In November, I upgraded Pulmonx Corp. (NASDAQ:LUNG) to a speculative buy rating, after a disastrous Q3/2022 earnings report caused LUNG stock price to plummet. I could envision a larger medical devices company take a run at Pulmonx, given it was only trading at $50 million enterprise value (“EV”) at the time.

Since my buy call, LUNG’s share price has more than doubled (Figure 1).

How do I view the company’s prospects now that its enterprise value has gone up 6x to ~$300 million?

I think LUNG stock is currently overvalued, given little improvement in the underlying fundamentals and muted management guidance for 2023. I recommend investors take their winnings and move on.

Brief Company Overview

For those new to the Pulmonx story, the company is a commercial stage medical devices company producing and selling its Zephyr Endobronchial Valve and associated management software. The Zephyr Valve is a treatment for patients with severe emphysema, a form of chronic obstructive pulmonary disease (“COPD”) (Figure 2).

Pulmonx actually received FDA approval for its valves technology in 2018 and began commercial production and sales shortly afterwards to target the $12 billion market. However, Pulmonx’s initial ramp-up coincided with the COVID-19 pandemic where mobility restrictions slowed the adoption of its technology.

As COVID restrictions were lifted in the past year, Pulmonx’s adoption remained slow, as the company blamed hospital staff shortages. More importantly, I believe Pulmonx faced serious competition from Olympus Medical’s Spiration Valve, a direct competitor to Pulmonx’s Zephyr Valve.

Both Zephyr and Spiration valves are FDA approved and eligible for insurance reimbursement. However, Olympus Medical is a trusted medical devices brand name with over 100 years of history while Pulmonx is a new entrant with limited history. Therefore, I would not be surprised if doctors preferred to use Olympus’ Spiration Valve instead of Pulmonx’s Zephyr Valve.

Latest Quarter More Of The Same Slow Growth And High Costs

A few weeks ago, Pulmonx reported its fiscal fourth quarter and full year 2022 results. Revenue was $15.4 million in Q4/2022, a gain of 12.4% YoY and $53.7 million for the full year, an increase of 11.0% over 2021 (Figure 3).

However, as I have been stressing since my initiation report, Pulmonx’s cost structure was far too high, leading to a Q4/2022 operating loss of $14.6 million, an increase from Q4/2021’s operating loss of $12.4 million.

On a positive note, Pulmonx’s full year revenue of $53.7 million was modestly ahead of the company’s guidance from November of $51.5 to $52.5 million. However, before investors rejoice, they should remember that the November guidance was lowered from $55 to $60 million previously, so Pulmonx only managed to beat its lowered guidance.

2023 Outlook Remains Muted

For 2023, Pulmonx also released initial guidance of $63 to $65 million in revenues (17% to 21% YoY increase) and 73-74% gross margin. LUNG also expects total operating expenses of $112 to $114 million.

This guidance implies an operating loss of $66 million ($64 million in revenues at 73.5% gross margin = $47 million in gross profit, less $113 million in operating expenses = $66 million operating loss) for 2023, which will be once again greater than 2022’s $59 million operating loss and 2021’s $47 million operating loss.

Valuation Back To Being Expensive

Having doubled in share price since my buy recommendation, Pulmonx currently has a $421 million market cap, $24 million in debt, and $141 million in cash for an enterprise value of $298 million (Figure 4). This is roughly 4.7x EV/Rev, which is creeping back to ‘expensive’ territory compared to 1x EV/Rev in November.

With no signs of operating leverage (management is guiding to deepening operating losses), it is hard for analysts like myself recommend buying the shares.

What Is Fair Value?

In my prior article, I attempted to derive a theoretical ‘take out’ value for LUNG shares. Using Medtronic’s SG&A as a % of revenue of 35-40% as a guide for ‘best in class’ performance, we can see from figure 3 above that LUNG’s cost structure is very bloated, with SG&A as % of revenue of 155%.

I believe if a medical conglomerate were to acquire LUNG and place the Zephyr valve onto its sales platform, the company should be able to bring SG&A costs down to the 35-40% level.

Using management’s guidance for 2023 revenues and gross margin, and maintaining the spending in R&D expenses, I believe the underlying business can generate $5 – 10 million in operating profit (Figure 5).

Depending on the operating profit multiple an acquiror is willing to pay, I estimate we could see a takeout valuation of $80 to $200 million in enterprise value (at 15 to 20x EV/Operating Profit). This could translate to a share price of $5.30 to $8.40 as ‘fair value’ in a takeout scenario.

Conclusion

Back in November, I saw the potential ‘takeout’ value in LUNG’s shares following a disastrous Q3/2022 earnings report. Since my recommendation, LUNG shares have more than doubled. I think at current valuations, LUNG shares are overvalued. The fundamentals of the business have not improved, and management’s guidance for 2023 remains muted. I recommend investors take their winnings and move to the sidelines.