Mylan (MYL): Big Drop Sets Up A Contrarian Value Play

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Contrarian trading — trading against conventional wisdom — is a risky business by definition. When just about every trader, investor, analyst and pundit agree on something, there is usually a reason.

The best contrarian trades, however, happen when just that scenario is playing out, and are based on two things: Firstly, when the fact that everyone on something is true, the market inevitably overreacts. Secondly, a focus on bad news that is front and center sometimes obscures the underlying potential of a company.

On its face, the fifteen percent drop in Mylan (MYL) yesterday, for example, is easy to justify and looks like just the beginning. An earnings miss, weak guidance, and well-publicized production problems all contributed.

Given that, buying the stock, even after the latest drop, would be foolish, right?

Not necessarily.

As you can see from the chart below, yesterday’s big drop in MYL is part of a downward trend that has lasted all year. To most people that is even more reason not to buy, but to a true contrarian that is a positive, at least with a couple of provisos:

If the issues that are driving the decline are structural and insurmountable, or if the company is piling up losses, then a big one-day drop following a steady decline is anything but an opportunity.

Neither of those things, however, apply to Mylan.

Let’s deal with the simplest first: Mylan is making money. They may not be making as much as the market would like, or more importantly expects, but they are not losing money hand over fist, either. That suggests that there are not any major structural problems. In fact, if anything, it indicates that Mylan doesn’t have a problem … the market does.

It is an issue of valuation, not profitability, and that is easily corrected by the kind of drop in the stock that we saw yesterday.

That is not to say that there aren’t problems. The biggest and most recent is the warning letter the company received from the FDA in November, regarding problems at its Morgantown, WV manufacturing facility. Things like problems maintaining a sterile operating environment, one of the issues detailed in the letter, should not be taken lightly, but they are reversible.

While the problems are being attended to, Mylan shifted production of some products to other plants which caused some supply disruptions. Once again though, those disruptions are temporary in nature.

Given the problems, the 45.6% drop since January of 2018 is, I guess, understandable to some degree, but it can be argued that the decline in sales evident in Q4 earnings and the problems at Morgantown are two sides of the same coin and can be dealt with. That would suggest that a turnaround in the stock is coming, and a simple analysis of price relative to the problems indicates that it is coming soon.

That 45.6% drop in the stock is as a result of, among other things, a decline in earnings from Q4 last year to Q4 this of around 10%. That is obviously out of whack, but it doesn’t necessarily mean that it is overdone. What matters is the price as it is now relative to earnings in the future, as expressed in the forward P/E.

For MYL that is currently around 5, versus an average for the S&P 500 of around 16.5. In a case like this, a low forward P/E makes sense as, following weak guidance, the estimates of future earnings that are part of the calculation will certainly be cut soon. However, for the stock to get back to an average P/E, those forecasts would have to be cut by around two-thirds. Can you really see a 66% cut in the consensus forecast? No, nor can I.

There are those who would not invest in Mylan on moral grounds after the scandal around the price increases in EpiPens. My role here, though, is not to pass moral judgement, but to analyze the price and potential of a stock. From that perspective, even that scandal led to some changes that may prove beneficial in the future.

Mylan learned that control over drug pricing is almost certainly coming in some form and increased their commitment to generics and biosimilars. There is, of course, an active conversation around pharma pricing right now, and one area of possible bipartisan agreement is in making copies of patented drugs more readily available.

That solution would influence overall pharma costs in healthcare, but without the direct price controls that most Republicans oppose, so has a good chance of being at least a part of any deal. If so, Mylan’s commitment to generics, forced or not, will look smart.

When considering a contrarian trade such as this, it is important to understand all of the reasons why a stock is being sold. If they are insurmountable problems, you should then leave the stock alone. On the other hand, if the issues are temporary and the drop creates future value, the inherent risk in opposing conventional wisdom may be worth taking. Mylan still has an image issue and production problems, and is seeing sales fall as a result. From a valuation perspective, however, the stock is clearly oversold.

Of course, the old traders’ saying that the market can stay illogical longer than you can stay solvent applies here. Even with the evident value, MYL could keep falling, so a sensible stop-loss is a must, but at some point, it will bounce, and yesterday’s big drop creates an attractive entry point.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Referenced Symbols: MYL

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