Good morning, ladies and gentlemen, and welcome to Baxter International's Fourth Quarter 2015 Earnings Conference Call. Your lines will remain in a listen-only mode until the question and answer segment of today's call. [Operation Instructions] 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 morning and welcome to our fourth quarter 2015 earnings conference call. Joining me today are Joe Almeida, Baxter's new Chairman and Chief Executive Officer and Jay Saccaro, Chief Financial Officer.

On the call this morning we will be discussing Baxter's fourth quarter financial results and outlook for the remainder of 2016 before taking your questions.

With that, let me start our prepared remarks by reminding everyone that this presentation including comments regarding our financial outlook, new product development 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 in 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 morning and available on our website. Now, I'd like to turn the call over to Joe.

Joe?.

Thanks, Clare. Good morning, and thanks for joining us. Before commenting on our performance in the fourth quarter, I wanted to share a few initial impressions of what I have observed during the past several weeks and why I'm excited about the opportunities that lay ahead. Clearly we're building on a very strong foundation.

Baxter has established one of the most trusted and respected brands in the healthcare industry, and over this rich history, we have built a durable portfolio of market leading projects with broad geography reach that spans more than 100 countries. Clearly, we have an outstanding base for expanding margins and accelerating performance.

And following last year's spin-off of Baxalta we can now devote our attention to the strategies and investments that will drive profitable growth across the business and create value as we aspire to deliver top quartile 5total shareholder returns for our investors.

The initial steps are already well underway which is reflecting Baxter's fourth quarter results. As you saw in this morning's release, we delivered adjusted earnings of $0.43 per diluted share, exceeding our guidance of $0.30 to $0.32 per diluted share. Operating income of 10.7% compared favorably of our guidance of 9.5% to 10%.

After adjusting for the impact of foreign exchange and a generic market entrant in the U.S. for cyclophosphamide, we reported sales growth of 4% in the quarter, also ahead of our expectations.

Key growth drivers in the quarter included strong performance in our US fluid systems franchise where our newly launched SIGMA SPECTRUM infusion pump continues to build momentum as well as increase the demand and favorable pricing for our IV solutions. Performance was also augmented by strength in our U.S.

peritoneal dialysis business which report the highest quarterly growth of the year. The U.S. PD business is seeing very promising early results on the recent launch of our AMIA APD cycler which features our SHARESOURCE two-way connectivity platform, and we look forward to expanding this launch in 2016.

So overall, a positive quarter and a great base to build on for the future. As for what the future looks like, we are in process of developing a strategic framework that will shape our priorities and direct our approach and investments moving forward.

I'm confident this framework will drive a sustainable growth for Baxter and create enhanced value for our shareholders. Simply put, our objective is to further accelerate and increase the impact of our margin improvement plans to support our goal of top quartile shareholder return.

To successfully achieve this outcome we will execute on three distinct strategic factors, including portfolio optimization, operational excellence, and capital allocation.

In terms of portfolio optimization, we have taken this passionate approach to portfolio management which we include – categorize our businesses based on the existing financial profile and future potential. And accordingly, we will reallocate investments based on the ability to drive innovation.

In addition, we're intensifying our focus on both R&D velocity and productivity to support our top and bottom line growth initiatives. The second area of strategic focus is operational excellence.

We are aggressively examining our cost structure in terms of how we do business from manufacturing and operations to commercial and corporate infrastructure. I'm confident we can take additional cost out of our business without compromise our commitment to quality and safety.

Related to this, we also ensure our capital expenditures are optimally allocated to projects that enhance bottom line growth and support long-term value creation. And the final strategic focus area for us is capital allocation where we are committed to deploying capital in a manner that creates value over both the short and long-term.

We'll be sharing more information about our strategy at our upcoming Investor Day on May 9 in New York City. At that meeting, we will provide more specifics around our objectives along with our three and five-year aspirational financial targets.

We know there's a lot of hard work in front of us, but our team is energized and well prepared for the road ahead. And with that, I will pass it to Jay for more details on our fourth quarter performance and outlook for 2016. Then we'll have time at the end for questions.

Jay?.

Thanks, Joe, and good morning, everyone. As Joe mentioned, adjusted earnings in the quarter of $0.43 per diluted share exceeded our previously issued guidance of $0.30 to $0.32 per diluted share.

Sales growth in the quarter benefited from strong operational performance in our fluid systems, PD, and acute businesses, as well as operating expense savings resulting from our disciplined management of costs and the restructuring initiative we announced last quarter.

In addition, other income from foreign exchange related gains and a favorable tax rate both contributed to our performance in the quarter. Now, let me briefly walk you through the P&L by line item before turning to the financial outlook for 2016. Starting with sales, worldwide revenues of $2.6 billion increased 2% on a constant currency basis.

This performance compared favorably to our Q4 guidance of a 1% sales decline with better than expected sales growth observed across the portfolio, particularly in our fluid systems, integrated pharmacy solutions, and renal franchises.

