Kenvue IPO Still Leaves Johnson & Johnson With Most Of The Talc Liabilities – An Update

Summary:

• To limit the legal liabilities related to talc, Johnson & Johnson has adopted a strategy that ensures pending cases are heard in bankruptcy court.
• The article explains why, contrary to popular belief, most of the talc-related legal liabilities are not being “spun off” along with JNJ’s Consumer Heath segment operations.
• In addition, I provide an update on the situation, given JNJ’s recent setback with respect to its proposed plan to manage the claims through a bankrupt subsidiary.
• I will also explain how I intend to proceed with my substantial JNJ position. After all, the stock has fallen by almost 15% in just over a month.

Introduction

As is widely known – or at least as has been communicated by various news outlets – healthcare giant Johnson & Johnson (NYSE:JNJ) will separate its Consumer Health division to protect the RemainCo (pharmaceuticals and medical devices) from significant litigation related to talc-containing products such as Johnson’s Baby Powder. The new company is expected to go public in 2023 and will be named Kenvue (KVUE).

Not long ago, I covered JNJ stock in detail, comparing it to Swiss pharmaceutical and diagnostics giant Roche Holding AG (OTCQX:RHHBY, OTCQX:RHHBF) and discussing its qualities as a dividend growth investment. I briefly discussed JNJ’s risks related to talc lawsuits in another article that looked at potential red flags at companies such as 3M Company (MMM), Kimberly-Clark (KMB), Altria Group (MO), Philip Morris (PM), and Lockheed Martin (LMT).

In preparation for the initial public offering (IPO), Kenvue submitted an S-1 filing with the Securities and Exchange Commission (SEC) on January 04, 2023. The document details KVUE’s operations and also provides a good overview of the risks associated with talc litigation for both the RemainCo and the emerging consumer health company. On February 03, 2023, Kenvue filed an amendment to the original S-1, including an update on the legal matters.

In this article, I will discuss the current state of affairs and explain why Johnson & Johnson will retain significant liabilities while Kenvue will largely be spared the legal burden associated with the talc-related litigation. I will also outline why I am holding on to my JNJ position and intend to also hold on to my KVUE shares, which I expect to receive as part of the transaction.

As an aside, I want to make it clear that my intent in writing this article is not to disparage people who have health issues and are taking action against JNJ. I only intend to evaluate the above risk from the perspective of a JNJ and prospective KVUE shareholder.

Brief Summary Of Johnson & Johnson’s Strategy In Relation To Talc Litigations

Discomfort among Johnson & Johnson shareholders emerged as soon as the first lawsuits were announced, but of course was exacerbated, especially after a $4.7 billion verdict in 2018. Ultimately, JNJ paid $2.5 billion in connection with the Ingham vs. Johnson & Johnson, et al. decision (U.S. Chamber of Commerce Litigation Center and p. F-18 of the S-1/A). Given the more than 38,000 cases pending and yet to be filed, JNJ has adopted a strategy of ensuring that pending cases are heard in bankruptcy court.

This is not to say, of course, that JNJ will file for bankruptcy protection. Instead, the company formed LTL Management LLC in October 2021 to hold and manage current and future talc claims. JNJ provides LTL with funds to settle current claims and will establish a $2 billion fund and provide approximately $350 million in royalty income for future claims. To enable this separation, JNJ had to form a limited liability company in Texas, which was then merged with the Consumer Health business. Under Texas divisional merger law, this step was necessary to allow for the split into two subsidiaries – one to assume the liabilities and another to continue regular operations. Anyone interested in the details can study the S-1/A, page F-55 et seq.

While this now sounds like JNJ has transferred the claims to the soon-to-be-separated consumer health company Kenvue – making it a potentially toxic investment – the reality is quite different. Kenvue will indeed assume liabilities related to talc, but only with respect to claims outside the U.S. and Canada, while JNJ will continue to carry the liabilities in the U.S. and Canada through its subsidiary LTL Management (p. 40, S-1/A). According to the discussion on page F-19 of the document, the U.S. and Canada claims represent the vast majority of all talc-related claims. In this way, all claims are expected to either be settled through the bankrupt subsidiary, limiting JNJ’s exposure to approximately $2.4 billion, and leaving Kenvue with the claims arising from litigation related to talc-containing products sold outside the U.S. and Canada. Of course, it should be noted that Kenvue also faces litigation risks related to its over-the-counter products Zantac (ranitidine, decrease of stomach acid production) and Tylenol (acetaminophen, a widely used painkiller also known as Paracetamol, first made in 1877 and on the WHO’s List of Essential Medicines).

That talc-related and other legal obligations represent a manageable liability for Kenvue is shown in its most recent financial statements reported in the S-1/A filing. According to page F-49, Kenvue had $553 million, $3,967 million, and $92 million in litigation-related expenses in 2019, 2020, and 2021, respectively. While the document does not go into detail about the 2019 and 2021 numbers, it states on page 18 that the $3.9 billion is primarily due to the impact of talc-related liabilities. Kenvue’s October 2, 2022 balance sheet shows $864 million in accrued liabilities, and considering the information on page F-18 of the S-1/A, it is reasonable to assume that most of this is due to talc-related liabilities that are already foreseeable. This also makes sense in the context of the above expenses, compared to the $1.0 billion and $4.6 billion in accruals reported on the January 2, 2022 and January 3, 2021 balance sheets, respectively.

