Good morning, ladies and gentlemen, and welcome to Baxter International's Third Quarter 2016 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, Candice. Good morning, and welcome to our third quarter 2016 earnings conference call. Joining me today are Joe Almeida, Baxter's Chairman and Chief Executive Officer, and Jay Saccaro, Baxter's Chief Financial Officer.

On the call this morning, we will be discussing Baxter's third quarter financial results and updated outlook for 2016 before taking your questions. I would just like to remind you that during the Q&A session, please ask just one question and one follow-up, so that we could accommodate others in the queue.

With that, let me start our prepared remarks by reminding everyone 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 details 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?.

portfolio innovation management, operational excellence, capital allocation. The results you have seen here today reflect the progress we have made across these three levers.

In portfolio and innovation management, we have selectively exited products from certain global markets when our presence and potential were no longer aligned with our go-forward strategy, while ensuring these markets continue to have alternate care options available for the patients.

We have also continued our candid assessment of legacy R&D, discontinuing several programs either in non-core areas or where our prospect did not merit projected resources and demands.

Choices like these are enabling us to refocus our investment on high-potential, high-value R&D and on a more strategic sales and marketing opportunities in biosurgery, PD nutrition, premixed injectables, and more. The third quarter was also a pivotal quarter in our cost transformation efforts.

In recent months, we have executed plans to rationalize our manufacturing footprint, including the closure or sale of a number of facilities in North America, Europe and Asia Pacific.

These actions will streamline and simplify our operations and better position us to manage costs while continuing to address patient and customer needs across the globe.

And earlier this month, we began a wave of organizational restructuring in our global commercial operations and certain other functions, which was the outcome of a rigorous zero-based organizational assessment.

This streamline is expected to generate a higher-performing organization along with cost savings that we contemplate in our May Investor Conference. Efforts like this work a leaner cost base, and again, the opportunity to channel investment in new ways.

Innovation is, of course, the most crucial ingredient in our ongoing success, and that you will continue to see capital allocation choices that reinvest in the business to bolster R&D as well as ongoing sustainable top line growth and margin expression.

And as you have heard me say repeatedly, we continue to evaluate business development opportunities in our core growth areas and high potential adjacencies. Any lack of news in this front should be interpreted as a sign of our discipline in assessing deals with strategic fit and financial merit.

So, in sum, our success this quarter represents significant progress on our strategic journey. And while we are pleased, we're not satisfied. We will continue to make progress on our journey to transform Baxter into a top quartile company. And with that, I will turn over to Jay who will walk you through the financials.

Then, we'll open it up for your questions..

Thanks, Joe, and good morning, everyone. As Joe mentioned, we're pleased with our third quarter results demonstrating continued progress towards achieving our long-term financial goals. Operationally, sales increased 4% in the quarter, and on a reported basis, sales grew 3%.

Growth came in at the high end of our expectations, driven primarily by favorability in PD and nutrition therapies.

Walking through the rest of the P&L, adjusted gross margin of 44.9% represents an improvement of more than 100 basis points over the prior year, driven by a positive sales mix, improved pricing in select areas of the portfolio, and favorable manufacturing performance in the quarter.

Adjusted SG&A totaled $611 million and decreased 9% on a reported basis. The primary driver of the improvement was our ongoing focus on controlling expenses and the benefit from lower pension expense. TSA income totaled approximately $25 million in the quarter compared to approximately $30 million in the third quarter of 2015.

TSA income from Shire will continue to decline as a need for these services ramps down, which is expected to be by mid-2017.

During the third quarter, we did report a charge of approximately $130 million for restructuring activities, of which approximately $100 million was related to employee termination costs which are expected to generate over $100 million of annual savings once fully implemented.

As Joe mentioned, these actions were initiated earlier this month and were contemplated in the long-term financial guidance we provided in May. We will continue to optimize our cost structure as we move forward. Adjusted R&D spending in the quarter of $129 million decreased 8% versus the prior year.

While we did benefit in the quarter from the discontinuation of selected programs, we expect to begin redeploying net spend in areas like biosurgery and premixed injectables beginning in the fourth quarter.

Adjusted operating margin in the quarter was 16% and compared favorably to our expectations, driven by positive product mix, lower R&D spend, and the benefit of our initiatives to control spending and reduce expenses. This represents a 480-basis-point improvement over the third quarter of 2015. Interest expense was $14 million in the quarter.