Including the impact of foreign exchange, sales declined 7% on a reported basis, and excluding the impact of both foreign exchange and U.S. cyclophosphamide, Baxter's sales rose 4% globally. Sales in the U.S. increased 1% on a reported basis and after adjusting for cyclophosphamide, U.S. sales advanced 7%.

International sales on a constant currency basis increased 2% and declined 12% on a reported basis.

Turning now to the drivers of business performance in the quarter, please note, I will be speaking to sales growth on a constant currency basis excluding any foreign exchange impact for each of the businesses and franchises to provide a clearer picture of Baxter's underlying operational performance.

Starting with hospital products, global sales totaled $1.6 billion and increased 2%, and after adjusting for U.S. cyclophosphamide, sales for the hospital products business increased 5%. Within the fluid systems franchise, sales of $569 million advanced 12%.

Performance in the quarter was driven by growth of more than 20% in the infusion systems business, supported by the successful launch of our next generation SIGMA SPECTRUM Pump and the related access sets pull-through. In addition sales of IV solutions in the quarter benefited from favorable pricing and demand, particularly in the United States.

Sales in the integrated pharmacy solutions franchise totaled $595 million and were comparable to the prior year period. Excluding U.S. cyclo sales, revenues in the category increased 8% driven by strength across the franchise, which includes our nutritional products, pharmacy injectables, and hospital pharmacy compounding services. Fourth quarter U.S.

cyclo sales totaled $65 million representing a benefit of approximately $10 million versus our previous guidance. For the full year, U.S. cyclo sales totaled approximately $270 million. Fourth quarter revenues in surgical care which includes our anesthesia and biosurgery products totaled $346 million and were comparable to the prior-year period.

Performance benefited from low single digit growth of our anesthesia business and core surgical sealants and hemostasis products which both increased in line with surgical procedure volume growth. This performance was offset by lower sales of select non-core biosurgery products.

Finally, sales in the biopharma solutions and other category which is our former partnering business, totaled $109 million and as expected declined 22%. As we previously highlighted, this decline is driven by a large customer electing to self-manufacture products that were previously contract manufactured by Baxter.

As we mentioned last quarter, this category also reflects sales for products Baxter is manufacturing on behalf of Baxalta, which totaled approximately $13 million in the quarter. Turning to the renal business, global renal sales totaled $984 million, representing an increase of 1%.

Performance in the quarter was driven by high single digit growth in our U.S. peritoneal dialysis business. As Joe mentioned, we're very excited about the prospects for this business which will benefit from the recent launch of our new AMIA PD cycler.

In addition, we experienced low teens growth globally in our acute business driven by underlying market growth and an increased adoption of continuous renal replacement therapy as a treatment option for acute kidney injuries.

Growth in the renal business was offset by lower sales in our in-center chronic hemodialysis business resulting from our previously discussed decision to forego certain lower margin sales opportunities along with competitive pressures for dialyzers.

Turning to the rest of the P&L, adjusted gross margin for the quarter was 42.6%, slightly ahead of our expectations driven by favorable products mix in the quarter. Adjusted SG&A totaled $672 million and decreased 17% on a reported basis.

On a constant currency basis, adjusted SG&A declined 11%, reflecting the benefit of the initial actions we have taken to rebase our cost structure and reduce discretionary expenses, and the impact from transition service income we received from Baxalta during the quarter which totaled approximately $30 million.

Adjusted R&D spending in the quarter of $158 million increased 2% versus the prior year. On a constant currency basis adjusted R&D expenditures increased 9% as we balance increased investments to support our new product pipeline with efforts to optimize our overall R&D spend.

Consistent with our portfolio optimization priorities, during the quarter we made the decision to discontinue the development of select programs and as a result absorbed approximately $15 million in expenses related to these decisions.

Adjusted operating margin in the quarter was 10.7% which compared favorably to our guidance of 9.5% to 10% driven by the positive gross margin mix and SG&A savings I just referenced. And as Joe mentioned earlier, we'll continue to streamline our operations and control spending to drive ongoing margin expansion.

Interest expense was $32 million in the fourth quarter. Last week we executed our first transaction with respect to the retained Baxalta stake. In this transaction, we exchanged approximately 38 million Baxalta shares or approximately 28% of the total original equity stake to retire $1.45 billion of indebtedness under one of our bank lines.

Over the next several months, we'll look to further deploy the remaining Baxalta equity through a combination of additional debt for equity and equity for equity exchanges as well as make a contribution of at least $600 million worth of equity to our U.S. qualified pension plan subject to final regulatory approval.

Our goal is to exit our retained equity position prior to any shareholder vote for the Baxalta Shire transaction to minimize the risk of any potential negative tax implications, and we have an agreement in place with Shire and Baxalta to assist with the orderly disposition of the stake.

