Description

Solventum (SOLV), the healthcare arm spun-out of 3M in late March produces ~58% gross margins, ~21% operating margins, ~28% EBITDA margins, ~27% ROE and operates in a number of mid-single digit growth industries, yet due to the typical dynamics that come along with a spin-out, is trading for only 7.4x EBITDA and 9.1x EPS – roughly half the multiple of comps trading at 13.5x EBITDA and 20x EPS. If SOLV were to trade in line with comps, the shares would be worth $140 per share or +146% upside. There is a massive margin of error in today’s trading price – it is rare to find an opportunity to acquire a company with such a strong moat (you don’t get 28% EBITDA margins without offering something special) for such a cheap price.

What does SOLV do?

SOLV operates four business segments (detailed below) focused on wound care, oral care solutions, healthcare information systems and water purification. To further drive home the absurdity of today’s price, if we assign 100% of SOLV’s $442mm of corporate overhead to their largest business segment MedSurg and value that segment in line with comps (14.2x EBITDA), we get $14,214mm of value vs. the current EV of $17,164mm. That means we get the remaining $1.33bn of EBITDA for only $2.95bn, or 2.2x EBITDA. We feel compelled again to point out that these are very profitable businesses, producing ~58% gross margins, ~28% EBITDA margins and ~27% ROE. Details on business segments are the following:

MedSurg (56% of 2023 total sales and 25% operating margin), formerly Medical Solutions, is a provider of solutions including advanced wound care, I.V. site management, sterilization assurance, temperature management, surgical supplies, stethoscopes, and medical electrodes. These solutions are designed to accelerate healing, prevent complications, and lower the total cost of care. Specifically, our advanced wound care solutions follow the patient from hospital to home and support them through the recovery process. We are a leader in the advanced wound care market based on the market share data presented in a BCC Research report (BCC Publishing, Markets for Advanced Wound Management Technologies, July 2023) and, based on internal estimates, our products currently treat more than 1.6 million hard-to-heal wounds annually. Additionally, our comprehensive range of surgical solutions are designed to mitigate a patient’s risk of infection or complications.

Dental Solutions (16% of 2023 total sales and 34% operating margin), formerly Oral Care Solutions, is a provider of a comprehensive suite of dental and orthodontic products including brackets, aligners, restorative cements, and bonding agents that span the “life of the tooth,” including products designed for preventative dental care, direct and indirect restoration, and broad orthodontic needs. We have a leading position in the dental and orthodontic bonding systems market based on published market share data from Key-Stone Network (Key-Stone Fast Track Clinical Report — Clinical Ranking, 2022), SDM Northcoast (SDM Dental Products Market Share Study, 2022) and Orthodontic Manufacturers Association (OMA Sales Survey by Association Research, Inc., 2022). Additionally, we estimate our 3M™ Filtek™ branded products have been used in over two billion dental restoration procedures worldwide over the last twenty years.

Health Information Systems (16% of 2023 total sales and 34% operating margin) provides healthcare systems with software solutions – including computer-assisted physician documentation, direct-to-bill and coding automation, classification methodologies, speech recognition, and data visualization platforms – that are designed to eliminate revenue cycle waste, create more time for patient care, and support value-based care. These solutions are designed to ensure accuracy of reimbursement and reduce the administrative burden that clinicians face. We have a leading market position in the United States for computer-assisted coding technology based on published market share data from Definitive HealthCare (Definitive Healthcare, HospitalView Database, Technology Search for “Computer Assisted Coding/NLP” technology, 2022) and, based on our internal estimates, more than 75% of U.S. hospitals currently use at least one of our software solutions.

Purification and Filtration (12% of 2023 total sales and 18% operating margin), formerly Separation and Purification Sciences, is a provider of purification and filtration technologies including filters, purifiers, cartridges, and membranes. These solutions are designed to simplify purification processes, reduce debris and bioburden in fluids, and remove contaminants to enable the development and manufacturing of biopharmaceutical and medical technology treatments and provide cleaner water. Based on internal estimates, our membrane technology is currently used annually in more than 25 million life-saving dialysis treatments and approximately one million open heart surgeries are currently performed each year using oxygenators that are enabled by one of our membranes.

