Solventum Corporation (SOLV) Earnings Call Transcript & Summary

All right. Well, good morning. Welcome to the second day of the Wells Fargo Healthcare Conference. I'm Nathan Treybeck, one of the medical device analyst at Wells Fargo. Pleased to introduce management from Solventum for the session. Joining us from the company are Bryan Hanson, the CEO; and Wayde McMillan, the CFO. Thank you for joining us, gentlemen.

Glad to be here.

So I thought we first touch on the HIS separation announcement. I think that's most pressing for investors. If we could just start off, talk about why it makes sense for you to superate out HIS right now? You previously framed autonomous coating as a revolution that is just beginning. Isn't that an argument for retaining an asset about to inflect?

Yes. So maybe we had a feeling, Wayde and I, that we might get a few questions around HIS. Go figure, right? And maybe the way I'll start with that question in the way that you framed it is just on the second part. I want to reiterate that statement that I really do look at autonomous coating as a revolution that's going to happen in revenue cycle management. And there's a couple of components that you need to make that a reality. Number one, is technology. And where AI is today gives us a leg up to be able to move us in that direction and move the market in that direction. But in concert with that, you've got to have a data set that is unique. And you have to have a know-how, I'm going to call it, tribal knowledge, algorithms that are unique to us to be able to train AI to be able to leverage that effectively. So those pieces are in place, and we're uniquely positioned to win. So I stand by that. I think that's going to happen. I also recognize that it's going to take a significant amount of investment and focus to get it accomplished. And we truly do believe that it will move faster and be more valuable if that entity is on its own and/or connected to someone who's in that space. We've got other businesses that we have to pay attention to. We want to be a medtech player. And strategically speaking, this business doesn't quite fit the same as the others. So that's really the reason why we're moving in that direction, and we think it's the right time to do it. It has nothing to do with how attractive the business is. We think it's fantastic. It's just not suited for us as it is for somebody else.

Okay. That makes sense. It seems that on the last earnings call, you were signaling that the LRP organic growth target of 4% to 5% in 2028 is likely still intact. As we think about the prior market growth rates you presented, HIS was 5% to 6%, MedSurg was 4% to 5% and Dental was 3% to 5%. So explain how the separation would not be dilutive to your top line growth? Are you assuming growing above market? And would that be in both MedSurg and Dental?

Okay. The only thing I would change there is the likely 4% to 5% is still intact. It is definitely still intact, the 4% to 5% without HIS. And I was just speaking to the market growth rate. Remember, HIS is less than 20% of the business. So Dental, the RemainCo Dental, MedSurg would be over 80% of the business. And when you look at the market growth of MedSurg, which is the largest majority of that, it's 4% to 5% and then Dental is 3% to 5%. So there's really not much change to the overall market growth of RemainCo. And I guess the other thing I would look at is we're already kind of moving in that direction. So we have a lot of confidence in it. So the only thing I would change in the question is, it's not likely it will happen. And then once we get there, our goal is to move beyond that.

Okay. So ex HIS, I estimate the Solventum grew about 3% in 2025 and is on track to grow about 3.7% in '26 when you normalize for the SKU rationalization. Assuming you are on track and what you said you are for the 4% to 5% in 2028 even excluding HIS, what is it that gets better in your business? Or are there any new product launches that drive this growth acceleration? Are there any specific areas you would point to that will give investors comfort in this acceleration path?

