Solventum Q2 2024 Earnings Call Transcript

Quartr
Provided by Quartr
August 8, 2024

There are 7 speakers on the call.

Operator

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 Solvintum Second Quarter 2024 Earnings Call. As a reminder, this conference is being recorded. All lines have been placed on mute to prevent any background noise.

Operator

After the speakers' remarks, there will be a question and answer session. Thank you. 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.

Speaker 1

Good afternoon and welcome. Today, we will discuss Solventsim's Q2 fiscal 2024 results along with an update to our 2024 outlook. Just after market close 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 Salventum website. Joining me today are Brian Hanson, our Chief Executive Officer and Wade McMillan, our Chief Financial Officer.

Speaker 1

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 statements 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 and A portion of the call, we kindly ask that you limit yourself to one question and one follow-up.

Speaker 1

And with that, I'll hand the call over to Brian.

Speaker 2

All right. Great. Thanks, Kevin, and thanks to everyone for joining us today. I'd 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. And 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.

Speaker 2

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. And 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.

Speaker 2

And then I'll pass it over to Wade for a deeper dive on the quarter and our improved outlook for 2024. And of course, we'll save time for Q and 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. And I think the right place to start is the spin itself. We've talked about this before, but we have extensive IP that we share with 3 ms.

Speaker 2

And as a result of that, we are executing a highly entangled and therefore complex separation. But to ensure in a situation like that, spin and transformation experience. And given the regulatory requirements of the sector, which can significantly impact the planning and implementation of a 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.

Speaker 2

We have strong sub brand recognition in those markets, significant IP protection, solid levels of investment in R and 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 end metrics, which resulted in commercial misalignment and poor R and 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. As you may remember, Phase 1 is focused on mission, talent, culture and structure, as well as the spin related activities to separate from 3 ms, which are critical, all of them, critical catalysts to driving business growth.

Speaker 2

Phase 2 is developing and implementing our long range plan that will reposition us for profitable growth. And Phase 3 is portfolio optimization. Okay, starting with Phase 1, specifically related to mission, talent and also culture and structure. We've already created a new mission statement and articulated our company values. And I got to tell you what an amazing opportunity it was to help write the mission and values for a new company.

Speaker 2

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 again, I see as an essential enabler of sustainable business performance. And we've held mission ceremonies around the globe, meeting with 1,000 of our employees to discuss how they bring the mission to life. It doesn't matter what region, what country or business I'm in, it is clear. The team is excited and ready for the future at Salventum.

Speaker 2

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 34 that are critical to the turnaround. And we're actively internally sourcing or acquiring experienced talent in these roles as well. 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 understand the value creation story and are interested in joining this team. We're also making great progress on our culture and structure project.

Speaker 2

This 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 very importantly accountability and will also help us ensure that we have the ability to invest for growth while enhancing margins. Moving to the separation activities inside of 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 alone 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 distraction.

Speaker 2

For areas like 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 months to 24 months post spin. I should also note that given the timeframe of Phase 1, it will naturally overlap with Phases 2 and Phase 3. Phase 2 is focused on a solventum wide long range plan to position us for profitable growth.

Speaker 2

Because we were able to accelerate talent acquisition in Phase 1, we've actually shortened the path to finalize our strategic plan in Phase 2. Now we expect to share this plan during our Q4 earnings call, which will coincide as one would expect with our 2025 guidance. So key elements of that plan, not comprehensive, but key elements of that plan will be our primary market and submarket selection, again those markets that we're going to double down in. Inside of those markets will be the growth driver initiatives to be able to build scale. And probably most importantly, showing that we're going to shift our commercial, R and D and eventually M and A resources to those growth driver areas.

Speaker 2

And as you would expect, we're currently assessing primary markets and growth drivers, and our intent is to finalize these decisions before the end of the year. Once we've identified the primary markets and the growth drivers, we'll begin shifting, as I said before, our resources, starting with commercial infrastructure changes, things like specializing the sales organization, things like changing the incentive plans that we have for the sales organization to bias our focus in the growth driver areas. We'll also shift where we spend R and D dollars, so that we align our new product pipeline toward innovation that matters and is material in the growth driver markets. And finally, as we expect that our focus on debt reduction over the next 24 months will allow more flexibility to expand our capital allocation priorities, including potential tuck in M and A tied to our again growth driver areas. Okay, moving on to Phase 3, we're looking at pathways for portfolio optimization through inorganic means in order to bring additional strategic clarity, organizational focus and value creation.

