Solventum Corporation ($SOLV)

I think we can make a start here. So I'm Michael Toomey, U.S. med tech analyst with -- covering Matt Taylor and joined today by Solventum's CFO, Wayde McMillan; and Investor Relations, Amy Wakeham.

So Wayde, maybe just to set the tone and set the scene, you could go through what Solventum does for people less familiar with Solventum, and what's kind of changed since the spin a couple of years ago now?

Okay. Yes, really good. Well, first of all, thanks for having us, Mike, and good to see people here. It was nice to see Matt as well, walking in. Great place to start. So Solventum, we are the 3M Health Care business that was spun off in April of 2024. And we are a diversified business in three segments today: MedSurg, Dental and HIS. MedSurg is the largest, about 60% of our revenue. And then Dental and HIS, both just over 15%. And I would say our core competency, our core capability is material science and data science. And that is at our core, what we're very, very good at. We brought over a lot of that DNA in our R&D teams, engineering teams, manufacturing areas and at the core, that's what we're driving in excellence in material science, data science in support of our new mission as a new health care IPO. Very excited about the mission that we've created. And we brought over just over 20,000 3M employees who are super excited about the focus coming out from an industrial company and the focus on a health care business. And so with that in mind, pivoting the second part of your question, Mike, around where we're at in the story today, we setup a 3-phase transformation for this separation from 3M at the -- actually even before the spin, our Investor Day in March of 2024 pre-spin, we said there's going to be three primary phases to the value creation for our business. The first phase is around commercial talent structure processes and the separation itself, which is a large body of work. And he second phase was our strategy and really building strategy for our new health care business and that's culminated into a focus on five key areas for us, five growth drivers, that are going to drive over 80% of our growth. And we created our first long-range plan for our company, which we launched at our second Investor Day, and we're well on our way to achieving. And then the third phase of our transformation was around portfolio management and portfolio optimization. We've done a lot of work in this area as well. In fact, last year, we announced the divestiture of one of our businesses, purification filtration to a strong buyer in Thermo Fisher, and we feel we got great valuation for that business and really unlocked shareholder value there. We also did our first acquisition last year of Acera Technologies, a fantastic synergy for us. That business is a nice, strong, growing technology right in the area of our negative pressure wound therapy. So we're building on our advanced wound care capabilities here. And we acquired that business right at the end of 2024. And in our first full quarter, we grew 40%, and that business is continuing its strong growth, and we're off to a great start, even ahead of our own expectations for that business in our first quarter. And so we're not done. We often say portfolio optimization is a continual part of our strategy, and we're going to continue to work on that. We also say that it's not just total segments, it's sub businesses as well as small product lines, whether we're either thinking about divesting them to unlock shareholder value or making acquisitions to create more shareholder value. So portfolio optimization certainly plays a large role in what we're doing to build value here. And then I'd probably just close by saying we're getting close to the end of the separation work. In any of these large-scale spin-offs that we're in like we are here, spinning out from 3M Health Care. There is a very large body of work that has to happen to separate, and our teams have done a great job over the two years that we've been separate. And we're now in our last large ERP cutover, and we're getting to the end of our TSAs. We plan to be done our transition service agreements, 90% of them by the end of this year. So that will really free up a lot of our best and brightest, a lot of our resources from working on the separation, to working on building the business going forward. So a lot of exciting developments in our first two years. It's hard to believe two years has gone by so quickly, but we are executing very well across each of those three phases, happy to jump into any of those today, Mike. But a significant amount of progress, really engaged, excited group of employees across Solventum, and we think we're doing a great job for our customers in this new more focused strategy to deliver improved health care for our customers.

I had to check it was only two years, like five. But maybe we could double-click on the recent results. A lot of moving parts of the guidance and the ERP cutover. I appreciate there wasn't a real change to the full year guide, but maybe you can walk us through that. And I guess now you expect from the higher end of the EPS range. A lot of moving parts, tariffs. Maybe you can just recap and tell us what's baked into the year.

