The LEAPS Option Trader
105 W. Monument Street
Baltimore, MD 21201
Wednesday, October 6, 2004
Email – #205
** A Forest Full of Money
There is no doubt that the pharmaceutical industry is experiencing pain. In fact, some of the stalwarts are facing patent expiration, litigation over failed drugs, and a slowing pipeline.
And then you have the other guys. The other guys are the new pioneers, researching and producing new drugs, important drugs like those for Alzheimer’s, antidepressants and the like.
As the population ages, it needs more healthcare – not a new observation, but still very potent. There are two classes of companies in the marketplace today. You have the stalwarts like Merck and Pfizer, which are no longer growing at double-digit rates, and experiencing huge competition from generics because of drugs coming off patent. And then you have the newer guys still firing up the afterburners and still growing both top and bottom line by double digits.
One such company is Forest Labs (NYSE: FRX). Forest is a growth story that began a couple of years back when they hit the market with several blockbuster drugs after years of research and development.
The company’s biggest sellers are drugs that treat depression, anxiety, hypertension, alcoholism and the first approved therapy for moderate to severe Alzheimer’s disease.
A few months ago, the company announced that one of its experimental drugs – one to CURE Alzheimer’s, not just treat it – did not show the efficacy it was looking for. That, combined with a rough market for pharmaceuticals, sent the shares towards new low territory, in the low $40s.
What did not fall, however, were the profit prospects from the company.
The other day, it announced that upcoming profits would not only grow in double-digit territory, they would exceed estimates by 20%. The shares moved higher, but have since retreated a bit, providing us with a great entry point. At current levels, the shares trade at about $46, down from recent highs in the mid-$70s. At $46, the company is trading at a P/E of less than 17 times next year’s earnings – a level that is less than its growth rate. This leaves a lot of room for an upside move back into the $50s.
Unfortunately, Forest LEAPS are very expensive, reflecting the potential for this company to explode higher. So we will have to use a bull spread in order to maintain an adequate risk profile. A bull spread, while still very profitable, limits your upside and also reduces your downside by reducing the amount you have at risk.
Here is what you need to do:
Buy the Forest Labs January 2006 $50 call options (WRT AJ), currently trading at $5.60, and sell the Forest Labs January 2006 $55 call options (WRT AK), currently bidding $3.60. The spread will cost you $2 (5.60 for the buy and $3.60 form the sell).
Our upside will be limited to $5 profit on $2 invested, or 150% if Forest moves back into the mid-$50s in the next 15 months. We will close the position early if we get a nice pop before then. DO NOT pay more than $2.10 for this spread – meaning your net outlay after buying the 50s and selling the 55s should be no more than $2.10.
Regards,
Karim Rahemtulla
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Bio:
Karim Rahemtulla is the former Investment Director of The Oxford Club. The editor of The Smart Options E-Report, The Income Trader – A Covered Call Strategy and The LEAPS Option Trader, Karim is also a regular contributor to The Oxford Club Communiqué. His highly successful trading systems use covered calls and LEAPS to boost returns on blue chip stocks, and during the bear markets of 2000 and 2001, his picks outperformed the major market averages. Educated in England, Canada and the U.S. and fluent in several languages, Karim travels the world to find the best investment opportunities for our members.
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