Solventum Corporation (SOLV) Earnings Call Transcript & Summary

All right. We'll get started here. I'm Jason Bednar. I cover Medtech here at Piper. Next fireside chat is with Solventum, long history in health care, but very young public company, having recently spun out of 3M, also the newest addition to our coverage. So very happy to have with us today Solventum CEO, Bryan Hanson; and CFO, Wayde McMillan, thanks a lot for joining us today, guys.

Thanks for having us.

Great. So we're going to dive right into Q&A. Just to start, maybe question for each of you. You're both part of the story of Solventum. You aren't strangers by any means to the Medtech community. You had really good seats at other high-quality Medtech companies before coming to Solventum. So just back to the question from a lot of investors who know you, why now, why Solventum? Do you want to first?

Yes. Okay. So for me, the previous role that I had was at Zimmer Biomet, as I think you know. And I love transformation, I love turnarounds. And when I came into Zimmer Biomet, I knew that I wanted to be there for that crazy time that you deal with when you're turning a business around. Once we got to the point where we went from 0% growth to pretty consistent upper end of mid-single, and I had the right team in place, I knew it was time for me to go on and do something different. The question was where and when. When 3M called, this is a 100-year iconic company that when they call, you pick up the phone and you have the conversation. And just the -- it helps so much like what we did at Covidien spinning out of Tyco. It was very interesting right out of the gate. So what I did immediately was picked up the phone and call this guy who used to work with me at Covidien and said, "Hey, listen, I think we've got an opportunity here that could be a lot like what we did back in the day. Would you be interested in going as a team." And as soon as he said, yes, I said yes. And here we are, we never looked back.

All right. Yes. I think Bryan covered it well. Maybe just to add a couple of the things we thought about with this business. I mean really great markets, which for us wasn't the case with the Tyco Healthcare Covidien spin. We had to do a lot of work and take a lot of risk to actually improve the market growth rates. And we are in some really great markets, 4 very different businesses, but all in that mid-single-digit range. And so that gives us a view that it's less risky at transformation because we don't have to change the markets we're in, we have to improve how we're performing in the markets we're in. And as Bryan said, we had great chemistry working together. And when this guy is kind of like 3M calling Bryan, when Bryan called me, I love the opportunity to work with Bryan again. I came from a Insulet, which was an amazing company. I really could have worked there the rest of my career, serving a mission for people with diabetes is incredible. But we've also got an amazing mission here. We've got a lot of excited people across the company to have a stand-alone health care mission. It's a bit challenged as a health care business under an industrial conglomerate. And so we've got a lot of excitement in the business to capitalize on right now. We've got a lot of work to do. And so we're going to need that extra energy to do the separation, but we think we'll have something special when we're done.

Yes. Great start. So I think a lot of investors probably have some working knowledge of some of the businesses you have. Some may still be new to the story. Maybe bridge the gap for those that are still kind of coming up to speed. You've got 4 different business units, help on how they all fit together because this isn't -- you look at some of the businesses and some of it doesn't look like natural synergies or natural -- a natural fit. So help where that makes sense and then maybe help us where maybe it doesn't make sense?

Yes. I'll start with that again. So again, one of the things that was attractive about this particular opportunity was every business segment is in markets that are large and attractive from a growth profile standpoint, that's rare, at least in my background, that's rare. So to see those, even though they're disparate was an attractive element of deciding to come here. What we found though is there is some overlap. What 3M does extremely well and has done historically extremely well is to create intellectual property that's extremely powerful. If you think about that, it's a chemical manufacturer that create compounds that's new to planet earth. And as a result, they create unique technologies that are significantly differentiated and they leverage that across their disparate segments. And so as a result, you see a lot of entanglements and a lot of that usage of the IP, but that's a powerful reason why our brands are strong, very strong. So that's the connected tissue between all the businesses other than HIS, which doesn't use the same intellectual property. And then with HIS, the commonality would just be the call point. HIS is a software business for sure, mainly in revenue cycle management, but they call on the very same customers that our MedSurg business calls on, and they have deep penetration in those customers as well. So those will be the connected tissue pieces, but clearly, they're disparate businesses.