Speaker 2

And as a result, we are actively assessing our various markets and businesses and their value contribution to deliver on our strategic and financial priorities. Now that said, given how early we are in the spin process, there are contractual considerations that will influence Phase 3. Okay. To summarize what I just said, because I think I have to rely at you. Number 1, our foundational work on mission, talent, culture and structure is ahead of schedule and progressing well and positively impacting our Phase 2 timing.

Speaker 2

From a separation perspective, it's early days, but also pivotal days in the process and things are progressing well and I have confidence in our team. Number 3, given our early progress on our strategic plan and SKU project, we now intend to share our long range plan during our Q4 call, which again will coincide with our 2025 guidance. And number 4, Wade will speak more of the quarter in a minute, but our Q1 as an independent company was a good early sign when it comes to business continuity and progress on our phased approach. Before I turn it over to Wade, 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, Wade?

Speaker 3

I'll start by echoing Brian's sentiment and thank 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 solventsum plants, 2 of which we're building new at this time.

Speaker 3

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. 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.

Speaker 3

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 was more than all the revenue growth for the year. As we move out of a hyperinflationary period and price normalizes, we are intently focused on turning around the negative volume growth. Brian covered the Solventum Way restructuring project, which touches every segment, function and region in the company.

Speaker 3

This effort is ongoing and will be an important part of our investment to reposition for growth and margin enhancement plan. 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 and 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 and they will not have a material impact to revenue and margin in 2024.

Speaker 3

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 before mentioned 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 percent in our 20222023 carve out financial statements in the Form 10 to our planned 21% to 23% in 2024.

Speaker 3

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 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 Q1 was still under 3 ms.

Speaker 3

With that, I'll provide an overview of our Q2 results and then shift to full year guidance. Starting with sales. For the Q2 of 2024, sales of $2,100,000,000 increased 20 basis points compared to 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 normalizing of price.

Speaker 3

While we reported a slight volume increase in the quarter, this included a discrete benefit from back order improvement without which volumes continued to decline. Moving to the segments, our largest segment MedSurg delivered $1,200,000,000 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 was the primary beneficiary of reduced back orders. Our dental segment delivered $331,000,000 of revenue, a decrease of 2%, which reflects volume pressures associated with challenging market conditions, partially offset by pricing. HIS segment contributed $328,000,000 of revenue, an increase of 3.6 percent, which was fueled by continued adoption of 360 Encompass inside of revenue cycle management and steady results in performance management solutions.

Speaker 3

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. Finally, in Purification and Filtration segment delivered CAD238,000,000 of 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 percent in the quarter. This represents a reduction of 200 basis points over prior year, primarily driven by increased costs in international and unfavorable mix within MedSurg that was driven by back order recovery in the lower margin OEM business.

Speaker 3

On a sequential basis, 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 spend includes standing up new functions and to support our growth strategy. It's also important to note that Q2 SG and A was high due to a stock based compensation charge for legacy 3 ms employees. This and other smaller discrete items in Q2 represented an additional spend of approximately 30,000,000 dollars In total, we delivered adjusted operating income of 430,000,000 which translates to operating margin of 20.7 Moving down the P and L.

Speaker 3

Interest expense also increased sequentially reflecting the 1st full quarter 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 due in part 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 $897,000,000 in cash and equivalents with no outstanding borrowings on our credit facility.

Speaker 3

We generated $297,000,000 of free cash flow in Q2, bringing our year to date total to $637,000,000 Importantly, we are committed to maintaining our investment grade rating and expect debt pay down will 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 CAD2 1,000,000,000 revolving credit facility. Now turning to guidance for 2024. We are raising our organic sales growth guidance range up to 0% to up 1%. This reflects first half performance including the benefit from back order reduction in Q2 and updated assumption that SKU rationalization will not have a material impact on 2024 results and importantly building confidence in business continuity.

Speaker 3

We are not providing quarterly guidance, but I do want to be sure to highlight 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 has a tougher comparison and results in expected flat to down growth rate in Q3 2024. While Q4 was the 2nd lowest growth rate of 2023 with an easing 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 $700,000,000 to $800,000,000 For reference, a few additional items we've previously shared.