During the quarter, we took advantage of favorable market condition and executed a $1.6 billion, three-tranche debt offering consisting of 5, 10 and 30-year notes. Proceeds from this offering were used to retire a series of existing bonds maturing in the near to intermediate term as well as pay off all of our outstanding commercial paper.

As a result of this transaction, Baxter's bond maturity profile increased from an average of 9 years to 15 years, and our average coupon rate declined by nearly 1%. Adjusted other income totaled $4 million in the quarter, primarily resulting from a foreign exchange gain on a balance sheet position.

The adjusted tax rate was 22% for the quarter, slightly higher than expectations, driven by earnings mix. And as previously mentioned, adjusted earnings of $0.56 per diluted share exceeded our guidance of $0.43 to $0.45 per share.

Relative to the midpoint of our range, this favorability was driven by approximately $0.11 of operational strength and a $0.02 benefit from interest and other income. This was partially offset by approximately $0.01 due to a higher share count and tax rate.

Along with our equity-for-equity exchange, which we executed in the latter part of the second quarter, during the third quarter, we opportunistically repurchased $40 million or approximately 1 million shares during the quarter.

These repurchases were more than offset by higher-than-expected option-related dilution, given Baxter's stock performance during the quarter. 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 now expect 2016 full-year sales for Baxter to increase approximately 4%. And after adjusting for the U.S. cyclophosphamide impact, we expect underlying operational growth of approximately 5%. On a reported basis including the impact of foreign exchange, we expect sales to increase approximately 2%.

We expect growth in the Hospital Products business of 3% to 4%, or approximately 5% excluding U.S. cyclophosphamide. Within the Hospital Products franchises, we expect sales growth of low double digits for Fluid Systems, driven by continued strength in the U.S. business.

For the Integrated Pharmacy Solutions franchise, we expect sales to decline versus the prior year including the impact of U.S. cyclophosphamide. We have adjusted our full-year sales forecast for cyclo and now expect full-year sales of $210 million with the assumption that no additional competitors enter the market during the fourth quarter of 2016.

After adjusting for cyclophosphamide, sales are expected to increase 2% to 3% in IPS or 4% to 5% excluding the impact of both cyclo and PROTOPAM. Within the Surgical Care franchise, we anticipate sales to grow approximately 1%. And finally, for the Hospital Products business, we now expect BPS and other to increase low single digits.

For the Renal business, we now expect full-year sales to increase 4% to 5%, driven by continued growth in our PD and acute businesses, offset by lower sales in our in-center HD business. Moving down the P&L, we now expect an operating margin of approximately 13%.

A 100-basis point improvement versus our previous guidance and a 200-basis-point improvement relative to our original guidance. This increase is driven by improved sales and ongoing disciplined management of expenses. We expect interest expense to total approximately $70 million.

For 2016, we expect other income of approximately $55 million, which does reflect a benefit of approximately $10 million in the fourth quarter related to the disposition of an equity investment. For the year, we now expect an average adjusted tax rate of approximately 21%, driven by the expected mix of earnings.

For full-year 2016, we anticipate an average share count of 550 million shares. Based on these factors, we now expect 2016 adjusted earnings, excluding special items, of $1.88 to $1.91 per diluted share as compared to our previous guidance of $1.69 to $1.74 per diluted share.

Finally, for the year, we expect operating cash flow of approximately $1.45 billion and CapEx of approximately $800 million, resulting in approximately $650 million in free cash flow. This represents an increase of 30% from our original guidance of $500 million.

We're applying the same discipline to managing capital expenditures as we are to our expense base, which has resulted in a benefit of approximately $100 million in lower CapEx for the year. In addition, we have initiated programs focused on improving our days payable and days receivable ratios which will benefit operating cash flow going forward.

Specific to the fourth quarter of 2016, we expect sales growth to increase approximately 2% on both a reported and constant currency basis. The growth does represent the deceleration from previous quarters, given our previously announced decision to exit select markets outside the U.S.

The collective impact of these exits impacts the top line by approximately 1 percentage point. In addition, lower cyclo sales compared to the prior year also negatively impact the top line by approximately 1 percentage point in the quarter.

Adjusting for these two factors, growth in the quarter would be approximately 4%, which is in line with our long-term projections. And we expect adjusted earnings excluding special items of $0.49 to $0.52 per diluted share. This guidance reflects increased investment in R&D and incremental investments in SG&A.