Okay. Yes, great. That's another great holistic question here just to update. And it is related to the separation work we're doing because it is always a little more complex as you're working through the separation. So after our first quarter, we had a really strong first quarter ahead of expectations, and that positions us to be very confident about achieving our full year guide, as you said, Mike. And then one of the things we introduced on our Q1 earnings call was one of our mitigation strategies for our last large ERP cutover because that's in the U.S. and Canada. And the mitigation -- one of the mitigation strategies because most of the business goes through distribution in the U.S., we're going to send advanced orders to our distributors here in Q2, basically increased the amount of inventory in the channel. And we're starting to get over the ERP systems here in Q2, but the majority of the cutover starts in Q3. And what that will allow is less orders have to be processed in Q3 because we got the advanced orders out in Q2. And that just gives a little mitigation to the ERP ramp up throughout Q3. And so we've communicated that we think $100 million is approximately the range at least $100 million in Q2 of advanced orders will increase our revenue in Q2. And then we think the mirror image of that most of it will come back in Q3 there going be a little bit left to take down in Q4, but we expect most of the $100 million that we are going to see extra in Q2 will be offset in Q3. And I think to your point, Mike, the full year guide is unchanged, and our expectations for still having a strong year and continuing accelerating sales growth rate. We did talk about our earnings per share as well. And given the strong start to the year, strong Q1, we moved the guide from the midpoint essentially to the higher end of our earnings per share guide because we're seeing some strong results in Q1 as well as strong expectations for the rest of the year. So that was the one update to our full year guidance was moving our EPS to the high end of the guide.

And when you're looking at the year, there are so many moving parts, I guess, what's the biggest upside, downside risk to guidance? Where do you have more certainty, and where's lease certainty, I guess, whether it's by segment or any of the moving parts here?

Yes, sure. Well, you mentioned tariffs in the previous question, I failed to cover that. So that is one of the areas that we have to watch here as well. So if I start on the top line for sales growth, market dynamics are always favorable or unfavorable. We pay attention to that across our businesses. But just on that one, I would say, we are a very durable business. We are in the primary areas of health care and dental care and our HIS business has a really strong position in its market. So I think -- as you think about us as a diversified health care business, we have some of the most durable markets that we participate in. We're in over 90 countries, tens of thousands of SKUs. So it's a very durable business. And so the market dynamics won't be as significant as, say, a single-product company or a company that is more focused on elective or specialized procedural areas. But market dynamics do play into, and we have to think about that as we set our guide. But from there, the midpoint of our guide this year is continued accelerated growth that we saw last year. If we continue to accelerate from there, we'll be closer to the high end of our guide, and that's where we were in Q1. On a normalized basis, we're approximately 4% growth, which would put us right at the high end of the guide already in the first quarter of the year. So strong start. As you work your way down the P&L, puts and takes for us, certainly, tariffs are something we have to keep an eye on. There's a lot of dynamics in the macro environment today, including oil pricing and other things. Again, what I would say is, although we have exposure to these areas, I think it's probably less than a lot of companies in the sense that oil doesn't play a major role in our raw material supply chain. It's certainly a factor for us. We do have resins for inputs, but not on a large scale. We have to keep an eye on the supply chain and distribution of our product in any oil-related increases there. And what we've talked about is that for this year, we don't expect oil to be a major impact. Depending on where the prices go for the rest of the year, we have to be cognizant of. But we have a lot of fixed pricing built into our contracts to start with, that would delay any increase in oil pricing as well as the capitalized variances. So at whatever cost is being built into our inventory, it gets deferred a little over three months. And so because of that and the oil hitting more in the middle of the year here, we don't expect that to be a major impact. And then from a tariff standpoint, we've said that we think the tariff headwind will be $100 million to $120 million. We built that into our guidance, and we're just holding that estimate at this point in time, very difficult to estimate what that is. And so if we see favorability to that, it could be an upside to our guide. If it ends up being more than that depending on where tariffs shake out during the year could be a headwind. So those are some of the material puts and takes. We also have a lot of programs running to improve our margins. We've got two major programs that we talked about at our last Investor Day, programmatic savings as well as our transform for the future programs. Both of those are designed to ensure; number one, we have flexibility to continue to invest in growth; and then two, to drive margin expansion for us. And that's why we've got a significant effort going in that area because we want to continue to accelerate sales growth, and we want to make sure we're continuing with those investments. And then we also want to make sure that we're driving operating margin expansion each year in pursuit of our long-range plan goal of driving 10% on earnings per share CAGR over that 3-year period of time.

Yes. Maybe double-clicking on the LRP there and the margins. Could you help us kind of build a bridge to that where that margin expansion is coming from. You've got a lot more innovations coming out higher price, but maybe the moving parts of the gross margin, R&D, SG&A, just a bridge to the LRP.