Speaker 3

On gross margins, we continue to expect incremental gross margin headwinds from the 3 ms supply agreement markup will begin to flow through our P and L in Q3 2024. For operating expenses, we anticipate the continued ramp for investment to build out standalone functions and support our growth strategy through the second half of the year. All in, we continue to expect full year 2024 operating margin in the range of 21% to 23%. Turning to tax rate, we are updating our full year effective tax rate to 18% to 19%, an improvement of 200 basis points from our earlier assumption of 20% to 21%. It's important to recognize that 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 certain jurisdictions.

Speaker 3

In conclusion, we're off to a solid start closing our 1st 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.

Speaker 3

I'll now hand it back to the operator for the Q and A portion of the call.

Operator

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

Speaker 4

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

Speaker 2

So, hey, Travis, this is Brian. Maybe I'll start with some of your question, particularly around just some of the confidence we have and what's kind of pushing our guide. And then Wade, I'll pass to you to get into more specifics there. So obviously, 3 components that we talked about that are driving our guide and really our confidence. The first is just the business continuity is feeling pretty good right now and we're making great progress against our plan.

Speaker 2

So that's number 1. Number 2 is Wade referenced in his prepared remarks, it's just the back order recovery that we banked in Q2. And then the SKU clarity and Wade will talk more about that in a second. But we just have better clarity of the impact we're going to see in 2024 versus 2025. That's broad based what we're feeling right now and that's the reason for the guide change.

Speaker 2

I think importantly though just to click down in the business continuity and progress against our plan. It doesn't feel like a long time. It's only been 4 months now, but those are pretty pivotal months in the separation. A lot can happen in those months. And for the most part, we delivered in pretty much every primary area during that time.

Speaker 2

And I think most importantly, business continuity. And that's where the biggest risk is. And every day that passes, Travis, we just feel better about reducing risk, retiring risk and then further executing on our turnaround strategy. I guess probably 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.

Speaker 2

But probably equally, maybe even more important than that is we're really moving fast in talent acquisition. And I think probably anybody would recognize that you don't really want to put a strategy in if you don't have the people in place that are accountable for the strategy. So the faster you can move to put people in place, particularly in L1 and L2 positions, it's just critical to formulating the strategy, having ownership of the strategy and then eventually that flawless execution of the strategy. So those are the things that we feel like are moving in the right direction, increasing our optimism and hopefully that's reflected in our tone in the guide. So maybe with that way we can give a little more color on the other components.

Speaker 3

Yes, sounds good. Happy to pick up on sort of how we're thinking about guidance here and SKU project. As Brian said, we're really pleased to be in a position where we can raise our full year guidance after just our first standalone quarter here as a public company. So let me talk about the new range. It really built off the back of what we called out in the quarter here.

Speaker 3

In Q2, revenue was totally ahead of our expectations because of the back order reduction that we got and that was from an improvement in service levels. So positive signs, as Brian said, for business continuity. So the new range then contemplates normalizing the second half for that for the price benefit that we've been seeing and it continues to wane into the second half as well as a tougher comp for that back order recovery. When you normalize for those two things from the first half, the high end assumes we see improvement in the business and then near the low end assumes more consistent performance. So we feel real comfortable with the range here that we have for the second half.

Speaker 3

It's early days, but we are pleased with the business and its performance to date through the first half of the year really with the second half to go. And just keeping a focus on that number one priority for us is our growth driver strategy. A little color down the P and L. If we think about gross margins, we mentioned in the prepared remarks a couple of things that drove costs higher in the quarter, both the international cost and some unfavorable mix in MedSurg really around the margin on those back order recovery products. And so lots to consider, puts and takes.

Speaker 3

It could be different next quarter. We are still expecting a step up in cost from 3 ms, but that doesn't necessarily mean a step up in gross margins because there are a lot of puts and takes. And so even with all that and the step up in cost, we are still comfortable with our 21% to 23% operating margin expectations for the full year of 'twenty four. And I should probably just touch quickly on OpEx because that is also an important part of how we think about modeling here. We called out in our prepared remarks that we had a good amount of discrete items, not unexpected in a separation.

Speaker 3

It's always a bit noisy with things that are coming out of the separation related work. So we called out 1 in particular, a large expense that we took for stock based comp and then a few other things that really were about $30,000,000 in the quarter. So with that, we still anticipate the continued ramp for the investment to build out our standalone functions and to support our growth strategy through the second half of the year, but that will be often normalized Q2 without those discrete items. So all in, feeling really good about the guide and happy to be raising both the high end and the low end at this time.

