Does Johnson & Johnson's Kenvue Spinoff Make Sense?

In this podcast, Motley Fool producer Ricky Mulvey and senior analyst Asit Sharma discuss:

• Johnson & Johnson's spinoff of its consumer health company, Kenvue.
• If Darden Restaurants is getting a good deal on its acquisition of Ruth's Hospitality Group.
• Yum! Brands quarter, and what it says about the global economy.

Deidre Woollard and Matt Frankel look ahead to Berkshire Hathaway's annual meeting, taking place this weekend. This podcast was recorded before the meeting. Check out some of The Motley Fool coverage here.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 03, 2023.

Ricky Mulvey: It's shiny, it's new, it's a Band-Aid. You're listening to Motley Fool Money. I'm Ricky Mulvey sitting in for Chris Hill, Asit Sharma joins us now. Asit, good to see you.

Asit Sharma: Good to see you, Ricky.

Ricky Mulvey: Just a quick note, we will cover the Fed announcement on tomorrow's show. It is a little past 2:00 P.M Eastern time right now. So we're not going to get to that or the regional banks nonsense. But there's a lot of earnings and even in IPO to talk about. Asit, tomorrow a very rare thing is happening, which is that a company is going public. Johnson & Johnson is spinning off Kenvue, the consumer health stable, which includes brands like Band-Aid, Tylenol, and Neutrogena. Is there a business reason to do this or is this just because analysts don't like mixing multiples and mixed fractions are hard?

Asit Sharma: Company like Johnson & Johnson very diversified conglomerate business tends to mask some of its strength by having this consumer health business nestled up beside a pharmaceutical business. The pharmaceutical revenue streams have a higher margin. So management feels that if we spin off the consumer-facing stuff, then maybe shareholders will value us more for what we can produce, the profits we're capable of. At the same time, a good consumer-facing company when it's managed by a set of dedicated capital allocators, and veterans, sometimes can improve the speed at which that business accelerates and the profits as well. In the best of both worlds, the two parts separated will each have better results and have more value assigned to them by shareholders. That's to be seen in the execution though.

Ricky Mulvey: Kenvue brands did about $15 billion in net sales last year. Right now the company, the conglomerate is being valued at around $40 billion. That's less than three times sales and when you look at a comparable company, let's say Procter & Gamble, which consistently trades around 4-5 times sales. Do you think Johnson & Johnson is asking too little here? Is this a good opportunity for investors?

Asit Sharma: I think they're asking what the market will bear. There are a few factors that informed this decision to go in at 40 billion bucks. One is this separate company Kenvue, is expected to grow in the low to mid-single-digits for the next couple of years. Out of the gate investors aren't going to assign it a crazy multiple. Second, if you look at Procter & Gamble's earnings multiple, and here it might be easier just to take their market capitalization versus their trailing net income, they're valued at around 13 times the net income they produce. Whereas in this IPO, Kenvue is going to be valued more like 20-25 times its net income depending on how you adjust the pro [inaudible] earnings. It is getting some love there from that perspective. The third is, I think the control factor that Johnson & Johnson is exercising. Not only are they going to own about 91.5% of shares after this company goes public, they will continue to exercise control even after that control percentage starts to dip down. This brings a question in the mind of investors who are looking for that earnings growth and net sales acceleration I talked about, if you're not going to let the robin fully leave the nest, is the management team really going to be able to allocate the capital in the fashion manner they want? This is the whole reason to do a spin-off so that accompany can function free of those corporate aprons strings. I wonder if I'm looking at this company, is it worth the 40 billion? Should I be discounting these shares for that reason?

Ricky Mulvey: According to the prospectus though, you're getting some top dogs. You get Listerine, the number one mouthwash. According to the S1, the leader in mouthwash research, you're also getting Nicorette, the number one smoking cessation brand and Zyrtec, the number one allergy brand. Does that give this company a little bit more of that premium you just described?

Asit Sharma: It's certainly in that premium in the consumer goods world. You mentioned Procter & Gamble, brands count for so much. In the pharmaceutical world, part of that brand power rests in your doctor's mind whether they're going to prescribe you that medicine or not. But on the consumer-facing side, brands like Nicorette have a lot of staying power, Listerine. There is a reason to want to buy these because they don't certify, but they suggest that those cash flows are going to be really stable for some time to come.

Ricky Mulvey: While some companies are getting spun off, others are getting spun up. Olive Garden parent company Darden Restaurants announced that it is buying Ruth's Hospitality Group or Ruth's Chris Steak House for $715 million. This will join it's stable of Steakhouses and fine dining brands like LongHorn and Eddie V's. Asit, the market sure thinks that this is going through. Ruth shot up more than 30% this morning to just 10 cents below the buyout price.

