Description

This is a funky little pitch to write the September $25.00 and $22.50 put options on Kenvue for $2.65 and $.95, respectively.  These options have been very active recently and should be liquid enough for most PA’s and very small funds.  The premise is the implied volatility and associated option premiums on Kenvue’s stock are way too high and being driven by technical-ish issues related to a pending split-off.  If successful, the trade results in a 6–12% gross return over six weeks for an IRR of 45-97%.  

Kenvue is a large, stable, high quality consumer health company.  Its major brands include Tylenol, Listerine, Neutrogena, Johnson's (as in baby shampoo), and Nicorette.  Other large brands include Benadryl, Zyrtec, BAND-AID, Sudafed, Motrin, Pepcid, Imodium, Lubriderm, OGX, Rogaine, Stayfree, Carefree, and Neosporin.  I list all these to drive home the simple point that this is a consumer brand powerhouse ala P&G or Colgate.  It is a stable consumer staples company that should have paltry option premiums.  But it doesn’t, thus the opportunity.  Why?  Continue on.

On May 8th Johnson & Johnson (JNJ) IPO’ed 10% of its consumer health business, Kenvue (KVUE), with JNJ retaining the remaining 90% of Kenvue shares.  On July 20th JNJ announced its intention to split-off at least 80% of the shares through an exchange offer (voluntarily swap JNJ shares for KVUE shares).  So, upon the split-off around August 18th Kenvue’s float is going to go from 10% to 90% (and possibly 100%).  This huge supply coming to market has understandably put pressure on Kenvue shares and is expected to continue until sometime after the split-off.  The shares are already down 6% since the split-off announcement and options premiums and implied volatility (IV) have spiked. 

The odd lot dynamics of the split-off may also be pressuring Kenvue’s stock.  To entice shareholders to convert, JNJ is offering the exchange into Kenvue shares at a 7.5% discount, subject to proration and an upper limit.  So for every $100 of JNJ stock you convert, you receive $107.50 in KVUE shares.  Odd lots are not subject to proration though, so you can buy 99 shares of JNJ and it should all convert into Kenvue shares at the 7.5% discount.  While it is best for the odd lot’ers to wait to buy their 99 shares of JNJ the day before the exchange ratio is set (around August 16th), and then short the equivalent dollar value in Kenvue stock to lock in the 7.5% spread, some may already be buying and hedging today, leading to further pressure on the stock.

Amidst all of this pre-split-off activity, the stock has declined and options activity has increased substantially.  Specifically, implied volatility and option premiums appear unrealistically high.

Exhibit A:

The IV of Kenvue’s September $25.00 puts is 55. To put that into perspective, that is higher than the implied vol. on Tesla and equal to Nvidia.  An IV of 55 implies a daily stock price move of 3.4%.  Since its IPO Kenvue has only had three days where the price changed +/-2.0%.  As shown below, implied vol. on other large cap consumer staples companies is in the mid teens. Kenvue’s high implied vol. is a direct reflection of the high option premiums and speaks to the opportunity.  

Exhibit B:

There is no time premium between Kenvue’s September $25 put and November puts.  That doesn’t make much sense to me and screams “technical issues” around the August split-off.  

The September puts appear overpriced relative to the rest of the calendar due to high demand for hedging strategies around the split-off, combined with a small float of only 10%.  A skeptic’s interpretation would be that the stock price may eventually recover from the split-off share dump but not until sometime after the September expiry.  

The crux of the thesis to sell Kenvue September put options is the premiums are too high due to current and aniticpated technical selling, resulting in attractive IRRs under various scenarios.  Alternatively, if put to you, your effective cost results in taking ownership of a high quality business at an attrative price.  The split-off has already pressured the stock price and that may continue until the split-off is complete.  But I can find no reason the stock should trade at a discount to peers.  Prior to the split-off announcement Kenvue traded in line with peer valuations, and between $25-$27.  It is the same high quality business after the split-off as it was on the IPO when it traded at $26.90 and 21x.  I believe the market will find the current valuation attractive once the split-off supply clears. 

For reference, the read line marks the split-off announcement.   

If you sell the Sept $25.00 put there are two primary outcomes:

1. The stock closes below $25.00 upon expiry and the stock is put to you.  If the stock is anywhere between $22.35 and $25 you can close the position for a profit.  If hypothetically, on expiration day, the stock closes at its current price of $23.60 you would have a profit of $1.25 ($2.65 premium less $1.60 ITM) on $22.35 in capital-at-risk, for a six week return of 5.6% and an IRR of 45%.  If the stock falls below $22.35 you have a loss, however, you’ve been given a great business at only 17.6x '24e, a discount to the market and a 16% discount to the peer group.    

2. The stock closes above $25.00 and the stock is not put to you.  You earn a return of $2.65 on $22.35 in capital-at-risk for a six week return of 11.9% and an IRR of 97%.  

Another more conservative option is to sell the September $22.50 puts.  Two scenarios:

1. The stock falls below $22.50 and the stock is put to you.  Your effective cost is $21.55 and you own the stock at only 16.6x '24e, a 21% discount to the peer group and a great price for a fantastic consumer franchise.