Speaker 4

Great. Thanks for all the color, Wade. And I guess the next question I have is thinking more when can you guys start growing earnings again? I know 2025 is kind of a down year, but if you think about the plans that you have, is 26% a year where you potentially could grow earnings? And I don't know if there's any way high level to think about some of the things that you have to deal with in 20 and some of the headwinds you have in 2025, like the 2 rationalization and kind of help us size some range of impact on that.

Speaker 4

Thanks for the question.

Speaker 2

Wade, if you want to provide a little more color on some of the pressure points in 2025. Obviously, Wade talked about in his prepared remarks, 25 has got some unique annualization of expenses that are going to put pressure on us and you're right, 25% is going to be a tough year for EPS. But we absolutely would expect that to begin to recover in 2026. We'd be extremely disappointed if we didn't start to head in the right direction in 2026. So Wade, I don't know if you want to provide anything more in 20 25.

Speaker 2

I thought you provided a lot in your prepared remarks, but

Speaker 3

Yes, I certainly can. Just I'll have to say we're not guiding to 20 25 and 20 26 yet. There are certainly a lot of moving pieces as we're in our 1st year post separation. We do have a lot going on to grow revenue and expand margins and as Brian said, resulting EPS growth over time. However, we do think it's well understood that we'll be pressured by the annualization of some of these costs post spin in 2025.

Speaker 3

So just to list them, we've got the 3 ms supply markup that we'll annualize. We'll be annualizing our stand up functional expenses. And then below the line, we'll be annualizing interest expense. And all of this is because we've got 3 quarters this year as a public company and we'll annualize a 4th quarter next year. And then I did mean to touch on the SKU project as well because this one is just great.

Speaker 3

Great progress out of the gate, real nice start. We found that there was a lot of opportunity to take out a significant number of SKUs already in our first wave here. And the good news is they don't impact revenue in a material way. There's a very small impact. We don't expect them to impact margins or revenue in 2024.

Speaker 3

And the real benefit is it will help us simplify the supply chain. It will save a few $1,000,000 on rebranding as well because we don't have to rebrand these SKUs that had very low value to us. So the team is continuing to work on the next wave, which we do anticipate will have more of an impact on 2025, but that work is still underway and we don't have an update there yet. Great.

Speaker 4

Thanks a lot.

Operator

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

Speaker 5

Hey, good afternoon and congrats on a nice quarter. A couple for me. So by our math, the revenue guidance raise as about $80,000,000 to $150,000,000 of dollar upside to 2024. Maybe just help us understand what business segments are driving this? And then I had a follow-up, please.

Speaker 3

Yes, Vic, happy to take that. We don't break it down by segment, but what we can say is that the message that we put into the prepared remarks was the most important one. There's a good amount of risk as we separate the business and business continuity and we gained a lot of confidence. We go from a long ways from having no quarters to having one quarter. As Brian mentioned, it was a pivotal quarter for us.

Speaker 3

That's where the confidence really grew. And so it's really across the board that we're thinking that we're going to see some strength. Obviously, the back order recovery in MedSurg was a good size, as Bryan called it banking it in the second quarter here, a good sized bump for us. So with that the business continuity and then also the SKU reduction program, we don't think it's going to have as much of an impact on 2024. That would be just across the 3 segments with products, not including HIS.

Speaker 2

Yes. I might just add to that too. If you think about really 4 vectors and I won't go through all these, but there's 4 vectors that you can accelerate growth with and there's no rocket science here. They're pretty basic. But there's the things you got to do to drive it.

Speaker 2

One of the first things you can do, the fastest impact is just upgrading talent to drive better commercial rigor and just changing incentives for your commercial organization to focus on growth. And those are the things we can do right now, right. We're bringing in great people. We've accelerated and promoted people that are very capable in the organization and bring brought people from the outside. That will have a dividend pretty quickly because they will increase the rigor and accountability in the organization.

Speaker 2

So that we would expect to help us in the back half of twenty twenty four and certainly into twenty twenty five.

Speaker 5

Got it. Very helpful. Then just my follow-up question. Can you just share some high level feedback on your conversation with the activist and just provide an update as to how much of a stake they've actually amassed? Thank you.

Speaker 2

As you would imagine as a public company, we don't talk about any individual investor. That said, as a public company and humble people, we absolutely listen to our shareholders and appreciate the feedback, but probably no more to say about that.