Asit Sharma: I think the market thinks that this is a fine deal for Darden, and it's a good deal for Ruth shareholders. They don't see much in the way of regulators stepping in or another company bidding for these publicly traded assets, we should note. I think that the consensus view this morning seems to be the deal will go through the pricing is fair. We can talk about the pricing in just a minute. I wanted to point out from Darden's perspective that obviously management thinks they can do a better job running this fellow steakhouse than the management of Ruth's Hospitality Group has done. Now there are some economies of scale that Darden can bring to this because they're a little bit larger and, as you point out, there are in the business of this fine dining higher-end steakhouses. But all-in-all, this seems like it is beneficial both to shareholders of Ruth's Hospitality Group and eventually, maybe not today, shareholders of Darden.

Ricky Mulvey: I want to talk about the valuation just for a sec. Darden has $900 million in current assets, more than double that amount in current liabilities. Again, this is around $700 million for Ruth's Hospitality Group. Is this a meal that they can choke down or is this unaffordable for that balance sheet?

Asit Sharma: Yeah, they've gotten liquidity, but its liquidity with an asterisk if you look on their balance sheet absolutely, Ricky. Where are they going to get this cash from? But they do happen to have a near billion-dollar line of credit with Bank of America. When they talk about liquidity in the press release, that's where that money is coming from. Bank of America is providing that cash. Now, the deal makes some sense on a valuation basis because Ruth's Hospitality Group was trading at a lower EBITDA multiple than Darden. If you look on a trailing basis, Darden was trading around 14 times its EBITDA, earnings before interest, taxes, depreciation, and amortization. Ruth's was trading at a much lower multiple, something like 6-7 times. Even with this premium of 30%, Darden is still acquiring its smaller rival at less than its own shares are trading for in the public markets. If they can bring those 2-3% points of operating margin that they enjoy, which are higher than Ruth's just now to this smaller company, they'll get a double whammy. They'll increase the earnings power of Ruth's, and they'll also eventually be able to enjoy those cash-flow streams being valued at their current multiple. That's the magic for them.

Ricky Mulvey: That's the bull case. Obviously, most acquisitions destroy shareholder wealth and Darden Restaurants shareholders really seem to take this acquisition with a straight-line face emoji. But it is a chain of steakhouses buying another chain of steakhouses. Is the corporate finance folks synergies in there?

Asit Sharma: I think they're in there. Ruth's does not break out their restaurant margin quite to the extent we'd like them to, but I suspect that Darden is better on both its labor costs and it's raw food cost. I think they are just that much better, let's say one to two percentage points in restaurant margin and that's part of where these synergies will come from.

Ricky Mulvey: Let's stay on food. Yum Brands, which operates KFC, Pizza Hut, and Taco Bell, reported first-quarter earnings this morning. Yum beat revenue and same-store sales expectations, but missed on earnings due to, ''Declines in the value of unnamed investments''. That's what I called my crypto era, Asit. What were your big takeaways from Yum's quarter?

Asit Sharma: I thought Yum did a fine job with the quarter. This is the time where a QSR operator with a lot of franchise revenues and not just operating restaurants, but taking in that high-margin franchise royalty should be able to make, hey, you want to bring customers in with limited time offers, consumers are looking to spend less. They're dropping down in their eating habits. This is the time to show that strong sales growth in the same store sales and also some restaurant additions. That's what we saw out of Yum Brands today.

Ricky Mulvey: It's also a canary in the coal mine for reopening across the globe, KFC has more than 8,000 locations in China. That's doubled the footprint in the United States. Anything you saw in the global reopening that caught your attention?

Asit Sharma: While China's coming back. The thing that I like for Yum Brands is that the majority of the take from China comes through its master franchising agreement with Yum China, which it's spun off I think in 2016. They have some insulation on the cost side. When consumers start coming back in China, they get a nice lift out at that without some of the risk of the operations. I think that's good for them, but I would be cautious. I saw some small bits of data coming out of China that said maybe this manufacturing rebound was a little bit of a flash in the pan, consumer spending follows that confidence. Just now we have a surge of Chinese consumers in all sectors of the market. They're eating out, they're starting to travel again. They were locked down much longer than the rest of the world. But I wonder how steady and strong that impetus to spend is going to be. I wouldn't be surprised to see it pulled back in a quarter or two.

Ricky Mulvey: Well, that's one of Yum's advantages, which is that they're looking at that lower price point. They have the Taco Bells two dollar under menu. You can get a grilled cheese burrito for five bucks if you want Pizza Hut's seven-dollar melts. Now that's in the United States, but it seems like the same strategy would apply globally compared to a company like Darden buying Ruth's Chris, where there's an easy trade down. Yum seems to be capturing those folks who are impacted by inflation may already be living in a recession.

