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Summary

  • Shares are trading near 52-week highs, but the recent insider selling prompts downside concerns that must be taken into consideration.
  • While there is no margin of safety at current levels, a conservative options strategy limits risk, while enhancing the current yield of 2.80%.
  • The company has a five-year dividend growth rate of 16.4%, and seven successive years of dividend growth.

Baxter International (NYSE:BAX) develops, manufactures, and markets products for people suffering from a wide spectrum of chronic and acute medical conditions, including hemophilia, immune disorders, infectious diseases, and kidney diseases.

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Fundamental outlook

The healthcare equipment sub-industry tends to be relatively stable, with limited downside susceptibility to recessions. While Baxter's growth has been robust over the last 10 years, it has temporarily faltered, due in part to suboptimal demand for both elective and non-elective medical procedures (eg., orthopedics, interventional cardiology, and cardiac rhythm management). Further, the new medical device tax imposed with the healthcare reform law has also had a negative impact on Baxter. As a result, we believe the company has implemented a cost reduction initiative by aligning its cost structure to offset the impact of the tax increase.

Nevertheless, Baxter's outlook is encouraging, as we expect that the demographic trends regarding the aging baby boomer population will translate to an increase in demand for elective and non-elective medical procedures, dictating the need for specialized medical devices. Thus, the sustained bear sentiment surrounding the reduced demand for such devices should be addressed with a steady influx of customer orders. Moreover, the impact of the new tax should be manageable, since it is income tax deductible, and the burden should be much less than it appears. As it stands, however, Baxter should continue on its course of modest revenue growth as it expands into emerging markets, pursues strategic alternatives--including the recent spin-off of its Bioscience division and the Gambro acquisition--and markets new products.

Earnings highlights

Baxter's most recent earnings report featured a 15% rise in global sales to $3.95 billion and a 5% rise in BioScience revenues, which was bolstered by double-digit growth in ADVATE for hemophilia. The progress of ADVATE is vital to Baxter as it strives to bolster its global leadership in hemophilia A. The following are highlights and milestone achievements which reflect a culmination of these efforts:

  • Authorization of a new manufacturing facility in Singapore to support production of recombinant proteins, including ADVATE and possibly BAX 855, if and when it receives regulatory approval.

  • The National Blood Authority (NBA) issued a four-year award for ADVATE as Australia's preferred recombinant FVIII product. Once it becomes effective on July 1, 2014, it will grant 2,300 people diagnosed with hemophilia A access to ADVATE. Recent efforts by Baxter to expand its commercial presence in the UK for the treatment of 5,600 people with hemophilia A complement this achievement.

  • Baxter receives regulatory approval for ADVATE in Russia and Turkey, following the approval and launch of the product in China, along with its increased market share in Brazil. Currently, 3,000 patients in Brazil rely on ADVATE, which translates to around 30% of those being treated for hemophilia A in the country.

  • With these approvals, ADVATE is now available to hemophilia A patients in 62 countries, and revenue continues to grow at an exponential pace.

Should investors buy or run for the hills?

Baxter is widely considered a high-quality security, with a stable history of dividend payments and growth, and reasonable prospects for share price appreciation. Case in point, the company has a five-year dividend growth rate of 16.4%, and seven successive years of dividend growth. However, recent insider sales prompt uncertainty regarding whether management is expecting a short-term pullback coinciding with slower-than-expected revenue growth during the remainder of the year. Over the last several months, more than 24,000 shares have been sold by insiders, while no shares have been purchased. This represents a significant decrease in insider positions, including that of Carole Shapazian, Kees Storm, and Blake Devitt, all of whom reduced their positions by more than 20%.

We are not going to pretend to understand why these directors sold shares, since it is ultimately impossible to determine whether these sales are meaningful or uneventful, especially considering that the stock has risen significantly following these transactions. Due to this uncertainty, we believe that buying the stock at current levels comes with an uncomfortable amount of risk that could be avoided. For those interested in a more conservative approach which offsets this risk, there is a perfect way to get in the game through a covered call that provides significant downside protection, while enhancing Baxter's 2.80% yield.