Without prejudice to the possibility of the occurrence of further claims, this is pretty good news for prospective KVUE shareholders. Currently, the company expects to be liable for less than $1 billion. JNJ shareholders are also likely to breathe a sigh of relief, as the bankruptcy maneuver should limit liabilities to about $2.4 billion. The progress made toward successfully managing litigation risk prompted Moody’s to reconsider its negative outlook on JNJ’s Aaa credit rating, which was changed to stable on May 25, 2022.

Recent Events

While the New Jersey Bankruptcy Court denied plaintiffs’ motions to dismiss JNJ’s bankruptcy maneuver in February 2022, some plaintiffs were successful after asking a panel of the 3^rd Circuit Court of Appeals to dismiss LTL’s bankruptcy case in September. In late January 2023, the judgment was reversed and the panel remanded the case for dismissal. JNJ, via LTL, has requested a rehearing, so the bankruptcy case remains in place for now (p. 41, S-1/A). However, given the possibility that LTL’s reorganization may be rendered impossible, the approximately $2.4 billion litigation-related claims cap noted above may no longer apply. Rating agency Moody’s commented on this setback as being a credit negative event, although it did not affect JNJ’s Aaa rating or stable outlook. The spread on JNJ’s five-year credit default swap (CDS) has also barely moved since the news broke – from around 28 basis points to currently around 32 basis points. As an aside, a CDS is best described as an insurance contract in which the seller indemnifies the buyer in the event of a default by the debtor. The higher the CDS premium, the higher the perceived risk that the debtor will default. During the Great Financial Crisis, JNJ’s CDS premium spiked to over 80 basis points, and at the height of the COVID-19 pandemic, it reached 40 basis points.

Against the backdrop of renewed uncertainty, it is of course important to consider the possibility that plaintiffs will seek to bring claims against Kenvue, knowing that the company contains the assets of JNJ’s former Consumer Health division. However, JNJ and Kenvue have made provisions in this regard in that the parent company will indemnify Kenvue for potential talc-related liabilities in the U.S. and Canada (likely via LTL Management). Nevertheless, the S-1/A states that JNJ may not be able to fully meet its obligations in this regard, but this likely refers to the originally envisioned cap of approximately $2.4 billion.

Concluding Remarks

The unbroken downward trend in JNJ stock since the start of the new year is, of course, discouraging. As I pointed out in another article, I consider JNJ fully valued at about $170 to $180 per share, so the market has priced in a significant increase in talc-related liabilities, with the stock now trading at almost $150. However, I believe a decline of more than $60 billion in market capitalization is an overreaction, although I acknowledge that some of the downward pressure is due to the recent shift into growth stocks and declining interest in healthcare stocks. I see Moody’s most recent comment as positive, assuming the rating agency has deeper insights into the matter and has studied the case in depth, as it would have a material impact on the company’s credit rating. After all, JNJ is the only Aaa rated company in the U.S., besides Microsoft Corporation (MSFT) and Apple Inc. (AAPL). Going forward, it will be interesting to watch the accrued liabilities on JNJ’s balance sheet ($11.5 billion at the end of 2022, down 16% YoY). Of course, these relate not only to talc claims, but also to other pending and already assessable claims. I think the claims – regardless of the form in which they are ultimately settled – should be considered in light of JNJ’s very strong balance sheet and reliable free cash flow of at least $20 billion annually, as outlined in my original article on the company.

In conclusion, I have no intention whatsoever of selling my sizable position in JNJ. In fact, I recently added a few shares as I believe the 14% decline so far in 2023 is quite exaggerated. For the first time in three years, JNJ stock is now trading at a blended price-to-earnings (P/E) ratio of 15 (Figure 1).

In light of KVUE’s upcoming IPO, it seems worth noting that JNJ will retain at least 80.1% of the NewCo’s voting rights and will also receive the net proceeds from the IPO. However, according to page 53 of the S-1/A filing, JNJ intends to make a tax-free distribution to its shareholders for at least a portion of its holding. It follows that as a JNJ shareholder, I will most likely receive KVUE shares. However, depending on how well Kenvue’s position with regard to the talc lawsuits is covered in the news, and how well it is understood by market participants, I can imagine the stock doing quite poorly, at least temporarily. As a result, it may be prudent to sell the stock as soon as possible with the expectation of buying it back at a later date. However, it is likely that the distribution of KVUE shares to JNJ shareholders will occur well after the IPO, so the damage to the share price has already been done. For this reason, the currently very manageable litigation-related liabilities, and because I can only guess at the broad market’s correct assessment of the situation, I intend to hold on to my KVUE shares.

Thank you very much for taking the time to read my article. Do you agree or disagree with my conclusions? I’d appreciate your thoughts in the comments section below – Also, if there is anything you’d like me to improve or expand upon in future articles. In any case, please consult with a registered and experienced investment advisor before making or arranging any trades.

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Disclosure: I/we have a beneficial long position in the shares of JNJ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The contents of this article and my comments are for informational purposes only and may not be considered investment and/or tax advice. I am neither a licensed investment advisor nor a licensed tax advisor. Furthermore, I am not an expert on taxes and related laws – neither in relation to the U.S. nor other geographies/jurisdictions. It is not my intention to give financial and/or tax advice and I am in no way qualified to do so. I cannot be held responsible and accept no liability whatsoever for any errors, omissions, or for consequences resulting from the enclosed information. The writing reflects my personal opinion at the time of writing. If you intend to invest in the stocks or other investment vehicles mentioned in this article – or in any form of investment vehicle generally – please consult your licensed investment advisor. If uncertain about tax-related implications, please consult your licensed tax advisor.

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