Speaker 1

Next question please, operator.

Operator

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

Speaker 6

Open. Thank you. Good afternoon, everybody. I hope to get one in here on the financial side and one follow-up on the strategic planning side. Maybe just starting on with respect to the outlook for the balance of the year, I'm trying to put together some of the moving parts as it relates to first half versus second half.

Speaker 6

And maybe, Wade, you could help us bridge a little bit the commentary around the reiteration of the 21% to 23% operating margin. That's roughly what you did here in the first half with some of the commentary around the 3 ms supply agreement as well as the incremental investments and what that implies for sort of an exit rate for the year? And then 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 maybe help us understand some of the moving parts there as well?

Speaker 3

Sure. So just to cover a little bit more, David, to your question on first half, second half outlook. I think I touched on revenue a good amount there, just highlighting that we had a couple items in the first half that won't repeat in the second half, pricing waning and then the back of recovery, which is opportunistic and we don't anticipate seeing that in the second half at this point. And so that's what gets us our revenue growth rate and it's a 0% to 1% for the year. And so you can do the math on that for the second half.

Speaker 3

I do just want to highlight from our prepared remarks that there is a comp significant comp issue between Q3 and Q4. So that's important for revenue. You mentioned bridging the and the exit rate around operating margins. The way we're thinking about this is Q2 had some headwinds in gross margins and operating margins for us. Those are offset with the favorability in revenue.

Speaker 3

And so that's what gives us confidence to hold the 21% to 23% for the year. We're not going to comment on an exit rate at this point. We're not giving the quarterly guidance. Obviously, we've just got 1 quarter under our belt and we've got a long ways to go. We're just not going to get to that level of detail.

Speaker 3

But what we can tell you is we had gained a lot of confidence in the quarter and we learned a lot about the business post separation. So it's building confidence and that's what allowed us to raise both the top and the bottom line here before we just after our first quarter. You mentioned cash as well. I would say probably the biggest things that we're managing here post separation is just all of the timing of the intercompany work that we're doing as well as standing up our capital expenditure processes. And so we do think we will be using more cash in the second half of the year to settle out some of those as well as ramping up our capital expenditure use in the second half.

Speaker 6

Got it. And then Brian, I appreciate your comments on kind of being ready to share more with us on the Q4 call. But I think you've made comments in other forums about kind of the turnaround on the top line being roughly a 5 year period of time. Can you maybe update us on any thoughts with respect to that outlook and how that falls into the context of the phasing of the different parts of the solvents and turnaround that you referenced earlier?

Speaker 2

Absolutely, and good to hear from you. So I would say, I'll repeat a little bit of what I said and then maybe add some additional color. I see this as an opportunity for us in our strategic plan to very clearly articulate what markets and submarkets we're going to care about, right, we're going to double down in. And those will be our faster growth markets as you can imagine. We're working through that now and would expect to pick those by the end of 2024.

Speaker 2

Once we do that, that begins the shift of resources commercially, R and D, M and A when we get to that point and that begins to drive traction and focus in those areas. That just takes time, but maybe I can double click on the revenue growth accelerators. I referenced that there were really 4 of those. And it just is again, there's no secret sauce here. If you've ever run a business and you've turned 1 around, you drove revenue acceleration, these are the things you have to do.

Speaker 2

It's just a question of doing them and how much time they take. And so I'll just kind of start with the first as I referenced, getting great people in place that know how to drive rigor in a commercial organization is paramount and it's the fastest way to drive revenue growth. 2nd fastest way is commercial structure changes, either specialization or just increasing reach in those important spaces that we're going to concentrate on. 3rd, as you would expect would be increasing the productivity of R and D. We have to do less of these iterative approaches in R and D and more impactful, more meaningful launches inside of the high growth areas.

Speaker 2

And then probably in parallel with that would be portfolio optimization. I look at that in 2 ways. The first would be tuck in acquisitions to give more scale in those fast growth markets and the other would be potentially exiting categories that are slow growth, right. Those are the ways that you would get there. If I just think about the timing of those things kind of going to your question, again, on a talent side, it's right now.