The conservative options strategy

While some experts opine that the stock's high share price level leaves little margin for safety, we feel that the 2.80% dividend and an additional premium garnered through the sale of a covered call makes the ongoing investment in Baxter a favorable proposition. While there are numerous variants, in simple form, one would purchase 100 shares of Baxter at the current price, which is $74.22 (at the moment of writing), and sell a commitment to deliver the stock at $77.50 on or before January 17, 2015. The price the investor receives for selling the option is $1.74/share, which totals $174 on the required 100 share minimum transaction. The outcome of these events falls into one of three possible scenarios:

  • Scenario 1) On or before the strike date of January 17, 2015, the stock trades above $77.50. At that point, the investor would have to sell the stock purchased at $74.22 for the strike price of $77.50. As noted above, the investor has received $1.74/share option premium. Additionally, the investor would harvest whatever dividend is paid in the intervening 7-month period, which is roughly half the dividend of 2.80%. This equals 1.40% (~$1.04/share), representing ~$104 received from the dividend alone. Overall, this transaction would profit ~6.05 points in 6 months, or ~$605. Disadvantage: The total profit from this transaction is limited to $605. If Baxter stock rises significantly higher than the strike price of $77.50, the investor would lose out on the margin between the new price level and the $77.50 strike price.
  • Scenario 2) The stock stays stagnant or does not reach the strike price of $77.50 prior to January 17, 2015. At that point, the investor would have then benefited from the option premium of $1.74/share (or $174), along with whatever dividends are paid by Baxter, which as noted above, are likely to be 1.40%. This transaction would yield $1.74/share over the simple strategy of buying and holding. Including the dividend, this scenario yields ~$3.14/share (or $314), which is a superior outcome to simply buying and holding and receiving the dividend. Disadvantage: None over the buy and hold strategy.
  • Scenario 3) Baxter stumbles and falls either on its own or in conjunction with a general market decline. Should this be the case, the option premium of $1.74/share (or $174) received by the investor serves to cushion the downturn and protect up to ~2.78 points of loss, or $278 when the dividend is included. In other words, the investor would break-even on this transaction at approximately $71.44/share, and would enter the red anywhere below this price. Disadvantage: None over the buy and hold strategy.

The ultra-conservative options strategy

To take this options strategy a step further in order to reduce downside risk, we recommend that the investor trade a Collar. What a Collar entails is 1) Sell a call, as shown in the three scenarios above, and 2) Buy a put to lower the risk profile by capping the downside. The Collar strategy obviously imposes further restraints on the profit garnered from the Baxter transaction, but compensates for the lower profit with insurance against a large loss. It should be perceived as ultra-conservative in the sense that investors should neither expect wild returns nor limitless downside; the Short Call and the Long Put ensure that both are impossible.

In context to the scenarios above, we recommend that investors purchase 100 shares at the current price of $74.22, and sell a commitment to deliver the stock at $77.50 on or before January 17, 2015. Second, since we identify $65 as a good 52-week support level, we recommend that the investor then purchase a put at a strike price of $65, for a put cost of $1.13/share (or $113). The transaction will then fall into one of three possible outcomes:

  • Scenario 1) On or before the strike date of January 17, 2015, the stock trades above $77.50. The transaction would yield a maximum upside of ~493 points (or $493), factoring in the dividend of 1.40%, the call premium received of $1.74/share (or $174), the $3.28/share increase, and the put cost of $1.13/share (or $113). Disadvantage: The total profit from this transaction is further limited to $493. If Baxter stock rises significantly higher than the strike price of $77.50, the investor would lose out on the margin between the new price level and the $77.50 strike price.
  • Scenario 2) The stock stays stagnant or does not reach the strike price of $77.50 prior to January 17, 2015. The transaction would yield ~1.38/share (or $138), factoring in the 1.40% dividend, the call premium received of $174, the ~$0.00/share increase/decrease, and the put cost of $113. Disadvantage: The total profit would be restricted by $176, as opposed to if the investor did not buy a put (see the previous Scenario 2). Despite this, an investor does better here than simply buying and holding.
  • Scenario 3) Baxter stumbles and falls either on its own or in conjunction with a general market decline. This is where the put comes in handy. With downside protection at $65/share, the risk is limited to ~$9.22/share, or $922. But after factoring in the 1.65 point cushion calculated by adding the 1.40% dividend and the call premium received of $174 and deducting the put cost of $113, the investor is only exposed to a maximum loss of $7.57/share (or $757). Imagine hypothetically, if Baxter stock was to go to $0.00, the investor's maximum loss would be relatively minor compared to the buy and hold investor or one without a protective put position. Disadvantage: If Baxter shares do not trigger the put, the investor loses out on $113 which he invested into the put. This could be analogous to paying for insurance and peace of mind. The investor is exposed to anywhere below $757 downside.

Bottom line

Given our view of Baxter, we endorse both options strategies constructed above. For the most conservative of our investors, we recommend a Collar strategy, which includes insurance against a catastrophic loss. For most investors, implementing a covered call may be slightly more aggressive and financially favorable. We suspect that Baxter's outlook is positive, and the need for additional downside protection through purchasing a Long Put could be unnecessary. Either strategy enhances Baxter's 2.80% dividend, and provides various levels of protection around which each investor individually must assess his/her risk tolerance.

Source: Baxter International - A Yield-Enhancing Strategy On A Diversified Healthcare Corporation