What Opioid Litigation Means for Healthcare Stocks

Across the United States, there are thousands of civil cases, mostly in state courts, represented by state prosecutors to compensate families who have been hurt by the opioid epidemic. The plaintiffs in these cases are accusing drug manufacturers of actively marketing addictive drugs and pharmaceutical distributors of failing to detect or report suspicious opioid orders. Many of the defendants in these cases are generic drug manufacturers, pharmaceutical distributors, and retail pharmacies that we cover.

The three pharmaceutical distributors we cover--AmerisourceBergen ABC, Cardinal Health CAH, and McKesson MCK--handle roughly 90% of the drugs dispensed across the country. Their sophisticated IT infrastructure allows them to track and manage the supply and logistics of drugs. As a result, a key role of the distributors is to track drugs and provide copies of drug orders to the Drug Enforcement Administration. Historically, this role didn’t require policing, but in the opioid civil suits, distributors have been accused of marketing and profiting from the distribution of opioids. The prosecution teams allege that the distributors should have alerted the DEA of suspicious spikes in opioid volume, a step over and above the required reporting. Walgreens WBA was included with this group as the company has a generic sourcing joint venture with and more than a quarter equity stake in AmerisourceBergen. There has been considerable speculation that the distributors are in active discussions with prosecutors with proposed financial settlements ranging from $3 billion to $15 billion for each distributor. The distributors should be able to absorb the proposed fines as long as they are spread over multiple years.

The first opioid case was settled in 2007, when Purdue Pharma agreed to the Justice Department fine of $600 million for the intense marketing push of a branded opioid drug, OxyContin, in the 1990s. Subsequently, Purdue also settled with 26 states and Washington, D.C., for charges of overprescriptions of OxyContin. In the years through 2017, there were at least eight state and federal opioid settlements where the defendants agreed to pay large fines, including Mallinckrodt MNK ($35 million), Costco COST ($12 million), McKesson ($163 million), Cardinal Health ($78 million), Cardinal Health and AmerisourceBergen ($36 million), and Purdue ($24 million). These cases were settled in aggregate for nearly $1 billion over a 10-year span.

More recently, financial demands have accelerated, fueled by political and social activists advocating for companies to compensate families affected by the opioid crisis. In the most recent civil cases, settlement sums have loomed over $2 billion. In a local Oklahoma court, Purdue and Teva Pharmaceutical TEVA reached out-of-court settlements for $270 million and $85 million, respectively. On Aug. 26, an Oklahoma judge ruled that Johnson & Johnson JNJ be fined $572 million, but the company plans to appeal to a federal court as a result of “abusive discretion” by the local judge, who is an elected official. We understand that Purdue and Teva settled out of court to avoid the potential negative sway onto the significantly larger federal case pending in hard-hit Ohio. In addition to these Oklahoma cases, two generic drug manufacturing companies, Endo ENDP and Allergan AGN, settled in Ohio for $10 million and $5 million, respectively. Reckitt Benckiser RBGLY also agreed to settle with the U.S. government for $1.4 billion.

The over $3 billion in cumulative settlements for these settled or decided opioid cases have not been financially crippling to the defendants. This does not include legal fees in mounting their defenses; for instance, we estimate that Teva spends roughly $50 million-$100 million annually. Unlike the prior civil cases, the federal court in Ohio has proposed the consolidation of roughly 2,000 civil cases from across multiple districts, or approximately 85%-90% of opioid cases in the country. This trial is scheduled to kick off Oct. 21, but considerable leaking of proposed terms suggests that there are active settlement negotiations in play that continue to exert significant pressure on relevant healthcare stocks and will probably be an impetus to settle. This consolidation of cases is similar to the landmark multidistrict litigation created in 1991 that was related to the over 100,000 civil personal injury and wrongful death cases against asbestos manufacturers, notably Johns Manville. Multidistrict litigation cases are tried en masse on behalf of the plaintiffs that are “similarly situated” at the federal level to improve efficiency.

