As we wrote in our latest earnings watch, we are bullish on Gilead Sciences (one of the four mature US biotechnology firms) despite disappointing pipeline news. The expected free cash flow over the next six years is sufficient to cover the current market value, so the current share price has likely hit the floor with limited downside risk.
Gilead Sciences shares are also on our global top 40 list in our monthly Alpha Picks publication.
With expectations as low as they are, there is the possibility of an upside surprise to the Q2 earnings to be released tonight after the US market close.
Gilead Sciences weekly share price since Q4 2011:
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Source: Saxo Bank
Buy four-day call spread
We have before been long Gilead Sciences but closed the position in April with a 10.5% profit after costs. However, the US presidential election is still a drag on the biotechnology industry due to the potential downside risk on drug prices post the election. As a result, we hesitated to establish a new long position again. But with the recent Biogen surprise in Q2, Gilead Sciences may follow up with a surprise as well.
The best way to express a positive view on Gilead Sciences that is short-term in nature and has limited downside risk is through a call spread. In particular we like buying the call with its strike at $88 (mid-price is around $1.48) financed partly by selling the strike at $92 (mid-price around $0.39) – both options with expiry at 2016-07-29.
So the downside is slightly above $1 with a potential $4 gain before costs. The key risk is Q2 earnings missing estimates and a dim outlook. In that case, the net premium ($1.48 - $0.39) x 100 = $109 per contract excluding commission is the maximum loss.
— Edited by Michael McKenna
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