Solventum Corp Q2 FY2024 Earnings Call

Good day. My name is Ellie, and I will be your conference operator for today. At this time, I would like to welcome everyone to the Solventum Second Quarter 2024 Earnings Call. As a reminder, this conference is being recorded. I would now like to turn the program over to your host for today’s conference, Kevin Moran, Senior Vice President of Investor Relations. Please proceed.

Good afternoon and welcome. Today, we will discuss Solventum’s second quarter fiscal 2024 results, along with an update to our 2024 outlook. Just after market closed today, a press release was issued with our earnings results and updated outlook. The press release and earnings presentation are available on the Investors section of the Solventum website. Joining me today are Bryan Hanson, our Chief Executive Officer; and Wayde McMillan, our Chief Financial Officer. During the call, we will be making forward-looking statements that are subject to risks and uncertainties. For a full description of these risks and uncertainties, please refer to our SEC filings and the forward-looking statement slide at the beginning of the presentation. Please note that during our discussion today, all our comments will be on a non-GAAP basis unless they are specifically called out as GAAP. GAAP to non-GAAP reconciliations for all relevant periods can be found in the schedules attached to our press release. For the Q&A portion of the call, we kindly ask that you limit yourself to one question and one follow-up. And with that, I’ll hand the call over to Bryan.

