Great research on Solventum and the current CEO, great article in general!
I wanted to ask what the reasoning is for ignoring the 4.3m additional shares in warrants and options, which would make a fully diluted market cap of 87m CAD (29*3CAD)
And I seem to be not be able to find a capital return policy, that's why I am not sure why EV should be used for valuation purposes instead of MC.
So ex-growth I come up with a fwd p/e of 15 (5,8/87).
Also, eventually the NOLs will run out, my research showed me that Canada currently has a 26,5% corporate tax rate, so for long term shareholders the fully normalised earnings power ex-growth is 5.8*0.735 = 4.263
fwd p/e: 87/4.263 = 20
I am not sure what the appropriate multiple for a Canadian listed medical devices company with patent protections in the microcap space is.
"the company is very dependent on few very large distributors as customers in this area"
This probably should be a consideration in the appropriate valuation as well
Thank you very much for the compliment and also for your points.
In general, I don't tell anyone what to think or how to view a company. I'm just stating how I think and I hope there's no confusion about that because that's a really important point.
So let's start with the comparison to enterprise value: if you think that the company can't do anything with the cash, i.e. not reinvest it or distribute it to shareholders, then you probably shouldn't invest at all, because then you should assume that this will also be the case with future cash flows.
The reason for not including warrants and options was just for simplification, as I don't think they have much impact on the investment case. If you want to include them in your considerations, you also need to make projections on the future share price as they are not all “in the money”, and you would need to include the cash the company receives from the exercise in your considerations, and you need to adjust the stock based compensation, which I have not done.
My valuation is simply an annualization of normalized earnings for Q3 2024 and is of course only meant to provide some guidance as a rule of thumb, and it should be clear that the company will have to pay taxes at some point. If you want to think about a valuation based on earnings in multiple quarters or even years, you should probably use a lot more assumptions than just Q3 2024 normalized earnings, but if your calculations suggest a P/E of 20 after you've done that, I wouldn't invest myself.
In my understanding of valuation you should model how many years the NOLS will be used over then discount the NOLS over that period and deduct it from EV.
Using earning multiples over non normalized earnings (with NOLS) doesn't make sense.
Assets on the balance sheet like cash should be deducted from EV for investing purposes IMO only if they are not part of the working capital needed to run the business.
For example banks have reserves for loan loss revisions, you don't deduct these from EV as there is no reason to assume they will be returned to shareholders and are needed for the functioning of the business producing the cashflow you investing in.
I would go the lazy route and just assume that a normalised fwd p/e ex growth is ~15. (For deeper work, I would do it like you said.) For the time being, I also wouldn't use EV as it is less conservative and I haven't seen signs of capital allocation policies to lower the net cash holdings.
Good to be conservative here, when the stock goes up, people use less conservative valuation matrix, when it goes down, they use conservative ones, it is better to be prepared.
Thanks a lot for your response, I've also been interested in the company, that's why I want to also say that I am grateful for you for undertaking the research work involved with writing this.
I should also add, that my calculations are very conservative, so a right valuation ex-growth is probably between a fwd p/e of 20 and ev/e of 8.2.
I have not calculated the NOLs, but on the face of it, it looks like they will be enough for multiple years, so I think it is fine to leave them out for an investment horizon of 1-3 years, I am not sure how to use these for valuation purposes, but they should be included somehow.
I think, in general, it is prudent to use a fully diluted market cap and to only use EV for valuation purposes when there is an active or announced significant return policy or when the EV is higher than the market cap. I think 17% possible dilution is probably too much not to be included in some way. Using EV instead of market cap makes a company look cheaper and it is probably good not to do that.
Additionally it looks like they needed the cash in the past but not for investment purposes but as a rainy day fund, which they actually also really needed, I think for the time being, even with new CEO and positive FCF, the cash will probably retain its function as a rainy day fund and that's why I don't think it's appropriate to use it instead of Market cap.
(I would change my mind if:
1. announcement of dividend or buyback
2. them investing the money and the net cash balance decreasing)
I was on a group call with the CEO this week....the cash will likely be deployed into bolt on / licensing deals - basically adjacent products where they can leverage their existing go to market.
Hi! Thanks for a thoughtful write-up. Very interesting when a new CEO with just the right background comes in and we can already se some proof of the turnaround. It would be interesting to know more about his incentives (shares/options/bonus targets) - do you have any insights there?
"On January 10, 2024 Company's Board of Directors approved the grant of 800,000 stock options to the Chief
Executive Officer. Of the 800,000 stock options, 400,000 stock options will vest over four years, with 25% vesting on each anniversary date, and the remaining 400,000 stock options will vest based on increases in the Company’s share price as follows:
i) 100,000 stock options will vest only after the first anniversary date and if the Company’s share price is $2.50 for 120 days after the first anniversary date;
ii) 100,000 stock options will vest only after the first anniversary date and if the Company’s share price is $3.00 for 120 days after the first anniversary date;
iii) 100,000 stock options will vest only after the second anniversary date and if the Company’s share price is
$3.50 for 120 days after the first anniversary date; and
iv) 100,000 stock options will vest only after the third anniversary date and if the Company’s share price is $4.00
Good structure! All questions coming up in my head got immediately answered in the following sentences :) I also like that you keep your writeups "short" and stick to what's most important! Good work Sven !
Great research on Solventum and the current CEO, great article in general!