Yes, yes. So I would say the 3.7% that you're referencing is just the middle of the 3.5% to 4% ex SKU that we gave for the holdco company. And I think it's good that you're using it for RemainCo, or in other words, MedSurg and Dental because the only way you can get there is if those 2 businesses, being that they're over 80% of the business, get to that growth rate. So I think the biggest proof point on us getting to 4% to 5% is that we're already pretty close to it. We're predicting to get pretty close to it in 2026. Outside of that, there are areas of concentration that we have. For those that are new to the story, we have these things that we call growth drivers. We spent a lot of time when we came into the business to select the markets we were going to concentrate on and then the growth drivers inside of those. We coalesce all of our resources or most of our resources around those growth drivers and 4 of those will be in the remaining business. One of them goes with HIS. Inside of those growth drivers, we really have, I'm going to call it, 3 organic areas that should give people confidence. The first is that we've changed the commercial organization to specialize in those areas. So I'll call that commercial optimization, which is a really important leg of the stool. The second, people may not recognize this, and I was very happy to find it, is we have legacy technologies that are very valued brands in the marketplace that are clinically differentiated, that have been around for a long time, that are significantly underpenetrated. And we've got an opportunity through that specialization just to get adoption of those technologies. And then the third leg of the stool from an organic standpoint is just new product innovation. And we've really seen great product launches since we spun, and we've got almost 20 new products that we're going to launch through the first quarter of 2028. We'll talk a lot more about those at the Investor Day in March. But those are the reasons why you should have confidence. And then in addition to that, from an inorganic perspective, Acera has been a great acquisition. And as we roll into '27, as you know, that becomes organic growth for us as well.

That's great. Our math on the HIS separation suggests about 300, 350 basis points of operating margin dilution after an assumption for stranded cost of about $30 million to $40 million. Wayde, any color you can give on that? Is that in the ballpark as investors model out the separation?

Yes. So obviously, a bit early to be talking about modeling the separation of HIS at this point. We've got multiple separation paths and we've got, obviously, timing and other considerations. But I think just working with the number that you gave, Nathan, 400 basis points, I think if you're estimating on a full year basis and you're netting that with some TSA offsets, and obviously, we've got a lot of work going on in the business getting ready for stranded costs and other cost reductions, I think that 400 basis points is probably a reasonable full year view of what the dilution could be. Obviously, it's a very profitable business for us, and we'll have some dilution. But maybe just thinking about it from a straight math basis, the dilution in total would be higher than that. But if you're netting out TSAs and other cost reductions that we have, I think that's a reasonable full year estimate at this point. Obviously, once we get further down the path with the separation, we've got more clarity to the separation path that we're choosing as well as the timing of that, we'll provide a forecast or an estimate for you all for 2027 and beyond when we get there.

Okay. That's helpful. So everything that you said there, Wayde, is it fair to assume that the LRP operating margin target of 23% to 25% in 2028 is basically not achievable at this point excluding HIS?

Yes. Happy to take that one, too. And clearly, the LRP for us is still in place, and we're still working towards that until we actually do separate from HIS. So we're not providing an update to that LRP at this point. It would be too early to do that. But it's no question that HIS will be dilutive for us. It's a very profitable business. So when we reset our LRP, we will -- we might be in a position, hopefully, we'll be in a position to update that at our Investor Day and provide a new LRP excluding the HIS business, and we'll do that at that time. So no update to the LRP at this point. What I would just share on this one is we've made great progress on the profitability of the business. In fact, this year, as we know, with the recent tariff refund that we booked in Q2, which really neutralizes tariffs for us for the year so we don't have a tariff impact, it shows the progress that we've made on profitability to this point. In fact, if you look at our operating margin guide for the year for 2026, at the high end, we're almost at that 23% low end of our LRP. So we'll see where we finish this year. But if we finish at the high end or maybe even a little better, we'll actually be touching the low end of that LRP guide 2 years early. So we'll see where we finish up 2026 here. And then, of course, in our Investor Day in Q1, we'll provide a new LRP based on the separation plan for HIS.

That's helpful. We appreciate that you're pursuing the most value-maximizing path for separation. But are there any specific factors that you're focused on that will determine what the ultimate deal will look like?

Absolutely, yes. So maybe just taking a step back there, we've talked about it a lot, but there're really 3 things that we look at just to make the decision whether we're going to separate or not. And for us, it's, number one, the most important thing is strategic fit, do we have the strategic fit for that business? We're not. That's going to be the first element. Then it moves to shareholder value. If we don't feel like the strategic fit is there, can we drive shareholder value either immediately or over time as a result of separating? And then the third is just you got to look at RemainCo financials to make sure you've got a company that you still feel good about. That's the way we make the decision, and we have made the decision to separate. Then you've got to click down from there to decide what separation path you're going to use. The first piece you look at for separation path is obviously, again, shareholder value or package value on the various separation methods. But then you got to look at things like the proceeds that you're going to get, cash proceeds, the time, the certainty, the complexity associated with any transaction. And we kind of put those variables together in an algorithm, if you will, and we make the decision on what makes the most sense, what drives the most value, not just for shareholders, but also for our customers, our patients and our team members. So that's the way we'll make that decision. And part of that can't be decided until you get the variables, the information. You got to have the information inside of those variables to make the ultimate decision.