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

Thank you. So that we may be respectful of everyone's time, please limit your comments to one question with one follow-up question, if necessary. We appreciate everyone's patience and would like to provide as many of you as possible the opportunity to ask a question. We'll pause for a moment while the list is being compiled.

I would like to remind participants that this call is being recorded and a digital replay will be available on the Baxter International website for 60 days at www.baxter.com. And our first question comes from David Lewis of Morgan Stanley. Your line is now open..

Good morning. Just two quick questions. One on margins and one on CapEx. So, maybe just starting with margins for a second. Just, if I think about the fourth quarter, Jay, I think your guidance of $0.49 to $0.52 kind of implies something around 14% margins.

So, two things, what would drive that depression sort of sequentially? And obviously, if you do 16% here in the third quarter versus your sort of 14% to 15% outlook for 2018, how are you feeling about those long-term margin targets, so fourth quarter and obviously the 2018 outlook? And then, I've quick follow-up..

Great. Good morning, David. So, as far as the fourth quarter goes, overall, we were obviously very pleased with the margin performance in the third quarter. So, 16% represents the highest quarterly margin target that we've achieved since the spin-off.

As we move to Q4, we do expect a slight downtick in the operating margin of the business, and really there is a couple of drivers to that. One is we are going to be accelerating some R&D investments in both biosurgery and premixed injectables, as I mentioned. So, that will be one factor that increases the R&D spending relative to our current level.

And then, the second item relates to SG&A. We do expect a slight uptick as well in SG&A in the fourth quarter as a percent of sales. There's a couple of factors going on there. One is we do have historic seasonality.

So, if you look at Baxter over the last many years, we normally have an uptick in spending in the fourth quarter, we do expect that to repeat. And then, the second factor that's going on with respect to SG&A is one of the topics we discussed in our May Investor Conference relates to what we call local initiatives.

The idea that given the diverse geographic portfolio that we have in place and the product portfolio, we really have a tremendous opportunity to accelerate growth by unlocking some of the entrepreneurial spirit outside the U.S. but frankly, that comes with it an SG&A cost.

And so, over the course of the last quarter, we have approved a number of investment initiatives which we believe will benefit 2017 and 2018, but do have a slight cost associated with them. So, for these reasons, we do expect a slight downtick as it relates to the overall margin, but again, feel very confident in the operational performance.

As we look to 2017, I think it's too early to get into forecast for 2017. What I can tell you is, in our May Investor Conference, we shared a series of projections for 2018 and 2020.

And it is clear, the data points that we have point to accelerated performance relative to those expectations, so we have a higher level of confidence in our ability to achieve those numbers and exceed those numbers today than we did when we shared them in May of 2016..

Okay, Jay, very, very helpful. And just one quick follow-up. I think, for me, you hinted this last quarter about the cash flow numbers here, specifically CapEx guidance was fairly kind of remarkable. So, can you help us understand what's driving an $800 million number? I think you gave us $750 million number as the long-term target.

So, that's sort of materially, sort of ahead of plan. How much of that is timing? Or does $800 million represent sort of the new normal as we cycle into 2017? Thanks..

Sure. One of the numbers I think the team is most proud of is the free cash flow performance. As I mentioned in the script, we're increasing it from $500 million to $650 million. And really, there's a couple of different components to that.

One is operating cash flow, we're raising approximately $50 million, and this is an area where I believe there will be more substantial benefits from some of the programs that we've initiated this year in future years. So, we're spending a lot of time as a team on working capital, days payable, days sales outstanding, and inventory.

How can we drive that down? And those are balances that you don't switch on overnight, but over time with rigor and focus, you can drive a real result in these categories. So, we don't really have much benefit this year but 2017, 2018, 2019, you'll expect to see some meaningful working capital improvements.

Where we were able to drive an impact this year, and frankly I believe this will be sustainable, is in CapEx. We did a couple things this year which I think provided a very real benefit. First, we did a zero-based budget for CapEx, which we review quarterly with our senior leadership teams.

So, our top executives at the company sit down on a quarterly basis and the result of that is twofold. One, we did cancel a number of low value-adding programs; but second, for every single program that we had, the challenge to the team was how can we do this more cost effectively. And the results were very, very impressive.

So, the second piece relates to an incentive change that we put into place at the beginning of the year. For our top employees, we have a short-term incentive plan for the top several thousand employees. And last year, there was no cash flow component to this.

