Good afternoon ladies and gentlemen and welcome to Baxter International's Second Quarter 2015 Earnings Conference Call. As a reminder this call is being recorded by Baxter and is copyrighted material. It cannot be recorded or rebroadcast without Baxter's permission. If you have any objections, please disconnect at this time.

I would now like to turn the call over to Ms. Clare Trachtman, Vice President, Investor Relations at Baxter International. Ms. Trachtman, you may begin..

Thanks, Stephanie. Good afternoon and welcome to our second quarter 2015 earnings conference call. Joining me today are Bob Parkinson, CEO and Chairman of Baxter International; Jay Saccaro, Chief Financial Officer; and Scott Bohaboy, Corporate Vice President, Investor Relations and Treasurer.

On the call this afternoon we will be discussing Baxter's second quarter financial results and outlook for the remainder of 2015 before taking your questions.

I'd like to take a moment to highlight that our second quarter results are inclusive of the BioScience business as the official spinoff of Baxalta occurred subsequent to the close of the quarter on July 1. Going forward, the financial outlook and results for Baxter will be reported on a standalone basis excluding the BioScience business.

On the call today we will focus the discussion on the performance of new Baxter, as Baxalta will host a conference call tomorrow to provide additional highlights on their performance in the second quarter and outlook for the remainder of the year.

We plan to post standalone new Baxter financial schedules for the quarterly periods of 2014 and the first half of 2015 to our investor relations website prior to our third quarter earnings release to enable year-over-year comparison.

So with that, let me start our prepared remarks by reminding you that this presentation, including comments regarding our financial outlook, new product developments and regulatory matters contains forward-looking statements that involve risks and uncertainties. And of course our actual results could differ materially from our current expectations.

Please refer to today's press release and our SEC filings for more detail concerning factors that could cause actual results to differ materially. In addition, on today's call, non-GAAP financial measures will be used to help investors understand Baxter's ongoing business performance.

A reconciliation of the non-GAAP financial measures being discussed today to the comparable GAAP financial measures is included in our earnings release issued this afternoon and available on our website. Now I'd like to turn the call over to Bob Parkinson..

Thank you, Clare. Good afternoon, and thanks to all of you for joining us. Today's call is a transitional event for Baxter. It comes on the heels of our successful spinoff of Baxalta.

The excitement level continues to build with the new Baxter as we embark on our journey as a standalone entity and begin to implement a number of the new strategic initiatives and margin improvement actions that will accelerate our profitable growth in the years ahead.

For the second quarter, Baxter delivered a strong performance with adjusted earnings of $1 per diluted share, exceeding our previous earnings guidance of $0.92 to $0.96 per diluted share. Worldwide sales also exceeded our guidance, increasing 3% on a constant currency basis, and after adjusting for the impact of increased U.S.

competition for cyclophosphamide, sales advanced 4%. Certainly our biggest milestone for both the quarter and the year was the successful completion of the BioScience spinoff, resulting in the establishment of two leading global healthcare companies.

The smooth transition that we've seen following the spin is a credit to the comprehensive planning and disciplined execution carried out by employees and leaders across both businesses.

And our strong second quarter results provide both Baxter and Baxalta with positive momentum as we continue our commitment to enhance value for all of our stakeholders.

As we laid out at our Investor Conference in May, accelerating profitable growth is critical to Baxter's future success and is an objective that the entire management team is focused on. We are not only striving to meet our profit growth goals, but frankly, we're aiming to exceed them.

Rebasing our cost structure, optimizing the existing portfolio, and launching numerous high-value differentiated products are the three focus areas that we will execute against over the long-range plan to drive the financial goals that we provided in May. Many of these initiatives have been launched and are gaining traction.

So with this as a backdrop, I'd like to highlight some of our recent achievements. First, addressing our standalone cost structure is crucial to meet our goal of increasing earnings at a rate meaningfully faster than sales growth, and we're making progress on a number of fronts. The Gambro integration program continues to advance.

We're on track to capture $100 million of cost synergies in 2015, and as we exit the year, we'll have successfully achieved two-thirds of our $300 million 2017 cost synergy target.

And more broadly, a comprehensive cost rebasing plan for Baxter is now under way, and we're executing on key opportunities to reduce structural costs and increase efficiencies across the global enterprise.

Now that the spin's complete, we've started to implement a number of substantive measures and look forward to sharing more information on these initiatives as we progress. With respect to portfolio management, during the quarter we took steps to optimize our global supply of IV solutions to address demand, while also improving profitability.

In May we received FDA approval establishing our Sabiñánigo, Spain, facility as an approved manufacturing site for saline for the U.S. market. The FDA is also in the process of reviewing our application to source saline from our manufacturing site in Cuernavaca, Mexico.

As all of you are aware, saline has been listed in Drug Shortage Database as maintained by the FDA over the past two years. So introducing a new supply from Spain and potentially Mexico to the U.S. market will provide us greater flexibility to respond to market demand.

It also reflects our commitment to ensuring that we are optimizing our global supply and allocating or reallocating products to markets that generate enhanced returns aligned with our margin improvement goals. Finally, I want to share some recent highlights from our new product pipeline.

As you heard, the leadership team emphasize at our Investor Conference, innovation is Baxter's lifeblood and fundamental to sustained growth. We have an exceptional pipeline that's well balanced among highly advanced new products, meaningful improvements to our existing offerings, and expanding our portfolio into new geographies.