Perfect. What some capital structure assumptions, our rough map suggests, if you apply all the proceeds to buying back shares, you'd be looking about $1 of EPS dilution. Wayde, any additional color you could give there? Is that in the right ballpark?

Yes. We're probably way too early for that one, I think, at this point, Nathan. I'm guessing inside of those assumptions you're going with the sales scenario. And so clearly, we've -- as Bryan just outlined, we've got a lot to work through yet until we make those final decisions. And so we're not going to be commenting on the dilution at this point. A little easier to talk about operating margin. Once you get down into EPS, you bring in a lot of these other assumptions. The path of separation, the timing of that as well as TSAs and our ability to get after stranded costs. I think, as everybody knows, as long as you have the business, before you divest it, you're supporting it. And then when you do divest it, there's a period of time where you have TSAs and you have to support the business. So you can't actually get after those stranded costs because you need that infrastructure to support the business until you're off the TSAs and then you can go to work on the stranded costs that are supporting the TSAs from there. So there is a lot to be worked out. I'm guessing you also have insight -- I'm thinking that's a sales scenario inside of that [indiscernible] (00:17:47) of a certain purchase price assumed in there and a certain use of proceeds. So there's just a lot, I think, that has to be worked out before we can communicate what we think the ultimate dilution will be. In most cases, divestitures are dilutive. I think most companies have that to deal with. We're obviously conscious of that. And so we're going to shift our use of proceeds to return to shareholders in some form or fashion. We want to keep a strong balance sheet. We want to keep our solid investment-grade rating inside of that strong balance sheet. And then from there, we're going to be looking to return a lot of that capital to shareholders and be working on the methodology to do that, again, in that sales scenario. There's obviously the spin scenario for us or anything in between, potentially some type of an RMT partner. So we've got a lot to work through before we can start communicating what an EPS dilution would look like, for what period of time. And when we get to the appropriate time, when we've made the decision on the separation path and we've got the timing in hand, then we can provide what that dilution, we think, will look like for '27 or 2028.

Sounds good. Bryan, as you think about the vision for Solventum, do you envision MedSurg and Dental as the end state of the company? And maybe just remind us of the benefits of the combined MedSurg and Dental business?

Yes, maybe I'll start with the benefit -- well, I'll start with, do I think it's the end state. It's perpetual, right? I mean this concept of portfolio optimization, if you're doing your job, as a leadership team, you're always looking at the portfolio to make decisions on what fits and what doesn't and what should fit that isn't here today. So that will be perpetual. I do like, though, the fact that post-P&F and eventually post-HIS, we are more of a medtech business. That's part of the transformation that we've been focused on. We want to be a medtech company and those 2 assets that we just talked about, P&F and HIS, are atypical in a medtech company. So I feel good about that. But again, this is a perpetual thing. We'll constantly look at it. The reasons why they go together, I'd say, first, they seem more natural in the medtech business. You've got a lot of medtech companies that have both. Analysts that cover us understand both markets, and they typically cover both businesses in both markets. So that's helpful as well from a clarity perspective. And for us specifically, there's a lot of, I want to call it, secret sauce, raw materials, IP that is used across the business. One of the best things 3M has done is they created unique-to-the-world chemicals and raw materials that make their products very special and hard to unseat. And we use those across these 2 businesses. Outside of just the raw materials, we have competencies in research and development that are very fungible across those businesses. So there's reasons for them to be together. It just doesn't mean that they'll always be together. And I just don't want to make that commitment. But I do like the fact that we're more of a medtech company post-HIS.

Perfect. You talked about that while the separation dilutes the operating margin, it will also help to mask the operating efficiencies that you've been generating in the business. And so potentially, we could see faster margin expansion and EPS growth post the HIS. Is that kind of a good way to look at the business?

You want to answer that, or you want me to...