Okay. Yes, you hit on a couple of the key ones there, Mike. I would probably start with as sales accelerates for us, that's one of the larger drivers of margin expansion and profitability improvement for us because we can leverage that faster sales growth and drop through. You mentioned pricing. Pricing for us, we're thinking the normalized range is plus 1% to minus 1%. And it's not our expectation that we're going to be pressing hard on price, although we do have areas within our business where we do have good strong brands and good brand recognition, and we do get pricing improvements every year. We've talked about it in our HIS business in our long-term contracts. We've talked about it in areas like in dental. We've got very strong brand recognition. So overall, we're expecting price to be consistent in that normal normalized range, plus or minus 1. We like it if we're on the positive side of that, leaning to plus 1. There may be years where there's negative pricing. Hopefully, that's because we're dictating that with achieving large volume contract wins and things where we may give up some price for volume. But as you mentioned, Mike, the key for us, and this is a change for the business is really focused on that sustainable volume growth. And inside of that is the innovation engine that you just mentioned. We have done a lot of work to improve both our existing pipeline but probably more important, the structure of our R&D organization, and how we innovate. And this is a change from a focused business under an industrial company that was more focused on the bottom line at 3M Health Care. And by pivoting our incentives and our focus to the top line, it brought a lens to our R&D pipeline. And we had a very low vitality index in the business two years ago. And so we spent a lot of time on the existing pipeline. We took out a lot of products that did not have the value that we saw or had carried too much risk. We've doubled down on the areas that we think are good products to invest in and are going to drive a lot of that pipeline value. As a result, we've seen our vitality index move from 2% at spin to now mid-teens, and we're expecting that continue to go up as we continue to improve it. But inside of that was also a structural change in innovation. We've moved a lot of the R&D spend that used to be corporate. In fact, more than half the R&D spend was at corporate. We've now moved all of that R&D teams and funding into the segment. So it's much more closely aligned with our strategy in each of the segments. And so the teams are working really well together. I'd probably just close out the work in innovation. We've also done a lot of work on the stage gate process, and how we innovate. We were typically a business that was creating hammers looking for nails. We're innovating exciting new technologies and then looking for where we would implement them. And our experience in med tech and dental areas, you really need to flip that around, and you need to focus on the customer needs, and then work it back up into the pipeline and develop products for those customer needs. So we've been doing a lot of work over the last two years to turn that. And it requires investments on the front end of that stage gate process. We have made investments in upstream marketing, clinical affairs, medical affairs, working with the teams so that they can get the customer needs nailed down and then work that back through to our talented R&D team so that we're developing products for that process. So with that in mind, innovation becomes the next layer for us. And to your question, becomes one of the bigger upside drivers for us over time.

Are there any particular ones or catalysts or events over the next kind of 18 months that you would point to on that pipeline? Or is it more a gradual increase on that vitality index and it's kind of bit by bit?

Yes. None we're announcing today. But we do have some exciting things in the pipeline that we will announce at the appropriate time as we go. We have announced some exciting new products recently. The peel and place product in our negative pressure wound therapy area is growing very strong. We've also just launched it in several countries outside of the U.S. that was new to the pro forma, was not planned to be launched outside the U.S., and so we've made the investment launching outside the U.S. and it's getting great traction outside the U.S. as well. So that's an exciting new product for us. The dental business has had a nice stream of new product launches over the last year. That business had not had new products in a couple of years, and the growth of our dental business is starting to improve, and a lot of that improvement -- in fact, most of that improvement is on the back of the new products that we've been launching there. And then our HIS business as well, doing a great job of continually innovating inside of our core revenue segment management area. And as we've talked a lot about in previous conferences, layering in AI and deliver -- creating new autonomous coding options for our customers, that have multiple benefits. It helps customers on the cost side. It helps them capture more revenue. And certainly for us, allows us to same-store sales, essentially, we're providing more benefit, more software, more content to our customers, and that allows us to build more for our services as well.

And you brought up AI, HIS business. And I guess that's been a question from investors. I think you have more flexibility now with the April expiration of the spin-related tax constraints. So not expecting an announcement today, but just wondering how you're thinking about rationalization of the portfolio now you have more flexibility.

Sure. Yes. Why don't we talk about AI first, and then we can come back to that third phase portfolio optimization. So around HIS and AI, and Amy was at a recent conference with our HIS leader. So Amy may bring you in on this one as well. What we've talked about is that AI is an advantage for us, and our teams have been working on it for several years. The key for us and really our strength in this business is the critical mass of engineering talent that we have and the decades of experience that we have in working with the reimbursement system, particularly in the U.S. Most of our revenue here is in the U.S. And we have said that we're in over 75% of U.S. hospitals, use our software. So we are heavily embedded with large scale and critical mass here, and that investment over decades has built algorithms and content and capability that positions us very well with our customers. And so with that in mind, what we've done over the last few years and continue to do is build AI into our service offerings, and that's allowing us to provide more autonomous coding options, but it's really only because we have all the content, all the algorithms, all the capability that sits behind it. For us, it's autonomous coding, not software coding, which I think we've seen a lot of the AI disruption more on the software side. And so for us, we think AI is an advantage. But Amy, you had the recent conference, anything else you'd add?