This year, recognizing the challenge that we face with CapEx being 9% of sales, we installed a free cash flow trigger for our short-term incentive plan. By focusing on free cash flow now, we have our entire organization geared and charging towards driving improvements in this important metric.

So, while that's harder to quantify, I believe that that's paid a real dividend in our numbers and creativity as we think about addressing CapEx spending. But frankly, this is one area where I believe we've achieved a new normal and will continue to drive performance from here..

I'd just like to add one component to Jay's great answer, is that this is a sustainable level of capital. So, this is not one-year conversation.

We have changed how we look at capital, how we invest in different places in the world, and also our new technologies, our point-of-care which is solution making on demand, and also how we service emerging markets with on-demand manufacturing of solutions for 100 to 120 patients will change how structurally we seek capital..

Great. Thanks, guys..

Thank you..

Thank you. And our next question comes from Matt Taylor of Barclays. Your line is now open..

Hi. Thanks for taking the question. I wanted to just touch again on the margins and talk a little bit about some of the components that are contributing to the good leverage that you saw in SG&A and gross margin.

Could you just articulate what you've sort of done and seen in the plan so far, and then the initiatives that are yet to be really tapped that we could see leverage from in 2018 and beyond?.

Sure. Yeah. Clearly, this was a fabulous quarter for our operating margin, and I would say it was – contributing to it were gross margin, SG&A leverage and some R&D leverage. From a gross margin standpoint, let's start with that. There were a number of factors in play.

We've talked a lot about this concept of portfolio management and business mix and upgrading the business mix. And as we look at the Q3 results from Baxter, you start to see that story playing out. So, for example, we saw very strong performance in our U.S. Hospital business in the sets area and access.

Our sets in the United States grew approximately 20%. That simple business mix factor contributed to our margin, and as we increased the installed base in the United States of SIGMA SPECTRUM, we'll continue to benefit from this mix factor as it moves forward. From an international standpoint, you'll see that we had lower Fluid System sales.

But in areas like Renal, in particular, where we had double-digit acute growth and PD growth where we've been very focused on accelerating growth, those are two good margin areas that provided uplift from a business mix standpoint.

And finally, from a business mix standpoint, you heard Joe comment earlier in this call about how we're going to manage in-center HD for profitability, very focused on driving this. So, while that business had lower sales, it had a business mix and from our standpoint, focus on profitability.

Those are three examples from a gross margin standpoint where business mix played an impact. The second comment related to gross margin is manufacturing and performance. Overall, we had solid manufacturing performance. We had good volumes in Q2 and Q3. The result of that is a P&L benefit from a manufacturing standpoint.

We'll expect to continue driving manufacturing performance going forward, this is a real area of focus for us. How can we effectively utilize our facilities? In Joe's prepared remarks, you heard him referenced, we've closed or sold a number of facilities over the course of this year, that leads to better leveraging of the network.

The final piece related to gross margin is this idea of how can we think creatively about our business arrangements, either through pricing or being thoughtful about the services that we provide. A simple example of this is we're really focused in our U.S. Renal business on limiting the amount of overnight shipping that occurs.

For us, that has historically been a real cost that we've borne, and it's impacted our margin. By focusing on that, we're able to drive a better margin. So, those are the three drivers that have impacted our gross margin. Moving to R&D, we made a couple of tough decisions over the course of this year with respect to project, a project like VIVIA.

And so, as a result of that, we saw a lower R&D spending in the quarter. Now to my earlier comment, I do expect an uptick in this as we start to reinvest in some exciting new areas for us that have nearer-term paybacks than the VIVIA project. But in the quarter, this idea of rigorous capital allocation did play out in the R&D spend.

And then finally, from the SG&A standpoint, I would make a couple of comments here. First, this idea of zero-based spending, challenging every single dollar that we have in place, that's something that the company has adopted from a process standpoint.

So, as we went through our budgeting process this year, we had a very rigorous zero-based spending approach, a zero-based organization approach in place applying these techniques to our cost structure. But I think beyond that, culturally, the entire organization is incredibly aware of spending and driving results.

The number of ideas that we're generating from our organization at large, with respect to the simplification, with respect to savings ideas, is remarkable. And that simple phenomena has played out in our SG&A numbers for the quarter..

