Motley Fool Hidden Gems Investing - J&J Attempts a “Texas Two-Step”

Episode Date: April 5, 2023

Johnson & Johnson proposes a $9 billion settlement and Chewy hits a speedbump. (00:21) Dylan Lewis and Tim Beyers discuss: - The fallout from Johnson & Johnson's talc settlement. - What the lawsuit could mean for J&J's spinoffs. - Why the US Department of Justice is taking a look at Activision Blizzard. (14:55) Ricky Mulvey and Emily Flippen take a closer look at Chewy's growth initiatives, and what they could mean for shareholders. Companies discussed: JNJ, ATVI, CHWY Host: Dylan Lewis Guests: Tim Beyers, Emily Flippen Producer: Ricky Mulvey Engineer: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Dylan Lewis, sitting in for Chris Hill, and I'm joined by Tim Byers. Tim, scale of caffeinated to very caffeinated. How are we doing today? Oh, we're fully caffeinated, Dylan. Ready to go. Let's do it. I'm excited that you're fully caffeinated because we are going into the often obtuse world of corporate settlements. We have a couple pieces of news related to that, and I thought it'd be interesting to dive into it. The first is Johnson & Johnson is proposing a $9 billion settlement to thousands who sued the company claiming its talc products caused cancer. And if this deal is approved, it would be one of the largest consumer liability settlements of all time.

Notably, it is a sizable jump from the $2 billion that the company had previously booked related to those claims in 2021. And Tim, as I see it, that seems quite intentional. It looks like Johnson & Johnson is trying to do a little bit of a maneuver here. And if you pay attention to the bankruptcy world and the corporate bankruptcy world, you'll know it as the Texas two-step, looking to use bankruptcy law to transfer this talc case liability to a subsidiary, which would then file for bankruptcy and disperse money to those affected through the bankruptcy process. J&J would fund the payouts, but it would cap the long-term liability and the cost for Johnson & Johnson. Do I have that right? I think you're in the right ballpark here.

And let's be clear, the court already saw this and decided, and it sort of said, time out. You know, wait a minute here. You don't just get to, you know, get rid of this and just sort of dismiss it. The company did propose a bankruptcy prior under the LTL subsidiary that you're talking about. And this was created in 2021. And a federal appeals court said, no, you don't get to do this. LTL does not get to qualify for protections of the bankruptcy court. And so this became a thing that J&J had to go back to the drawing board.

So they literally did try this once and say, hey, we have this subsidiary. We're going to file bankruptcy. The appellate court said, nope, you don't get to just get rid of this. And so, now what we're seeing is a revised version of this that roughly more than 60,000 claimants here. So, this is a class action lawsuit. And so, there's a lot of people with claims who are now backing this and saying, okay, this is better. This is a better settlement. And so, now we're going back to the bankruptcy court. Now, LTL will go into bankruptcy and say, look, here's what we're going to do. We have the backing of a bunch of claimants here and our total

payout will be roughly, the present value of that will be $8.9 billion. We already settled a 2018 claim for $2.1 billion. Here's an additional $6.9, roughly $7 billion. And let's get this off the books. Now, to be fair, LTL, which will be a subsidiary and will have its own operations here, and J&J will deal with this differently, and there will still be costs associated to both. It doesn't get immediately rid of all of it, but what it does do, I think the language that you use that's most important there, Dylan, is capping the liabilities. It sort of settles the major claims so that we don't have a bunch of new lawsuits heaped upon J&J or LTL. We start settling out the things that have been agreed upon, and then we move on from there. So it's

a platform from which J&J gets to move on from some, I would argue, some really damaging litigation, both from a human perspective, a lot of cancer patients here, there's a lot of human tragedy here that no amount of money can make up for, but also some real damage to its reputation because this has been going on for a long time. So actually settling this, not admitting any wrongdoing, but saying, here's a thing that we want to make sure we get behind us. And claimants are saying, we deserve some compensation here. And they're getting that.