Yes. And you made a comment to start that this is going to be a transformational type spin. I remember back from the Investor Day, you got up and said, portfolio transformation is going to be part of the story. Maybe talk about some of the investor feedback you've gotten since that time on that topic. And then for those in the room, what do you think Solventum looks like maybe 2 to 3 years from now?

I can't tell you that yet. Now -- I'll tell you that now. But you'll probably get a better picture of that when we come into our February call, earnings call, fourth quarter earnings call, and we talk about our LRP at least in certain areas. But what I would say is right away, again, looking at the different segments, you say, okay, not everything fits perfectly. Let's run the analysis. I don't want to make any snap decisions. So we've been running in parallel with Phase I and Phase II or Phase III, which is portfolio transformation. And we've been analyzing the value of each of our businesses, are the markets that we want to be committed to? Do they have fast-growth markets? Are they markets that we can win in and are they profitable? Other considerations go into it, like capital intensity, those types of things. But the biggest thing would be, is it an attractive growth market, can we win in that market? And is it a profitable market. And so that's what we're going through. Once we land the plane on the markets that we're most attracted to, we will overinvest in those. And the other ones, we're going to manage differently. That could mean as simple as we're going to harvest those businesses to be able to fund the other ones, up to and including potential divestiture if somebody sees more value in those businesses than we do. So that's where we are in the process. So if I really kind of give you a view without too much color on what I want to be in the future is a more streamlined, more focused organization that is really doubling down in their growth driver areas, which will be those very specific markets that we select.

Okay. All right. Well said. One other thing that resonated with me from the Investor Day and can still like see up there on the talking and you're saying, this is going to be a lot of hard work. So like, I think that might have been the line. But from your ZB days, you were all about retiring risk and Zimmer Biomet add a lot of other challenges as well when you entered. So where are we at? Do you think it's still early days? Where are we at in terms of addressing some of that hard work and retiring the risk at Solventum. I'll let you start, and wait, I'm sure you've got some opinions you can weigh in on as well.

Yes. So maybe I'll start just with why we were saying that it's going to be a lot of hard work. I think any separation, by the way, because we've been through them before are hard. There's just a lot of challenges to go into separation. What I probably didn't fully appreciate is what I was just talking about is the interconnectivity between all the 3M businesses. I did not expect intellectual property in the way that we have it. I think of intellectual property typically is a patent in a drawer that you just transfer. This is literally know-how, bespoke equipment, it's a bespoke process. And the only way you can protect that intellectual property is to verticalize it. And so you see a lot of connected tissue as a result of that, $3 billion of our revenue require those raw materials that are unique to 3M and have intellectual property. That's very unusual in the business. I did not fully appreciate that until we got in. And once, of course, we realize that, that's why we are being cautious out of the gate to say, listen, this is more complex than we expected. Now the good news is we intentionally hired leadership team members that have been through separations before, and we're prepared for that kind of complexity. But that's the reason why we came out of the gate saying, okay, this is a little more complex than we've seen in the past.

Yes, I think you covered it well, Bryan. I would just maybe add more around the separation work itself. As Bryan said, it's hard work and it's work on top of your day-to-day job. So what's different than us from other companies who aren't in the middle of a separation is people have a day job. Here, you have a day job and you have to work on the separation. In a lot of cases, you have to work with your 3M counterparts. And that's because a lot of the systems and services that we use are still with 3M. And we've got transition service agreements in a process to move those systems and capabilities over to Solventum. On the services, which is mainly the ERP finance side of things, that will happen over the next 2 to 3 years. Manufacturing has a little longer period of time because you have to move manufacturing lines and manufacturing capability, verify it, validated inside of a regulated manufacturing process. So that's 3 to 4 years. So the main TSA work will happen over the next 1 to 4 years as we move all those services, manufacturing, distribution centers over. And then as Bryan highlighted, we actually have a longer period of time for the IP and supply continuity project. We have 10 to 12 years there. So we have a good amount of time to work with 3M by moving that intellectual property over.

