Solventum

Solventum posted second-quarter revenue of $2.2 billion, up 2% year over year. Quarterly operating income of $627 million rose 32% after adjusting for amortization, separation costs from 3M, and litigation.

Why it matters: We're pleased to see advanced wound care (up 14% in constant currency) and infection prevention and surgical solutions (up 10%) grow strongly, which reflects the attractiveness of the product portfolio and the addition of Acera. The medical-surgical business ultimately relies on procedure volume growth, which has been robust over the last couple of years thanks to higher medical utilization. With the rising uninsured population from loss of subsidies on the exchanges and upcoming Medicaid cuts, we're cautious about how procedure volume might slow in the coming year, which would also hit Solventum's biggest business.

The bottom line: Because our relatively minor adjustments didn't affect intrinsic value, we're leaving our $71 fair value estimate for no-moat Solventum unchanged. Shares remain modestly overvalued, in our view. We expect Solventum's revenue growth to normalize at 4% by the end of our explicit forecast period. But if the firm's lineup of new products is compelling, there could be upside to our projections. Much of our valuation hinges on management's ability to wring out efficiencies. We assume gross margin improves by 250 basis points and SG&A falls by 400 basis points by 2030. Given CEO Bryan Hanson and CFO Wayde McMillan are proved in this area, we think it's doable.

Big picture: We like management's plan to separate the health information systems business. Although it offered attractive margins and likely benefited from switching costs that are common in software applications, there was little synergy with the rest of Solventum. As management indicated, the level of investment required to incorporate artificial intelligence-oriented functionality was both costly and, on the whole, outside this management team's expertise.

We're reiterating our fair value estimate of $71 per share. We assume that, after jettisoning its purification and filtration business, the firm can maintain organic low-single-digit revenue growth through 2030, reflecting Solventum’s portfolio that skews toward mature markets. While Solventum has indicated it plans to shift the product portfolio to focus on faster-growing products to accelerate consolidated growth, we’re holding off on giving it any credit for this until we see some hints of success in medsurg and dental.

As management reorganizes and ekes out efficiencies, we estimate gross margin can improve by roughly 250 basis points as the firm rationalizes its sourcing and production footprint. We also project selling, general, and administrative expense as a percentage of sales to decline by 190 basis points this year as the firm gets beyond some one-time costs of establishing an independent entity. Conversely, we anticipate the firm will need to incrementally raise research and development investment as a percentage of sales by roughly 100 basis points through the midterm to support Solventum’s aim to generate more innovation. This translates into consolidated operating margin hitting 14% at the end of our explicit forecast period, up significantly from 7.6% in 2025, but not far from 12.5% seen in 2024. We estimate Solventum’s cost of capital at 7.4%, which incorporates a 9% cost of equity.

We think Solventum has yet to dig a moat around its business. Though returns on invested capital for the healthcare segment remained over the cost of capital while this entity was still housed within 3M, the path forward will be more challenging as the new costs of operating as an independent company and debt service for newly acquired debt weigh on returns.

While Solventum is a sizable competitor in advanced wound care, we don’t see many sources of moat in this market. Indeed, we’ve long viewed the category of foams and silver antibacterial and hydrocolloidal dressings as vulnerable to low switching costs. As a result, we have not awarded moats for the wound care business at any of Solventum’s direct competitors in AWC, including Smith & Nephew, Convatec, and Coloplast (though these rivals may sport moats derived from other businesses).

Most advanced wound products are not protected by intellectual property, and few manufacturers invest in clinical trials to help differentiate products on efficacy. This has laid the groundwork for companies to compete on the basis of marketing, detailing of wound care nurses, and persuading group purchasing organizations to carry their AWC products on their formularies. It’s not clear that Solventum’s brands of AWC are viewed as superior to those of its key competitors.

We note that, unlike highly engineered physician preference items such as pacemakers and knee implants, most advanced wound care products are more commoditized and are sold mainly through a consolidated set of GPOs. This means the AWC manufacturers face more price pressure in negotiating with the GPOs.

Solventum’s primary strategy for expanding its AWC business is through its negative-pressure wound therapy devices. While this niche in advanced wound care holds some potential because the competitive field is largely a duopoly between Solventum and Smith & Nephew, the clinical data to support its efficacy has been slow to come. Additionally, NPWT is relatively expensive compared with most other engineered dressings. For this reason, the Centers for Medicare & Medicaid Services cracked down on coding and reimbursement for NPWT from 2006 through 2016, significantly reducing payments for the core vacuum machine and corresponding consumables.

Since then, NPWT devices have evolved into single-use, disposable items that have managed to raise reimbursement rates, but we remain wary that the CMS could lower rates again unilaterally.

Solventum recently acquired Acera Surgical, which gives it entry into the most dynamic and fast-growing niche in advanced wound care, skin substitutes. This area has faced major cuts to previously generous reimbursement at CMS. However, the CMS cuts were aimed at the use of skin substitutes for chronic wound care. Smith & Nephew, Convatec, and Coloplast all have various skin substitutes, from placenta-based products to fish skin, that were exposed to these payment reductions. Acera's synthetic products are largely used in the acute care setting, which means it has dodged this round of cuts.

Perhaps more concerning, if the favorable early clinical data on these skin substitutes is borne out in large-scale studies, we think this category could pose a significant threat to NPWT. Thus far, small-scale studies have suggested that fish skin and placenta-based wound therapy is surprisingly efficacious on hard-to-heal wounds such as diabetic foot ulcers. This could cut into demand for NPWT, or relegate it to acute wound care, while expensive-to-treat chronic wounds migrate to these skin substitutes.

Solventum’s dental business is mainly driven by its resin composite business for fillings and secondarily by its orthodontic clear aligners. While margins on this business are currently healthy, it is difficult for us to see how Solventum will be able to defend its price over the longer term when barriers to entry are so low and there are already a number of competitors offering comparable composites. On the orthodontic side, we already see low-cost new entrants like SmileSet. For instance, the typical cost of treatment with Solventum’s Clarity clear aligners is $2,500-$4,500, depending on the complexity of the malocclusion. For SmileSet, the recently promoted price was roughly $1,500.

Unlike Align Technology, which enjoys a narrow moat as the overwhelming market leader in clear aligners with a known brand, we don’t think Solventum likely has as large a database of cases on which to base its models. Align also benefits from switching costs associated with its iTero scanner, which is integrated with its aligner platform. Solventum doesn’t offer that type of closed ecosystem.

On the whole, we view Solventum’s environmental, social, and governance risk as low. The most material ESG risk is related to product governance, though Solventum’s products generally don’t fall in the category of life-saving or life-sustaining. For this reason, we think Solventum has lower exposure to product governance risk than device makers that offer implantable hardware.

CEO Bryan Hanson and CFO Wayde McMillan are both highly seasoned leaders with solid records at Covidien, Medtronic, Zimmer Biomet, and Insulet.

We think Solventum’s health information systems business, while relatively small, could retain clients through high switching costs, like other software firms.

We think there are relatively near-term, high-impact actions management can take to rachet up operations and profitability.

Many of Solventum’s medsurg products are sold to group purchasing organizations, where there is more price pressure than with highly engineered physician preference items marketed directly to doctors.

We think it will be challenging to create a moat around Solventum’s advanced wound care business, as switching costs are relatively low.

The jury is still out on whether Solventum can roll out innovative products that can secure price premiums. While we’ve seen this happen at C.R. Bard, we remain skeptical about Solventum’s products.