This Trade Can Work When You Know News Is On the Way
Among the most active stocks on Friday morning was Gilead Sciences, Inc. (Nasdaq: GILD). The stock was most likely on the list because of news out of Europe. The company announced that the Committee for Medicinal Products for Human Use (CHMP), the scientific committee of the European Medicines Agency, has adopted a positive opinion related to the company’s drugs.
The CHMP approved the company’s Marketing Authorization Application (MAA) for Vosevi, an investigational, once-daily, single tablet combination of drugs known as SOF/VEL/VOX for the treatment of chronic hepatitis C virus (HCV)-infected patients. The approval is wide ranging.
Each of the individual drugs in the combination had been previously approved. Gilead has also submitted a regulatory application for SOF/VEL/VOX in the United States. Gilead filed the New Drug Application for SOF/VEL/VOX on December 8, 2016, and the Food and Drug Administration (FDA) has set a target action date under the Prescription Drug User Fee Act of August 8, 2017.
It seems reasonable for investors to believe the drug combination will be approved in the US as well, after the European regulator’s approval. Gilead already controls a commanding market share for HCV treatment.
Gilead is a research-based biopharmaceutical company that discovers, develops and commercializes innovative medicines in areas of unmet medical need. Gilead’s therapeutic areas of focus include HIV/AIDS, liver diseases, hematology and oncology, inflammatory and respiratory diseases and cardiovascular conditions.
The company’s portfolio consists of 24 marketed products including a number of category firsts, including complete treatment regimens for HIV and chronic hepatitis C infection available in once daily single pills. Gilead’s portfolio includes Harvoni for chronic hepatitis C, which is a complete antiviral treatment regimen in a single tablet that provides high cure rates and a shortened course of therapy for many patients.
The company reported revenue of more than $30 billion last year and profits of more than $13 billion. High sales and profits are largely due to pricing decisions. Harvoni costs $95,500 for 12 weeks, and an older HCV treatment the company offers, Sovaldi, costs $84,000. That’s $1,000 per pill.
The company’s success and the market reaction to its pricing decisions can be seen in the long term chart of the stock shown below. This is a monthly chart showing the nearly 700% gain over five years and subsequent 46% decline over the past two years.
The $1,000 Pill Backlash
Gilead and other drug companies have endured ample criticism of their pricing policies. Companies, including Gilead, often make a vigorous defense of their decisions.
One argument is that the list price of the pill is not what most patients pay. Discounts are negotiated with insurers and government insurance programs. These negotiations often result in prices that are less than half of the list price.
Another argument is that the pills are inexpensive compared to the alternatives. For HCV, patients have long suffered steady declines in their health. Many would eventually need a liver transplant which could cost $500,000 or more. A treatment costing $95,000 that prevents this is cheaper and immeasurably better for the patient.
The arguments may be sound but public opinion is not on the side of the drug companies. Cost controls, whether voluntary or legislated, seem inevitable at times and companies have responded by holding down price increases.
Gilead, and other drug companies, also argue that they have just limited times to make back their investments in research. The company spent more than $4.2 billion in research and development in 2016 and has spent almost $15 billion in R&D over the past five years. Not all research is successful and pricing decisions must reflect that.
Gilead can also point out that success of HCV drugs reduces the market size of the drugs. Patients are being cured. This improves their quality of life but reduces future drug sales. This is a tradeoff society gladly makes, but pricing decisions must consider this reality.
While there are valid reasons drugs cost so much, there are valid reasons for a public uproar over the pricing. This uproar, and the downturn in sales resulting from curing so many patients, has led to a decline in Gilead’s stock price.
Support and Fair Value
After selling off, the stock seemed to find support in the mid $60s. Support is a level where value hunters seem to find the stock attractive. For GILD, value hunters seemed to be accumulating the stock near $65.
While there are technical reasons to believe that at least the worst part of the decline in the stock price is in the past, the fundamentals are not especially bullish. The trend in revenue is down as the next chart shows. This graph was included in a presentation Gilead’s management made to analysts.
The presentation was bullish, but seemed more in line with managing expectations than arguing that the stock price could move sharply higher. Part of managing expectations included telling analysts to expect revenue of $22.5 billion to $24.5 billion for the full year.
Using the midpoint of $23.5 billion, management is warning investors that revenue could decline by nearly 28% in 2017 compared to 2016. Earnings are also expected to decline. Analyst expect earnings per share (EPS) of $8.35 this year, down from $11.57 in 2016.
The decline is expected to continue for at least the next two years. Analysts expect EPS of $7.42 in 2018 and $7.35 in 2019. This would mark a 40% decline from peak earnings of 2015. Given the outlook for earnings, the stock could be considered fairly valued in the mid $70s, about ten times expected earnings.
A Trading Strategy for the Next Month
Traders seem to have become optimistic about Gilead. Their optimism comes at an important time. The company is expected to report in late July. It is likely the stock will make a big move on that announcement, either up or down.
When earnings are announced traders will have important new information. Their recent bullishness may be warranted and they may have, in fact, underestimated the company’s prospects. But, just a quarter ago, management was warning analysts not to expect too much from them.
If the earnings announcement is good, the stock price could soar. If the news is bad, the stock is likely to sell off. To benefit from the likelihood of a big move, traders can use a long straddle. This involves buying a call and a put to benefit from a large move. This strategy does not require a trader to make a prediction on the likely direction of the move.
For GILD, we know earnings will be out by the end of July. Options expiring on July 28 are available. The stock closed at $70.54 on Friday. A July 28 $70 call can be bought for $2.25. A July 28 $70 put is trading at $1.67.
Buying both options will cost $3.92. This trade is profitable if GILD falls below $66.08 or rises above $73.92 within the next month. This is very likely given the upcoming earnings report. The stock has made a price move of at least 10% within a week of its earnings report in three of the past four quarters.
The long straddle is a strategy designed to benefit from a large move. This strategy can deliver a profit no matter which direction the move is. This eliminates forecasting the direction of the trend as a requirement for success.
This strategy can be especially useful when an earnings report is expected. The earnings announcement often creates volatility but the direction of the volatility is unpredictable. But there are risks. This trade can lose the entire amount paid for the options purchase if the stock fails to make a large move.