Why a Fairly Valued Stock Can Shine with Options

If the potential market opportunity for a drug firm's pipeline is big enough, even stocks trading near their fair value estimates--like the one that we'll focus on today--can offer promising opportunities for option investors. This stems from the bimodal nature of many drug firms, especially those with a large portion of their value wrapped up in one drug candidate. Because we probability-weight any future sales for drugs that haven't been approved by the FDA, our fair value estimate is an average. With options, however, the astute investor can capture the big payoff of positive results, and sometimes even benefit from bad news as well.

The Story of Keryx
Most of the value we see in Keryx Biopharmaceuticals (NasdaqGM: - ) rests in one drug candidate. Sulonex is in Phase III trials to treat diabetic nephropathy, which is a life-threatening complication of diabetes that involves progressive damage to the kidneys. While treatments already exist, such as angiotensin converting enzyme (ACE) inhibitors or angiotensin receptor blockers (ARBs), they're not effective enough to stop disease progression in many diabetics. If Sulonex were approved, it would enter a large and growing market; half of the 13 million Americans treated for diabetes show early signs of nephropathy.

Keryx owns rights to Sulonex in the U.S. and Japan, and because the company plans to market the drug to specialists, sales could grow nicely with just a small salesforce. Data indicates that Sulonex could improve upon current treatments, and we like the fact that Sulonex has an unusually strong track record for safety; the drug has been marketed for years outside the United States in cardiovascular indications. We expect to see key data in the first quarter of next year, and if the drug successfully reaches the market in 2009, we think sales in Keryx's U.S. market alone could reach $700 million within five years.

How to Invest in Keryx with Options
You can investigate the option opportunity for yourself by clicking on Morningstar's options chains for Keryx. After examining the call options expiring March 21, 2008, we can see that the call spread between call options with strike prices of $10 and $15 per share costs $1.50 at the midpoint of the bid/ask prices, as of Oct. 15. Doing a little basic math, we can calculate that the option market is pricing a 30% (1.50/5) chance that the stock will move from $10 (slightly below where it's trading today) to above $15 by the expiration date. However, we think there's a 60% probability that Keryx will see positive data before the expiration date, and if it does, we think the value of the stock should approach $20 per share. By our estimates, the market is serving up a bet at half of what it is worth.

That said, we estimate that this investment has a 40% chance of going to zero, so it is only for the risk tolerant, and only for a small percentage of a portfolio. Also, the bid/ask spread can eat into the edge on this bet, and executing at the ask produces a less attractive return. Each option would pay roughly $1.60 (a $5 payoff if the stock moves to $20 and the strike price is $15, minus the $3.40 cost at ask price), so the expected value of the bet is $0.96 (60% * $1.60), which is a 28% return (0.96/3.40) over five months, or 68% annualized. One way to improve this situation is to place a limit order to buy the call spread for a nickel or a dime more than the midpoint, and wait to see if your order is filled by the market maker.

A key with this option investment is timing. We expect the company to release a preliminary analysis of Phase III data in early March, so the announcement should occur before the option expiration date. Unfortunately, there is always a risk that the analysis could take longer than management is predicting, in which case these options could expire worthless, regardless of the drug's potential.

A Second Strategy
Another way to invest with options is to examine the highest upside scenario, which also avoids some of the timing risk. In our current model, we assume that 15% of diabetic nephropathy patients who see specialists will receive Sulonex at its peak. However, if further data behind the initial Phase III data prove impressive, or if Keryx finds a partner with a large salesforce to extend marketing to general practitioners, our estimates could prove conservative.

Let's assume that Keryx is able to garner a 25% share of the market for patients who see specialists, and that the firm receives a 20% royalty on sales generated by a future partner in Japan (which has a population of approximately 7 million diabetics). Using these assumptions and removing the probability weighting on Sulonex sales (in other words, assuming that the drug is approved) yields a fair value estimate of $25 per share.

Because this is a longer-term option investment, we've looked at call options with a $20 strike price expiring in January 2009. An investor purchasing these call options would spend $3.70, so in a successful scenario, the investment would pay approximately $5. (This includes a time-value-of-money adjustment of one year to our fair value estimate, from $25 per share to $28.75.) The expected value of this bet is $3 (60% * $5), which is an 81% return (3/3.70) over 15 months, or 65% annualized.

However, positive data for Sulonex doesn't guarantee that this investment will pay. Due to the length of time that needs to pass before an investor can cash in on this investment, there is a greater risk that Keryx could be acquired by a large drug company at a price that results in a loss or low return for the options. It's also important to note that Mr. Market might not cooperate, and the value he places on the results might not be the same as our fair value estimate. However, we like the odds of these investments for a small percentage of a portfolio.

For more option strategies, insights, and investing ideas, visit Morningstar's Option cover page: