Forest Labs May Soon Lose Its Independence: Options Play

| About: Forest Laboratories, (FRX)

Last week I wrote an article making a case for an Eli Lilly (NYSE:LLY) takeover. One day later, the Indianapolis Business Journal reported that Lilly's shareholders will take aim at the removal of an 80-percent approval poison-pill provision at the April 16 shareholder meeting. If passed the proposal would require just a bare majority of shareholder votes to approve key moves commonly used in hostile takeovers.

As such, Lilly and its board could find itself in a defensive mode. One defensive move could be to make a purchase of its own, specifically, to bid for Forest Labs (NYSE:FRX). Such a purchase would allow Lilly to cut someone else's expenses and preserve its own jobs. Also, Forest is vulnerable because Carl Icahn owns 10% and the chief executive, Howard Solomon is 83.

Lilly's expertise clearly is drugs for central nervous system. Prozac for depression and Zyprexa for schizophrenia built the company. Now are both generic. Cymbalta, lilly's greatest-selling drug, is an antidepressant that goes generic the end of next year. Forest is in a bind because it's antidepressant, Lexapro, just went generic by Mylan. A flood of competitors will hit the market in six months. So Forest's cash flow is about to disappear. Forest just launched a new antidepressant, Viibryd, and it's doing well. It will file for approval of another antidepressant by the end of the year. Results on that one look fantastic. Plus Forest will file for another antidepressant by the end of the year and has a schizophrenia drug in the pipeline as well as others.

Key issue is antitrust. Forest sells a drug, Savella, that competes with Cymbalta. But, that will cease to be an issue when Cymbalta goes generic at the end of 2013. In other words, about a year after any merger would close. So we're just trying to solve a year-long problem.

The bottom line is that large drug companies have bloated sales forces, large R & D expenditures and no new drugs. Carl Icahn would clearly push for a sale.

At four times gross profit FRX could fetch a price of low to mid 40's.Having said that, I will analyze two bullish options trades in lieu of outright buying stock. I prefer low debit options or spreads that can really pay-off substantial returns if my story is right.

Senario I: Purchase one naked FRX January 2013 40 Call @ .70

Now let's fast forward in time to January Expiration of 2013. Our TOT P&L is based upon one options contract given the hypothetical stock price in the left column.

FRX Call Value Call Purchase Price TOT. P&L
35 0 .70 -$.70
40 0 .70 -$.70
41 1 .70 +$.30
42.5 2.5 .70 +$1.80
45 5 .70 +$4.30
46 6 .70 +$5.30
50 10 .70 +$9.30

Senario II: Purchase one FRX January 2013 35 Call @ 2.15 and sell one FRX January 2013 40 call @.65 for a total debit of $1.50.

Now let's fast forward in time to January Expiration of 2013. Our TOT P&L is based upon one options contract given the hypothetical stock price in the left column.

FRX Spread Value Spread Purchase Price TOT. P&L
30 0 1.50 -$1.50
35 0 1.50 -$1.50
36 1 1.50 -$.50
37.5 2.5 1.50 +$1.00
40 5 1.50 +$3.50
45 5 1.50 +$3.50
50 5 1.50 +$3.50

In either scenario, I am limited to what I can lose. I prefer to minimize my risks as any unforeseen event can sideswipe any thesis, no matter how bulletproof it may seem to be.
If you are a seasoned trader, you may consider doing any variation of the above-constructed trades.

I personally prefer scenario II as the breakeven point is $36.50 vs. $40.70 in scenario I. Scenario I may seem more tempting with its unlimited upside, however, I am of the opinion that FRX does not fetch a price much higher than $45.

Disclosure: I am long LLY, FRX.