Alright. Great. Thanks, Kevin, and thanks to everyone for joining us today. I’d like to say it’s exciting to be here for our first earnings call as a publicly traded company, and I want to start that call by saying that I’m encouraged by the progress that we have made and with the results of the quarter, which reflect our ability to come together as a new team and maintain business continuity in the midst of the separation. We’re raising our full-year outlook as we continue to progress our plans to get this business to where we expect it to be. Simply said, we are moving with urgency, and we remain confident in our ability to create value. And for all the Solvers that I know are listening out there, I want to say thank you. It’s your hard work that has gotten us to this point. Make no mistake, this would not be happening, we would not be here without you. For the call today, I’m going to provide a brief reminder of our Investor Day presentation, specifically around our situation analysis and reasons to believe in the value creation story, as well as a reminder of and update on our phased approach for the transformation and turnaround. Then I’ll pass it over to Wayde for a deeper dive on the quarter and our improved outlook for 2024, and of course, we’ll save time for Q&A and certainly look forward to that conversation. As some of you may be new to the story since our Investor Day in March, let me start by giving some background on Solventum, our team, and again, why we’re confident in the value creation story. The spin itself is something we have discussed before, but we have extensive intellectual property that we share with 3M. As a result of that, we are executing a highly entangled and, therefore, complex separation. To ensure that we proactively mitigate the risk associated with this separation, we have intentionally assembled a team with significant spin and transformation experience. Given the regulatory requirements of the sector, which can significantly impact the planning and implementation of the separation, we have also ensured this team has deep regulated business experience. Simply put, we have done this before, and we are going to do it again. Now relative to the business setup, our business segments are in attractive and growing markets. We have strong sub-brand recognition in those markets, significant IP protection, solid levels of investment in R&D, and we have global reach. That said, we also have businesses that have consistently underperformed their markets with flat volume growth over the last 2 years, coupled with a declining volume trend mainly due to misaligned and unfocused metrics, which resulted in commercial misalignment and poor R&D productivity. Now with this as context, and of course, what are we going to do about it, I’d like to remind you of our phased approach to stabilize and then separate the business, reposition it for profitable growth, and optimize the portfolio. As discussed at our investor meeting, we have outlined this in 3 phases, which are all currently underway and running in parallel. Phase 1 is focused on mission, talent, culture, and structure as well as the spin-related activities to separate from 3M, which are critical catalysts to driving business growth. Phase 2 is developing and implementing our long-range plan that will reposition us for profitable growth, and Phase 3 is portfolio optimization. Starting with Phase 1, we’ve already created a new mission statement and articulated our company values. It was an amazing opportunity to help write the mission and values for a new company. I feel incredibly lucky to be a part of something so meaningful. I see the mission and the values of a company as absolutely critical to its success, because when done right, it becomes a common purpose and connection across the team, capturing the hearts and minds of all of our team members, which I see as an essential enabler of sustainable business performance. We’ve held mission ceremonies around the globe, meeting with thousands of our employees to discuss how they bring the mission to life. It doesn’t matter where region or country or business I’m in; the team is excited and ready for the future as Solventum. Now relative to talent, which is really one of the key areas where spinning a company creates value, we continue to move fast. We’ve completed the selection of our level 1 leadership team, finalized the structure for level 2, and identified key positions at levels 3 and 4 that are critical to the turnaround. We’re actively sourcing or acquiring experienced talent in these roles. At the end of the day, we’re trending ahead of my expectations in talent acquisition, benefiting from a lot of high-level industry talent that understands the value creation story and is interested in joining this team. We’re also making great progress on our culture and structure project, which is a restructuring project we are calling the Solventum Way. The goal here is to create a more nimble and less hierarchical structure that drives increased autonomy, speed, and accountability, and will also help us ensure that we have the ability to invest for growth while enhancing margins. Moving to the separation activities for Phase 1, it’s obviously early days with most of the work still ahead of us, but these are critical months in the separation, and I’m happy with our progress. This quarter’s financial performance speaks to a successful start with our business continuity efforts while standing up a newly independent company. Again, I want to compliment the teams for delivering on their commitments in the face of separation distractions. Regarding our supply continuity project, manufacturing, and IT separation, I feel good about our disentanglement plans. This is hard work, but the teams are progressing these initiatives with speed. From a timeline perspective, our supply continuity project will extend beyond 24 months, but we expect the majority of Phase 1 activities to be completed in 12 to 24 months post-spin. I should also note that, given the time frame of Phase 1, it will naturally overlap with Phase 2 and Phase 3. Phase 2 focuses on a long-range plan to position us for profitable growth. Because we were able to accelerate talent acquisition in Phase 1, we’ve shortened the path to finalize our strategic plan in Phase 2. We expect to share this plan during our fourth-quarter earnings call, which will coincide with our 2025 guidance. Key elements of that plan will be our primary market and submarket selection. Inside of those markets will be the growth driver initiatives to build scale, and importantly, we will shift our commercial R&D and eventually resources to those growth driver areas. Currently, we are assessing primary markets and growth drivers, and we intend to finalize these decisions before the end of the year. Once we’ve identified them, we’ll begin shifting resources, starting with changes to our commercial infrastructure and modifying the incentive plans for our sales organization to bias our focus on the growth driver areas. We will also adjust where we spend R&D dollars to align our product pipeline toward innovation that matters and is material in those growth driver markets. Finally, we expect that our focus on debt reduction over the next 24 months will provide more flexibility to expand our capital allocation priorities, including potential tuck-in M&A tied to our growth driver areas. Moving on to Phase 3, we’re evaluating pathways for our portfolio optimization through inorganic means to bring additional strategic clarity, organizational focus, and value creation. We are actively assessing our various markets and businesses and their value contribution to deliver on our strategic and financial priorities. Given how early we are in the spin process, there are contractual considerations that will influence Phase 3. To summarize, our foundational work on mission, talent, culture, and structure is ahead of schedule and positively impacting our Phase 2 timing. From a separation perspective, it’s early days, but also pivotal days in the process. Things are progressing well, and I have confidence in our team. Given our early progress on our strategic plan and SKU project, we now intend to share our long-range plan during our fourth-quarter call. Wayde will speak more to the quarter in a minute, but our first quarter as an independent company was a promising start when it comes to business continuity and progress on our phased approach. Before I turn it over to Wayde, I just want to reiterate that we have an incredible opportunity to create significant value and that I believe the actions we are taking today, relative to executing the separation and identifying opportunities to reposition this company for profitable growth, will set us up for significant value creation in the future. Okay, Wayde?