Yes. I would definitely encourage any of you, if you didn't get a chance to listen to Garri Garrison, our President of our HIS business, speak at BofA. He's mentioned a competitor conference, but it was a really great opportunity to hear from her, but specifically around building on what we've said, kind of a lot of people think about it, you just take the codes, and you kind of just code them and submit the claim. But it's the deep years of knowledge, and it's not as simple as a code to a claim. It's understanding the procedure, and the nature of the visit, and that changes what the claim may be and making sure that we're doing it accurately. And the hospitals and the health systems depend on the accuracy when they think about compliance and when they're submitting they want to reduce denials, they want to make sure that they're derisking their revenue, essentially their ability to capture revenue and building also on what Wayde said, one of the key areas is that decades of experience in all the years and the algorithms and the information that not only helps enable our autonomous coding, but it also is the layer on which many other payers and health systems are relying on. We partner with CMS and helping to build their reimbursement system where kind of the information engine behind a lot of the payers and the DRGs that support reimbursement across 30- to 40-plus health care systems across the U.S. from a state perspective. So it's -- we're very much embedded, and that's because of the expertise and the accuracy and the dependency that our customers and the health systems have on us and the information and the data that we have behind the scenes.

Great. Thanks, Amy. And then just to pick up on the second part of your question on portfolio optimization. We're not going to talk about any specific segment other than to say that this third phase of our transformation that we call portfolio optimization, like all phases is running in tandem. And it's been a key for us as we talked about with the divestiture and acquisition that we've done to date, but it's going to be perpetual for us. We're going to continue working on our portfolio. And that both -- that means both potential divestitures and potential acquisitions over time. And we've also talked about, it's not just segment level, but it could be sub business or even a small product line category that we may look to either divest or acquire. So I'd say, as you said, no updates today. There's been a lot of speculation on different parts of our business that we may be able to unlock shareholder value. For us, we think about it in three categories. First, strategic rationale. Is it the right strategic rationale for us to keep a business or acquire a business or divest it? And then we think about the shareholder value unlock potential. And we think like with the P&F divestiture we did last year, we unlocked significant value there. And then we think about RemainCo financial attractiveness and the attractiveness of the remaining business if we do make a divestiture, or if we do an acquisition and layer it on top. So we've got a significant amount of work perpetually running on our portfolio optimization lever and thinking about how we can continue to unlock value here.

All right. Great. We've got 1 minute left. So maybe just we'll touch on capital allocation. You talked about a bit with tuck-in M&A, but you've got the share buyback. So maybe just final thoughts on how you're thinking about capital allocation?

Yes. This is a great one for us in the sense that when we spun from 3M, we had a lot of debt, like a lot of spins do. And the P&F divestiture brought in a lot of cash that we were able to pay down a significant amount of debt, and that got our balance sheet strong, got us in a much stronger financial profile. We're right in line with our competitors. So our access to capital and our ability to compete for deals we're on par with our competition now. So we feel really good about our debt position, and we don't feel like we need to pay down significant more amounts of debt. So what that leaves us with then, and what we've communicated is a balanced capital plan strategy, one that's going to be focused on tuck-in M&A, like we've done with Acera last year and looking for ability to add shareholder value by acquiring businesses over time. But importantly, these aren't large-scale transformational deals. We're very much focused on tuck-in acquisitions, and we said that's anything up to $1 billion. And so keeping it in that hundreds of millions or less type of range because we really have a target-rich environment. We've got a broad swath of very strong positions and strong brands in the marketplace. And we think we can leverage that like we've done with Acera and bring in strong growth categories for us. And so that's the key on the acquisition side. We're going to balance that with share repurchases, and we announced a $1 billion share repurchase program at the end of last year. We started that program in Q1. We also said publicly on our earnings call in the start of Q2 here that given the share price performance for our stock and a lot of stocks in med tech, that if we see more value in acquiring more shares faster, we will do that. And so you should expect us to be accelerating share repurchases when we see our stock at lower levels than we would anticipate that they should be at. And so we're going to balance that over time. So how does that play out over the next several years, we're going to continue to evaluate our acquisition pipeline, and where we see value to acquire assets we will. We'll continue to evaluate the value we can unlock from repurchasing our own shares. We've committed to a minimum anti-dilutive strategy, which means every year, we will purchase at least shares -- at least enough shares to keep our share count approximately neutral. And then from there, we'll be opportunistic to deploy more capital, like we said that we're planning to do given current levels.

Great. We're out of time, but thank you very much, Wayde, Amy. Thank you very much.

Yes. Thank you, Mike. Thank you, everybody.