Asit Sharma: I think they are. The one caveat for investors like why this doesn't become a slam dunk investment at a time like this is they're struggling with the same things we are. Their costs are going up too. So commodity cost, packaging costs in QSRs, the food cost, labor costs, all that's rising. So you have to be able to make something out of that on the bottom line, at least the top line though, we are seeing those numbers come through.

Ricky Mulvey: You saw that with Yum's leadership answering and the analysts calls. The analysts, of course, across every company poking and prodding, hoping that leaders will update their guidance, put that a little bit higher for my model. Yum is not keen to do this. They're sticking with last year's projections and I think if I were CEO, I'd be doing the exact same thing because throughout this earnings season, companies are getting punished for missing expectations, but there has been absolutely no benefit if they're solidly crushing them.

Asit Sharma: Sometimes we ask too much of CEOs when we desire them to get their head out of their own businesses and become macro experts and make these big calls, and Wall Street tries to demand, tell us what the economy is going to do over the next four quarters. Then tell us exactly what your company is going to do and its top and bottom lines, that's a hard exercise. I don't blame Yum either.

Ricky Mulvey: Sharma. Thank you for your time.

Asit Sharma: So much fun, Ricky. Thanks a lot.

Ricky Mulvey: Up next to Deidre Woollard and Matt Frankel preview Berkshire Hathaway's Annual Meeting which kicks off this Saturday.

Deidre Woollard: So you went last year. What are you hoping to get from this year's event?

Matt Frankel: Obviously you can watch the Buffett Q&A live online if you wanted to, you could read about it after the fact. It's really the experience of it. You really get a feel for what Berkshire is, this is a company that you don't get online. I was shocked at how many people there were over 85 and had been investors in the company forever. But you get to meet some of the original investors and talk to them about what they saw in it because you can talk a lot about Buffett's investment style, but especially from talking to the people who have been invested in Berkshire forever, that was one of the coolest experiences there of getting that insight of what they saw in this company 30, 40, 50 years ago. And try to apply that to my investing style today and just learn a lot of valuable lessons from people who really got it right.

Deidre Woollard: Well, that's interesting because I can imagine that Berkshire as a conglomerate has changed over the years in terms of what those people bought at that time versus what it is now. Do you have any favorites among the investments that Berkshire has made?

Matt Frankel: Well, obviously my bank and real estate guy, I am biased toward those. But I love how this investments will evolve over time. Talking about banks of real estate. At one point, Berkshire owned Freddie Mac. And obviously, no one wants to own Freddie Mac stock these days. The company shifted, so Buffett shifted. One of my favorites that he invested in recently, I'd say as Ally Financial, a smaller bank, especially in the regional banking turmoil because it's gotten caught up in it. But doesn't have the same lack of FDIC insurance, the same big corporate clients, things like that. I really like that. I like how his Bank of America investment. When Berkshire bought into Bank of America during the financial crisis, it really made me look at it while I otherwise probably wouldn't have considered it. I would've said too risky things like that, but if Buffett was willing to put his money in. But I don't know if I could pick just one favorite, especially when you consider that they own 60 or so companies that they've bought over the years, as well as about four dozen stocks. That's more than 100 investments to choose from. It's really hard to pick just one or two.

Deidre Woollard: No doubt. Well, you mentioned banking and real estate. These are going to be hot topics, I'm assuming at the conference among the questions asked. I know Charlie Munger recently spoke about commercial real estate, which protect people feeling a little jittery. If you could ask Buffett or Munger, one question, what would it be?

Matt Frankel: My name is on the list to ask a question, but I'm with about 10,000 people there.

Deidre Woollard: What's the question?

Matt Frankel: It's not a banking or real estate question. I would ask him about the Activision investment that he made the day before last year's meeting, they announced that they bought a 9.5% stake in Activision. I think it's actually increased a bit since then as an arbitrage play. It's Europe and Great Britain are blocking the deal. The opposite of how Buffett saw that going. It sounds like on the surface. So now my question is, was it an arbitrage with backups situation? Meaning that if it didn't work out, he's happy to hold it because it's a great business? Or is it an arbitrage play that if it doesn't work out, he loses? So the Activision investment, especially since this news just came right before this year's meeting. I'm sure someone will ask that question while we're there or Buffett will just volunteer the information. But that's really the biggest question on my mind going into the meeting.

Deidre Woollard: Well, in terms of things that Buffett has done recently, he went big on oil with Occidental Petroleum. Everybody was following that for a while. This year it's been interesting. He's done different things with some of the Japanese trading houses. What lessons can we take from his moves?