All are focused on improving the quality of care, while addressing key areas of medical need. So some recent milestones include, in our hospital products business, the full-scale launch of the next generation SIGMA Spectrum infusion pump is now under way in the U.S., Puerto Rico and Canada. And I'm pleased to report that demand is strong.

The Spectrum platform has been honored with the best in class customer satisfaction award for four consecutive years, and the latest generation pump includes several innovative features, including an enhanced master drug library, which helps to reduce pump-related adverse drug events and improve patient safety.

Customer response has been very positive, and the SIGMA Spectrum is currently being used or in the process of being placed in six of the top seven hospital systems in the United States as ranked by the U.S. News & World Report.

In our renal business, we initiated the launch of our AK98 in-center hemodialysis monitor in several markets in Eastern and Central Europe, the Middle East and Africa. The AK series is our flagship in-center HD monitor, and this latest version offers advantages in usability and reliability while reducing the total cost of operation. In the U.S.

we completed a 510(k) submission with the FDA for AMIA, our next-generation peritoneal dialysis cycler now integrated with our SHARESOURCE web-based connectivity platform.

AMIA incorporates user-friendly features like a graphical touchscreen interface along with secure two-way connectivity that lets healthcare providers mobilely monitor treatment and adjust prescriptions as necessary.

And finally, I'm also excited to share that the FDA has approved Baxter's investigational device exemption for our VIVIA home-based hemodialysis system. This milestone helps clear the way for the final U.S. study.

And as we've previously shared, the VIVIA technology has the potential to transform home hemodialysis and allow more patients to benefit from high-dose HD in their homes. These are just a few of the new products that we'll bring to market over the next several years.

Our pipeline is well-positioned to make a meaningful impact on both near and longer-term performance, and I look forward to providing more details on the progress and potential of this pipeline going forward.

So with that, I'll now turn the call over to Jay for a discussion of our second quarter results and outlook for the remainder of the year, and then I'd like to make some closing comments before then opening up the call to Q&A. Jay, please..

Thanks, Bob, and good afternoon, everyone. As Bob mentioned, adjusted earnings in the second quarter of $1 per diluted share exceeded our previously issued guidance range of $0.92 to $0.96 per share.

GAAP earnings of $0.60 per diluted share included net after-tax special items totaling $218 million or $0.40 per diluted share primarily for costs associated with the company's planned separation as well as business development initiatives and intangible asset amortization.

These charges were partially offset by a benefit related to a legal settlement. Now let me briefly walk you through the P&L by line item before turning to the financial outlook for the third quarter and second half of 2015. Starting with sales, worldwide revenues of approximately $3.9 billion declined 6% on a reported basis.

On a constant currency basis, sales increased 3% which compares favorably to our guidance for the quarter of approximately 1%. Excluding the impact of increased competition for U.S. cyclophosphamide, Baxter's sales advanced 4% globally.

Medical Products sales were in line with our expectations while strong growth across the BioScience portfolio contributed to the overachievement. Sales in the U.S. increased 1% or 5% after adjusting for cyclophosphamide. International sales on a constant currency basis increased 4%.

In terms of individual business performance, within Medical Products, global sales of approximately $2.5 billion declined 9% and on a constant currency basis, sales were comparable to the prior year period. Adjusting both periods for the impact of U.S. cyclophosphamide, Medical Products sales rose 3% on a constant currency basis.

Within the product categories, renal sales totaled $949 million, reflecting a decline of 9% on a reported basis, excluding the impact of foreign currency sales increased 3%. Performance in the quarter was driven by mid to high single digit growth in our peritoneal dialysis business and double digit growth in the acute business.

This growth was offset by lower sales in our chronic hemodialysis business resulting from our previously mentioned decision to forego certain lower margin sales opportunities as well as the impact from increased austerity measures in Western Europe.

Within the fluid systems franchise, sales of $518 million declined 3% and on a constant currency basis sales advanced 3%. Performance was driven by the relaunch of the SIGMA Spectrum pump in the U.S. during the quarter and strong demand and favorable pricing for IV fluids.

Sales in the integrated pharmacy solutions franchise totaled $548 million and declined 16%. On a constant currency basis, sales declined 8% as strength in our hospital pharmacy compounding service business was offset by lower cyclophosphamide sales in the U.S. Excluding this impact, sales in the category advanced 1%.

This growth was somewhat dampened given the tough year over year comparison as growth in the second quarter of 2014 was the highest quarterly growth for the year as product availability improved for certain nutritional products that had previously been supply constrained.

Revenues in surgical care, which includes our inhaled and aesthetics and biosurgery products were $333 million in the quarter and declined 4%.

On a constant currency basis, sales rose 4% driven by strong performance globally in the anesthesia business and solid growth of our core surgical sealants and hemostasis products including our market leading flow seal hemostatic matrix. This performance was partially offset by lower sales of select non-core bio surgery products.

Finally, sales in the biopharma solutions and other category, which is our pharma partnering business, totaled $116 million, declining 6% on a reported basis. Sales increased 2% on a constant currency basis driven by increased international demand from our contract manufacturing partners.

Global BioScience sales totaled approximately $1.4 billion in the quarter and declined 2% on a reported basis. On a constant currency basis, BioScience sales advanced 7%. Additional details on the BioScience performance in the quarter will be available on the Baxalta earnings conference call tomorrow morning.