Thanks. Maybe just one follow-up. You've had a lot of momentum in the pumps.

Can you talk a little bit about how durable that could be as you continue to kind of gain back share there, and whether that's going to create any headwind for you in 2017 as you try to grow over these strong placed (33:43) numbers?.

We had a very good performance in SPECTRUM since its launch about a year ago. We gain market share. We're back to number two position in the market. And clearly, that was a very rapid penetration. We don't see the same rate of penetration going forward, but we continue to see us gaining market share in this large volume pump market in the U.S.

We're also very committed to this pump business and technology, and we will be continuing to invest resources in developing not only the portfolio for the U.S. but also for outside the U.S.

But to the point of comparables, we are coming to the point we are anniversarying our pump launch, so clearly we cannot expect this business to continue to deliver growth in the 20-plus percent every quarter..

Great. Thanks for the comment..

Thank you. And our next question comes from Vijay Kumar of Evercore. Your line is open..

Hey, guys, congrats on a great quarter. Maybe one near-term and one medium-term question. Obviously, phenomenal 3Q numbers.

When you look at the fourth quarter numbers, right, an organic of 2%, that's a sequential decel, I'm just going to – what kind of cycle assumptions do we have? Can you just give some clarity on the top line, please?.

Yes. So, overall, there is essentially two drivers of the deceleration in the fourth quarter. One is cyclo. While we don't – we're not anticipating an incremental competitor in cyclophosphamide, we do expect lower levels than prior year. It's down about $20 million or roughly 1 point of growth, to $45 million in the quarter.

So, that's a deceleration that we've expected and kind of consistent with how we thought about things.

As we look at the other area that has impacted our Q4 result, we have always talked about this idea of rigorously going through our portfolio and ensuring that every single sale that we make is one that contributes positively to the economics of Baxter.

And so, in support of that, we did walk away from roughly $130 million in sales on an annual basis, which amounts to roughly 1 point of growth impact in the quarter. Now, the good news is this has limited to no impact on the bottom line. The sales were essentially breakeven, and we've been able to eliminate all the costs associated with those sales.

So, while on the bottom line there's no impact, it does impact the top line a bit. If I were to adjust for these two factors, the 2% growth would be more like our normal expected run rate growth of 4%..

Great, Jay. And then, maybe a quick follow-up on – sticking to the theme of top line. And I guess one of the feedback we get from investors is, look, I mean the company has – they've done a phenomenal job on the cost side, on the margins and EPS growth.

At the end of this – the products, there's always – it's hard to model a company when you have so many SKUs.

What gives you the confidence that Baxter could be 4% to 5%, when you look at the next two to three years, can you talk about when we can annualize some of the in-center HD business on the Renal side and some of these growth initiatives can kick in? Thank you..

Vijay, this is our challenge, and I think we are on our way to create that environment. First thing we did was completely reallocate capital. If I showed today to you the dollars invested by franchising the company versus 12 months ago, you'll see a significant difference.

We are doubling down in areas like biosurgery, it's going to take us a couple of years to pick up momentum there because we fell behind in a lot of different things, but we are looking at some M&A augmentation for the short term. We also are doubling down in the PD business, the peritoneal dialysis business.

I have great confidence that we're going to unveil a very different model of doing business in some parts of the world.

We're working with payers at this moment, and I think that will be a very interesting way of expanding the use of PD, which has proven to be, economically and from the access point of view, a better way forward for the patient and for the system. And with SHARESOURCE, we're going to continue to invest there.

I see us very focused on the M&A area associated with organic growth in our generic injectable business. We think we have a platform opportunity at the moment, plus our internal growth engines in terms of new molecules, which we're accelerating. So, all of this gives me the confidence that we can achieve 4% to 5% in a couple of years.

I tell you, we are trimming our portfolio. We're removing a significant amount of unprofitable dollars, which will boost our 2017 bottom line, but cleaning up the portfolio and simplifying Baxter is also part of the playbook.

So, the playbook is innovation, really good capital allocation practices, use our capital dollars in the way that was different in the past. As you can see, our free cash flow numbers will allow us to generate more profitability for the company.

And lastly, when we talk about transformation, it's not just cost reduction and reduction of personnel, but is also the complete restructuring of the company in terms of its processes. Baxter grew up to be a very complicated company with a lot of SKUs, and we're working very hard to the Office of the Business Transformation to redo that.