For 2016, we expect these retained stake-related actions to benefit our earnings by approximately $0.15 per diluted share.

In terms of key balance sheet items, after giving effect to the extinguishment of the bank line, our current gross outstanding debt balance is approximately $5 billion, and cash on hand at the end of 2015 totaled approximately $2.2 billion.

Other income totaled $36 million and included a foreign exchange gain from hedges on balance sheet positions of approximately $20 million, and dividend income of approximately $10 million associated with our Baxalta equity stake. The adjusted tax rate was 16.6% for the quarter.

This compared favorably to our guidance and contributed approximately $0.02 to our earnings per share in the quarter. The lower tax rate was driven by the extension of the R&D tax credit, a slight shift in our sales mix and certain other adjustments.

And as previously mentioned, adjusted earnings of $0.43 per diluted share exceeded our guidance of $0.30 to $0.32 per share. Let me conclude my comments this morning by providing an update on our outlook for 2016.

Starting with sales on a constant currency basis, we expect 2016 full year sales for Baxter to increase 2% to 3%, and after adjusting for the U.S. cyclo impact, we expect underlying growth of 3% to 4%. On a reported basis, including the impact of foreign exchange, we expect sales to decline approximately 1%.

This is driven by growth in the hospital products business up 2% to 3% or 4% to 5% excluding U.S. cyclo. Within the hospital products franchises, we expect sales growth of 6% to 8% for fluid systems driven by strength in the U.S.

business partially offset by the international business where we continue our efforts to optimize our geographic footprint for this franchise. For the integrated pharmacy solutions franchise, we expect sales to decline mid-single digits including the impact of U.S. cyclo.

For full year 2016, we anticipate at least two additional competitive entrants, specifically one to enter mid-year and the second to enter towards the latter part of 2016. As a result, we expect U.S. cyclophosphamide sales to total approximately $180 million, representing a $90 million year-over-year decline.

Sales for the category after adjusting for cyclophosphamide are expected to be comparable to prior years. I would also remind you that in the 2015, we recognized approximately $40 million in government sales for PROTOPAM. Given the purchasing pattern associated with this product, we do not anticipate any sales in 2016 in IPS.

Within the surgical care franchise, we anticipate sales to grow 2% to 3%. And finally, for the hospital products business, we expect the other category, which includes our biopharma solutions franchise, to increase low-double digits as we anniversary the impact of our customer transitioning their manufacturing in-house.

This also reflects an incremental year-over-year benefit of approximately $25 million associated with contract manufacturing revenues from Baxalta. For the renal business, we expect full year sales to increase approximately 3% driven by continued growth in our PD and acute businesses and a stabilization in our in-center HD business.

Moving down the P&L, we expect an operating margin of approximately 11%, which compares favorably to the guidance we provided at our 2015 May Investor Conference of approximately 10%. We expect interest expense to total approximately $90 million.

This reflects the recent extinguishment of our bank line along with additional debt repayment based on further utilization of the retained stake. For 2016, we expect modest other income of approximately $10 million. This represents a year-over-year decline of approximately $150 million.

In 2015, we benefited from certain balance sheet hedge gains and select equity gains related to our Baxter Ventures portfolio, neither of which is planned to repeat in 2016. For the year, we expect an average adjusted tax rate of 19.5% to 20%. This represents an increase from 2015 driven primarily by the change in earnings mix.

For 2016, we anticipate an average share count of approximately 540 million shares. This reduction is driven by equity-for-equity exchanges that we anticipate to execute as part of our retained stake strategy later in second quarter.

Please note that our interest expense and share count guidance reflects a preliminary base case retained stake execution plan and is subject to change as we reassess the optimal size and mix of our remaining transactions as market and other conditions evolve.

We anticipate providing updates to our guidance and/or additional detail around the actual impacts of our retained stake transactions as appropriate as we move forward. Based on these factors, we expect adjusted earnings excluding special items of $1.46 to $1.54 per diluted share for 2016.

Finally, for the year, we expect operating cash flow of approximately $1.4 billion and CapEx of approximately $900 million resulting in free cash flow for 2016 of approximately $500 million. This is also favorable to the guidance we provided in May.

Specific to the first quarter of 2016, we expect sales growth excluding the impact of foreign currency to increase 3% to 4%. At current foreign exchange rates, we expect reported sales to decline approximately 2%, and we expect adjusted earnings excluding special items of $0.28 to $0.30 per diluted share.

With that, we can now open up the call for Q&A..

Thank you. I would like to remind participants that this call is being recorded and a digital replay will be available on the Baxter International's website for 30 days at www.baxter.com. Our first question comes from David Roman with Goldman Sachs. Your line is open..

Thank you. Good morning, everybody..

Good morning..

Good morning..

Good morning, David..