Turning to the rest of the P&L, gross margin in the quarter was 50.7% compared to 50.3% last year. Positive mix, select pricing improvements, and foreign currency hedge gains more than offset the impact from increased generic competition for cyclophosphamide and incremental manufacturing investments made in the quarter.

SG&A totaled $951 million and was comparable to prior-year levels. On a constant currency basis, SG&A increased high single digits.

Growth in the quarter reflect continued investments in promotional and market activities to support new product launches in BioScience, certain costs incurred to establish the regional commercial organizations for Baxalta, and adjustments to bad debt reserves in emerging markets. R&D spending in the quarter of $292 million increased 1%.

On a constant currency basis, R&D advanced mid-teens and was driven primarily by increased investments in the BioScience business. Interest expense was $30 million in the second quarter compared to $42 million last year as we benefited from a favorable rate and debt mix, and higher capitalized interest.

Our second quarter ending debt balance included approximately $5 billion of debt issued by Baxalta in June, which upon the spin has moved to their balance sheet, as well as the retirement of $1.1 billion of commercial paper. Subsequent to the second quarter, we successfully tendered for $2.7 billion of outstanding bonds.

Both the commercial paper reduction and bond tenders were paid down with proceeds from the $4 billion cash dividend that Baxter received from Baxalta in June. Other income totaled $15 million and included planned gains related to the sale of select equity investments.

The tax rate of 23.2% for the quarter was slightly above expectations driven by the one-time impact associated with completing select tax audits, primarily outside the United States. And as previously mentioned, adjusted earnings of $1 per diluted share exceeded our guidance range.

Let me conclude my comments this morning by providing an update on our full-year sales guidance and outlook for both the third quarter and second half of the year. But before I do that, many of you have inquired about restated historical quarterly income statements.

We do plan to post adjusted non-GAAP financial statements to our website prior to our third quarter earnings call to provide investors with historical baseline financials for new Baxter.

This timing allows for the completion of the final carve-out process and associated discontinued operations presentation of the BioScience business, as well as the confirmation of the baseline run rate associated with the transition services agreements we have set up with Baxalta for which billing will commence in the third quarter.

Now, turning to our guidance and starting with sales, on a constant currency basis we continue to expect sales for the full year 2015 for new Baxter to be comparable to 2014, primarily due to the impact of generic cyclophosphamide. Adjusting both periods for this cyclophosphamide impact, underlying growth is approximately 3%.

By franchise, we continue to expect renal sales to increase approximately 3% and surgical care sales to advance 4% to 5%. For fluid systems, we expect sales growth of approximately 3%. We now expect sales in the integrated pharmacy solutions franchise to decline mid-single digits. As you know, this category includes cyclophosphamide.

For 2015, we now estimate U.S. cyclophosphamide sales of $190 million to $200 million. This is an increase from our previous guidance and reflects a benefit of approximately $20 million in the second quarter and an incremental $20 million to $30 million benefit in the second half of the year relative to our original guidance.

While we continue to expect additional competitors to enter the market, the timing of these entries remains uncertain. Growth for the category after adjusting for cyclophosphamide is expected to increase mid-single digits.

And finally, we expect the other category which includes our biopharma solutions franchise to decline approximately 10%, as a major customer elects to self-manufacture products that were previously contract manufactured by Baxter.

Moving to the second half of 2015, our outlook remains consistent with the guidance we provided at our Investor Conference in May. We expect second half sales growth excluding the impact of foreign currency to be comparable to the prior year, and after adjusting for U.S. cyclophosphamide, to increase approximately 3%.

At current foreign exchange rates we expect reported sales to decline approximately 9%. We anticipate the gross margin for new Baxter to be approximately 42% and we continue to expect an operating margin of approximately 9%.

As previously mentioned, the 9% initial operating margin reflects the impact of stranded costs and incremental pension expenses following the spinoff of Baxalta. It also incorporates investments we've made to enhance our manufacturing and quality systems.

For the second half, we expect interest expense to total approximately $70 million as the benefit of our reduced debt levels is more than offset by lower levels of capitalized interest. We expect other income of approximately $15 million, reflecting a benefit from the sale of select equity investments in the back half of the year.

Given the geographic mix of our earnings for new Baxter, we expect a tax rate of approximately 20%, and for the balance of the year we expect an average share count of approximately 550 million shares. As stated in our press release, we expect adjusted earnings excluding special items of $0.58 to $0.62 per diluted share.

Specific to the third quarter, we expect sales growth excluding the impact of foreign currency to be comparable to the prior year, and after adjusting for cyclophosphamide, to increase approximately 3%.

At current foreign exchange rates we expect reported sales to decline approximately 9%, and we expect earnings from continuing operations excluding special items of $0.29 to $0.31 per diluted share. Before we open up the call for Q&A, I'd now like to turn the call back over to Bob for some closing comments..

innovation, quality, efficiency, market access and improved clinical outcomes for patients worldwide. So with that, I think we can now open up the call to Q&A..

Thank you. We will now begin the question and answer session. Our first question comes from Bob Hopkins with Bank of America Merrill Lynch. Your line is open..

Thank you.

Can you hear me okay?.

We can, Bob. Go ahead..

