Sanofi-Aventis: Play This Low-Risk Combo Along with Buffett

Sanofi–Aventis (SNY) is the 4^th largest drug company in the world and a big holding of Berkshire Hathaway (BRK.A) (BRK.B). They've earned an 'A+' financial strength rating and an 85^th percentile 'stock price stability' grade from Value Line.

2008 sales, earnings, cash flow and dividend payout are all expected to hit all-time highs. Despite that, the ADRs hit a new four-year low yesterday and now trade at $32.62/ADR.

That's well off their 2006, 2007 & 2008 highs of $50.10, $48.30 and $49.00 respectively.

This year's annual dividend was $1.604 per ADR [before foreign tax withholding] for a pre-tax current yield of 4.50% - the highest ever for SNY.

Here's a very conservative way to play with a Warren Buffett favorite while it appears to be very undervalued.

…………………………………………………Cash Outlay …………..Cash Inflow

Buy 1000 SNY @ $32.62 ……………….…….. $32,620

Sell 10 SNY Dec. $32.50 Puts @ $2.55 ………………………………… $2,550

Sell 10 SNY Dec. $32.50 Calls @ $3.00 ………………………………… $3,000

Net Cash Outlay ………………………………. $27,070

If Sanofi-Aventis ADRs stay above $32.50 until expiration date on Dec. 19, 2008:

[The ADRs are slightly above that price right now.]

• Your stock will be called [sold] for $32,500.
• Your $32.50 puts will expire worthless [a good thing for you as a seller].
• You will have $32,500 cash - no ADRs and no option obligations.

That's a $5,430 net profit on a cash outlay of $27,070 or + 20% in just over 6 months.

Not too bad on a stock that did not need to move up at all to achieve this result.

Risk?

• Break-even on the shares is $32.62 less the $3.00 call premium = $29.62.

• Break-even on the puts is the $32.50 strike price less the $2.55 put premium = $29.95.
• In a worst case you will be forced to own 2000 ADRs of SNY at an average net cost of $29.79. That's lower than the lows for these ADRs since early 2004 and way cheaper than Mr. Buffett's cost basis.

GuruFocus.com noted that Berkshire Hathaway increased its SNY position by 69.6% during the March quarter (at an average price of $44) and held 828,500 total ADRs at that time.

Disclosure: Author is long SNY and short SNY options.

Comments

[cy]

In order to write the naked puts that this strategy is calling for, isn't there an additional cost (or cash outlay) that is not being accounted for?
For example, if using ETRADE, the initial margin requirement is "Proceeds of the sale plus 20% of the underlying value less out of the money amount OR proceeds of sale plus 10% of strike price, whichever is greater", which works out to $6412 in this case.

Am I making a mistake or shouldn't the cost of that money also be included in this calculation?

[cy]

Correction, that requirement is $8962, not $6412.

[BS Detector]

Now let's see what happens if there's a major shock to the stock.

Let's say it recovers to $40, the midpoint of its 52-week average, in six months. Your puts go away, and your underlying gets sold for $32,500. No change - still up 20%. Of course, had you just bought and held, you'd be up 23%.

Now let's say it goes the other way by the same amount, to $25. As you say, you now have 2,000 ADRs at $29.79 - and a loss of $9,580, or more than a third of your original investment.

For your limited gain if SNY stays within a specific range, you're trading away ALL of your upside potential if it exceeds this range and HUGE potential losses if it falls out.

By the way, I don't think there's much chance of SNY hitting $25 this year. But the other way? Six months ago, it was just under $46. If it gets back there this year, your strategy misses out on nearly $8,000, or an additional 21%, in appreciated value.

[Paul Price]

Mr. B.S.

If SNY go back to $46 in one year as you propose [and is possible] you would make a 41.2% gain on the shares.

My combination play written up above is for SIX MONTHS [half a year] and will net 20% even if the shares DO NOT go up. The last time I checked a 20% half-year return is just as good as a 41% full-year return on an annualized basis and I don't need the big move in the stock that your example includes.

[Paul Price]

SNY ADRs have never traded as low as $25 since they were first offered in the United States in 2004.

Fundamentals are much stronger now than then so I believe that the chance of that low a price is quite remote.

[BS Detector]

I clearly gave the six months ago price of $46, and offered a six month scenario of it returning to the same level wherein you would miss out on 21% of additional gain. So I was comparing the same timeframe and not, as you would like, comparing a 20% half-year gain to a 41% full-year gain.

My problem is not with the idea - it's with the partial information you provided. There is SIGNIFICANT risk involved in your play, which you don't even mention. As I stated, the upside risk is much more likely than the downside risk; if the fundamentals are as solid as you say, there's no reason to think that SNY couldn't outperform your play as I suggest.

But that does not mean there is no downside. At this time in 2004, MRK was at around 47, having traded between 40 and 65 for 2.5 years. In November it hit 26 when Vioxx turned south. What happens to SNY if Plavix turns out to be killing people? Imagine the public reaction if strong evidence came about indicating that SNY's vaccines were, in fact, responsible for autism in thousands of children.

Odds of this happening? Remote. Impact if it did? Severe.

Also: you'll need to grow a thicker skin if you want to be a journalist. You would have been better served acknowledging my legitimate criticism and providing more information to allow those reading to decide for themselves, rather than trying to point out holes in my post which weren't there.

This additional information is what was missing in the first place - a meaningful discussion of risk.

[Dean Morel]

Hi Paul
Thanks for taking the time to layout your SNY play.
I like your play, it makes sense to me. I use options extensively and have suggested a possible simplification below.
I do think BS has a point. It is good to point out the upside potential that you are foregoing with such a strategy. However, I think it is a common mistake to view option risk as missed upside; the real risk is always to the downside as you outlined. Missed profits are not a risk, they are a trade off. I am sure you’ll still be smiling even if SNY hits $46 and you miss out on some upside. Your strategy has a much higher likelihood of success.

However, I am not sure why you’ve entered three trades when simply selling 20 $32.50 Dec Puts would provide the same return. 10 Puts as per your trade and 10 Puts as an equivalent to the covered call. This is a less complicated trade, no cash outlay and the same risk reward profile.
Best - Dean

[Paul Price]

Dean,

You are correct that long stock & short calls is equivilent to just selling naked puts. I like owning ADRs of SNY, though, as their dividend [if you do this over a full 12-month period] far exceeds current money-market rates.

[BS Detector]

"Missed profits are not a risk, they are a trade off."

Investopedia defines risk this way: "The chance that an investment's actual return will be different than expected." Notice, no difference is indicated between losses and missed profits. To not think of opportunity cost as risk is to miss out on half of the equation.

"I am sure you’ll still be smiling even if SNY hits $46 and you miss out on some upside."

Here's the scenario that would bother me the most: I'm sitting there with $30K of covered stock when SNY introduces the wonder drug. Not only do I miss out on the additional profit, but I'm stuck holding a non-appreciating asset until expiration. But buying back the calls would kill my return on the play, so I try to stick it out. Then SNY cures cancer, and my depression deepens.

BTW, I never saw a response to the legitimate cost of money question related to holding the naked puts.

[CNG]

BS

You're absolutely right. The cost of holding the naked puts should be added to the cash outlay analysis. I pointed this out on the same post on Gurufocus. Somehow I don't think the author believed me.

C