So you hope calling it a win-win doesn't feel right, considering the scale of the tragedy that, you know, because cancer is never great under any circumstances. So win-win feels wrong to say, but getting to a point where there's an agreement and hopefully that agreement can satisfy some people who have legitimate claims. You talked about this being a platform for J&J to move on, and there is the liability element of the talc powder, and then there's kind of the corporate direction of J&J overall. and this is a business that is really trying to focus on its pharmaceutical and its medical

device units and is looking to take a lot of the consumer brands that I think we're very familiar with from this company and move it to another business, a kind of self-contained business that will have its next chapter. Do you see this as kind of another piece of that path for them? It sure seems like it. I mean, LTL is going to take essentially the consumer health unit. And I don't know if it's specifically LTL. It's hard to tell from the reading of the filings here. What we do know is that J&J will separate into a separate unit. And the separate unit will be called Kenview. And that's going to take on the new version of Johnson's Baby Powder, which I believe now, instead of talc powder, we'll be using things like cornstarch,

cornstarch powder, and then Tylenol. That becomes a standalone company. Then you have Johnson & Johnson, which is the much bigger company that will focus on things like medical devices and pharmaceuticals. Let's remember that Johnson & Johnson was one of the big providers of COVID vaccines. Not that long ago, Dylan. So this is still a big pharmaceutical company that does make medical devices. So it's known for things like Tylenol, but there's a lot more to it. So these two separate. And it does appear, when we look at the market action around this settlement, or this organization plan, this bankruptcy plan, that there may be some investors who are looking at this and saying, hey, you know what? If I buy J&J now, not only am I

getting the settlement, but I might be getting two companies. So at one point, how does this Kenview spinoff occur? Will it become a public company? Will I get shares in a new public company called Kenview? There's a lot to be determined here, Dylan, but there is potential for value to be created out of this settlement. Speaking of settlements, we also have settlement talk in the gaming space today. The U.S. Department of Justice is taking a look at Activision Blizzard's competitive balance tax in its esports leagues. And Tim, this is a story that developed pretty quickly. We saw a claim earlier this week, and then I believe yesterday or earlier today, we saw that the DOJ was already reviewing a proposal from Activision Blizzard related to

the claim. Right. Yeah. And it was, what, within like three or four hours? I mean, it was astonishing. But you know what? To me, this feels like, and I know I'm being a little bit, this might be a little bit of a salty take here, Dylan. I feel like the Justice Department is maybe overstepping feels wrong to say, but here's what's going on. This idea of a competitive balance tax, Activision Blizzard essentially assigned to these e-sports teams. They have these e-sports leagues. And so the competitive balance tax idea is that you don't want a team that is essentially paying an extraordinary amount of money for a ringer and say like leagues that have to do with games like call of duty or overwatch right and so the the notion is

that we want a league of teams that are pretty evenly matched and so this is going to be fun to watch it's not like one team is going to come in pays all the ringers blows everybody else away and now this is like, it's a rigged game. So the idea of a competitive balance tax, honestly, Dylan, kind of makes sense to me because in a league, I mean, we've seen this in American sports. We even see it in European sports. In the NFL, for example, we have a thing called a salary cap. Does the competitive balance tax sound all that different from a salary cap? I mean, I'm sure functionally it is. And because we're talking about a business and a business that is actually getting revenue and shareholders presumably get a claim on profits from that revenue, so you can't sort of use the same governing dynamics of like a league. And yet you kind of want a league to be competitive. So in a way, I feel like this is

a nonsense claim from the Justice Department. So settling it quickly feels right to me, Dylan. I was going to ask Tim, if this is kind of just part of the path from esports being gaming to becoming sports and sports leagues in the way we think about it in the conventional sense, because we do have these mechanisms in a lot of the major sports. I guess maybe some of the difference there is we have players' unions and collective bargaining that plays into some of that. There's probably a little bit of maturation that just needs to happen for esports to catch up to that environment. That's probably right. As part of the reporting on this, Activision Blizzard has been very clear that there really hasn't been an application of the competitive balance tax.

there's been no impact on player salaries. We haven't suppressed player salaries in order to rig the game in the way that we want it, which is kind of the argument of the Justice Department. Activision Blizzard is saying, that just hasn't happened. So, in a way, the Justice Department might be jumping the gun here to prevent something that hasn't happened. But yeah, You make a good argument here, Dylan, that we're talking about the idea of competitive dynamics and ensuring competitive dynamics in a nascent league that still has a lot to mature, develop. We haven't seen any of this yet because esports are so new and esports leagues are so new. But there's an argument to be made if you are the Justice Department to say,

like, hey, look, no matter how you structure an esports league, you can't make it where players don't get to benefit or reap the rewards of providing value to shareholders. And in that sense, I agree. But at the same token, I disagree that you have to impose some draconian rules before we don't even know what the market dynamics of esports are yet. The thing I want to leave folks with here, Tim, is we had pretty clear sense of consequence with the J&J story. There's a dollar figure that's being talked about. With this Activision story, I'm sure there are Activision shareholders that weren't even aware of this, or maybe it was flying under the radar. Is this a big deal for Activision? Is this a big deal for esports? Both? Neither? It's too early to say,