Great. Thanks. So I just want to take the opportunity, Bob, to follow up on your comment about succession and your comment about you want to wait until progress is evident.

Is it reasonable to assume that by early 2016, we're going to know what kind of progress or that progress would be evident? I'm just trying to put some timeframes around your commentary around succession..

Yeah, I appreciate the follow-up question, Bob, and again I don't want to be specific in terms of dates. The reason I did mention what I did is it's fair to characterize this to say what I would call a front burner issue with the board.

I mean, the fact of the matter is our board has had in place through the governance committee an established succession plan process for a long time. And in fact, just to provide a little color for everyone, we had discussions on this going back over the last few years.

But clearly as we approach the spinoff, we kind of took the notion of succession and set it up on the shelf a little bit. I will say the decision to spin off BioScience clearly wasn't a result of any succession planning, but the reality is as a result of the spinoff, it did answer the succession question for that big piece of the business.

It also allows the board to go forward now and evaluate succession in the context of a medical products/medical device company which in terms of experience and so on, can be a much more focused search I think.

So now, given the fact that the spin has taken place, recognizing the progress and the momentum that's building at new Baxter, as I said, this has now become a new priority. And as I said in my prepared comments, with that, the board has formed a working group to manage the process, retained a search firm.

I don't want to get into all the specifics of that including timing other than to say I wouldn't have raised it in this sense if now that the spin has been completed, we've got renewed enthusiasm, energy and focus and alignment behind what we want to do at new BAX and now is appropriate for the board to reengage on this and that's why I wanted to comment on this this afternoon..

Great. That's very helpful. So I think I'm hearing, what I think I'm hearing from you, it doesn't sound unreasonable that something could happen in 2016 just kind of hearing the things that you just mentioned..

No. That's not unreasonable at all..

Okay..

Yeah. It's not unreasonable at all. The fact of the matter is, we retained a search firm shortly after the spin. We didn't do it before then because there's no secrets in the world. Stability in this organization is important and we intentionally, as I said, kind of put that on the shelf until the spin was completed.

But shortly thereafter we formalized it, and particularly with our employees, I always try to be forthright and transparent in communications and that's another reason why I wanted to communicate it today, so they have some expectation in that regard..

Great. And then just one really quick one for Jay. Given your back half guidance, can you just give us a sense as to the revenue contribution from cyclo in the back half and then the total debt of new Baxter in the back half that drives that interest expense number you mentioned? Thank you..

Yeah, certainly. As far as cyclo in the second half of the year, we currently expect approximately $70 million in the second half of the year which is a slight increase over our prior guidance.

And then as far as the new Baxter debt balance in the second half of the year, we completed a debt tender successfully as I commented on in my prepared remarks. At this stage, we're not reflecting any utilization of the retained stake beyond that.

But overall from a debt standpoint, post-spin we're anticipating approximately $6.3 billion in debt, which reflects the benefit of utilizing the cash from the cash dividend from Baxalta to retire certain debt and commercial paper. So that's the current expectation..

Great. Thank you very much..

Our next question comes from Matt Taylor with Barclays. Your line is open..

Hi. Thanks for taking the question..

Sure..

I wanted to ask a question I guess about the overall guidance and any thoughts you have on margins. I mean specifically on the guidance, you gave a second half number.

Can you put that in context in terms of what that implies for earnings power for the year? And then also, talk about some of the levers that you have year-over-year and whether there's been any change to your thoughts on margin expectations for next year?.

Yeah. I would say our margin expectations for the second half of the year, first let's start with that, are very consistent with what we shared in the Investor Conference. So the 9% operating margin reflects our expectation around start point, and there are a number of factors that are impacting that 9%.

As we move forward, we are increasingly confident in our ability to achieve our long-term margin projections. Having said that, I don't think it's appropriate at this stage to modify our target for next year. As you know, we expect 100 basis points of improvement relative to the second half.

So 10% margin for next year and that would include approximately 100 basis points of negative drag from cyclo. So really the organic improvement would be approximately 200 basis points relative to the second half of this year.

As it relates to the full year comparables and the earnings power, given the complexities of a mid-year split, we're really not in a position at this stage to comment on new Baxter as a standalone enterprise. We reported Q2 as a consolidated enterprise.

We expect later in the year as we approach the Q3 earnings call, we'll have the ability to report Baxalta not only from a discontinued operations basis, but also at that stage reflect the transition service agreements and the actual consumption of transition services by Baxalta. We'll start billing for that, those services that we provide next month.

So from an overall standpoint, the first half of the year really is a Baxter consolidated view until we modify that later in the year..

Matt, this is Bob. Maybe just to add some higher-level color. It's really too early subsequent to the Investor Conference for us to modify either our outlook for this year or next year.

But I think probably as you gathered from our commentary in our prepared remarks, we increasingly are confident in our ability to achieve what we disclosed to everybody and what we project at the Investor Conference.

I think the momentum is building and just to reiterate our aspiration, if we can do better, we're totally committed to do that over the next five years in the LRP and certainly subsequent to 2020. So good momentum building, but it's too early in the game to, I think to modify any of our financial projections..

Okay. Thanks a lot for the color..

Sure..

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

Thank you, and good afternoon everybody..

Hi, Dave..

