Name That Trade – $GILD: It’s Da Balm Yo

by Dan May 6, 2015 1:53 pm • Commentary

Biotech stocks have in focus of late, as they appear to be ground zero for concerns of an equity bubble as a result of strong performance, non-stop m&a activity, recent volatility and valuation concerns among small and mid caps and the prices being paid for acquisitions.  The XLV (the Healthcare Select Sector etf) is the best performing sector etf in the U.S. for the second year running, which is made up of potential acquirers, with its largest components sporting fairly reasonable valuations, especially relative to growth.

One such company is Gilead Sciences (GILD). Since breaking out to new all time highs in late July 2014 the stock has traded at an average of $102.50, almost exactly where it is today, with a high of $117 in early November, and a low of $86 in late December:

GILD since July 2014 from Bloomberg
GILD since July 2014 from Bloomberg

The chart above shows the stock’s magnetism to the $100 level (red line), but also shows the 50 day moving average (purple line) just this week trading below the stock’s 200 day moving average (yellow line), which some would call the “death cross”, implying waning momentum and lower prices.

But the stock is cheap, trading less than 10x expected earnings with a strong balance sheet (10% of $151 billion market cap in cash, no debt), and despite fears of pricing pressures from generics in the widely profitable Hepatitis C market, the company last week reported results that blew the doors off, with Hep C revenues coming in a $1 billion above consensus estimates of $3.5 billion, per Barron’s:

the drug maker said first-quarter earnings almost doubled as its key hepatitis C drugs, Sovaldi and Harvoni, generated about $4.45 billion in sales, beating estimates. Gilead earned $2.94 a share as revenue surged 52% to $7.59 billion. Analysts polled by Thomson Reuters expected per-share profit of $2.32 and revenue of $6.92 billion.

Gilead raised its 2015 forecast for product sales by $2 billion, predicting between $28 billion and $29 billion. It also announced that it would start paying a quarterly dividend of 43 cents a share in June.

Trust me, I am not the go to guy on Biotech, but it seems they are poised to make another acquisition, and in this market, biotech stocks, both those acquired and acquirers are being rewarded.

The stock’s waning momentum could be a problem, especially as it seems volatility has picked up a bit with the XBI (the SPDR S&P Biotech etf) which has far less concentration among the larger names and is down almost 13% from its 52 week highs made in March.  If I were to get involved at these levels with a large cap stock like GILD, that is crowded and slightly controversial, I would consider doing so with defined risk.

One trade I would consider in place of long stock in the near term is:

Hypothetical Trade: GILD ($102.35) Buy to open June 100/110/120 for 3.25

-Buy 1 June 100 call for $4.70

-Sell 2 June 110 calls at .85 each or 1.70 total

-Buy 1 June 120 call for .25

Break-Even on June Expiration:

Profits:between 103.25 and 116.75 up to 6.75 with max gain of 6.75 at 110

Losses: up to 3.25 between 100 and 103.25 & between 116.75 and 120, with max loss of 3.25 below 100 and above 120

Rationale:  Short dated options prices have gotten back to 52 week lows as the stock has apparently found a home in and around $100:

GILD 1yr chart of 30 day at the money IV from Bloomberg
GILD 1yr chart of 30 day at the money IV from Bloomberg

Short dated options are cheap, and the in the money call fly helps to further reduce decay as break-even is less than $1 above current levels. This is essentially defining risk on a long stock position with a move back to 110 offering a similar risk reward as stock but with only 3.25 of risk.

We’ll circle back on the stock to see how it acts with this “death cross” and perhaps pull the trigger on this trade or something similar if it looks like it will bounce near these levels.