrenia or bipolar disorder.

Teva will make an upfront payment of $40 million, plus future milestones tied to post-approval studies and sales breakpoints that could be worth $195 million in total. In addition, Alexza will have access to up to $25 million in convertible debt funding.

The two companies also agreed upon a tiered royalty structure. Details haven't been given, but I'd assume based upon the upfront and similar deals that the royalties would likely start somewhere in the high single digits or low teens and stretch perhaps into the 20%s (as a percentage of sales). Alexza will also maintain the manufacturing rights for Adasuve, and will sell it to Teva.

With the drug having been approved back in December of 2012, Teva should be on the ground relatively quickly with this drug.

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If It's Approved And Effective, Why The Controversy?
This is a good deal for Alexza – the company ended the last quarter with very little cash and no credible hope of marketing Adasuve itself, at least not unless they went with a third-party sales organization and surrendered a lot of the potential profits.

It's not so clear that it's a great deal for Teva, though.

While the drug is effective, safety and market potential are both significant negative issues. The FDA had some fairly serious concerns about the safety of this inhaled drug (including reduced lung function in the immediate aftermath), and insisted upon a rather harsh REMS (Risk Evaluation and Mitigation Strategy – basically a set of guidelines governing the marketing and administration of drugs).

To use this drug, the facility will have to have immediate access to airway equipment (ventilators, etc.), short-acting bronchodialtors, post-administration monitoring, and staff training. While that doesn't sound like a particularly severe set of rules, in the real-world of how many mental health facilities operate, that could be difficult to put into place and many administrators may shy away from the drug, fearing patient/family lawsuits if something were to go wrong. As such, it will likely limit use to healthcare settings like hospitals.

Market potential is also an issue. Most patients with acute agitation currently get quick-dissolving tablets. They work for many, but not all, patients and they're both cheap and easy to administer. If oral tablets fail, there are injectable alternatives – a wide array of generic drugs as well as a few branded drugs from the likes of Bristol-Myers (NYSE:BMY) and Lilly (NYSE:LLY). While injectable drugs have serious drawbacks (including potential injury to patient and/or the healthcare worker, as well as heavy sedation), they are part of the established treatment regimen and inertia can be a more powerful factor in medicine than investors realize.

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At a minimum, Teva is going to have to roll up its sleeves and do some work to get this drug into wide use. Granted, Teva already makes generic drugs for the psychiatric/mental health market, and the company has made it known that management considers central nervous system (CNS) drugs to be a cornerstone to their strategy going forward. Even so, this could prove to be a challenging missionary sale for Teva's reps. If nothing else, consider the fact that Valeant (NYSE:VRX) is not shy about picking up controversial drugs (including those that are often thought to have low sales potential), but chose to return this drug to Alexza after buying Biovail.

On Balance, A Worthwhile Shot On Goal?
Acute agitation is not an uncommon issue. Of the 8.5 million or so patients with schizophrenia and/or bipolar disorder, it is estimated that more than one-third will experience an incidence of acute agitation (in actual practice, many patients go years between episodes, but others will suffer from them 12 or more times per year). That's over 3 million potential administrations of Adasuve (including close to 2 million annual ER visits), and over $200 million in potential sales per year in the U.S. (on the basis of management's guidance of $75 per treatment).

The real question, then, is market penetration. I don't see Adasuve replacing oral treatments, particularly as front-line treatments, but I could see rigorous marketing from Teva leading to $40 million to $70 million a year in sales. That, then, is part of the problem – Teva is paying quite a lot upfront for a drug that may struggle to generate substantial revenue.

At a minimum, it will mean a much longer payback period than is typically seen for such partnerships. By the same token, it's possible that the available data on acute agitation underestimates the problem and that actual real-world experience could see much higher usage (and higher revenue). In any case, it's a bold gamble for a company where many investors have already grown tired of what they perceive to be a lack of focus and discipline.

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The Bottom Line
For Alexza investors, this is pretty good news. It's not the buyout that some no doubt wanted, but it provides a badly-needed infusion of non-dilutive capital and puts Adasuve in the hands of a credible marketing partner.
For Teva, though, time will tell. I find it curious that the company felt it had to pay so much upfront, and I think this will be a drug that requires considerable effort to develop into a success. That said, it does confirm Teva's commitment to the CNS space and Teva just may be getting a diamond in the rough that pays off down the road.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.