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GlaxoSmithKline plc (NYSE:GSK) is a global pharmaceutical company that engages in the creation, discovery, development, manufacturing and marketing of their pharmaceutical products. GSK, like many pharmaceutical companies, is faced with the ongoing challenge of coming up with a new fleet of innovative drugs that can get FDA approval and begin to replace their older blockbuster drugs whose patents are either getting close to expiring or have already expired.

GSK's most popular drug is Advair, which generates on average total sales of $4 billion and its patent is set to expire later this year. Patent expiration is an issue facing all of the major pharmaceutical companies. Pfizer (NYSE:PFE) is seeing it with Libitor and Protonix which represented total sales (combined) of $6.01 billion; Merck (NYSE:MRK) with Singulair, total sales of $3.22 billion; Bristol Myers Squib (NYSE:BMY) with Plavix, total sales of $6.15 billion; Eli Lily (NYSE:LLY) with Zypreza, total sales of $2.5 billion; and Johnson & Johnson (NYSE:JNJ) with Levaquin and Concerta, total (combined) sales of $2.24 billion. As new generic drugs continue to replace these older drugs, the rush for new drug development continues to be the current focus for all of these companies.

Among all major drug companies there is a lot of smaller specialized drug companies that are usually focused on one or two specific drugs. Since these types of companies' core business plan is the development and testing of their drug(s) with the ultimate goal of receiving FDA approval, it is becoming very advantageous for the major drug companies to simply buy up these smaller companies that have already spent the time and money on R&D for their drug(s). An excellent example of this was the recent acquisition by Bristol-Myers Squibb and AstraZenca (NYSE:AZN) of Amylin Pharmaceuticals (AMLN) for $7 billion.

GSK is also in the process right now of finalizing their purchase of Human Genome Sciences (HGSI) for $3 billion or $14.25/share. This purchase on GSK's part will be financed with a combination of cash and debt. The overall premium offered to HGSI shareholders was 100% of the stock price the day the deal was announced on April 18th. HGSI currently has a drug called Benlysta that treats patients with lupus, which has already been approved by the FDA. This drug already being approved should start having immediate positive effects on GSK's earnings.

HGSI also has two other drugs that are still pending FDA approval that GSK will now gain control over. The first is a drug called Darapladib, which is supposed to help counter the effects of heart attacks and strokes due to plaque buildup in the heart's arteries. The second drug, called Albiglutide, modified GLP-1 peptide that uses an albumin-based technology. Although both of these drugs have yet to receive FDA approval, there continues to be a lot of upside potential for GSK if or when they do get approved.

GSK stated in a press release after the deal was announced that they expect the deal with HGSI to not only save the company $200 million in cost savings alone by 2015, but they also expect that Benlysta will begin contributing to core earnings as soon as 2013. Fundamentally, GSK is already a strong company and this most recent acquisition should only add to it. The company in their most recent quarterly results this past week generated revenues of $6.46 billion with an overall net income of $1.254 billion. These numbers unfortunately missed analysts' expectations and the stock has consequently sold off, pushing the firms P/E to 13.79. The company stated on their quarterly call that the quarter has been characterized by a continued deterioration in the external environment, especially in Europe, where it took a 7% negative price hit during this quarter.

The company during the quarter did increase its overall cash position by $1.6 billion and now currently has $7.59 billion in cash. Being that GSK is parting with $3 billion (both in cash and debt) to acquire HGSI, the immediate reaction of the market is to sell the company, but I think that is a mistake. It is hard to say at this point what type of revenue Benlysta will generate for GSK, but the fact that it has already received FDA approval should provide nothing but upside for GSK, not to mention the $200 million in cost savings that the deal will provide.

GSK currently trades for $44.25/share, which in my opinion is not representative of the real fair value of the firm. After listening to the guidance for the remainder of the year that was provided in the recent quarterly call and the positive effects that should come out of the HGSI acquisition, I feel that the increased profit potential and market share should push this stock up to a high valuation. GSK's competitors are already trading for much higher valuations and in my opinion do not have nearly the upside potential that GSK has, see the chart below.

Company

P/E

GlaxoSmithKline

13.79

Pfizer

18.98

Merck

19.02

Bristol Myers Squib

15.68

If GSK were to trade for multiples similar to that of their competitors, the stock price would be somewhere between $50 - $61 per share. This price to me would be a much more accurate picture of the company's true potential and value.

Now there are several ways to capitalize on this undervalued situation. The obvious would be to simply just buy the stock outright and wait for it to appreciate in value. This is a very good option, not to mention that GSK is currently yielding 5.14%, so you get paid to wait. I will admit I like this option, but I feel that is a bit capital intensive, not to mention that I also fear that the stock could continue to go down before it goes back up. With that being the case, I am more prone to do a trade that does not require as much capital up front but still allows me to capitalize in the appreciation of the stock.

I would suggest selling some cash secure out of the money put options while at the same time using that premium from those put options to help offset the price of some deep in the money call options. I would suggest selling the $41 January put options for a premium of $1.50/contract and then buying the $30 January call options for $14.50/contract, for a net out of pocket cost of $13.00/contract.

Doing this trade provides the spread buyer with several ways to play this stock that provide in my opinion benefits that buying the stock outright at market does not.

  • The put options that were sold help offset the price of the calls while also allowing the seller the opportunity to buy the stock outright at a cheaper price than the stock is currently trade if the stock is at or below $41/share at expiration, almost a 7.4% discount from the current market price.
  • The call options allow the seller to capitalize on any upward movement between now and January in the stock price. Since the options are deep in the money the options should be far more stable and will already have some intrinsic value built in which will help keep the option prices more stable even during volatile times.
  • The final benefit of this trade is that the spread buyer controls 100 shares of stock for a price of $1,400, versus the $4,425 that it would cost to buy outright at market.

I will be the first to admit that the one downside of this trade is that the spread buyer is not able to reap the benefits of receiving GSK's dividend during the duration of this trade, but if the stock were to decrease in value toward the put contracts strike price and spread buyer decided to buy the stock at $41, the new dividend rate that they would receive would be far better. At the current dividend payout of $2.20/share, it would yield almost 5.4%.

Source: Using Options To Find Value In GlaxoSmithKline