Hi, Joe. Good to hear your voice again here. I want to just start with one strategic question and then one follow up on the financial side. And, Joe, I imagine you'll get into this in more detail come May, but maybe you could just start from a top-down perspective in where are you ultimately hoping to take Baxter.

As I sort of think about the profile of the business today, relatively low-single digit top line growth, room for margin expansion, how do you want the business to be perceived, and where do you ultimately want to take the story over time?.

David, I don't want to preempt our meeting in May, but I will give you a few things that we're considering very seriously. First of all is taking from the top, we need to alter the weighted average market growth rate of our businesses.

By doing that, we will look at some organic programs that can help us get into some adjacent markets and also some acquisitions. When also we look at execution, we need to continue to improve our execution on a global basis and make sure that we are in the right businesses around the globe.

Being global is not to be all over the place, so we need to make sure that we're focusing in countries and geographies for businesses that make sense. So all this work is in process as we speak.

When I look at on the cost base and expense, we want to take the company to a rebase exercise, cost rebase, and find out what is the appropriate level of support that we need to maintain our company and provide for continuous improvement and operational excellence programs that will deliver better results than we have spoken about in terms of operating income back in May last year.

So we are working very diligently right now in creating this strategic framework. We're working on our portfolio initiatives.

But we understand some of these initiatives on the top line take a little longer, and I have no issues augmenting that with some acquisitions, and I have no problems accelerating our cost reduction rebasing the cost of the company to be able to create momentum until we can get the innovation machine reignited again..

That's very helpful. Thank you. And then just on the financial side.

Jay, maybe you can sort of help us talk through the difference between the 10% operating margin guidance that you provided at last May's analyst meeting and the 11% that you're presenting today for 2016? What are some of the factors that influenced the 100 basis point better performance?.

Great. So there are a number of different variables that have impacted our performance since we sat together in the May. I'll highlight maybe the four most significant. As David pointed out, we guided to an operating margin of 10% for 2016. Obviously, we're very pleased to report our expectations now are an 11% operating income margin.

One of the key drivers relates to foreign exchange. The foreign exchange environment since May has moved very significantly. We can talk later about EPS impacts, but from an operating margin impact relative to our May expectations, we're down about 1.4% in terms of margin impact due to foreign exchange.

As you'll recall, in the second half of the year, a lot of the emerging markets currencies moved while the developing markets currencies stabilized, and for us because we don't hedge emerging market currencies it did have a 1.4% impact on our overall margin. We did have higher than expected cyclo in 2016.

So as I pointed out in my prepared remarks, we'll achieve about $180 million of cyclo sales in 2016. That's roughly 1 percentage point higher than we expected. We also have positive pension.

There are a number of impacts that we have with respect to our pension, some of which we had anticipated in part related to the contribution of the retained stake, but some of which we did not anticipate, and that's about 60 basis points of improvement as we move to 2016.

But I will tell you the area that's most important as we look at the stability of the operations from my perspective relates to the operational performance and OpEx savings which contribute about a point of margin improvement relative to our May investor conference expectations. So those are the four factors.

With cyclo and pension, essentially offsetting FX and then the over achievement really, in my view, coming from operational strength..

Thanks for all the detail..

Our next....

Go ahead, Stephanie..

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

Good morning, David..

Good morning, Joe, just a couple of questions here. I'll start with strategic for Joe and then a follow-up maybe for Jay. Joe, just – I know we're not going to get a lot of commentary before May, but just very broadly, I know you've only been there a short period of time, kind of a couple of questions for you.

The first is how do you see the balance of pursuing large M&A in the near term versus delivering your organic margin plan? And if you think specifically about your hospital business and the four segments there, do you have a sense of which segments are likely to see further investment versus which ones are likely to be optimized for return or cash? And then a quick follow-up for Jay..

Yeah, David. We almost there are completing that analysis. We've put our portfolio through about five different filters, and we actually have a pretty good idea of the things that we will invest for top line growth versus ROIC and ones that are strategic bets and ones that we're going to manage more for cash. I would say to you.

I'm going to give a few examples. We have a very good IPS business, the integrated pharmacy solutions is a very good business, and it's something that we probably can double down as an example. We will be making organic investments, possibly inorganic investments. I just want to circle back to your comment about large size M&A.

When we go down this path and we look at inorganic opportunities, size is not what matters but the ability, the ability to change the weighted average market growth rate of our businesses is key to us. And those acquisitions will be singles and doubles. They will not be big things in one shot.

We're going to make right decisions with our shareholders' money. And we need to balance that well, but we need to make sure also that we can successfully integrate and generate a step change in how we grow that business that we acquired.

So we'll be focusing great deal of our attention in the value the business brings to us strategic, but IPS is a good place to start..

Okay. That's very helpful. And then Jay, just on fluid systems, it was the driver obviously in the quarter and it does seem to be the principal driver for next year's acceleration.