But it does remove a blocker, doesn't it? And in that sense, removing any blocker hopefully greases the skids to completion of the acquisition we've all been waiting for. We really want this acquisition to go through with Microsoft. And so anything that gets out of the way of that is a good thing. but it's probably too early to know just what happens here. I think esports are so new and what kind of dynamics they have, like the economics of an esports league and how it works with other professional sports leagues, it's just too new. And how it contributes to Activision's overall business, it's just too new. But it does have the potential to be massive.

I myself am shocked by how compelling I have found it to watch esports competitions. This is real, Dylan. I actually did watch the FIFA E-Premier League final tournament, and I was shocked by how compelling I thought that it was. So there's definitely something here. I bet it wasn't more compelling than watching Crystal Palace, though. Well, it was Digital Crystal Palace, and they lost. So, yes, not as compelling because they lost. Tim, thanks so much for joining me, as always. Thanks, Dylan.

Pet retailer and pandemic-era darling Chewy lost 250,000 customers in the latest quarter. Is this a speed bump or a long-term problem? Ricky Mulvey caught up with Motley Fool senior analyst Emily Flippen to take a look at the online pet retailer. The first step in Peter Lynch investing style is looking around you. There are probably a lot of Chewy boxes in your apartment complex, your neighborhood, or in your home, but the online pet retailer is facing some more headwinds. Joining us now, Emily Flippen and Chewy stakeholders Xiao Bao and Stevie. Emily, you talked about Chewy on the show a couple of weeks ago, and I got the vibe that you had more

to say. Oh, I certainly did. If you let me go on about Chewy and my cat, Xiao Bao, go on about Chewy, we will be here forever. And that's because it's one of those few businesses that I think does benefit from being consumer-facing. As you mentioned, everybody knows what Chewy is because their boxes are ubiquitous, at least across the United States right now. But also because it's a relatively easy-to-understand business, that Peter Lynch style of investing, where you can easily wrap your head around it. Also, it's extremely straightforward in terms of their growth strategy. All they need to do is expand their relationship with customers, acquire new customers, and sell more things for this investment to pay off. Let's start with the bad news though. Chewy's

active customer base dropped by about 250,000 accounts in its latest quarter. Now stands about 20 million customer accounts. How concerned are you about this? How concerned should long-term investors be? Like I just mentioned, one of the key factors in their growth plan is to acquire new customers. Anytime you see active customers dropping quarter over quarter or year over year in this case, it can be concerning. That's certainly what the market was reacting to in Chewy's most recent quarter, but I don't think it's a reason for investors to be overly concerned because we did expect some level of churn in active customers coming out of the pandemic. They count their active customers as anybody who's made a purchase on their platform over

the course of the past year. They are still very much coming out of this massive influx of users they received during the pandemic. What's important to remember is they still have more than 20 million active customers. That's around 20%, 22% of the total number of pet households in the United States. It's a massive number of users. When you think about how much more can Chewy grow, I've always been much more focused on them expanding their margins, so giving more profit to shareholders, increasing their relationships that they have with those active users, so finding new reasons for them to engage on the platform, purchase more things, and entering ancillary sections. So pet healthcare, pet insurance, these types of value added

services. So my thesis has always been much more about acquiring value from their most loyal customers, as opposed to acquiring more than a quarter of every single pet household in the United States. So when you see that drop, do you think that's a macro problem? A lot of people got pets over the pandemic. Maybe some of those went back to shelters, unfortunately, or do you think that's a problem with the company? I think it's showing up as a macro problem right now. We're seeing this headwind for the pet industry across every retailer, which is to say pet inflation has been incredibly high. People who got pets can't necessarily afford them. There has been a lot of discounting, churn, these types of headwinds that have