Why does this opportunity exist?

The most obvious explanation for the poor trading performance most likely has to do with indiscriminate retail selling. Post spin, there was a spattering of X posts from accounts either asking if anyone knows anything about the ticker SOLV they just received or stating they plan to sell their SOLV shares to buy more MMM so they can get a dividend (more on this point later). Shortly after the spin, SOLV also made an appearance on Jim Cramer’s Mad Money (you can watch the post on CNBC’s YouTube channel) where Cramer points out that SOLV has not had a single year of negative organic revenue growth in over a decade, is set up in industries that will be growing mid-single digits annually, operates businesses that are extremely profitable and calls the stock “super cheap” at the then price of $69 but recommends waiting to buy over the next 6 months due to the typical trading dynamics of spin-offs. These two items speak to the retail trading dynamics of SOLV but obviously don’t explain all retail trading. One item that tends to really miff the retail crowd is SOLV took on $8.3bn of debt in the spin (net leverage is only 3.2x, not exactly ideal but also not a thesis killer) and will spend the next 24 months paying down debt rather than paying a dividend. Further, 3M will retain 20% ownership in SOLV and plans to sell down their position over the next 5 years – again, not ideal but also not a thesis killer at this price. Another explanation is the dynamic of almost every spinout: a business that historically hasn’t gotten the love it deserves.  The whole point of spinning out Solventum is to focus managerial energy on the business to drive growth. While SOLV’s business lines were operated under 3M, they achieved organic growth, just not in line with the overall market. SOLV’s management is now focused on rationalizing their SKU offering and driving growth in line with their overall markets (mid-single digits growth). It is possible the market is waiting to see that growth before it gives SOLV a multiple in line with comps – that said, it certainly doesn’t deserve a multiple at roughly half of its peers. Lastly, we would be remiss not to point out 3M’s recent PFAS (forever chemicals) settlement. More specifically, 3M has agreed to pay $12.5bn over the next 13 years to US public water suppliers that detect PFAS in their water systems. 3M has also agreed to phase out the use of these chemicals through the end of 2025. SOLV products currently use these PFAS chemicals, however they have also agreed to phase out these chemicals and most importantly, 3M has agreed to "assume, indemnify and defend" SOLV against PFAS liabilities through the end of 2025. Due to this indemnification, it seems unlikely PFAS will be a major overhang on the stock, but it is worth noting.

What is SOLV worth?

On May 9th, SOLV released their 1Q24 results which put them well within guidance and sets them up to potentially raise guidance as the year progresses (though this is not crucial to the investment). 1Q24 EBITDA was $632mm vs. 2024 guidance which implies EBITDA of $2,331mm, EPS of $2.08 vs. full year guidance of $6.10-$6.40 and FCF of $340mm vs. full year FCF guidance of $700-800mm. Although this was the first quarter reporting as a standalone company, SOLV will not hold their first quarterly earnings call until 2Q24. As the year progresses and management hits their easy guidance targets, we expect the shares to rerate higher.

Below we’ve compared each of SOLV’s segments to a group of comps with similar growth and margin profiles. Given the fact SOLV will be focused on debt paydown over the next 2 years rather than a dividend and still needs to prove it will grow in line with the overall market, does it deserve to trade at a discount to peers? Sure – but a 50% discount is excessive. In our SOTP, we applied multiple discounts of 4x, 2x and 0x vs. peers to show upside potential. The current trading price offers an immense margin of error – it is hard to imagine we lose money at the current price with the potential to make 146% as the market wakes up to SOLV’s value. 

Catalyst

End of retail selling post spin

Company shows stable results / hits guidance

Growth eventually matches overall markets for business segments