Can you give us a component right now, what principally is driving the success? I know it's capital and consumable, but can you give us a sense of how large of a role capital sales are playing in 2016 and any sense of backlog in terms of sustainability of those capital sales over the next couple of years? Thank you..

Yeah, sure. I mean, look, fluid systems really has two primary drivers of growth in the fourth quarter, and then also as we move to next year we'll see similar levels of performance based on those two drivers. And the first one, I would say, is the infusion systems business. In particular, in the U.S.

we had well north of 20% growth in our infusion systems business. And breaking that down, there's two components of that. One is the sale of the SPECTRUM Pump, which has recently relaunched, and that clearly is capital related.

But as I think about the long-term sustainability of the business, really we were very pleased with the sets associated with that. And so we had very strong performance in set sales as well, well into double digits. So those were the two drivers on the infusion systems side.

From an IV therapy standpoint, we've commented previously about the marketplace conditions, some of the actions that we've taken and also continued demand for this important product. And so we did report very solid growth in the IV therapy business as well, well into double digits. And so in combination these items contributed to -- in the U.S.

and my growth rates are in relation to the U.S. -- the fluid systems growth that we reported of 27%. So clearly this was a bright spot for us. We do expect this to continue, but of course not at the Q4 rates. So we'll see some moderation as we move to the 2016 plan. So overall very pleased with it.

Some of it is related to capital spending but, as you know, most hospitals have lacked for many years an attractive alternative from a pump standpoint for a variety of different reasons. So we do believe there is some level of pent-up demand.

We have a fairly good line of sight to the sales plan for 2016, so this is an area that I think is really one of the growth drivers for Baxter in 2016 and beyond..

Great. Thank you very much..

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

Thank you, and good morning, everybody. Jay, just want to circle back to a couple of the line items in the guidance. The share count guidance seems to imply that you're going to use $1 billion of the retained – the remaining Baxalta stake in the stock for stock exchanges.

Is that about right in terms of – is that about what you're applying in your assumptions for 2016? And if so, why is that the right mix in terms of what remains?.

from a placeholder standpoint, our current view is that we'll use at Baxalta's current price a little more than $2 billion to retire debt and a little less than $1 billion to retire equity.

But as I said before, these transactions are subject to market conditions, optimal pricing, and our objective is to maximize long-term value and optimize economics with respect to these transactions. So as far as definitive plans, I can tell you these are our very preliminary plans, but by no means definitive.

We're evaluating what the optimal mix is, so there may be changes to these transactions as we move forward based on the receptivity of the market and a number of other factors. As we finalize plans and execute transactions, clearly we'll update guidance.

But, you know, we have enough information today to share with you these preliminary estimates which provide sort of some balance around the guidance range that were given. In combination, we expect about a $0.15 benefit this year.

There would be some increase to next year in part because the equity for equities transaction would occur very close to mid-year in this plan assumption and also the equity for debt exchange we'd have at least a quarter more of benefit rolling into 2017..

That's a great overview, Jay. Thanks very much. And, Joe, let's just talk strategy for a minute. So you touched on a number of the themes that you talked about in San Francisco including portfolio optimization and, improving R&D productivity, improving the overall growth mix of the business, and being in the top quartile of shareholder returns.

The big part of that is putting this Baxalta stake in ultimately your balance sheet to work to create value. You talked about doing more likely a series of smaller deals to achieve those objectives.

As you think about that, is the number one priority to accelerate the overall mix of growth in the company's end markets, or should we look at it as more ROIC driven, more margin driven? Maybe just help us think about if you're looking – if you have targets and if you're looking to do something in particular for the company, is it accelerating the top line? Or how do we think about that mix?.

Well, we're going to, Mike, take a look at, we have three to five years horizons. Right? So what can we do to change the trajectory of the company's top line growth and bottom line? What comes first? So we need to – we already have embarked on this extensive operational excellence program to cut cost.

We're going to double down on that and become a little bit more aggressive. That will create some momentum as we continue to look for the opportunities at the top line.

When you talk about the capital allocation at top line, we have about four, five businesses that we probably get a significant amount of investment from the company on the organic arena. I'm going to talk more about that in May. I don't want to pre-empt that now. But also we're going to invest inorganically in opportunities for those businesses.

When we talk about how to hit it well, we want to change – we want to buy business that they're growing faster than our current based business. That is a pretty obvious thing. The second thing is if we can combine that with good synergistic deal, we'll do it as well.

And why do I put a bracket around very large deals? Because very large deals are very difficult to find. We can keep looking for a deal like that. It will take a couple of years versus just creating a really good strategy by looking at adjacencies and pairing (38:20) good businesses with acquisitions that makes sense.

I don't discard size being large, but I'd just say, it's much more difficult to encounter that than something else that will create value almost instantly and you can execute a little faster.

So I'm looking at this whole thing as a journey where we make sure that our cost is in place while we augment our internal innovation and supplement internal innovation with some really well thought out acquisitions..