Yes. And I'm sure it's much more than this, but forgive me. But it's -- a lot of it's like hard work seems more kind of middle of the P&L related, maybe manufacturing, cost of goods, OpEx not necessarily impacting revenue. So correct me if I'm wrong on that. But the -- I guess, the piece that I'm wondering about is why wouldn't revenue growth be faster given how strong other parts of Medtech are right now. You talked about kind of underperforming right now within some of the categories you play in? What's -- why is your business not yet at that level?

Yes. Maybe -- because I'll get right into why it's not what we're going to do about it. But maybe speak to some of the changes we did have as a result of separation with some of the regional structures, commercial structures that did create a little of disruption, and then we'll go into the [ GAAP Bill ].

Yes, sounds good. It's a perfect bridge from all that separation work as we separate from 3M. And so as Bryan said, as part of that separation, we relied on 3M in a lot of the regional countries, a lot of the smaller countries out there, I think, like 60 countries where we had different integrations with 3M that had to be separated at the spin. So a big part of that was us actually creating new entities and, in some cases, new distribution channels and new sales and commercial structures in those regions. And in a lot of cases, we've gone to distribution because we didn't have the economies of scale we used to have as 3M in some of these regions. So we've got a lot of new people in a lot of countries outside the U.S. working through a different sales and operational channel out there, distribution channel out there. So there's a lot to do with revenue as part of the separation there as well.

Okay. I want to make sure that was clear mainly in the U.S., not so much, but outside the U.S., what we just referenced is absolutely true and created some level of disruption, even on the revenue side. But that's not really the issue. If you look back before the separation, these businesses, although they're in attractive markets, have been underperforming pretty consistently. And I'd like to say it's 1 or 2 businesses, but it's pretty much every one of the businesses are underperforming their markets, which is part of the reason why we're here, you'll love that. You love seeing an underperforming business that's actually spending money in R&D that is underperforming in an attractive market. And that's a great place to start. So perfect scenario. Here's why I see it as the underperformance has been there, probably the most critical of which is even though we're spending a very reasonable amount of money in R&D, we're not getting the vitality index one would expect of that spend. And that's frustrating. Typically, you would see vitality index in the teens to potentially even 20%. We're more in the single digits, low single digits, even though we're spending 4% to 5% of our overall revenue in R&D. So what are we going to do about it? Really, for me, the change in trajectory of the business has 4 elements to it. And this is not rocket science. There's no whizbang here. It's just basic blocking and tackling because we're already in attractive markets. The first is very easy and fast. You just hire really strong commercial leaders, and they drive a different cadence and culture of accountability in the organization. Operating mechanisms change, incentives change so that there's more risk, but less cap so that you're just changing the aggressiveness of the sales organization. That happens very fast. That's the fastest way to turn. The second is you change structure. So you go in and say, "Listen, I'm going to specialize in a specific area. And now I've got to hire those people. I'm going to expand the sales organization," takes a little more time, but it's still pretty fast. You've got to hire people and you've got to develop them, you got to train them, you've got to get them productive, but still relatively fast. The third would be product development. I've got gaps in the technology in those areas I want to focus. I've got to invent new technologies to create traction in those areas, that takes a little more time, but it's low risk. If you're in attractive markets, you ideate, you develop, you commercialize, you get regulatory approval, you're ready to go, very low risk just takes time. And the fourth one is once we get our leverage ratio down, we're going to be looking to pepper in tuck-in acquisitions in those attractive markets that we're already in and drop them in the bag. Those are the 4 components of the turnaround. I think the really important message though is it's a low-risk turnaround. If you're trying to turn the business around that's in a slow growth market, you've got to take a bigger risk as Wayde referenced Covidien, you've got to make big decisions to be able to get into other markets, and that is a risky proposition. We don't have that. We also have a W2 sales organization, which is fantastic. I did not have that in my previous life, we had a 1099. In a 1099 sales organization, you're paying a percentage of every dollar you sell. So if I buy a company, and I put it in the bag of a 1099 rep, I'm immediately paying a tax on that revenue. If I buy a company today and I have a base and bonus, base and bonus don't change for the rep. I just drop it right in and get immediate leverage. So we're in attractive markets with a W2 sales organization, that's a really nice thing to have.

