With so much happening in the market these days, it’s easy to forget about one of the most game-changing battles a handful of Big Pharma companies are facing right now… the opioid epidemic.
Johnson & Johnson (JNJ) has been fighting its role in the terrible drug crisis surrounding opioids in court. On Monday, it received its first (of many) rulings.
Instead of the $17 billion that was asked for, an Oklahoma judge ruled that the company has to pay out $572 million to the state for its part in fueling the epidemic.
The stock actually jumped on this news initially, due to the size of the fine. And you have to agree, from an investor/company point of view, $572 million looks a lot better than $17 billion.
But investors made a mistake… one that we’ll see immediately hurt those going long JNJ stock right now.
The judge, Thad Balkman, said J&J’s marketing was deliberately misleading and that the company significantly downplayed the risks of addiction for its opioid products. Moreover, this $572 million figure covers just one year of fines. It could add to this number over the next 20 years.
Nothing is set in stone just yet. J&J has been on the front lines for the pharma industry fighting these cases… and will continue to do so. It is appealing this ruling. But a bigger problem for the company is at play.
This is just Oklahoma… the first such ruling. $572 million is less than $17 billion, sure. But if we see even a fraction of this awarded amount in other states across the country and in future years in Oklahoma itself, this is going to eventually weigh heavily on the giant.
No, Johnson & Johnson isn’t in immediate danger from this. The way this is likely to play out is years of legal battles and nickel and dime fines like this one. The company can handle that with its massive $14.4 billion in cash on hand and $18.5 billion in annual free cash flow.
However, as other states begin the litigation process against J&J and its “co-conspirators” in Big Pharma, investors are going to have to take a closer look at the direct impact.
Johnson & Johnson is a household name and hugely successful business. One reason for its century of success is its financial and operational acumen. It makes wise investments, develops and sells a wide variety of leading brands and is able to grow its margins over time. Pharmaceuticals, just one part of its total business, is the best at this. But that’s also a problem.
No matter how the company is able to write off these likely decades of large fines and settlements, they are going to essentially be a tax on the company’s pharma sales. Those tremendous margins that help prop up the company’s other segments – consumer products and medical devices – will shrink with this new “tax.”
Investors aren’t stupid… at least not always. Monday’s ruling sets in motion a long chain of like rulings, fines and potential settlements. $572 million is the tip of the iceberg. And even the mention of future suits – of which there already are several – will act as a short-term depressant on J&J’s share price.
That’s why it looks like a prime short-term short candidate. No, JNJ isn’t going to collapse. But it also isn’t going to perform as well as Monday’s post-ruling movement suggests either.
So, instead of simply short JNJ shares or outright buying puts on them, we turn to another strategy. One with far less risk and greater opportunity for gains.
A Strategy For Short Term Bears
A bear put spread is a type of trade that involves buying a put option on a stock you think will fall and selling a second put option with a lower strike price.
The income from the sold put offsets a portion of the cost of buying the first one. This results in a reduced overall cost of the trade and therefore the amount at risk.
Now, this offset cost comes in exchange for a capped maximum profit potential. What this means is that a bear put spread trader isn’t looking at limitless profits if shares tank. Those profits are capped.
However, for a stock like JNJ that is very unlikely to crash even in the face of additional lawsuits, fines and settlements, this strategy offers a better than average return on risk than a straight up put or short position.
You can see how this strategy works here:
Source: The Options Industry Council
To see just how perfect this strategy is for JNJ’s current situation, let’s look at a specific example.
A Specific Trade on JNJ
Right now, a trader can buy an October 18 $130 put for $4.40 per share and sell an October 18 $120 put for 1.17 per share for a total cost of $3.23 per share. Since each contract is worth 100 shares of JNJ, that’s a net debit of $323.
That’s the total amount at risk with this trade. Only if shares somehow grow from here above $130 and remain above that amount would the trader lose on this one.
A far more likely outcome would be at least a sideways or downward movement in J&J’s stock price. If other states make headlines by taking the company to court… or other rulings come in over the next few months, shares should drop.
If that happens, and they fall down to or below this trade’s floor, the return would be even higher than the amount to get in.
To find that maximum profit potential, take the difference in strike prices ($130 – $120 = $10), and subtract the cost ($10 – $3.23 = $6.77). On 100 shares, that’s $677 in awaiting profits if shares fall. In other words, the trader would be sitting on more than twice his investment in pure profits in just two months.
Now, all kinds of things could happen in the next two months. But none seem especially good for J&J. The risk of litigation is always a factor to consider, especially for pharmaceutical companies. But today’s situation with J&J makes it an even larger threat.
If you’re looking for decade-long investments, J&J is likely going to be fine. But if you’re looking for a two-month double, going short with a bear put spread is the way to do it.