Perfect. That's helpful, Joe. Thanks. I'll let someone else jump in..

Thank you, Mike..

Our next question comes from Bob Hopkins with Bank of America. Your line is open..

Oh, thank you, and good morning..

Good morning, Bob..

Good morning..

Good morning, Joe. Great to hear your voice. A couple of quick questions. First of all, to start out with, with Jay on the operating margin guidance for 2016, you're exiting the year at just below 11% and you're guiding for 2016 at 11%. And it sounds like cyclo pension FX are kind of a wash.

So can you give us a sense as to what kind of underlying operating margin improvement you're assuming for 2016 relative to where you're exiting the year?.

Yeah, there is an important point to make which is – and you know this about our business, Bob. We have seasonality, which typically the second half of the year is stronger than the first half.

And the fourth quarter is typically one of the strongest margin quarters that we have, in large part because of incremental sales performance that naturally occurs. And so as we think about margin performance next year versus this year, I do think it's important to look at the entire year holistically.

And if you think about the full year for 2015, we're at about approximately 9% margin going to the 11% that we've guided to. So it is a fairly substantial step change improvement in margin. The other point I will make is our Q1 guidance does have the lowest margin of the year.

Again, in part driven by the fact that Q1 sales are typically the lightest because of all of the fixed costs we have in place, there is some absorption that does not occur due to the lower level of sales. So I think those are a couple of important points. By and large we're very pleased with the margin improvement that this plan indicates.

The second half of the year was very important for us, in large part because it gave us confidence that we could give solid guidance for 2016 and that we could operate effectively on a standalone basis. But I do think it's important to consider the seasonality and the trending in margin when we think about 2016..

Right.

So maybe just year-over-year then, ex the things that are affecting margins like cyclo pension and FX, what kind of year-over-year underlying margin improvement are you assuming with the 11%?.

Yeah. So essentially we're talking about, as I said, 200 basis points from 2015 to 2016. And let me highlight a few items for you that impact that. Cyclo is about 80 basis point or 90 basis point drag relative to 2015. PROTOPAM is another item that we've discussed previously, which is approximately a 30 basis point item.

Foreign exchange is about a 1.6 point on a year-over-year basis margin drag. So it's a very substantial – relative to May, it's less. On a year-over-year basis, it's even more than that. The pension, again, is about a point of improvement year-over-year.

But then there are a number of other critical items, and again, these are the ones that I'm happiest to point out. SG&A savings, we're talking about a two percentage point improvement in SG&A. R&D savings, we're talking about a 60 basis point improvement.

And then operationally, because many of the initiatives that we're putting in place from a mix volume standpoint along with some of our pricing and economic value capture initiatives along with general business growth yields approximately a little more than one percentage point of margin improvement.

So I walked you through a number of items there, and there's a lot of moving pieces that take us from the 9% to 11%. But as I say, there are a number of important ones that we can point to operationally that are really driving this improvement that I think, based on the second half of this year, we have confidence in as we move forward..

Great. And thank you for that. And then, Joe, just real quickly, one of the questions that we're getting a lot from investors is, you're articulating a plan to drive faster growth for the company on the top line basis.

And people are I think very curious as to how the balance will look, what the balance will look like in terms of the need to invest in the business incrementally to drive that top line growth versus what investors are looking for in terms of operating leverage in the business as you look forward over the next couple years.

So how do you respond to that kind of question about the need to invest to get top line growth, but the desire for people to see real operating leverage progress here?.

Bob, we need to look this in phases. We need to bring the leverage at the same time that we invest, meaning we need to accelerate some of our cost reductions. Secondly, our spending in R&D today is adequate for the portfolio as we see in the near and midterm. Meaning we don't need to spend more money than we're spending today as a matter of mix.

And if we need to spend more money, we need to self-fund that and make sure that does not impact our earnings. So this is not an investment story where we have an R&D budget that is completely underfunded to deliver an innovation. We just need to do a better job in allocating capital to the right franchise that have the chance to grow faster.

So I had mentioned for instance IPS. We'll double down in IPS to be able to get more molecules to the marketplace, so we're working on plans like this very rapidly. But that is a reallocation of resources.

I want to make sure our investors are clear that as we work to accelerate our cost reductions to provide for improved bottom line, we will create a mix change in how we spend money to be able to invest in the right things and concurrently look at some good acquisitions that will come in and create a momentum and change in our weighted average market growth rate..

Great. Thank you very much..

Thank you..

Our next question comes from Matt Miksic with UBS. Your line is open..

Hi. Thanks for taking our questions. So wanted to just one clarifying question, Jay, on Q1 guidance. You mentioned the sort of puts and takes and I think some seasonal effects that maybe show for a little – the weakest quarter of the year in terms of margins and a touch below where we were expecting.

Was there anything else other than just absorption, or was there any FX impact there that you can quantify?.