Hey, Jay. Hey, Bob. I wanted just to start with a couple questions just on the business. If you look at very specifically I guess the fluid systems franchise, it looks like in the U.S. that business continues to do a little bit better than one might expect your end markets to be growing at right now.

Can you just sort of talk about the key drivers underpinning the strength in the U.S.

and to what extent these type of growth rates are sustainable?.

Well just maybe high-level comment, then I can maybe tee it up for Jay for more specifics. Some of the strength that you're seeing demonstrated is really a result of some pricing power, pricing latitude in the U.S.. The underlying volume is I think pretty consistent with what we've been generating.

As you now, it's a fairly low growth market on a volume basis but what you're seeing the strength from is really, in the core solutions business is really pricing, but then of course we're starting to pick up momentum more broadly with the relaunch of the SIGMA Spectrum.

And I will tell you, again, and you know this, Dave, but for the others that are calling in, we projected in the long range plan to recover 5 of the 10 share point loss within the LRP.

And early days with orders we have in hand and what we expect this year, I would anticipate that we're going to get at least 1 share point of 5 back before the end of the year. So that's part of the momentum that's building there and that's contributing to the strength as well. Jay, I don't know if there's any..

No, nothing to add..

Specifics you want to add to that. Those are the key components, David..

Okay, that's helpful. Then maybe turning just to the surgical care franchise. That's a business that looks like it's maybe doing a little bit better but obviously an area that is fairly intense on the pricing competition side.

Do you think this is a business that we can see accelerate on a go-forward basis, particularly as sort of evidence continues to come through on better U.S.

hospital volumes and surgical volumes, or just a franchise that's sort of permanently constrained to sort of a lower single digit growth rate?.

a fairly mature market in the U.S. and growing with surgical procedures with some additional penetration. The opportunity for growth longer term is clearly O-U.S. and that's an area of additional promotional investment and focus going forward. The anesthesia business continues to perform quite well.

The adoption of inhalation anesthetic agents in emerging and developing markets continues to grow. As you know, we have the only full line of inhalation gases and Suprane continues to perform very well. So the anesthesia business is a little different than the biosurgery business, if you will, not constituting our surgical care franchise.

But I think realistically the kind of growth that we projected at the Investor Conference in the range of 4% to 5% at this point continues to be a prudent expectation. I wouldn't increase expectations beyond that at this stage.

And guys, you want to add anything to that?.

No. That's good answers..

Okay..

Okay. Thank you very much..

Sure, Dave..

Our next question comes from David Lewis with Morgan Stanley. Your line is open..

Good afternoon. Just Jay, a quick question on the Baxalta stake. I know you talked about the balance sheet moves here in the back half of the year. But obviously a lot of what you've talked about implies you sell a material portion of the Baxalta stake before the end of 2016.

So, are there any special dynamics underpinning the timing of that sale process? Meaning should we expect it to be more immediate post the spin or closer to the end of 2016? And then I have a quick follow-up..

Yeah David, if you think about our objectives with the Baxalta stake, it's really to maximize the value of the stake to Baxter. And as part of that, we're going to look to carefully evaluate the different levers that we have and be opportunistic in terms of timing and amounts in each.

And so I wouldn't say specifically there is a specific time that we're targeting.

We're probably not going to do anything in the first 60 days, allow the Baxalta stock price to stabilize and we would probably not wait until we get too close to the 18 month timeframe because as you know there are very significant tax benefits to achieving our objectives within the 18 month timeframe.

Beyond that, we expect to start certain transactions this year and then we'll do a number of other transactions next year, but we haven't reflected the benefit in reduced share count or reduced interest expense for late-year transactions that we're currently contemplating.

The key inputs as we think about this, with respect to the pension, we're going to carefully evaluate the prevailing interest rate environment because we don't want to oversize the pension contribution depending on the size of that liability.

We're going to carefully evaluate the evolution of the Baxalta stock price and then the receptivity to, the anticipated receptivity from Baxter debtholders and Baxter shareholders to the different tactics that we're pursuing. So those are some of the key inputs that we're evaluating as we look at timing and sizing of the different transactions.

At this stage I wouldn't expect one very large transaction but more multiple transactions..

Okay, that's very helpful color, Jay. And then, Bob, I just want to come back to renal for a second here. I feel like it's sort of a tale of two cities. You have great enthusiasm around CRRT and some positive secular tailwinds and you have the more traditional HD business which is perhaps a little sluggish.

So, what assumptions are you making for price erosion in the traditional HD business? You talked about some of those in this quarter. How much of this is coming from true austerity, how much is coming from direct decisions you're making about mix, and how much is just coming from frankly competitors using price as a weapon in the channel? Thanks..

It's probably some of each. Thanks for the question, Dave. And I'll play it back in and I'll ask the team to contribute as appropriate. It's kind of a tale of three cities, maybe. One is the acute piece in the hospital, which continues to grow very nicely, double digits and higher margin. And we continue to increase our focus on that.

The traditional in-center hemodialysis business, which I'll come back to in a second, and then the third leg of courses is peritoneal dialysis which continues to be an attractive growth vehicle and also an area that has pricing latitude going for it as well.

So the area that I think used the word sluggish is probably a fair way to describe the traditional in-center hemo business, although I would say that having the full product line, we're seeing that manifest itself in helping us on the PD business as well. So I think increasingly going forward, we have to look at this business in its totality.