I’ll start by echoing Bryan’s sentiment and thanking everyone at Solventum for their hard work, getting us to where we are today. Our 3-phased approach is designed to create significant value over time. I’ll keep my remarks mostly focused on updates related to Phase 1 and separation activities before getting into Q2 performance and then wrapping up with guidance. To separate, we have significant efforts underway. We’re moving our manufacturing lines from 67 plants to 29 Solventum plants, 2 of which we’re currently building. We’re also separating our distribution and supply chain by changing from 122 to 73 distribution centers. Our rebranding efforts are significant across 90 countries, and we have changed our commercial distribution models in over 60 countries. The IT work streams may be the most complex as we’re working to transition over 1,000 systems and stand up over 70 new platforms, including our new SAP ERP system globally. In parallel to the separation work, we are already making progress on the turnaround, which is centered on improving revenue growth and expanding margins. It’s important to understand the historical baseline, and I’ll provide some background for each metric as well. For revenue, we have historically underperformed our mid-single-digit markets with flat and declining volumes over the past 2 years. This was clearly reflected in 2023, where price contributed more to revenue growth than volume. As we move out of a hyperinflationary period and normalize prices, we are focused on turning around the negative volume growth. Bryan covered the Solventum Way restructuring project, which touches every segment, function, and region in the company. This effort is ongoing and will be an important part of our investment to reposition for growth and margin enhancement. Additionally, we remain focused on a comprehensive global SKU rationalization initiative. Our goal is to streamline and simplify the company by eliminating less strategic, low-growth, or low-margin SKUs or product families. We have already identified approximately 3,500 SKUs to be eliminated as part of Wave 1 of this initiative. They represent about 5% of total SKUs and will help simplify the supply chain without having a material impact on revenue and margin in 2024. This is a promising start and real progress achieved to date. Wave 2 is expected to be more impactful to revenue and margin in 2025. The turnaround is also focused on improving margin. The aforementioned Solventum Way and SKU projects are designed to identify efficiencies to reinvest and improve margins. We have seen our historical operating margins step down from approximately 25% in our 2022 and 2023 carve-out financial statements in the Form 10 to our planned 21% to 23% in 2024. We’re not including 2021 in our baseline, given it was significantly inflated by the post-COVID rebound. This 200 to 400 basis point decline is due to the additional cost of products supplied by 3M as well as increased operating expenses to stand up as a public company and the investments to reposition for growth. Turning now to the financial update. I want to remind everyone this is the first time we’ll be presenting financial results as a standalone company. We previously reported Q1 2024 results under a carve-out basis as the first quarter was still under 3M. With that, I’ll provide an overview of our Q2 results and then shift to full year guidance. Starting with sales. For the second quarter of 2024, sales of $2.1 billion increased 20 basis points compared to the prior year on a reported basis while improving 1.3% on an organic basis. During the quarter, foreign exchange was a headwind of 110 basis points. Sales growth reflected the expected normalization of prices. While we reported a slight volume increase in the quarter, this included a discrete benefit from backorder improvement, without which volumes continued to decline. Moving to the segments. Our largest segment, MedSurg, delivered $1.2 billion of sales, an increase of 1.8% on an organic basis, led by the negative pressure wound therapy product category and continued adoption of our antimicrobial IV site management solutions. This segment greatly benefited from reduced backorders. Our Dental segment delivered $331 million in revenue, a decrease of 2%, which reflects volume pressures associated with challenging market conditions, partially offset by pricing. The HIS segment contributed $328 million in revenue, an increase of 3.6%, fueled by the continued adoption of 360 Encompass in revenue cycle management, and steady results in performance management solutions. Similar to the prior quarter, strength in these areas was partially offset by declines in clinician productivity solutions due to changing market conditions and inconsistent investment. Lastly, the Purification and Filtration segment delivered $238 million in sales, a decline of 0.9%, which was impacted by performance in drinking water filtration, partially offset by better-than-expected strength in bioprocessing filtration. Overall, volume declines were partially offset by pricing. Gross margins were 55.8% in the quarter. This represents a reduction of 200 basis points over the prior year, primarily driven by increased costs in international and unfavorable mix within MedSurg due to backorder recovery in the lower-margin OEM business. Sequentially, these two factors, along with the return to more normalized pricing, weighed on gross margins. As expected, operating expenses increased both versus prior year results and sequentially compared to Q1. The added spending includes standing up new functions to support our growth strategy. It’s important to note that Q2 SG&A was high due to a stock-based compensation charge for legacy 3M employees. This and other smaller discrete items in Q2 represented an additional spend of approximately $30 million. In total, we delivered adjusted operating income of $430 million, which translates to an operating margin of $20.7 million. Moving down the P&L, interest expense also increased sequentially, reflecting the first full quarter's impact of our February 2024 debt issuance, which was partially offset by interest income. Lastly, our effective tax rate of 12.2% came in favorable, partly due to the estimated geographic mix of our statutory income post-spin, which includes a year-to-date adjustment. All in, we delivered earnings per share of $1.56, ahead of our internal expectations. Turning to the balance sheet, we ended the quarter with $897 million in cash and equivalents with no outstanding borrowings on our credit facility. We generated $297 million of free cash flow in Q2, bringing our year-to-date total to $637 million. Importantly, we are committed to maintaining our investment-grade rating and expect debt paydown to remain the priority over the next 24 months. We maintain a strong liquidity and financial position with continued free cash flow generation in addition to our $2 billion revolving credit facility. Now turning to guidance for 2024. We are raising our organic sales growth guidance range up to 0% to 1%. This reflects first half performance, including the benefit from backorder reduction in Q2, an updated assumption that SKU rationalization will not have a material impact on 2024 results, and importantly, building confidence in business continuity. We are not providing quarterly guidance, but I do want to note the second-half dynamics of the year-over-year comparisons which will play a large role in the organic sales growth in Q3 and Q4. For background, Q3 was the highest growth rate in 2023, and therefore, is a tougher comparison resulting in expected flat to down growth rates in Q3 2024, while Q4 was the second lowest growth rate in 2023, with an easier comparison for Q4 2024. For earnings per share, we are raising our guidance to $6.30 to $6.50 on our improved sales outlook and favorable estimated tax rate. We continue to expect free cash flow in the range of $700 million to $800 million. Regarding gross margins, we continue to expect incremental gross margin headwinds from the 3M supply agreement markup, which will begin to flow through our P&L in Q3 2024. For operating expenses, we anticipate continued ramp-up for investment to build out standalone functions and support our growth strategy through the second half of the year. We continue to expect a full-year 2024 operating margin in the range of 21% to 23%. Turning to the tax rate, we are updating our full-year effective tax rate to 18% to 19%, which is an improvement of 200 basis points from our earlier assumption of 20% to 21%. This change to our tax rate is expected to be temporary for 2024, as we’re benefiting from a near-term favorable mix based on where we are generating our income, which is a function of realizing separation costs in specific jurisdictions. In conclusion, we are off to a solid start, closing our first public quarter. We’re delivering on our near-term financial commitments, executing on separation activities, focusing on turning around the business while raising the top and bottom line guidance for the year. Looking ahead, we will continue to execute on our phased approach to transform our business and make improvements across our key operational metrics, accelerating revenue growth, expanding margins, driving free cash flow, and optimizing our capital allocation. We will use our expertise in health, material, and data science to deliver our mission. We are encouraged by the early progress and look forward to the value creation plan ahead. I’ll now hand it back to the operator for the Q&A portion of the call.