Speaker 2

In the back half of 'twenty four, into 'twenty five, we should expect it to see that benefit. Commercial structure changes just take a little longer because you got to know where you're going to do them and then you got to actually hire people and change the structure. That's more probably a latter part of 2025. I think about R and D productivity, once you start a project, probably best case when you start one is 2026, but likely beyond that just depending on the product complexity, the regulatory requirements and then portfolio optimization really at least on the acquisition side depends on just deleveraging timing. And so when I think about the LRP, why these are important is because we're figuring out now the mix of these elements that we're going to need to accelerate growth, where the major gaps are.

Speaker 2

And as we work through that mix, that will inform not just our LRP, but the time to accelerate the revenue growth. So hopefully that gives a little more color versus what I've said in the past, but those are the elements to get us there.

Speaker 6

That's great. Appreciate all the detail. Thank you.

Operator

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

Speaker 5

open. Hey, just hopping in back to you for a couple of quick follow ups. That $22,000,000 of corporate and allocated revenues, do you expect those to continue going forward? Should we be building those into our revenue projections?

Speaker 3

Yes. I'm glad you asked that one, Vik. An approximate number to the 22 for the rest of the year, yes. So in other words, that's a good estimate for the next couple of quarters this year.

Speaker 5

Okay. So build out $22,000,000 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?

Speaker 5

Thank you.

Speaker 3

So FX. So we're we just use the current FX rates at this point. For the following Kevin, do you actually have that?

Speaker 1

Yes. So right now, the last assumption we provided from a revenue perspective is 50 basis points of impact. We did not update that. So it's safe to assume that that's still our best guess.

Speaker 3

And the way we do that, Vic, is we just take the current rates approximately right now and apply that. So we're expecting 50 basis points for the full year.

Speaker 5

Got it. Thank you very much.

Operator

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

Speaker 6

Thank you. Appreciate you taking the additional questions here. Just maybe a few clarification items. Maybe, Wade, starting with the tax rate. I know you talked about some catch up items here that occurred in the quarter.

Speaker 6

But I think as you look at the year to date tax rate and the updated guidance, it kind of puts the tax rate in that 20% to 21% range in the back half of the year. I guess, is that a fair characterization of where that should land? And then secondly, you did make a passing reference to restructuring. Are you already at a point where you are ready to start rationalizing down costs? And is that and how is that impacting your outlook here?

Speaker 3

Sure. I'll pick up on tax rate. And then Brian, if you want to talk about some of our strategies here, that's probably the right way to take it. Yeah. So for tax rate, you've got it.

Speaker 3

Basically, we've had better than expected tax rate for the first half of the year. We had a pretty sizable year to date catch up here in our Q1 post separation. And the second half is similar to what we expected for the full year when we gave our full year expectations. And this is one of the areas that has to settle out a little bit as we separate and our tax team is hard at work at it. So that's what we're comfortable with for a guide at this point.

Speaker 3

And then from a restructuring standpoint, Brian?

Speaker 2

Yes. Great question, David. Glad you asked it. So what I would tell you is our work is we do feel like we're in the right position to start this project. And I think it might be it might surprise you actually the primary reason for it.

Speaker 2

So there's really 2 in my mind, but the one that comes to me is the most important is the restructuring is focused. We're calling it again, Solventum Way. It's focused on streamlining our structure so that we can complement the culture shift that we're putting into place. We are going to change the culture of this company. We're going to look for speed.

Speaker 2

We're going to move faster. We're going to be autonomous and we're going to drive accountability in the organization. You have to have the right structure to drive that culture shift and I promise you when we do it and we are doing it today, it will turn into growth. That drives growth in an organization and as we know growth drives leverage in an organization in a really sustainable way. The second part of a program like that is what you would normally do in a business and wait and have done in the past.

Speaker 2

It's to allow us the headroom to not only invest for growth, which we have to do, that's the primary area of focus, but also drive margin expansion. So we absolutely feel like that's the right thing to do now for those reasons. Brian, I

Speaker 3

think you covered that really well. I'll just add, I think part of the question was around timing and just maybe to reflect back on the Investor Day in March, where we laid out our 4 key actions for value creation and we talked about driving efficiencies to fuel the investment that Brian just covered. And so no change in strategy, just sharing more about our efforts as we go here. Revenue growth remains the top metric for sure. But as Brian said, driving efficiencies will help us first fund additional growth initiatives as well as we look to expand gross margins over time.

Speaker 6

Got it. Thanks for the clarification.

Speaker 1

Okay. 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.

Speaker 2

Yes. Thanks so much.

Operator

Thank you everyone

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Earnings Conference Call
Solventum Q2 2024
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