2. The stock remains above $22.50 and the stock is not put to you.  You keep the premium and earn a return of $.95 on $21.55 in capital-at-risk, for a six week return of 4.4% and an IRR of 37%.

Here are the numbers and how I am thinking about it:

Summary of Kenvue

Because this is most likely going to be a short-term trade in a super high quality business, a fundamental deep dive is beyond the scope of this pitch. This is more about mispriced options resulting from an event rather than a fundamental issue.  But I will summarize.

Kenvue is a $15B+ portfolio of well-recognized consumer health and beauty brands that exhibit high levels of loyalty and strong category positioning.  They have seven products with #1 one category positions in North America (~ 50% of sales), 13 #1 positions in EMEA (~20% of sales), and 10 #1 positions in APAC (~20% of sales).  According to management, private label penetration within the categories they compete in is ~10%, a manifestation of the strength and resilience of their brands.  (According to BAML it is 21%, the difference probably being sales not captured by Neilson data).  Many of their products exhibit extraordinary high market share within their categories.  For example, in the U.S. Listerine has 41% market share, BAND-AID 45%, and Neosporin 58% share.  

Organic growth has been and is expected to continue to be in line with category growth of 3-4%.  Honestly this is a little disappointing given their category dominance.  Their products are virtually recession proof.  During the financial crisis and COVID their brands maintained positive organic growth.  The company has gone through a portfolio repositioning the last several years with 15 divestitures and 10 acquisitions.  Their focus has been on increasing their exposure to faster growing premium categories.  Looking forward they expect to just do tuck-ins rather than anything transformational.

EBITDA margins are roughly in line with peers (Kenvue has some intangible amortization so it is best to judge them on EBITDA rather than EBIT).  They report adjusted EBITDA margins of 24.5% vs. Haleon at 25.1%, Colgate at 23.0%, and P&G at 25.4% (the main adjustments they make to arrive at adjusted EBITDA are intangible amortization and separation costs…seems legit).  There may be some opportunity to drive margins higher as their transition and manufacturing agreement with JNJ is phased out over the next two-ish years.  Also, they have faced severe cost headwinds since Covid and have taken significant pricing as a result, as most consumer staples companies have.  I would not be surprised to see margins expand as costs are now normalizing, yet pricing is maintained. Management has specifically stated “you should expect to see continued sustained gross margin improvement, and the same thing on the SG&A side…”.  They spend 2.5% in R&D, slightly higher than peers at 2.0%.  Advertising is 9.5% of sales, below comps ~10.5%.  

Inventory turn is a little lower than peers which leads to an ROE slightly below peers but not enough to drive any meaningful difference in valuations given the low growth rates and limited reinvestment.  Free cash flow conversion is beautiful at ~100%.  Net leverage is 2.1x, on the way to 1.8x by year-end.  Capex is 2.5% of sales, below peers at 3.3%.

Kenvue has committed to a 55-65% dividend payout ratio, leading to a dividend yield much higher than peers at 3.4% vs. 1.9% for peers.  

Second quarter results were fine.  Organic sales growth was 7.7% driven by 9.4% pricing and -1.7% volume (but were flat ex-Russia exit).  Growth was balanced across regions and divisions.  FX was a big -2.3% headwind to sales.  They are guiding to $1.28 (mid-point) for adjusted EPS this year.

Kenvue could be subject to litigation outside the U.S. and Canada relating to claims that talc causes cancer.  J&J has unequivocally and unambiguously agreed to retain all talc-related liabilities and indemnify Kenvue for any and all costs arising from litigation in the United States and Canada.  The company states there are currently only a few active claims relating to talc outside North America and the company does not see this as a material risk.  As such, the company has not taken any reserves against these claims.  Of course there could be additional lawsuits outside North America in the future, however, given the current state of litigation (currently hung up in appeals court) and the small number of claims outside the U.S., it appears unlikely to impact their stock price over the next six weeks, if ever.  Importantly, it does not appear to be a driver of the IV and options premiums, as they spiked upon the announcement of the split-off while the talc risk was widely understood at IPO.  It is also worth noting that their best comp, Haleon, faces similar product litigation issues with Zantac, yet it trades at a slight premium to Kenvue.  

DISCLAIMER: THIS IS NOT A RECOMMENDATION. The securities described are neither a recommendation nor a solicitation. There are no assurances that securities identified in this note will be profitable investments. The stated opinions are for general information only and not meant to be predictions or an offer of individual or personalized investment advice. This information and these opinions are subject to change without notice. Security information is being obtained from resources I believe to be accurate, but no warrant is made as to the accuracy or completeness of the information. Any type of investing involves risk and there are no guarantees. The author may or may not have material positions in the securities mentioned in this note and will not be obligated to give notice of any changes in their views or positioning. The author makes no representation or warranty, express or implied, regarding the accuracy, completeness, or adequacy of the information. The author accepts no duty of care to you in relation to investments. Past performance cannot be relied on as a guide to future performance.

Catalyst

Split-off, techinical selling ends, recovery, expiration.