Solventum Corporation (SOLV) Earnings Call Transcript & Summary

Good afternoon. Travis Steed, the medical device analyst at Bank of America. And last up for today on the fireside chats, we have the newest company that we cover, Solventum, spun out at 3M recently. So we have Wayde McMillan, which a lot of people know is the former CEO of another public company, but he's the Executive Vice President and CFO at Solventum; and we have Head of IR, Kevin Moran. So welcome. Wayde, if you have any opening remarks that you want to do or just jump kind of straight in?

Well, yes, sure. Happy to be at the conference here. So thanks for having us, Travis, and I appreciate you picking up coverage just before the conference. As you mentioned, it's a brand-new company. We're in our second month after our initial public offering here and a lot of excitement across the business. It's really fun to be part of an IPO and a new exciting start to a brand-new public company. Having said that, we got a lot of work to do. We're going to definitely capitalize on the energy that's being built within the company right now. We think that we've got a real incredible opportunity to build on the foundation that 3M handed us. 3M has built a really exciting group of markets for the businesses we're in. Having said that, we've been underperforming them. So I'm sure we'll get into some of that today. We've got a lot of work to do to turn around the business. But turnaround is an exciting opportunity unto itself. And inside of a spin, separation here is also exciting. We kind of feel like we have 2 significant value-creating opportunities together. And so thanks for having us, Travis. This is our first investor conference as Solventum.

Great. That's awesome. Glad, welcome to BofA. Just a bit background on kind of you've taken the job at Solventum, it's a little kind of a surprise at first for some people. Just kind of curious why you're excited about the spin and kind of the biggest opportunities you see as a stand-alone company here?

Well, yes. Maybe I would just start with that prior company. I really love that company. It was incredible growth opportunity. I could have spent a long time there. But having said that, I just mentioned, this is a really unique opportunity here. I've been in med tech for a long time, and I'll always serve a med tech mission. And we've got another great mission here with this company. And the opportunity to partner up with Bryan Hanson, again, I had been his CFO previously. We've got great chemistry together. He's an incredible cultural leader and strategist and so the opportunity to join him in this really rare opportunity for an IPO of a company of this size, with the markets that we're in. And for me, it was also an opportunity to get back into a larger cap portfolio company. And in my past, I had spent a lot of time working in a larger cap portfolio company. And so an opportunity to sort of exercise those muscles and that playbook again. And Bryan has assembled a really strong leadership team. So excited to join the whole team and participate in some of these really great markets that we're in. We think we've got a real value creation opportunity as well.

That's great. And so just kind of somewhat reported Q1 earnings last week. It wasn't -- it was part of the Q1 was with the former company. So not quite apples-to-apples, but you did grow kind of 0.9% in the quarter, well ahead of your guidance for the full year and kind of the same thing on margins as well. So just can I talk about how Q1 kind of played out? And came ahead of your guidance for the full year, but what kind of what changes now that you're kind of a public company here?

It's a great place to start. And as you mentioned, our first quarter was still under 3M. And so it's under a carve-out basis. And we won't -- we spun and did the IPO on April 1. And so we're really reporting the last quarter underneath 3M. And this quarter starting April 1, will be our first public company quarter. Our guidance in Q1 was 0.9%, as you mentioned, just ahead of our 0% to negative 2% guide for the year. There's a few reasons for that. Some of them are structural and then some of them are some of the strategies that we'll be deploying throughout the year. In Q1, 3 of our segments were just above flat. About 85% of our business was just over flat and then we had a purification filtration, and one of our segments benefited from order timing and had pretty significant growth, almost 7% growth rate, which is uncharacteristic for that business. So it's really order timing. So we're going to see that reverse out mostly in the second quarter, kind of a mirror image in the second quarter, maybe some of it into the second half. And so that will put some pressure on the rest of the year. The other thing is we've been benefiting from significant price increases throughout 2023, given the inflationary environment that we are in and seeing a lot of costs, the business had increased prices to try to offset those cost increases. And we're not doing that again here in 2024. So the price increases, just to give order of magnitude, the business grew about 0.9%. The price benefit was more than double that, and it was just over double that. And what that means is, without the price benefit, the volumes would be declining and would be much more in the range for the full year. So as you see price start to wane throughout the year because we're not continuing with that level of price increase, we're going to start to see that price benefit diminish and then the growth rates of the business will be impacted. And then I mentioned a couple of strategic things that we're doing. We are working on a SKU reduction program, which is just an opportunity to look across our business and simplify it in areas where we've got SKUs that we don't think should be part of the portfolio. It's a major lift. There's going to be some impact, we think, in 2024, but the majority of it will be in 2025. It just takes time to work through the inventory and it takes time to notify customers and work through that whole process. But the team is setting up now to quickly look where we've got some opportunities in '24, but that will put a headwind on our growth rate in the second part of the year as well as into 2025. I think the majority will be in '25. And then a harder to quantify thing is just the impact from separation. I'm sure we'll talk about this a little bit more. But in summary, we've got a lot of separation activity going on around the business. We're separating our manufacturing, our distribution centers, we are implementing a new ERP system, and we're doing all of that at a pretty rapid pace as part of the separation. And so we don't know exactly what the headwinds will be from that. We just know that any company just implementing an ERP or just implementing a new distribution center change or trying to move manufacturing lines can, from time to time, get some unfavorable impacts from that. And so we're thinking about that as what could drive us to the lower end of the range in the second half of the year. Hopefully, we'll get through the year and not have impacts from that, but it's highly unlikely given the confluence of all the projects that we're working on together. It's not saying we don't have confidence in the teams to execute. Every single function in the company is working incredibly hard on their day jobs as well as on top of that, the separation-related activities. Now we've got good plans in place. We've got strong leaders in place to execute. We're just thinking that there could be some headwinds from separation-related issues.