Our first question comes from Travis Steed from Bank of America. Your line is now open.

Hi, everybody. Congrats on your first earnings call. I guess, Wayde, I wanted to start with the guidance raise and really understand all the moving parts there. I guess a lot of the EPS raise came from the tax, but it sounds like things have been tracking ahead of plans and pushed the SKU rationalization to 2025. If anything, are you kind of more confident in the outlook here that drove the guidance raise and how to think about Q3 and second-half modeling for the different line items?

Hey, Travis, this is Bryan. Maybe I’ll start with some of your questions, particularly around just some of the confidence we have and what’s kind of pushing our guide. The first is just the business continuity is feeling pretty good right now, and we’re making great progress against our plan. That’s number one. Number two is Wayde referenced in his prepared remarks, just the backorder recovery that we banked in Q2. The SKU clarity is something Wayde will talk more about in a second, but we have better clarity on the impact we’ll see in 2024 versus 2025. That’s what we feel broad-based, and that’s the reason for the guide change. Importantly, to maybe click down on the business continuity and the progress against our plan, it doesn’t feel like a long time. It’s only been 4 months now, but those are pivotal months in the separation. A lot can happen in those months. We delivered in pretty much every primary area during that time. Most importantly, business continuity, where the biggest risk is. Every day that passes, Travis, we just feel better about reducing risk, retiring risk, and further executing on our turnaround strategy. The simplest way to say it is a lot could have gone wrong, and it didn’t, which is great. It doesn’t mean it’s going to be simple from here, but the momentum is positive, and that drives our confidence. Probably equally, maybe even more important than that, is we’re really moving fast in talent acquisition. You don’t want to put a strategy in place if you don’t have the people accountable for it. The faster you can move to put people in place, particularly in L1 and L2 positions, it’s critical for formulating the strategy, having ownership of the strategy, and ensuring flawless execution. Those are the things that we feel are moving in the right direction, increasing our optimism. I hope that’s reflected in our tone in the guide. Wayde, can you give a little more color on the other components?

