Jeff here. In today’s Digest, we wanted to do something a bit different.
There’s a market strategy few investors know about. It utilizes proven risk-mitigating tactics that can provide a tremendous boost to your portfolio’s returns, while also lowering overall portfolio risk.
The strategy involves making calculated “asymmetrical” bets with a small portion of your money using options. In short, an asymmetric “bet” is when the potential upside of a position is much greater than its potential downside. Think “risking $1,000 to make $5,000” rather than “risking $1,000 to make $1,000.”
So, where can you find these asymmetric bets? In the options market. And for our money, few investors are better at finding these trades than our own Eric Fry, editor of The Speculator.
To illustrate, in this Digest, we’re bringing you a recent trade which Eric just closed out a portion of for big gains. Part of the trade, however, is still actionable. So, today, you’re getting a peek behind the curtains at Eric’s analysis, as well as an actionable trade.
Here’s the context so you can follow along …
This past summer, Eric identified a handful of challenges facing the massive, generic drug company, Teva. Given these headwinds, he recommended subscribers buy put options on the company.
If you’re new to options and “puts,” an easy way to think of this for the moment is “If you buy a put option on a company’s stock, that put option will become more valuable if the company’s stock falls in value.” In essence, when you own a put option, you’re betting that a stock price is going to decline.
It turns out that, as Eric suspected, Teva reported disappointing earnings this past Wednesday. The stock sold off nearly 8% on the day. Eric recommended that his subscribers sell a quarter of their put option, locking in 75% gains on that portion.
With that context behind us, here’s Eric’s original trade recommendation. Enjoy.
Bad Prescription
Teva Pharmaceutical Industries (NYSE: TEVA) is the world’s largest generic drug company. It supplies one in six of the generic drugs used by Americans. And yet, Teva can’t seem to find the right prescription to cure its sickly financial condition.
In no particular order, the company is facing the following challenges:
• Falling generic drug prices • Looming loss of major revenue stream as the company’s multiple sclerosis drug faces new generic competition • Amazon’s two-part foray into the pharmaceutical benefits business • A massive debt load
Starting with the last item on the list above, Teva’s debt load is nothing short of titanic. In absolute terms, the company’s net debt totals $29 billion — up from just $3 billion three years ago.
For added perspective, this mountain of debt totals more than nine times the company’s annual gross earnings (EBITDA). That’s a very big number. In fact, it is so big, it could be life-threatening.
Teva amassed most of its debt load when it launched an ill-timed $40.5 billion buyout of Allergan PLC’s generics business in August 2016. Generic drug prices have been falling ever since, making the repayment of this debt burden even more burdensome.
chart1
Teva’s U.S. generics revenue fell 23% in the first quarter of this year, compared to the prior year’s first quarter. And the road ahead won’t be getting any easier.
Competition in the generic drug industry has intensified up and down the distribution chain. Major pharmacy chains, drug wholesalers, pharmacy benefit managers and insurance companies are merging or forming alliances. These liaisons create colossal buying groups that can apply continuous downward pressure on generic drug prices.
Walgreens, for example, is bulking up its healthcare services platform by partnering with insurers Humana and UnitedHealth Group and lab testing provider LabCorp. Meanwhile, Cigna announced a deal to acquire Express Scripts, the leading pharmacy benefits manager.
CVS Health already owns Caremark PBM, a competitor of Express Scripts. And now CVS is upping the ante by acquiring health insurer Aetna. This deal would integrate CVS’ retail pharmacies and Caremark’s pharmacy benefits management systems with Aetna’s insurance plans.
And then, just when you may have thought the competitive environment couldn’t get any tougher, a company named Amazon tossed its hat into the pharmaceutical ring.
First, Amazon teamed up with Berkshire Hathaway and JP Morgan to form an independent company to provide comprehensive healthcare and pharmacy benefits to their 1.2 million U.S. employees.