So the kind of the 0% to negative 2% guidance, a lot of that is driven by price. It sounds like, right? Majority -- kind of the biggest factor in the guide and then SKU's kind of -- the rationalization is the #2 factor or...

It's tough to quantify yet because we haven't finalized the SKU reduction program, and we certainly don't know where the separation-related impacts are going to come. We certainly hope the separation impacts are on the lower end of that scale. Having said that, there's just a lot of moving pieces in the business right now. So it will be to be determined. And really, what that sets up, Travis, is hopefully, people understand all of the work that has to happen to separate the business, and that's primarily over the next couple of years. There will be a tail to that over time. But there's a lot of work, and that's just going to make it more difficult for us to predict the business here for the next few years.

And then kind of the margin guide for 2024, 21% to 23% op margins. We try to kind of back out some of the allocated, unallocated stuff in corporate expenses, and it seems like a big step down even after assuming some stand-up costs and stuff like that. What's driving the kind of the big step down in margins pre-spend versus what you're guiding to, even including some of the kind of stand-up costs that you typically would see for a company?

Yes. Again, we have some unique things that come with the separation. The first and one of the largest in our gross margin is the COGS step up that starts on April 1 from the product that's supplied to us from 3M. And so 3M is increasing the cost on the product that they supply to us. And that starts on April 1, but just for modeling purposes, a lot of that increased cost will go into inventory. And so we may start to see some products pulling through in Q2, but the majority of that will be deferred into the second half of the year, Q3, Q4, which means 2025, we'll then be annualizing that. A couple of other things putting pressure on operating margins. Obviously, we're ramping up our stand-alone costs as a public company. 3M had us start or worked with us to start some of those expenses while we're under 3M. And so some of that is built into the run rate, but we're going to be increasing and building up our stand-alone public company costs as we go throughout the year here in Q2, Q3 and Q4 to finalize our structure as a stand-alone public company. And then just keep in mind, on the bottom line, one of the biggest impacts to earnings per share is going to be the step up of an interest expense. And so we had some interest start in Q1. Some of the financing vehicles that we put in place started in Q1. So we had a little bit of interest there. But our full run rate of interest starts on April 1, so it will be a pretty large step up in interest expense given the debt levels that we have as a separating company.

When you think through kind of the multiyear turnaround story. I'd love to kind of think about like '24, you've kind of got the initial that we just talked about and kind of how '25 probably steps down, I think you've talked about in some ways, and then '26 and '27, When you think about the culture of things you're trying to drive, R&D, things you're trying to drive. Just trying to kind of keep -- kind of lay out kind of the multiyear turnaround strategy and kind of give investors a sense for what gets better when?

Yes, you hit on a lot of the key items there, Travis. There is a lot that we want to do to move the business from how it was operating under 3M in an industrial world with different metrics, with a heavier focus on free cash flow. And obviously, we're still going to be focused on free cash flow, but we're going to move our focus more to growth orientation. And we think we've got some great markets here in the 4% to 6% market growth range, and we've got an opportunity to grow better inside of those markets, but we have to do a lot to improve it. As you mentioned, we're heavily focused on the cultural elements, we've got a strong foundation to build upon, but key areas that we're going to be focusing on are really 4 areas. We've got to identify the areas we're going to focus on for growth drivers. And moving more of our resources to be more focused on the areas where we think we can generate the most growth and really compete and grow. And we're going to do that by adjusting our commercial structure, putting a new commercial apparatus behind that. It could be areas where we want to invest in clinical trials or we want to invest in sales force expansion or specialty sales forces, but really designed to support that growth infrastructure. And then next will be the R&D investments and turning around our R&D pipeline. The performance in R&D is just not where we want it today. So we've got a lot of improvements to make there. We've got some structural things that we think we're going to see. The R&D team has a lot of ideas to how they can improve performance as well. And then moving on to portfolio management from there. As you know, we're highly levered today. We're going to be focused heavy on debt paydown. But as we do that, we'll start to layer in some tuck-in acquisitions, bolt-on acquisitions, things that are pretty typical of well-performing med device companies. We'll get to that later in the turnaround story here. So we've got a lot of work to do to define those growth drivers, get our commercial structure performing better, get our better performance in R&D and start to layer in some portfolio management here. If you put all these things together, what we're looking at is a pretty challenging '24 and '25. It's just a bit messy as you're working through a separation. I think '25 is probably more difficult than '24. A lot of the things that we just talked about are going to be bigger headwinds in '25 than they were in '24. We're not guiding to '25 yet. But just to keep that in mind, as we put our plans together, when we do get them finalized and communicate guidance for '25, a lot of these headwinds will annualize in '25. But as you said, it's really -- if you think about it like a 5-year turnaround story that's back-end loaded. Our whole objective here is to reposition the business for growth, make the investments, make the structural changes we need to make over the next few years. We think those commercial investments will impact quicker. Those are more in that 12- to 18-month timeframe after we pick our growth drivers. So think about '26, '27. R&D starts to kick in. The pipeline starts to kick in a little longer, that's more like '27, '28. Some of the portfolio moves once we delever and have more dry powder and a stronger balance sheet to be able to make some of those portfolio moves in those later years. But just putting it all together, we think we can separate -- do a great job of executing the separation, get ourselves reset and in a position to grow and in that 3-, 4-, 5-year timeframe, start to accelerate the business with a much better growth profile on the top line but also still focused on expanding margins as well.