Yes, sounds good. Happy to pick up on how we’re thinking about guidance here and the SKU project. As Bryan said, we’re pleased to be in a position where we can raise our full year guidance after just our first stand-alone quarter as a public company. The new range is built off the back of what we called out in Q2. Revenue was ahead of our expectations because of the backorder reduction that we got, a positive sign for business continuity. The new range contemplates normalizing the second half for that price benefit we’ve been seeing, and it continues to wane, as well as a tougher comp for that backorder recovery. When you normalize those two things from the first half, the high end assumes we see improvement in the business, and the low end assumes a more consistent performance. So we feel comfortable with the range here for the second half. It’s early days, but we are pleased with the business and its performance to date.

Great. Thanks for all the color. I guess the next question I have is thinking or kind of when can you start growing earnings again? I know 2025 is a down year, but if you think about the plans that you have, is ’26 a year where you could potentially grow earnings? And is there any way, at a high level, to size some of the things you have to deal with in ‘25 and some of the headwinds you have there, like the SKU rationalization?

Wayde, could you provide a little more color on some of the pressure points in ‘25? Obviously, you talked about that in your prepared remarks; ‘25 will have unique annualization of expenses that will pressure us. We expect that to begin to recover in ‘26. We’d be disappointed if we didn’t start to head in the right direction in ‘26. Wayde, do you want to provide anything more on ‘25? I thought you provided a lot in your prepared remarks, but…

Yes, I certainly can. We’re not guiding to ‘25 and ‘26 yet. There are a lot of moving pieces as we’re in our first year post-separation. We have a lot going on to grow revenue and expand margins, resulting in EPS growth over time. However, it is well understood that we will be pressured by the annualization of some of these costs post-spin in 2025. To list them, we have the 3M supply markup annualizing, annualizing our stand-up functional expenses, and below the line, we will be annualizing interest expense. And all of this is because we have three quarters this year as a public company and will annualize our fourth quarter next year. The SKU project is off to a great start with a significant number of SKUs already identified to eliminate in our first wave. The good news is they do not materially impact revenue. The real benefit will come from simplifying our supply chain and saving costs related to rebranding.

Our next question comes from Vik Chopra from Wells Fargo. Your line is now open.

Hey. Good afternoon and congrats on a nice quarter. A couple for me. So, by my math, the revenue guidance raise is about $80 million to $150 million of upside to 2024. Maybe just help us understand what business segments are driving this? And then I had a follow-up, please.

Happy to take that. We don’t break it down by segment, but we can say that the most important observation is that we gained a lot of confidence in business continuity. It goes from having no quarters to having one quarter. It was a pivotal quarter for us. Across the board, we expect to see strength, particularly with backorder recovery in MedSurg.

Yes, I might just add to that. If you think about the four vectors to accelerate growth—they're pretty basic—upgrading talent to drive better commercial rigor will have a fast impact. We’re bringing in capable new people and promoting from within, and that will yield a quick benefit in the back half of ‘24 and into ‘25.

Got it. Very helpful. And then my follow-up question is, can you just share some high-level feedback on your conversation with the activist and provide an update on how much of a stake they have amassed? Thank you.

As you can imagine, as a public company, we don’t talk about any individual investor. However, we absolutely listen to our shareholders and appreciate their feedback, but probably no more to say about that. Next question please, operator.

Our next question comes from David Roman from Goldman Sachs. Your line is now open.