Yes, sure. Yes. Again, we're obviously focused on driving top line sales growth and operating margin expansion. You've heard us say many times since our IPO that we think we've got opportunities both on the top line, which Bryan covered earlier, and we're doing a great job of improving that since our spin. And on the bottom line, we've made good improvements there as well. And so we expect to be improving sales growth and operating margin expansion each year. When you think about the post-HIS, which I think is the essence of your question, it does put us in a position to potentially accelerate faster because HIS is obviously a very profitable business. But as Bryan outlined earlier, the strategy there is a heavy investment strategy to compete in that fast innovation cycle HCIT market that it's in. And we've been significantly increasing investment in that business since our IPO and investing in growth drivers for that business, but it can obviously benefit from, as Bryan laid out earlier, a new strategy, either on its own or as part of a broader group of HCIT companies. And so for us, with the remaining business within MedSurg and Dental, we do think we've got more margin expansion opportunities. So if you think about the RemainCo business with medtech and Dental, you could see us accelerating operating margins even faster given that RemainCo portfolio. We've been talking a lot about the 2 major programs that we have running, programmatic savings and our Transform for the Future. Programmatic savings, we outlined at our last Investor Day, is heavily focused on our cost of goods sold, cost of delivering our product and the supply chain. And so we've got significant efforts there. And you can imagine most of that or all of that is focused on the MedSurg and Dental businesses. It's not focused as much given the different business model for our HIS software business. And then in our Transform for the Future area, which is some cost of goods sold, but primarily focused on our operating expenditures and the OpEx across the business. And a lot of that is focused on MedSurg and Dental as well. So if you think about those 2 programs and what we've been working on over the last year or so to ramp those programs up, and they're multiyear programs. They will run for a few more years yet where we're driving significant efficiency and effectiveness. It's an efficiency for sure, but it's also driving more effectiveness throughout the organization. So if you put all that together, we certainly have a lot of focus through those 2 programs driving efficiencies and more so focused on the MedSurg and Dental business. So to your question, post-HIS, we will certainly have margin expansion as we've been planning, and you could see it even faster on the smaller base of business without HIS.

Maybe I'll just draft off of that because I think it's a really -- it's a great question. It's an important question. It's connected to the growth driver strategy because to make it to a growth driver, that specific market or technologies need to be mission-centric. They have to be a very attractive market. We've got to understand the barriers and the solutions, and that's where we're going to focus our efforts to grow, but they also have to be profitable. That goes back to the concept of is it an attractive market, a profitable market. So as we grow faster because that will be 80% of our growth going forward as we've talked about, you get a natural mix benefit in margins. It's not only getting the growth benefit, but you're getting a mix benefit as well from a margin perspective. So on top of that programmatic savings, on top of TFF, we also have this mix benefit as we grow faster in those more attractive spaces. So those are the things that we're going to be focused on. And remember, as I said before, in those growth drivers, 4 of those were actually in the Dental and MedSurg business.

Great. Well, I think we beat that one down, the HIS operation. So maybe let's move on to Q2 and full year guidance. So you raised full year organic growth guidance from 2% to 3% to 2.5% to 3%. And I guess, talk about what you're seeing that drove that guidance raise? And do you see areas for upside to the new guidance? And where would those areas for upside come from?

Yes. What I'd say is you're kind of looking for proof in the pudding on why do we feel confident. And I'd say the first piece, I would say, is just the performance of the business so far. If you're looking at where we are today, we're already approximating that guidance. And all we really need to do is to keep that momentum that we've already created in the first half of the year to be able to deliver against it. Of course, our goal is to always make sure that we deliver the guidance range, if not do more than that, that's the intent. Outside of that, it's the very things that we talked about before. It is those growth driver areas and it's the 3 subcategories of growth drivers, the commercial infrastructure that we put into place, that underpenetration that we can use now for market development capabilities we didn't have before and product innovation that we've already launched in and will launch.

Okay. Touching on MedSurg performance. In Q2, organic growth after adjusting for the 700 basis points of ERP cutover was about 1.9%, which is up from 1.2% in Q1. Can you talk about what's assumed for the second half for MedSurg growth? Yes.

Happy to take that one if you like, yes. There's a lot of numbers in that one.

By default it goes to you.