So on a constant currency basis it grew 3% in the third quarter. As you know we're projecting the long-term growth to be in the 5% to 6% range and that will be driven over time by capacity expansions later in 2016 with dialyzer expansion and then augmented by PD capacity expansion largely in Asia subsequent to that.

And then augmenting that of course are the new products which we're very excited about. So let me come back then to the traditional in-center piece. It is a combination of things. We are being more discerning relative to the profitability of that business.

I think we commented in the first quarter about some tenders that, candidly, we walked away from because of the returns.

It is a price competitive business, and we have assumed, in answer to your question specifically, price erosion for that segment over the LRP on the very low single digits, but I think a practical recognition of the continued competitive nature of that.

And then there are austerity measures, one of which was recently implemented in France, where as a matter of policy, they've said we want to extend the useful life of monitors from seven years to 10 years.

So that obviously has an impact on revenue of monitors, and I would emphasize, our profitability on monitors is at the low end, and whether it's an old monitor or a new monitor, they chew up the same number of dialyzers, and frankly it reduces our CapEx to some degree as well.

So net-net, I'm not sure on the bottom line how significant that is, but it is a contributing factor to the top line. So I touched on a number of things there. I think I've answered each of your specific questions. I'll stop there.

Does that address your questions, David?.

Yes, Bob. Very helpful. Thank you..

Okay..

Our next question comes from Mike Weinstein with JPMorgan. Your line is open..

Thanks. So, Jay, a quick one first. The FX hedges you mentioned on the gross margin line, how much did they contribute in the quarter? And then, Bob, I just want to follow up Bob Hopkins' discussion with you on succession.

So it sounded like a few weeks ago, let's call it late June, you were talking about the dialogue with the board being, you need to get the spin and new Baxter, if you would, off on the right foot, and you wanted to see that through. But it sounds like now what you're saying is, it's more likely that a new CEO is on board at some point in 2016.

Just want to make sure we're hearing that correctly. Thanks..

Well, I said it was possible that a new CEO could be on board in 2016. The reality is, I think there has been benefit and will continue to be benefit by my continued involvement post-spin for a lot of different reasons.

But the reality is, the progress we're making, I think that the focus and the momentum and the alignment behind what we need to do is really good. And I'm going to be 65 in January, and I've been around almost 111/2 years and so inevitably this has to be dealt with.

So I think actually the stage is set very nicely for the board now to do what they have a primary responsibility of doing, is to revisit the issue of succession now that the spin has been successfully executed and transition and succession has been defined for Baxalta, now to focus on the Baxter piece.

So I think that we can achieve the objective of stability post-spin. I intentionally didn't define a specific date, but I did respond to Bob's question in the fashion that you reiterated, and I think that's fair. So I think it's a good plan where all objectives can be effectively met..

And then Jay..

Mike, yeah, on your gross margin hedge question, we did have the benefit of $25 million of hedges in the second quarter on the gross margin line..

Wow. Okay. And then maybe just one follow-up. And this is, Jay, probably for you. One of the discussions coming out of the analyst meeting on new Baxter is the spread or disconnect, if you would, between the net income and free cash flow.

I think you guys guided to basically what amounted to about $1.40 in cash earnings, depending on what the share count is next year, and the timing of some of what you do with Baxalta. And that compares to free cash flow of $400 million, which would be about $0.75, $0.80.

And so, can you just talk a little bit about that quote-unquote "disconnect" or that spread, and then how you think about that narrowing, if you would, over the next several years? Thanks..

Great. So the primary driver of the spread between operating income or cash earnings and free cash flow relates to, in the short term, CapEx. As you know, Mike, our business is capital intensive. A lot of that has to do with the fact that we're in the IV and PD business, and those have a higher capital burn.

In addition to that, in the near term, we've announced a number of important capacity expansion projects that start to benefit sales in 2016. The three major projects that we have ongoing that we'll complete in 2016, we have a China PD expansion, we have a Thai PD expansion and we have the Opelika dialyzer capacity expansion.

All of these are revenue generating. All of these generate positive economics for Baxter, but they do have the impact in the near term of depressing free cash flow relative to operating income.

Over time, as we migrate and improve the operating margin of the business, we will hold CapEx flat or even as I said in the Investor Conference, we'll see a decline in CapEx, and so the relationship between free cash flow and operating income becomes much more normalized.

Mike, but having said all of this, I want to emphasize that the entire management team is very much focused on free cash flow generation, and while we have a plan on CapEx, we are extremely focused on every single capital project to ensure that those dollars are dollars that create economic value for the company.

So that's a little background color and some further information for you..

That's good. Thank you, Jay..

Our next question comes from Danielle Antalffy with Leerink Partners. Your line is open..

Hi. Good afternoon, guys. Thanks so much for taking the question. Bob, just a follow-up on a question from earlier regarding the sales outlook. I mean this was obviously a very strong sales growth quarter, so I was hoping you could help me better understand – I guess, I should say very strong, better than expected.

So I was hoping you could help me better understand the sort of near to medium term. I mean, actually let me ask it medium to longer term headwinds that make you think that you can't grow faster than that sort of long term 4% sales growth target that you put out at the analyst meeting..

Well, actually – thanks for the question, Danielle. I mean, we need to pick up the pace a little bit right now to get to the 4%. We were at 3% for the quarter.

