It's always interesting when a new company comes to market and doubly interesting when it's a spinoff. In reality, two new companies came out of the spinoff of Solventum (SOLV 1.70%) and 3M (MMM 1.98%) -- a newly created healthcare company and an industrial conglomerate without a healthcare business.
Introducing Solventum
Solventum is a healthcare company operating in four segments and serving end markets that management believes have a market size of at least $93 billion and are growing at a rate of 4%- 6%. The table summarizes each segment.
|
Solventum Segment |
Revenue 2023 |
Expected End Market Growth |
|---|---|---|
|
MedSurgery |
$4.6 billion |
3%-5% |
|
Dental solutions |
$1.3 billion |
4%-6% |
|
Health information systems |
$1.3 billion |
6%-8% |
|
Purification and filtration |
$1 billion |
4%-6% |
|
Total |
$8.2 billion |
4%-6% |
Data source: Solventum presentations.
The investment case for the stock is relatively simple and based on a compelling valuation argument. In the last three years before the spinoff, the company generated an average of $1.4 billion in net income and free cash flow (FCF) averaging $1.66 billion, with a minimum of $1.4 billion. Not only has Solventum been very good at converting net income into FCF, but its current market cap of $11.2 billion means it trades at less than eight times its lowest FCF in the last three years, an extremely low valuation for a company that arguably has growth prospects now its freed from a struggling parent company.
Three reasons Solventum isn't a buy
Unfortunately, there are some significant negatives, and they come in three buckets.
First, 3M saddled Solventum with debt to shore up the balance sheet of the former as it faces multibillion-dollar legal settlements. Wall Street expects Solventum to end the year with $7 billion in net debt, and servicing the interest on the debt is eating into FCF. Management is candid that paying down debt is a strategic priority over the next two years.
As for FCF, the added $400 million in interest expense increased capital spending and working capital requirements resulting from the spinoff, which means management estimates it will generate $700 million to $800 million in FCF in 2024. The midpoint of which puts Solventum at 14.9 times FCF.
Second, Solventum has far from an impressive growth record. For example, management expects its organic revenue growth to be between a 2% decline and flat in 2023. As for the 4%-6% expected end market growth, the figure looks familiar enough because it's what 3M's management told investors to expect from its healthcare end market on 3M's investor day in 2016 and 2019.
However, whether it's 3M's healthcare business or Solventum, the company simply isn't growing near its estimate for end-market growth. Only the pandemic-impacted year of 2021 took its healthcare revenue growth above the low point of the 4%-6% range.
Data source: 3M and Solventum presentations.
Third, it's worth noting that 3M Healthcare/Solventum was the focus of 3M's merger and acquisition activity over the past five years. 3M bought M*Modal's technology business for an enterprise value of $1 billion in early 2019, and later that year 3M bought advanced and surgical wound care company Acelity for an enterprise value of $6.7 billion. In 2020, 3M sold the majority of its drug delivery business.
Unfortunately, none of the healthcare portfolio restructuring appears to have tangibly improved the company's overall growth rate. Moreover, management plans to rationalize its stock-keeping units (SKUs) over the next couple of years with "a waning benefit from pricing for the remainder of 2024 and a return to a normalized pricing environment," according to the company's latest earnings release.
Image source: Getty Images.
3M investors got a good deal
While acknowledging that 3M has lost a business with relatively stable cash flows, according to Solventum's SEC filings, it will make cash payments to 3M of about $7.7 billion as a result of financing raised in connection with the spinoff. In addition, 3M retains a 19.9% stake in Solventum, which it can sell to raise cash.
Furthermore, a business that starts life cutting its SKUs indicates that it hasn't been run optimally in recent years. Everything points to further challenges for Solventum, and the remaining 3M looks like a stronger company because of the spinoff.