I wanted to ask what the reasoning is for ignoring the 4.3m additional shares in warrants and options, which would make a fully diluted market cap of 87m CAD (29*3CAD)
And I seem to be not be able to find a capital return policy, that's why I am not sure why EV should be used for valuation purposes instead of MC.
So ex-growth I come up with a fwd p/e of 15 (5,8/87).
Also, eventually the NOLs will run out, my research showed me that Canada currently has a 26,5% corporate tax rate, so for long term shareholders the fully normalised earnings power ex-growth is 5.8*0.735 = 4.263
fwd p/e: 87/4.263 = 20
I am not sure what the appropriate multiple for a Canadian listed medical devices company with patent protections in the microcap space is.
"the company is very dependent on few very large distributors as customers in this area"
This probably should be a consideration in the appropriate valuation as well
Thank you very much for the compliment and also for your points.
In general, I don't tell anyone what to think or how to view a company. I'm just stating how I think and I hope there's no confusion about that because that's a really important point.
So let's start with the comparison to enterprise value: if you think that the company can't do anything with the cash, i.e. not reinvest it or distribute it to shareholders, then you probably shouldn't invest at all, because then you should assume that this will also be the case with future cash flows.
The reason for not including warrants and options was just for simplification, as I don't think they have much impact on the investment case. If you want to include them in your considerations, you also need to make projections on the future share price as they are not all “in the money”, and you would need to include the cash the company receives from the exercise in your considerations, and you need to adjust the stock based compensation, which I have not done.
My valuation is simply an annualization of normalized earnings for Q3 2024 and is of course only meant to provide some guidance as a rule of thumb, and it should be clear that the company will have to pay taxes at some point. If you want to think about a valuation based on earnings in multiple quarters or even years, you should probably use a lot more assumptions than just Q3 2024 normalized earnings, but if your calculations suggest a P/E of 20 after you've done that, I wouldn't invest myself.
Minor correction: The options are in the money, but for the most part unvested.
In my understanding of valuation you should model how many years the NOLS will be used over then discount the NOLS over that period and deduct it from EV.
Using earning multiples over non normalized earnings (with NOLS) doesn't make sense.
Assets on the balance sheet like cash should be deducted from EV for investing purposes IMO only if they are not part of the working capital needed to run the business.
For example banks have reserves for loan loss revisions, you don't deduct these from EV as there is no reason to assume they will be returned to shareholders and are needed for the functioning of the business producing the cashflow you investing in.
I would go the lazy route and just assume that a normalised fwd p/e ex growth is ~15. (For deeper work, I would do it like you said.) For the time being, I also wouldn't use EV as it is less conservative and I haven't seen signs of capital allocation policies to lower the net cash holdings.
Good to be conservative here, when the stock goes up, people use less conservative valuation matrix, when it goes down, they use conservative ones, it is better to be prepared.
Thanks a lot for your response, I've also been interested in the company, that's why I want to also say that I am grateful for you for undertaking the research work involved with writing this.
I should also add, that my calculations are very conservative, so a right valuation ex-growth is probably between a fwd p/e of 20 and ev/e of 8.2.
I have not calculated the NOLs, but on the face of it, it looks like they will be enough for multiple years, so I think it is fine to leave them out for an investment horizon of 1-3 years, I am not sure how to use these for valuation purposes, but they should be included somehow.
I think, in general, it is prudent to use a fully diluted market cap and to only use EV for valuation purposes when there is an active or announced significant return policy or when the EV is higher than the market cap. I think 17% possible dilution is probably too much not to be included in some way. Using EV instead of market cap makes a company look cheaper and it is probably good not to do that.
Additionally it looks like they needed the cash in the past but not for investment purposes but as a rainy day fund, which they actually also really needed, I think for the time being, even with new CEO and positive FCF, the cash will probably retain its function as a rainy day fund and that's why I don't think it's appropriate to use it instead of Market cap.
(I would change my mind if:
1. announcement of dividend or buyback
2. them investing the money and the net cash balance decreasing)
I was on a group call with the CEO this week....the cash will likely be deployed into bolt on / licensing deals - basically adjacent products where they can leverage their existing go to market.
Hi! Thanks for a thoughtful write-up. Very interesting when a new CEO with just the right background comes in and we can already se some proof of the turnaround. It would be interesting to know more about his incentives (shares/options/bonus targets) - do you have any insights there?
Thanks!
"On January 10, 2024 Company's Board of Directors approved the grant of 800,000 stock options to the Chief
Executive Officer. Of the 800,000 stock options, 400,000 stock options will vest over four years, with 25% vesting on each anniversary date, and the remaining 400,000 stock options will vest based on increases in the Company’s share price as follows:
i) 100,000 stock options will vest only after the first anniversary date and if the Company’s share price is $2.50 for 120 days after the first anniversary date;
ii) 100,000 stock options will vest only after the first anniversary date and if the Company’s share price is $3.00 for 120 days after the first anniversary date;
iii) 100,000 stock options will vest only after the second anniversary date and if the Company’s share price is
$3.50 for 120 days after the first anniversary date; and
iv) 100,000 stock options will vest only after the third anniversary date and if the Company’s share price is $4.00
for 120 days after the first anniversary date."
Good structure! All questions coming up in my head got immediately answered in the following sentences :) I also like that you keep your writeups "short" and stick to what's most important! Good work Sven !
Thank you! :)