Very helpful color on that outline there. I'm trying to think where to follow-up. Maybe on kind of market selection, like how are you thinking about which markets you're going to go after? Are you in the right markets today? And can you do some of that kind of through R&D? Or is it more -- got to wait for the balance sheet to kind of change the markets?

Yes. We are very fortunate to inherit the businesses that we have in the markets that we're in. We think 3M did a great job of picking some of the stronger growing markets in med tech. However, inside of those markets, we're overweight in some of the slower growing submarkets. And so in addition to the heavy lift we talked about in improving commercial, improving R&D and some of that portfolio work, we also have to look at the submarkets within those markets that we're in today and start to move our investments and start to pull our weighted average market growth rate because we're overweight, as I mentioned, in some of those slower growth markets. And as we do that, we'll start to drag the growth rate up. So we both need to perform better as well as shift our resources to the faster-growing areas within those markets. Again, we've got some great businesses, some great markets. We're improving processes, improving investments. I think R&D is going to be a really important metric, as you mentioned, inside of that and the production from R&D. It's just takes a little bit longer to generate new product revenue coming off that pipeline.

When you think about the kind of the multiyear revenue growth turnaround story, like risk, kind of things you kind of -- the puts and takes on risk and upside risk and downside risk, or some of the stuff that you can maybe accelerate and pull forward? Is there things that maybe -- might have kind of downside risk potential. Just kind of thinking about the kind of the puts and takes on kind of that multiyear turnaround story.

Yes, just -- I think one of the things that is hard to estimate right now is when we're making changes to the structure, how much of an impact does that have? And we have to allow our segment leaders an opportunity to make changes to their structures in order to get themselves ready or reposition for more growth. That may be changes in marketing teams or changes in sales teams, so the way we support the teams with R&D. And so it's really hard to tell at this early stage, a couple of months in to resetting our strategy where the puts and takes exactly are going to be. We're optimistic that given enough time, and we don't want to put timelines too specific here because we just have a lot of work to do to decide and it may be a little bit different by segment as well. But at the end of the day, if we can start performing better in our commercial metrics, we can start performing better in our R&D metrics. If we can layer in some portfolio, either some trimming on the divestiture side or acquisitions or small bolt-on acquisitions, nothing big certainly in the first couple of years. But over time, start to augment that growth profile with some of the faster-growing market focus, I think we can certainly improve upon the growth rates here over time.

Anything you'd call out by segment, kind of the turnaround by different segments?

Not at this time. Yes, each of them are early in this new growth-oriented strategy. And we're going to be working throughout 2024 here, the second half of '24 and into '25. We're giving ourselves a year. And keep in mind, a lot of the leaders are new and the leadership team. We've been fortunate to have some of the 3M segment leaders stay with us. 3 of our 4 segments are led by former 3M folks who are really valuable members of the leadership team because they can help share that legacy knowledge. We have a new leader of the medical surgical business, which is almost 60% of our business, so it's going to take him some time to get in, learn the business and make decisions on where we think those growth drivers are. But I can't emphasize enough how important it is for us to spend the time, understand the markets, pick those growth drivers, the submarkets within those growth drivers, and then we're going to shift a majority of our resources to those growth drivers and really be very focused on knowing exactly where we're going to be driving the growth.

Anything you'd like to highlight on the kind of the changing the culture, things you're doing there and like when we could see some of the benefits there?

There's several elements. Again, we've got a team working on this right now, and it's in concert with designing our organization of the future as well. So there's a lot of structural things we're doing. Specific to the culture, Bryan's leadership style is very much a delegation of authority and pushing authority deeper into the organization, which allows us to make decisions faster and start to move quicker. It also pushes authority to the segments. So a lot of the centralized structure that we have today, we're changing and moving that structure into the segments so they have much more autonomy and independence to make decisions more specific to their businesses. And so I think that's where you'll see the biggest cultural shift.