Yeah, sure. Just a couple of comments in terms of Q1. Historically for Baxter, Q1 has been the weakest quarter of the year with approximately 23% to 24% of full-year sales occurring in the quarter and 2016 is no different for us. The result of that of course is you have a lower drop through both in terms of margin and then ultimately in terms of EPS.

And then there is another factor which is, we do have a slightly larger FX impact in the first quarter than we do in later quarters in the year. So roughly 40% of the FX impact on a full-year basis occurs in the first quarter of the year. So really those would be the two items that I would point to.

There's nothing specific beyond that as we look at sales and performance in 2016..

That's great. Thank you. And then one follow up on one of the things that's driving much of your growth in the current portfolio of businesses is around pumps. And really impressive number in Q4. Stepping back and thinking about that business, as we all know, it has had its challenges in the past as a category.

And I just look to get an update on how you feel you're positioned with the new business coming in from SIGMA with some of the new FDA actions and guidelines on cybersecurity and some of the competitor that have had problems with that sort of new category requirement.

How you're positioned going forward to help sort of mitigate the risks of other kinds of problems that you've had in the past as a group in pumps, not just Baxter, obviously..

Matt, this is Joe. I can only speak about the Baxter product. In terms of the industry, you outlined well. There's always a concern. But this is not only – the only programmable pump that you have in that category. You have (48:28) pumps, you have all kinds of different things that fall into that category.

But speaking specifically about our business, we have launched a really good product. And you can attest to – the testament to it is the sales growth and how we are gaining back market share and how that business is doing well. The team is executing very, very well. Our objective is to continue to improve the operation ability of the pump.

We have new versions coming up in a couple more years. We have two more versions of the same platform. We are very excited about the prospect to create some new features within this pump, and we think in terms of cybersecurity, our pump has performed well. You can't in this area always guarantee 100%.

We're doing the best we can to make sure that the platform we have is safe and secure for the clinicians who are programming it for the patients who are receiving the fluid..

That's great. Thank you..

Our next question comes from Larry Keusch with Raymond James. Your line is open..

Oh, hi. Good morning, everyone..

Morning, Larry..

Good morning. Joe, I'm wondering if we could start out perhaps just talking a little bit about how you see the health of the emerging markets as you look into 2016. And I'm not so much talking about FX rates, but just more about just the baseline fundamentals within the various regions..

Well, as you read the same headlines I do read, there is a contraction in some of the major – the larger emerging market economies. Very different in nature between China and Brazil and Russia, but nonetheless, we do 25% of our business in those regions.

I think one particular thing about our business is that we are not a physician preferred product in those regions, and we are a hospital necessity. So we're talking about infusion, we're talking about dialysis, and those products are needed.

So we have seen price pressure in those markets, but we probably saw that ahead of many people because of the nature of the products. So we feel that the risk of those markets for Baxter deteriorating further is pretty low.

With all that said, is our responsibility to look at our portfolio in those countries and make sure that we're selling the right products to the right markets. And we're going through that process as we speak. But in terms of the headlines for Baxter is those are necessity products in hospital settings, and we've seen most of the contraction already.

I'm not saying that we're not going to have them in the future, but we are not a physician preferred product company in those markets. So I feel very comfortable that our strategy at the moment is solid.

But going forward, rest assured we're going to look at every region and every country to make sure that the business we have are profitable and have good prospects going forward..

Okay. Terrific. And then I wanted to, Joe, perhaps get at again the growth question a little bit differently.

And I think in your prepared comments you talked about reigniting the innovation engine at Baxter, and so you talked about sort of reallocating resources to drive inorganic and you talked about potential – excuse me, organic means, and then potential organic opportunities.

But I guess as you've been there, and I know it's a short time, what do you really need to do to change, again, the ability of Baxter to innovate? Do you need to change the culture? Do you need to hire folks into these various categories to really drive the innovation? What needs to happen to get that engine ignited?.

So just a comment on how new I am. I can tell you I know where the cafeteria is because I eat there almost every day. So the culture of the company is one of innovation for many years.

I think by not having Baxalta as part of Baxter today really puts the spotlight how we take those franchise that have been trusted in a long-term franchises around the globe and make them more innovative, create adjacencies within our own capabilities, our four walls here for organic growth.

And the culture that I'm passing on to our employees is very clearly is about having a strategic direction, and that's about 10% of the conversation. 90% of the conversation is execution. So it's making sure that once we make the allocation of capital to the right programs, that our people deliver on time or better than that.

And that's all about execution. So that's what I'm watching very closely, because I think we have very, very smart people at Baxter. I'm not surprised, but I'm very pleased with what I found here, and I want the folks of Baxter to understand that from this point when we get this strategy going, it's all about execution.

And I think I have everybody behind me when it comes to that..

Okay. Terrific. Thanks very much for the comments..

Thank you..

