Please ensure Javascript is enabled for purposes of website accessibility

A Super-Cheap Call Option

By Brian Orelli, PhD - Updated Apr 5, 2017 at 6:58PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Glaxo's pay-if-the-drug-works scheme should pay off.

When an investor buys a call option, it's a bet that the value of the underlying security will go up in the future. For instance, buying a $60 call option on Procter & Gamble (NYSE:PG) is a bet that P&G's stock price will close higher than that by the time the option expires. The investor puts up a little now to make a lot later.

Investors use call options to limit risks and supercharge rewards -- hit up the Motley Fool Pro guys to view this in action -- and companies like GlaxoSmithKline (NYSE:GSK) can do the same kind of thing. Let me explain.

Today the company announced it's partnering up with tiny Dynavax Technologies to develop up to four drugs for autoimmune and inflammatory diseases such as lupus, psoriasis, and rheumatoid arthritis.

Glaxo paid a measly $10 million dollars to tie up the four drugs. It'll owe more -- up to $200 million per drug -- if it decides to develop the drugs and they turn out to be successful, but Glaxo gets to wait and see if the drugs are able to achieve proof of concept before deciding to develop them further.

I really like Glaxo's system of using call options to gain access to the drugs. In this case, just like an option buyer, instead of paying more up front -- it probably could have just bought all of Dynavax for $50 million more -- Glaxo gains control of those drugs. But, it doesn't have to fund the development program and so doesn't run the risk of losing more money if the drugs turn out to be duds. Glaxo has similar deals with Alnylam Pharmaceuticals' (NASDAQ:ALNY) and Isis Pharmaceuticals' (NASDAQ:ISIS) joint venture Regulus Therapeutics, among others.

By not buying the company outright, Glaxo also keeps the fire under Dynavax. Sometimes small biotech companies are successful not because they're smarter than their pharmaceutical counterparts, but out of necessity. Employees know that the success or failure of their company depends on success in the lab. Incorporated into Glaxo, Dynavax would just become another division with a safety net underneath it.

The deal structure also allows Glaxo to make the decision farther down the line when it has a better look at how its pipeline is shaping up. In a similar situation, Glaxo turned down Exelixis' (NASDAQ:EXEL) thyroid cancer drug XL184, which Bristol-Myers Squibb (NYSE:BMY) licensed last week. Some -- including me and Exelixis CEO George Scangos in an interview done for our Rule Breakers newsletter -- speculated that the decision was based on the needs of Glaxo.

Glaxo's option drug deals -- with 16 different companies -- take time to develop, but I think they're a wise use of Glaxo's cash, and should pay off handsomely in the long term. While it will occasionally forfeit the upfront money, when it does pick a winner, the return could be fantastic. Go options!

GlaxoSmithKline is a Motley Fool Income Investor selection. To see how dividend-paying stocks can offer both secure income and the opportunity for growth, take a free look at this newsletter with a 30-day free trial.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. Exelixis is a Rule Breakers pick and the Fool owns shares. The Fool also has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

GSK Stock Quote
$36.03 (0.84%) $0.30
The Procter & Gamble Company Stock Quote
The Procter & Gamble Company
$146.67 (0.97%) $1.41
Bristol Myers Squibb Company Stock Quote
Bristol Myers Squibb Company
$75.57 (1.49%) $1.11
Ionis Pharmaceuticals, Inc. Stock Quote
Ionis Pharmaceuticals, Inc.
$44.10 (1.52%) $0.66
Exelixis, Inc. Stock Quote
Exelixis, Inc.
$19.48 (1.30%) $0.25
Alnylam Pharmaceuticals, Inc. Stock Quote
Alnylam Pharmaceuticals, Inc.
$233.85 (1.94%) $4.46

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/13/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.