So we know the primary driver for that will be with the capacity expansions in renal, both dialyzers and PD capacity, as well as momentum with the SIGMA Spectrum relaunch and the other new products.

To get ahead of ourselves, first of all, if you adjust – if you go back to the 4% CAGR that we talked about over the LRP at the Investor Conference, adjusting for cyclophosphamide, that's actually closer to 5%. So that means you're really growing from a current run rate of 3% up to 5%.

And the other point that I would reiterate is as part of our margin improvement program and really addressing the product portfolio, we are going to aggressively evaluate certain product categories in certain geographies which may result in us exiting those product lines in certain geographies which obviously has a depressing effect on the top line as well.

So we do have some momentum implicit in our long-term projections. But we wanted to also reflect the fact that we are going to be proactively addressing portfolio in a way that may result to some decreases in revenue, not unlike the tender position we took in the first quarter on hemodialysis monitors. So I think overall it's balanced.

I think our long range sales projection in the LRP is very achievable. Adjusting for cyclophosphamide, I think it's pretty stable and fairly predictable and again of course it doesn't reflect anything and therefore, not only M&A obviously, but any further business development as well.

So I think, Danielle, it's a pretty balanced forecast both for the rest of the year, 2016 and throughout the LRP..

Okay. That's helpful.

And then just to follow up on your comment on business development, M&A, given the fact that the board is actively now searching for your successor, is it fair to assume that nothing major will happen on the business development side until a new CEO is in place? Or are you still actively looking to do things for the rest of your tenure?.

Look, we're continuously looking at deals. Our, kind of other than Gambro, our historical MO of doing kind of bolt-on deals and so on, we certainly, we conceivably can do over the next 12 months. But as a practical matter, we have financial constraints.

So the notion of a transformational deal is interesting and we can talk about it in a hypothetical context, but as a practical matter in the short term, we don't have the financial wherewithal to do anything in the short-term.

And if that's the case, then to speculate one way or the other, telegraph intent ahead of time doesn't seem to serve any stakeholder's interest effectively. The Gambro deal I think represents the fact that we're willing to think bigger if the value is there.

And whether it's me or a successor, I think there's an open-mindedness to that, but again right now today, it's not a practical option just due to constraints, right, financial constraints. Not to mention, I would say organizationally we're still completing the Gambro integration.

This company has been consumed over the last 12 months as a result of the spinoff, which has been the number one priority, and appropriately so, because I believe we'll look back and realize that that decision will have generated significant value for all stakeholders and all shareholders for both companies.

Now that that's done, we refocus our attention on other priorities. And, but I think a transformational deal in the next, say, 12 months or something, it just isn't in the offing because we don't have the financial latitude to do it..

Okay. Thanks so much.

Stephanie, this is Clare. We have time for two more questions..

Thank you. Our next question comes from Kristen Stewart with Deutsche Bank. Your line is open..

Hey. Thanks for taking the question. I just wanted to go back to Gambro, and just better understanding on what's changed on the sales growth forecast, because it seems like you're hitting the metrics from a cost synergies perspective, but the sales growth outlook seems to be very different.

It was one that was, at least at the time of acquisition, supposed to accelerate the overall growth profile of Baxter as a whole. And obviously with them there, the Medical Products business and here we are talking about the HD business only growing 2% to 3% over the long range plan.

That was certainly not something that was my impression that was going to be the growth forecast for Gambro at the time of the deal. So what's really changed about that business or the market that's really leading that Gambro, or maybe just the market, to be a lot slower now versus just only a couple years ago? Bob or Jay..

Okay, Kristin, thanks for the questions. So let me start at a high level, okay. I'm really glad that we did the Gambro deal. Things always change in big acquisitions, but looking back now a year-and-a-half on or thereabouts, almost two years on now, I'm really glad we did the deal. Things always turn out differently than what you anticipate.

And you're absolutely right. The core – and it's really a follow-on to commentary I made earlier. I don't know if it was David Lewis or David Roman's question, I can't recall, in terms of the traditional in-center hemo business, okay. Because that has fallen behind what our expectations are, so your commentary in that regard is spot on.

I would agree with that. But if you take a step back and look at the total deal, first of all, much of the value of the deal, more so than typically in acquisitions, was based upon the cost reduction. And as we've commented today, we're well on track to achieve – frankly it's not – slightly exceed that $300 million target, so that's really positive.

In terms of the higher growth higher margin business, the in-center CRRT, that's moving along totally in accordance with our expectation. The other thing that has been favorable, and I think going forward increasingly you have to look at our renal performance in aggregate.

Part of the rationale was to complete the full product line, thereby enabling us to participate in commercial opportunities where previously perhaps we didn't, because we didn't have all the clubs in our bag so to speak in the traditional in-center piece.

And so the commercial synergies that we're getting, particularly on PD and so on, have certainly achieved if not exceeded our expectation. The piece that has been slower is the traditional in-center piece. Part of it is market driven and part of it is organizationally driven.

I think the integration of the commercial organizations has been more challenging than what we anticipated bringing the Gambro and the Baxter pieces together, including change out of leader – most of this business as you know is outside the U.S., so it's a byproduct of 50 general managers around the world and making sure the right leaders are in the right place in each market.

And so the sorting out process in that regard has been somewhat more challenging than we had anticipated in the modeling.