Our next question comes from Joanne Wuensch with BMO Capital Markets. Your line is open..

Good morning, and nice quarter. And it's good to hear your voice on a conference call again, Joe..

Thank you..

Couple of things. First of all, we haven't heard in a while where you are on home hemodialysis and if you can give us an update on that, that would be great.

And then in no particular order, second question, is there a way to quantify the $600 million in FX – not FX, pension impact on gross margins? And last but not least, M&A clearly is going to be a theme here. Big picture thoughts on adding additional legs to the stool and how you think about that. Thank you..

Thanks, Joanne. How are you? Listen, I'm very, very excited about home hemodialysis, first of all. It is what I call blue ocean for the company. It is a great clinically needed innovation. It is not a easy market to get in because the technology has to be absolutely perfect for bringing this therapy to the home.

But we think we have the right technology and working very hard to refine technology. Right now we already have kicked off our U.S. clinical trial for VIVIA, and we're excited about that. In Europe, we have early patients and we're learning very quickly about our VIVIA platform, and the use of this device is proving to be well received in Europe.

So we like our technology. It is an area that I will call is a strategic bet and why is it strategic? Because it's high end market growth, potential for good revenue per patient, but more so the therapy itself is absolutely fantastic for the hemodialysis patient to be able to do this at home.

So we're going to continue to improve our technology, and we will try to put some momentum behind accelerating the U.S. trial as much as we can and work with the agencies and CMS and see if we can get this technology at a different level..

Joanne, you asked a question about pension and quantifying, and you commented on $600 million. I think – I hope I didn't say that. That's an overstatement in terms of the impact on operating margin. On plan, it's about 60 basis points, which is closer to $60 million of unplanned benefit.

But maybe taking a step back to talk about the overall impact of pension, overall we expect approximately a $0.14 benefit year-over-year from pension. $0.07 roughly of that relates to the retained stake contribution that we plan to make in the coming month or so. And then the remaining portion, there's a few different pieces.

First, the actual discount rate used to measure the liability has increased, and the result of that is approximately a $0.035 benefit. Second, as we've evaluated our accounting for our pension plan, we made three adjustments. One is we updated the mortality table that we're using.

The second is we are now employing the recently approved methodology for accounting for discount rate and that's a benefit. And then the return on asset assumption is an item that we've lowered. So those three accounting changes that we've made impact us positively by about $0.02. And then we have some amortized losses that are rolling off.

So that's about $0.01. So in combination, we're talking about a $0.14 year-over-year impact, and importantly this counteracts some of the negatives like the lack of sundry income that we experienced in 2016 along with the significant headwind on foreign exchange. But overall, the pension impact is in that order of magnitude..

Thanks. And the last question, add a leg of the stool..

We will continue to work on inorganic and organic areas. I would say to you that a leg of the stool may be just enhancing a franchise that we have. We spoke about IPS and very, very excited about that. I like our specialty injectable business today, and I think augmenting that can become a real good business.

And in terms of white space is a little early. We need to kind of get our capital allocation going well, and once we have that well segmented within our population and our management objectives then we can do a white space analysis, and we will proceed on going down that path.

But we really have enough opportunities right now to augment the current businesses. And their adjacencies as well. Thank you..

Thank you..

Our final question comes from Glenn Novarro with RBC Capital Markets. Your line is open..

One, in the fourth quarter, your surgical business grew low single digits and you said it grew in line with the market. And then for 2016, you're talking about the surgical business growing 3% to 4%.

So are you saying that you expect surgical volumes and utilization to pick up in 2016? Or are you just saying the better rates are more specific to Baxter? So any thoughts on utilization rates, especially the U.S. And then my second question has to do with the U.S. renal business specifically with PD.

I know PD did better in the fourth quarter that was some of your new products. But are you also seeing an increase in penetration in the U.S. with PD? Thanks..

Glenn, how are you?.

Good..

So, listen, the utilization that we see, I just want to clarify, the next year's growth is 2% to 3%, Right?.

For surgical care..

For surgical care. So the utilization remains at a good point in U.S. I would say the U.S. has shown really good resilience, and we're happy about that. There's a couple things about the surgical business, one that our anesthesia gases are performing very well, and we need to do a better job in our biosurgery business.

We're going to be coming up with some specific actions in terms of execution, but also how we're going to manage that business on a global basis, as well as that is an area that we probably should be looking to augment our portfolio. It's a great area of opportunity.

Baxter has fantastic franchises within that category, and we want to make sure we don't miss the opportunity to take advantage of the market growth. So speaking about the PD business, we are growing our patient basis. So that is market share growth.

And I'm going to tell you our new technology, new platform AMIA is fantastic, and we're having some really early successes and we're looking for a very good 2016 in that arena..

Okay. Great. Welcome back, Joe..

Thank you, Glenn..

Thank you. This will conclude....

Thank you....

Yeah, Stephanie, we'll conclude the call..

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