Thank you and good afternoon, everybody. I hope to get one in here on the financial side and then one follow-up on the strategic planning side. Maybe just starting with the outlook for the balance of the year, I’m trying to bridge some of the moving parts for first half versus second half. Wayde, could you help us with the commentary around the 21% to 23% operating margin and what that implies for an exit rate for the year? As I look at free cash flow year-to-date and the updated guidance, it implies a significant step-up in cash utilization here in the second half. Can you help us understand some of the moving parts there as well?

Sure. Just to cover first half versus second half outlook, I highlighted earlier that we had items in the first half that won’t repeat. Pricing is waning and backorder recovery is not likely to be repeated in the second half. Regarding operating margin, Q2 had some gross margin and operating margin headwinds for us, offset by favorable revenue which gives us confidence to hold 21% to 23% for the year. We’re not giving exit rate guidance at this point, but we’ve gained a lot of confidence in the quarter and learned a lot about the business post-separation. About cash, we are managing the timing of our intercompany work and standing up our capital expenditure processes. We expect to use more cash in the second half as we settle those and ramp up capital expenditures.

Got it. And Bryans, I appreciate your comments on being ready to share more with us on the fourth quarter call. However, you've made comments about kind of the turnaround on the top line being roughly a 5-year period of time. Can you provide an update on that outlook and how it falls into the phasing of the different parts of the Solventum turnaround?

Absolutely. I see this strategic plan as an opportunity to clarify the markets we'll care about. These will be our faster-growth markets, and we expect to pick those by the end of 2024. Once we do, that will shift our resources commercially, R&D, and M&A. Getting that traction and focus will take time. We have four key actions for value creation. Getting great people in place to drive commercial rigor is the fastest way. The second fastest would be commercial structure changes and increasing the productivity of R&D. Finally, we have portfolio optimization, which could include tuck-in acquisitions or exiting slow growth categories. So, it’s a timing issue. Talent acquisition is critical. The back half of ‘24 into ‘25 should show benefits. Structural changes may take until late ‘25, and we likely won’t see R&D benefits until 2026 or beyond.

Our next question comes from Vik Chopra from Wells Fargo. Your line is now open.

Just hopping back into the queue for a couple of quick follow-ups. That $22 million of corporate and unallocated revenues, do you expect those to continue going forward? Should we be building those into our revenue projections?

Yes, an approximate number to the $22 million for the rest of the year is reasonable. So that's a good estimate for the next couple of quarters this year.

Okay. So, build out $22 million roughly for Q3 and Q4. Got it. And then I don’t think I heard an updated FX assumption for the year. Can you help us out with that?

For FX, we use the current FX rates at this point. The last assumption we provided from a revenue perspective is a 50 basis points impact. We did not update that, so it’s safe to assume that this is still our best guess.

Our next question comes from David Roman from Goldman Sachs. Your line is now open.

Thank you. I appreciate your taking additional questions here. Just maybe a few clarification items on the tax rate. I know you talked about some catch-up items that occurred in the quarter, but the year-to-date tax rate and updated guidance puts it in that 20% to 21% range in the back half. Is that a fair characterization?

Yes, that’s correct. We had better than expected tax rates for the first half of the year. The second half is similar to our earlier full-year expectations, but it’s expected to settle out as we separate.

I think you mentioned restructuring. Are you ready now to start rationalizing down costs, and how is that impacting your outlook?

Yes. Our work is underway, and we feel we’re in the right position to start this project—what we're calling the Solventum Way. This will streamline our structure to complement the cultural shift we're implementing. We are changing the culture of this company to focus on speed, autonomy, and accountability, which will drive growth. This restructuring will also give us headroom to invest in growth and drive margin expansion.

I think you covered that well, Bryan. The timing of our restructuring aligns with the key actions we discussed for value creation during our investor presentation. We remain focused on revenue growth as our top metric, and driving efficiencies will help us fund additional growth initiatives and expand gross margins over time.

It looks like there are no further questions. So, I will close it by just saying thank you so much for joining us on our first public call, and we look forward to engaging with many of you over the coming months. Thanks, and have a great day.

Thanks so much.

Thank you, everyone, for attending today’s conference call. You may now disconnect. Have a wonderful day.