And secondarily, as we've converted from distributors to going direct, which is our mode of doing business as you know, while we fully anticipated that as a result of the due diligence, there have been some challenges associated with converting from distributors largely in emerging developing markets in ways that we didn't anticipate (58:35).

So it's been slower than we anticipated. That was operationally related. Then in terms of the marketplace, frankly in terms of the pricing, it's performing pretty much in accordance with what we modeled. We anticipate in the acquisition analysis that this was and would continue to be pricing competitive.

We didn't anticipate perhaps some of the austerity measures. I cited just one recently in France.

And then the other piece of it is we have been consistent with our overall priority at new BAX going forward, more discerning and more demanding in terms of returns through our new mindset of new Baxter, and that's had an impact in terms of some of the profitability.

So I touched on a lot of it, but I really – maybe I'll just end where I started, Kristen, which is I'm very pleased that we did the deal for a lot of different reasons and confident that the value clearly is going to be generated over the long term..

Great. And there's no update on the home hemodialysis timelines for the U.S. relative to the -.

I had – Clare, make sure I don't misspeak..

Obviously we announced, we said that we've filed. The FDA accepted the investigational device exemption so that allows us to start the U.S.

trial which we continue to expect that will begin before the end of the year with filing likely sometime in the 2017 timeframe and a launch in 2018 consistent with what we shared at the Investor Conference in May..

Okay. And then for Jay, just in terms of the Baxalta stakes, sorry if I missed this. Can you comment on just how the split will be in terms of how much will go towards the U.S. pension? I think it was about $1 billion.

And how much will go towards paying down debt or how much will just go towards acquisitions and whatnot or just will become cash on the balance sheet? And I think there was something in one of the filings that mentioned a potential stock exchange as well..

Yes. So, Kristen, there's really three uses for the retained stake, pension, a stock for stock exchange or split off as it's termed and a stock for debt exchange which essentially amounts to a secondary offering coupled with a debt buyback.

So those are the three vehicles that we're currently evaluating, each of them to the extent that we pursue them within an 18 month window, are tax-free uses of the stake. So what we've said is we expect a 50 basis point benefit from contributions to the pension which would imply approximately a $600 million contribution to the pension.

But frankly, the sizing of that ultimate contribution will very much depend upon the prevailing interest rate environment. We don't want to go well north of 100% funded status. As we sit today, we're at roughly 80%, and so this would close a portion of that gap but it wouldn't close all the gap.

To the extent that interest rates rise between now and year-end when we would contemplate a transaction of this nature, we're going to watch that very carefully..

Okay..

As it relates to the other two pieces, it really is going to depend upon our ability to execute those transactions with the least amount of cost. Because to the extent that we over delever, we always have the opportunity to lever back up to buy shares or to pursue M&A.

The important thing is we want to use the retained stake with the limited, the least amount of economic loss to Baxter, so that we're going to be very thoughtful about transaction costs and premiums and things of that nature..

Yes. Okay. Thank you..

Thank you..

Our final question comes from Josh Jennings with Cowen & Company. Your line is open..

Hi. Good evening. Thanks a lot. Just wanted a quick question on the operating margin front.

Can you talk about the operating margin baseline and trajectories for the four business units relative to the corporate margins? Or is there one or two units that has more depressed margins where you can give us some more specifics or granularity on how the margin turnaround can be achieved?.

We really haven't disclosed margins by segment or area except to say that there are certain businesses that carry a higher margin than the Baxter average, and those businesses include the CRRT business, our surgical care business, our nutrition business within integrated pharmacy systems.

Those are a few of the businesses which carry a higher margin than the corporate average. In the case of those businesses, our full expectation is to grow them as fast as we can with promotional investments to support that. By doing that, we expect to see a positive benefit on the margin.

There are other categories of businesses which we would characterize as having lower margins. And what we've said is, it's really not a global question to ask, but it's more specific than that. In certain products in certain geographies we have margins that are below our corporate target.

With respect to those businesses, our expectations are we're either going to fix, shrink or exit those businesses over time. So we have a very disciplined framework in place, but it's a more fine-tuned methodology than a global methodology with businesses that have lower margins or higher margins.

Because frankly in some businesses that may have a lower margin in one market, that margin may be dramatically different in another market depending on the nature of the dynamic..

Great. And just on that portfolio optimization point that you brought up, can you talk about the pace of product pruning or exiting suboptimal geographies? You've already started in renal.

It sounds like you do have strategic plans in place, but is this going to depend on balancing this portfolio optimization and then loss of revenues and how that flows down to the bottom line?.

Yeah, so we've completed the portfolio analysis. We have clear line of sight to the fully loaded profitability and the economic returns of our businesses. But before we exit a business, our first expectation is that our general managers will attempt to fix it, and that takes some time in certain instances.

So the pace at which we do this will really be gated by how successful we are in turning around some of these businesses or not. And to the extent that we're not, we will make very clear and definitive decisions about exit, but only after we've given the opportunity to the operations team to actually fix that business.

Bob, I don't know if you want to add anything to that?.

All I would say is, but that's not going to be a protracted period of time..

Yeah..

There will be a sense of urgency on this. But there is a disciplined process, as Jay described, Josh..

Excellent. Thank you very much..

Sure..

Ladies and gentlemen, this concludes today's conference call with Baxter International. Thank you for participating. You may now disconnect..