Matt Frankel: That is unpredictable. Who would've a guessed Japanese trading houses. I put that in the two hard basket personally. With the Occidental Petroleum and Chevron too last year before the meeting, he put a lot of money into oil last year. A lot of that was after the price started to rebound. Remember, during the early days of COVID for a while, oil prices actually went negative at one point because they just didn't have anywhere to put it. All the oil stocks were tanking at that point. But then fast-forward like a year, oils had really rebounded nicely. Buffett puts a ton of money into Occidental and Chevron. Chevron's, I think Berkshire is number 3 investment right now. Buffett doesn't try to time the market. He's willing to sell at a loss if his thesis didn't work out. The airlines were a big example of that, that he sold a couple of years ago at a big loss and said, it just didn't work out. He doesn't ask the question, did I miss this opportunity? He looks at the snapshot of the company now and whether or not it looks like a good long-term opportunity. Occidental Petroleum's doubled. Did I miss the boat? I'm very guilty of this. I've added with speaking of real estate, I've been building a position at Redfin over the past six months. Now the stock has doubled from its lows are a little bit more and I'm still buying shares because I'm looking at it as a snapshot in time. Are they making progress, is the real estate market stabilizing and things like that. Not did I miss the boat by not buying more at three dollars a share as opposed to seven dollars a share. So Buffett applies to the same logic is using the snapshot in time rather than wondering if he's missed the big move and that's a big lesson. It doesn't matter if the stocks already rebounded, if it's still going, if it still has a lot of long-term potential.

Deidre Woollard: So if you're not at the meeting, that you've mentioned, it is still broadcast live. It's a long couple of hours, but there are always a lot of moments of wisdom. Give me a reason that investors should take the time spent there Saturday afternoon listening to that broadcast?

Matt Frankel: As you mentioned, it's a long Q&A session. It's actually broken into two parts other than, I think an hour break for lunch, they're answering questions from about 9:340 to 4:30 straight. So it's a long day of questions. If you read the transcript, it's going to be a very long transcript. So that's one. If you watch and if you read a recap like seven things you missed from the Berkshire meeting. It's going to be a very condensed version of what was said and things like that. A lot of it is in the long answers that Buffett gives. If you actually add up the number of questions he answers in that period, it's a lot lower than you might think it is, because he takes us time and gives a drawn-out answer to each one. There's a lot of little tidbits of wisdom in each answers. It's really interesting to watch and how his thoughts evolve overtime. The same general framework applies when he's answering questions over time, but there are certain questions that come up all the time. Have you ever considered paying a dividend? This a big one that is asked it like every other Berkshire meeting. The answer really evolves over time. Or why don't you buy back more shares? That answer has definitely evolved over time as the Berkshire buyback plan has. Or do you think you'll beat the market over time? Do you think you'll replicate your last 20 years performance or something? The answers change over time. But the general idea is he's conveying are really very timeless. You can find a lot of timeless investment wisdom in listening to the Q&A. You don't have to listen all seven hours. There are times at the meeting when I get up and need to stretch my legs and take a walk. I can't sit in that arena seat for seven hours, but that's just me. But it's a very valuable experience and I always feel like I come out of it a better investor. I've watched it ever since they started live streaming it a few years back. But last year was the first time I went in-person.

Deidre Woollard: We've got two men, 99 and I believe 92. We have to know they'd probably aren't going to be around forever. Thinking about Berkshire going forward, are you still going to be a Berkshire shareholder once Buffett is no longer in charge?

Matt Frankel: Yeah. To be clear, I hope they both live to 120.

Deidre Woollard: Don't we all?

Matt Frankel: Having said that, at some point they will not be around anymore. Buffett could retire. He's definitely hinted before that if he doesn't feel like mentally clear enough to run the company or anything like that, he would step down. I will still be a shareholder. I actually think that when Warren Buffett's no longer running things in the succession plans put in place, it could end up being a net positive for long-term investors. I'm not in the camp that Buffett's investment style is outdated. You'll see a lot of that on Twitter and things like that. Buffett doesn't get technology, things like that. But he's grooming two investment advisors to take over the portfolio. They do get newer technologies and newer investment ideas. They were the ones who initially got Apple into the portfolio, which has been his most successful investment of all time in terms of dollar amount. They're the ones who invested in Snowflake pre-IPO, which as far as tech stocks go, has held up pretty well in the recent turmoil. They've added Amazon to the portfolio. It will broaden the investible universe of Berkshire stock portfolio when his proteges are running the entire thing. Right now, they run less than 10% of the portfolio between them and have outperformed, buffeted most recent years. So I almost think that, that could take Berkshire's stock portfolio, which is about half the company by market gap, really into the next 50 years. 

Ricky Mulvey: As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll see you tomorrow.