been influencing pet owners in the United States. From that aspect, it's certainly a macro issue. But when you think about what the issues, the company specifically is dealing with. They've dealt with supply chain constraints, potentially losing active customers because they haven't been able to ship things as quickly as they've planned to. Those have subsided in recent quarters, but that can still lead to, again, that churn being a year-over-year churn, that can still lead to some of the decline in active customers that we've seen. I think it's mostly macro, but there are certainly some micro aspects that could be playing on here. I also think that it has to have some long-term tailwinds, though. Not just the pandemic,

but a lot of folks treating more of their pets like children and being inflation-resistant especially in a higher income household, to get their pets the best food they can. Yeah, that's certainly the case. We've seen that time and time again, where people will be more willing to spend money on their pets than they will on themselves. So when you see pet food inflation up 15%, people are still buying their pets pet food and fancy pet food. They're still spending more money on their pet food, even though they may be discounting the type and quality of the food that they're consuming on their own. It's the pet humanization trend that we've heard and seen so much of, and it's especially prevalent among Chewy's younger users. That's still

very much a tailwind. The fact that prices have increased so much, they've been able to raise prices on their platform. That's also been a margin tailwind for Chewy. With all the headwinds that are existing in the world right now, certainly those tailwinds benefit Chewy as well. Chewy's leadership very much enjoys talking about international growth plans, their pet insurance program, the pet pharmacy, their auto-ship revenue, automatically shipping folks things like pet food. It's more than 70% of the total sales. Why is this such a big part of Chewy's business and is this something that you'd like to see the leadership spending more attention on?

Let's explain why this metric is important for investors. We talked about the decline in active customers, that's concerning. But when you see a rise in auto ship sales, rising to over 73% in the most recent quarter, that says, the customers they're losing are not the same customers that have the deepest relationship with Chewy. The same is true for their net sales per active customer, which continued to rise more than 15% in the most recent quarter. Despite the fact that they're losing users year over year, the users that they're retaining are spending more time and money on the platform. Autoship sales are a function of that. For investors, they also provide a really nice level of visibility into Chewy's revenue

stream because the perception is that autoship sales, despite the fact that they can be canceled, everyone knows this, we've all canceled autoship, but they provide some type of recurring revenue for the business. In general, people aren't going in and changing their autoships every single week or every single month. That provides visibility, it provides stability, and more importantly, it provides a sign that, okay, the customers that Chewy is engaging the most with are still very loyal, still spending a lot of time and money on the platform itself despite the decline. What's the customer's reason for going auto-ship on that? Is it predictability? Are you getting a better deal on pet food? There's some deal. Chewy will offer,

I believe, a 5% discount on auto-ship. You know, every single month, my cat will eat three cans of this type of fancy feast, which Xiaobao is very particular about the food he eats. So I have to auto ship very particular things. I know what he likes and I know he eats it on a consistent basis. I feed him on a consistent basis. It just makes sense to have that auto ship set up. And if you read through Chewy's most recent annual report, they actually showed that more than 58% of pet households get the majority of their food through these auto ship relationships. So this is all to say that people like the predictability that comes with ordering auto ship. I think there's an element of, I save a little bit of money when I do that, but at the

same time. I don't have to be constantly thinking about, okay, what food does Shabba want to eat this week? I know it's coming to me automatically. It's kind of nice when an investing thesis is that cats are picky. Chewy's got a pet insurance program, Chewy Health, that also operates the largest pet pharmacy in the United States. Unfortunately, this does kind of bring to mind when Amazon tried to disrupt healthcare with health insurance and operating a pharmacy. Is this a different situation? Yeah, I think that's a totally fair comparison. And I will say that I do think it's a different situation. People are already accustomed to combining pet healthcare with pet food and pet retailers. Think about the relationship that Banfield Pet

Hospital has had with PetSmart. That's been a wildly successful investment for PetSmart. So the exposure to pet health is something that I think all consumers are already aware of. And if you go onto Chewy's healthcare offerings right now, you can get on there and order pet healthcare the same way you can order your pet food, these medicine and drugs. And the fact that they have a relationship with insurance providers as well, so they have underwriting services provided by companies like Trupanion, means that it simplifies the process of, I go to the vet, I need a prescription for my pet, I can get it paid for through my insurance that's managed by Chewy, delivered by Chewy Health. It's a symbiotic relationship.