Yes. I know it's hard to compare. No company or turnaround is like another. But you talked about the success you had at ZB, taking that from little to no growth to mid-single digit, [ midterm SSS-type ] growth. Are there -- the actions you've taken here? Do you think they're similar? Or what are you -- what is similar? What are you replicating here on that experience in order -- because I think you probably want to get to that mid-single-digit target over time at Solventum?

So interestingly enough, although they're different by phases of the transformation are the same. So I pretty much sold them. I'm laughing because Rachel, I see she sitting over there, she's my head of strategy before. She's like, "I think I've seen these phases before." But it really is, first and foremost, around mission, talent, culture. That's the first phase, and we spent a lot of time on that. Whether it was a Zimmer Biomet or here, that is where we have spent an enormous amount of time. You've got to have a purpose in an organization. That's the mission. That's the reason why you wake up every day. And in health care, that's a great mission, as Wayde referenced. The second is you got to hire great people and then you're going to have a culture to maximize the benefit of those people that you've hired. In other words, decentralized, fast decision-making power that those people have to move, so that's what we've been working on. The second phase, just like Zimmer Biomet is a true 5-year plan. What is the 5-year plan going to be, which says that we are going to be very focused in the markets that we're going to spend time in. So we're going through that process today. We'll announce it at our LRP, what are the markets that we're going to concentrate on. We're going to do, again, all of our resources then focused in those areas, and we're going to double down. And the third phase, again was portfolio transformation. As you saw at Zimmer Biomet, we made some moves to make certain businesses out and acquired a bunch of smaller companies to be able to build in other areas. So it's a very similar phased approach. I'd say what I like more here is that people really want it. I don't know that everybody wanted it as much because you kind of had the Hatfields and McCoys at Zimmer Biomet back then. Zimmer and Biomet were competitors, all of a sudden they came together, they didn't like each other very much. So it took a long time to get people to act as one. Here, people are already acting as one and they really want the change. They want to get out from underneath the industrial conglomerate, and they want to move faster. They want to make decisions and they want to become a health care company. So to me, this is easier because people are probably more excited out of the gate.

Okay. All right. easier, but still a similar timeline put on it. Okay...

That was going that was a good way to put a timeline in...

So on the tariff topic, and I'm asking all my companies this. So again, we're -- don't have like necessarily the history here to work with like what happened under the last cycle of tariffs, but maybe help us out with what your current manufacturing exposure looks like, your sourcing exposure. I know that the response is probably going to be way too early to tell. We'll update you when we can update you. But so we can at least level set ourselves. Do you have manufacturing in Mexico? Do you source out of China at all? So just so we can have a sense of like what impact this might be as we start to think about this?

So you knew my answer. So you...

I took your answer before you gave it...

It's like [ 8-mile ] right there. So what I would say is, first of all, to your point, I've been around long enough to be through a number administrations and not everybody does what they say, it's hard to predict what's going to happen. But any time somebody is talking about tariffs of this size, you got to pay attention. So we're clearly paying attention. The good news is, is we probably have a little less exposure maybe than others because of our regional setup in manufacturing. Just as an example, if I think about China, most of our China manufacturing is for China or for that region. So it doesn't really come back into the U.S. Mexico is a little more, Canada, a little more. So we'll just have to wait and see where this actually goes? Do we do the tariffs? Do we not? And what countries are impacted by those tariffs? But it would be crazy for us not to be paying really close attention to this.

Yes. And -- but it sounds like maybe ability to flex a little bit like maybe manufacturing one location or another to, I don't want to say, circumvent but to -- yes, get around the tariffs?

That's harder to do. So if you did have a tariff in a specific country where you had a large amount of product coming in from that country to the U.S. the pivot in a regulated environment is pretty tough. So it would take time. And I don't know that the return on investment would be there. It's certainly something that we'll pay attention to, but it wouldn't be a quick turnaround.