This heavyweight alliance amounts to a beta test of next-generation group insurance. Amazon and its partners say they will focus initially on “technology solutions” that will provide U.S. employees and their families with “simplified, high-quality and transparent healthcare at a reasonable cost.”
Although details about this new venture remain fairly sparse, it aims to squeeze costs along the entire healthcare supply chain, including prescription drugs.
Amazon followed up this initiative a few months later by buying PillPack, an online pharmacy that is licensed to ship prescriptions in 49 states. “PillPack’s visionary team has a combination of deep pharmacy experience and a focus on technology,” beams Jeff Wilke, Amazon CEO Worldwide Consumer.
Now that Amazon has decided to make a push into the pharmaceutical business, we should expect the company to do what it usually does: lower prices, improve the customer experience, grab market share and undermine the profitability of established competitors.
Amazon’s foray into the pharmaceutical business may not make any immediate visible impact. But this “category killer” company is likely to make a long-term impact.
“Alexa, please refill my generic drug prescriptions,” is a phrase that could become very costly to a company like Teva down the road.
But Teva also faces a serious immediate challenge. Its blockbuster multiple sclerosis drug Copaxone has been under assault since last fall when rival drugmaker Mylan NV (Nasdaq: MYL) began selling a cheaper generic version of it.
Mylan has already captured about 15% of the market. This new competition is forcing Teva to cut prices on Copaxone in order to maintain market share … or rather, to lose market share most slowly.
Copaxone revenues are plummeting already. In the first quarter of this year, U.S. Copaxone sales fell to $476 million from nearly $800 million in the prior year quarter.
Not surprisingly, Teva’s sales and earnings are moving in the wrong direction. And the company’s big debt load still sits there every day, just like an unemployed roommate on the living room couch.
To address its life-threatening challenges, Teva announced late last year that it would slash more than 25% of its workforce, suspend its dividend, close factories and mothball research facilities worldwide.
Even though this fight for survival faces daunting obstacles, one high-profile investor seems to believe Teva will achieve a successful turnaround. Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A) scooped up about $350 million worth of Teva stock earlier this year.
Presumably, therefore, Buffett considers Teva to be a good investment, or at least a worthwhile speculation. But this purchase might also have something to do with Buffett’s recently announced entry into the U.S. healthcare market.
Although Berkshire’s collaboration with Amazon (Nasdaq: AMZN) and JPMorgan (NYSE: JPM) is still in its early stages, Buffett may be taking a stake in one of the world’s largest generic drug producers as a way to gain preferential access to Teva’s expertise and generic pipeline.
Whatever the rationale for Berkshire’s purchase of Teva stock, I doubt this investment will be a long-term winner.
Simply stated, Teva is a struggling, debt-laden company in a hyper-competitive industry.
Action to Take:
Speculator’s Portfolio: Buy the Teva Pharmaceutical Industries (NYSE: TEVA) January 2020 $22.50 put options below $4.25. The current offered price is $3.60. Use a “limit order.” Do not use a “market order.”
Editor’s Note:
Jeff again. As mentioned earlier, Eric just recommended that his subscribers close out a 1/4th position of this trade for 75% gains. But the remaining 3/4th position is still actionable at the time of this writing. As to initiating a new put option trade today, Eric told me:
“Yes, I still consider the trade actionable. I think Teva is facing serious headwinds and is going to continue overpromising and under-delivering … just like it’s been doing for several months. But remember, put options are risky, so don’t bet too big.” If you’re comfortable with options, Eric suggests not paying more than $5.50 for any new trades today. At the time of this writing, the specific put is trading for a few pennies below this price.
Please note — if you’re new to options, we strongly suggest you do NOT place any new Teva trade. We do, however, recommend that you begin learning more about options — they can be a powerful addition to any investor’s toolkit. Whether or not you decide they’re right for you, it’s still valuable information to have.
We’ll be featuring more from Eric over the coming weeks. But we hope you enjoyed his analysis and his live trade.