I think consumers are just more willing to approach that relationship with Chewy than they were in a way that I don't normally go onto Amazon to seek out healthcare. That was a harder uphill battle for Amazon to fight. One major growth plan, though, is going international. I'm going to quote from CEO Sumit Singh in the latest earnings call, quote, we plan and expect to bring all components of our value proposition to the international market. And at the same time, we are going to be very actively listening to the voice of the customer and designing our launch working backwards from that. So there's no dissonance in the way we show up in the cultural nuances as Chewy brand enters the international market,

end quote. What's your reaction? Well, I can't have a reaction because that says nothing. That tells investors absolutely nothing. You can go back, rewind, listen to Ricky read that again, because that tells investors virtually nothing other than, hey, we're interested in expanding internationally and we're going to be conscious about the way that we do it. It's okay, but conscious how? They've given investors effectively no information about how they plan on entering international markets, which international markets they're planning on entering, if they're going to use third-party logistics or distribution systems, if they're going to build out their own. As an investor in Chewy, if anybody who's listened to the Motley Fool Money radio show, when we talked

about this previously, this was a big pause for me because it's a massive change in strategy for the business. We just started to see them get some operating leverage here in the United States. They save a lot of money by not having to spend a lot in marketing to acquire customers here in the U.S. Great brand reputation. So why now became the question of why did Chewy decide to seek out international expansion the same quarter that they're announcing this decline in active customer growth. There's a fear amongst investors, myself included, that this decision was made not because they see a massive opportunity that they think can be really profitable, but because they see an opportunity to expand users once again and assuage investors' fears that they are a declining

business. I would much rather have a business that is mildly declining in active users, but still growing relationships with the most loyal users, producing more profits, expanding margins, dominating the market here in the United States rather than spending a lot of time, money, and effort trying to expand internationally in markets that may already be saturated. I'm a little bit concerned. I don't like the lack of color that investors have about international expansion, but I'm doing my best to be patient, it's a hard thing for me to do, and wait for management to give us more information over the coming quarters. They seem to be playing a 2021 game in 2023. Exactly.

All right. Let's say you had a few minutes with CEO Sumit Singh. What are you pitching him as another growth driver? Maybe try this idea instead right now. Yeah, I love that. There's a lot of things that I would rather see right now than them expanding internationally. The first thing I'd say is, you don't need another growth driver. Your core business is a growth driver right now. Net sales grew 13% over the most recent quarter. That's incredible for a company of Chewy's size. I would be hyper-focused on growing the bottom line just as quickly. I would be focused on, let's continue the leverage that we've already developed in the United States, monetizing the distribution better than we have. We've already

spent a lot of capital, intensive money expanding here. Let's see the profits of that. Let's understand the customers a bit more. Now let's think about international expansion. Now let's talk about market research. Which markets are we entering? What can we leverage there to maintain our margin profile while also expanding internationally? I mean, I dislike this so much that I think I would rather have heard Chewy's leadership come out and say, we're going to build physical retail Chewy stores. We're going to build out physical stores to sell pet food in the United States rather than expanding internationally. I think that would be less of a money suck than this potential international expansion.

You're going to put a lot of management consultants out of business if they follow that advice. With these warts and strategic questions though, are you still holding onto your Chewy stock? I'm a shareholder, I'm still holding it. Yeah. Look, as negative as I've been in the second half of this conversation, I'm still a Chewy shareholder. I'm still buying from Chewy. I'm still planning on holding Chewy's shares. I think it's important to be really critical of the companies that we own to always be evaluating whether or not they are right for our portfolios, whether or not their strategy has broken our thesis. At this point, I don't have enough information to determine whether or not I

think this is going to absolutely destroy Chewy's focus. If they pull a Wayfair and spend a lot of money trying to expand in Europe, I would consider that potentially a reason to be selling this stock right now. But I don't see that as the case at the moment. Until I see that as a case, then I'm continue to hold my shares, take the long-term approach here, and going to trust that management is going to do what they do best, which is be measured, calculated, and very conscious in their approach. To give Sumit Singh some credit here, when they expanded to me when they went public, they were a very metrics-focused business. They had a deep understanding of the lifetime value of their customer and their acquisition costs. If they take that same approach to

international expansion, then this could be really successful. I'm hesitant, but I'm still a shareholder, still holding, still following this company. Still hanging on. Emily Flippen, Appreciate your time, as always. Yeah, thank you so much. As always, people on the program may have interests in the stocks they talk about, and Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis. Thank you for listening. We'll be back tomorrow.