Okay. All right. Maybe a more uplifting topic, sorry. And a question for both of you. I think we're all getting comfortable with your styles here at Solventum, not that they're necessarily entirely different from your last experiences, but I think the impressive piece out of the gate is that you're already establishing a pattern to the least of the financial community raising guidance elements in each of your first 2 quarters of reporting. I guess what should we make of that as we think forward and the way this may even be more of a question for you. Is that by design? Is that how investors should think about how you'll be framing outlooks as you give those outlooks?

Yes, sure, to start that one. Maybe a bit of context would be certainly with the separation, there's more risk or variability with the numbers. And so we are very happy to have 2 strong quarters in our first 2 quarters here where we were on track and didn't see a lot of disruption from the separation. So that adds just a little bit of additional variability as they think about setting guidance. The other thing is just to keep in mind, our first [ 2 ] quarters, we had actually for the year, we had thought about a SKU rationalization program that could create some headwind through the year. And we were very fortunate to have our wave 1 of our SKU rationalization get out over 5%, over 3,000 SKUs without having a major impact to revenue. So by taking that out of our planned guidance for the year, that gave us the opportunity to raise. We also had a really strong Q2 in our medical OEM business in MedSurg, and some of that was unexpected because it was a large back order recovery. So those 3 things were really what fed into our thesis to be able to go from what was at the start of the year, flat to down 2 to now flat to up 1 moving from below flat to above flat. It was a big deal for us. And so we are seeing some fundamental strength in the volume of the business as well, starting to improve, and we're -- that's the signs that we're looking for. But it was really important for us out of the gate to have 2 quarters where we set appropriate expectations and then meet or beat them. We want to build credibility with all of the shareholders and investors watching our business just right out of the gate, that we have good credibility built here is really important to us.

Okay. All right. And then I'll ask you, and you got Bryan as a buffer here. So '25 Street numbers are kind of all over the place. This is something that came up on the last call even without talking about specifics, do you think the Street is mismodeling anything right now? Or are there certain line items where you say, that's really out of whack?

Yes. It's interesting, you brought that one up, Jason, because we haven't guided to 2025, yet most companies don't until they get to either close to or at their Q4 number and understanding that we have probably significantly more moving parts than most companies do at this point in time. Because of that feedback, we built a lot of additional information and color into our prepared remarks and public commentary. And so I do think we've seen 2025, in particular, come into not an unreasonable range. Actually, it's really tightened up recently. And even the long term, we're starting to see some improvement there, even before we can put on our long-range plan. So we're very happy that you've launched coverage on us now. Thank you for joining. We actually just had another one over the last couple of days. So we're building -- starting to build a nice sell-side coverage base and folks like you all that understand us very well, can help communicate all of that additional information we're providing to people to help put all those pieces together so that we have, again, a fairly tight range to '25. And once we get our long-range plan out, I think that will help the future years as well.

Yes. Absolutely. I totally understand that. Last minute here. As we think forward to the next month or 2, we don't have a history of Solventum preannouncing in conjunction with a big institutional conference. I don't know if that's something that either of you feel comfortable saying, hey, sitting here today, we plan to preannounce when we get to that conference or around that conference? Or no, we absolutely won't. Any comments on that?

I think we'll say the same thing, but why don't you go...

Yes, sure. So we're not planning to at this point in time. Yes, we are very much focused, and as you all know from the Investor Day, that was very early and Bryan and my tenure with the business. And so we've been working really hard since spin to build our 2025 and our long-range plan. And all of our plan has been designed to launch that in 2025. And Bryan has talked about earlier, how we've had good success hiring people earlier than expected. So we've got the leaders in place, and that allowed us to pull that long-range plan into our February Q4 call. So that will really be a big point for us is when we give our 2025 guide, we'll give our long-range plan. And I think it will be a real seminal moment for this business.

All right. Something to look forward to for sure. We are out of time, unfortunately. But Bryan, Wayde, thanks so much for joining us. Really appreciate it. And thanks to everyone in the room, too.

Thank you. Appreciate it.