Because of the large number of parties involved, the civil trials are scheduled to occur in multiple tracks. Overall, the defendants anticipate the federal court to be a more neutral venue relative to local courts run by judges who have a special interest in collecting the largest fines from drug manufacturers and distributors to improve changes of re-election. Although active negotiations in Ohio are behind closed doors, unidentified sources have indicated that Purdue may be exploring an unprecedented $10 billion-$13 billion settlement for deceptive marketing of the most well-known opioid painkiller, OxyContin. The Purdue case is front and center as the company actively marketed branded opioids with aggregate revenue of more than $35 billion. As in the asbestos multidistrict litigation, the defendants filed for bankruptcy protection, which is a strategy Purdue may or may not pursue.

Many of the other defendants in the opioid litigation have been very attentive to events transpiring in Ohio to prepare their respective defenses. Based on the figures presented by the DEA, Purdue manufactured only 3.3% of the opioid pills during 2006-12, but unlike its larger peers, the company actively marketed these branded drugs. Teva manufactured 0.9% of the opioid pills distributed throughout the country during this period, while Actavis, a company Teva acquired in 2015, manufactured 34.5% of the opioid pills distributed during this time frame. Although the opioid pill counts for Purdue are relatively lower than the other manufacturers listed, the prosecution appears to be aggressively targeting Purdue as all its opioid drugs were branded and heavily marketed. Drug manufacturers spend significant dollars to market branded drugs, which is likely the crux of the civil case. Unlike branded drugs, generics are significantly cheaper formulations that are sold based on price and not actively marketed. As a result, we think generic manufacturers that have produced larger quantities will likely not be penalized as heavily as peers with branded opioids.

AmerisourceBergen is the second-largest distributor and is growing faster than its peers. The DEA has indicated that AmerisourceBergen is the distributor with the fourth-largest volume of opioid prescriptions during 2006-12 (9 billion pills), while Amerisource distribution partner Walgreens was estimated to be the second-largest opioid distributor (13 billion pills). Amerisource’s growth is largely driven by its larger exposure to specialty drugs and improved sell-through of services into Walgreens. AmerisourceBergen’s operations have been hindered by remediation costs for its compounding business (acquired in 2015), but the continued success in specialty is probably masking any of the drag. For the next five years, we forecast cash flows of more than $2 billion.

Cardinal Health is the smallest distributor, with growth driven by an increasing specialty mix. The company has been hindered by the integration of prior acquisitions, especially in contract manufacturing of commodity medical devices. The DEA indicated that Cardinal is the distributor with the third-largest volume of opioid pills (11 billion). We model free cash flows of over $2 billion in the next several years. On Aug. 20, the company filed a prospectus with the Securities and Exchange Commission for an unidentified mixed shelf offering (common, preferred, and debt securities). We suspect that this filing is to pre-empt the need to fund a proposed opioid litigation settlement.

McKesson is the largest distributor and continues to be challenged in its U.K. and Canada segment. As a result, we anticipate the company to grow slightly slower than its peers. The company is the least leveraged and is forecast to generate the largest free cash flows in the next five years at $7 billion. The DEA indicated that McKesson is the distributor with the largest volume of opioid pills (14 billion).

Because it is relatively highly leveraged, Teva is the company we cover that has been the most negatively hit by opioid litigation. Our current estimates assume a settlement of approximately $1 billion. However, in light of recently accelerating settlements, we have taken a closer look at our cash flow forecasts. As of the second quarter, Teva had $26.5 billion in net debt. We estimate that Teva will generate approximately $8 billion in cash over the next 10 years, with the leanest years in 2021 and 2023 due to debt maturities. It will probably not need to refinance until the maturation of three senior notes of roughly $4 billion in 2021. We have conservatively assumed the blended interest rate will increase from 3.3% in fiscal 2019 to 8% in fiscal 2021. The shares are more than 70% off their 52-week high, reflecting significant uncertainty surrounding the opioid litigation, and are trading at 3 and 2 times price to 2020 and 2021 free cash flow, respectively. We think the shares will remain highly volatile until the resolution of the Ohio trial, but we believe Teva is undervalued, and we maintain our fair value estimate of $15 per share with a very high uncertainty rating.