So, that accumulation of factors give us pretty good odds of hitting the numbers, we just need to continue forth with a lot of tenacity to achieve what we set forth to do..

Thank you. And our next question comes from Mike Weinstein, JPMorgan. Your line is now open..

Thank you. Good morning, and congrats as well on the quarter. Jay, I wanted to just clarify, in the footnotes on some of the charges that were taken this quarter. It talks about $25 million of costs to implement business optimization programs, and that includes consultants and employees' salaries.

So, just maybe walk through why are those costs backed out of adjusted earnings?.

Yeah, I mean. Look, Mike, there are a couple of major programs, kind of onetime programs that we have ongoing which we don't expect to be permanent costs in place. And so, for example, we have a, what we call, our Project Touchstone which is related to the implementation of a global business service center.

It really is not part of our ongoing operations. We do not have the expertise to do this ourselves. So, we have brought in some consultants to assist in this process, and we have some employees dedicated to this process – to the project, I should say.

At some point, once implementation is complete, those costs will all go away and they will benefit future periods, not current period. So, that's just one example of a number of programs that we have in place which are not really a part of our ordinary operations, which we've chosen to special out..

Got you. Maybe I should go to (42:07) Joe on this.

Joe, if I think about the pushback I hear from people just kind of on how the story has evolved here, it really revolves around just the idea that the success the company is seeing is almost like a playbook of what we'd saw earlier from spec pharma companies where they took some otherwise mature, older products, raised some prices and cut some costs.

And that drove a rise in profitability in the short-term.

How do you evolve the story from being one of growth and earnings growth off of the instant price increasing and cost cutting at the front end to one that's a more sustainable top and bottom line story?.

Mike, we don't have the portfolio of a spec pharma company. So, our playbook is not quite the same. Do we have....

Yeah, I did say – I said the comments are really focused on the price increases in the Fluid Systems and the PD businesses..

So, I was going to add that our pricing to date is slightly over 1.1% of our growth. So, it's a fraction of the overall growth. Do we have price increases? We do have price increases like many companies. But its sustainability, what I see in the long term, is neutral to a slight positive on pricing. So, I want to make that very clear.

The other thing is how do you sustain that top line with transforming the gross margin contribution in participating markets that have higher growth rates than our current one is using the playbook we're using today.

So, going into premixed and going into perhaps the manufacturing of very difficult to make KPIs, give us gross margins much, much different than we current today have in terms of average for the company. So, we will double down on that.

So, Jay's comments in the very beginning about redeploying of R&D in the fourth quarter is actually doubling down in all the programs that we have in bringing new molecules to premixed using our capability of, we call, the GALAXY.

Looking into adjacencies and doubling the amount of R&D in biosurgery is another sustainable way of being in this business. Creating local initiatives that we are and right now we have more than probably 70 local initiatives in all countries. Remember, Baxter is 60% outside U.S.

sales, and we had put in place a franchise system as a company that completely took away the ability of our local and regional businesses to operate a little bit more independent.

And we have great opportunities and we totaled (45:18) significant amount of money in the next three to four years that will sustain our top line, revamping our R&D organization to be more focused by business than focus in overall company.

So, there's significant amount of things we're doing that are not related directly to price, but eventually plays a role in pricing because your mix will be different if products have higher margin and will change the profile of the company. It's not an easy thing to do, but we're working very hard to do it right.

Hence, one of the things that we haven't rushed into doing was acquiring companies, we want to make sure that we have the discipline to acquire the companies, where it matters and be strategically accretive to our business..

Understood. Thanks, Joe..

Thank you. And our next question comes from Bob Hopkins of Bank of America. Your line is now open..

Hi, thank you very much.

Can you hear me okay?.

Yes, we can, Bob..

Great. Congratulations on a great margin performance. So, I wanted to focus both of my questions on the margin performance. And Joe, maybe I'll start with you, and then a question for Jay to follow up. So, Joe, I was just wondering if you could kind of characterize the outperformance on margins from a big picture perspective.

What I'm curious about is how much of this outperformance is basically pull-forward of margin opportunities that you anticipated in the long-range plan, versus finding new areas of savings that were not originally anticipated in the LRP? So, I'm just kind of curious how much of this is pull-forward versus finding new opportunities..

Well, Bob, you answered 50% of your own question. We got accelerated programs in place, and we're getting faster results on our zero-based organization, zero-based budget and zero-based spending, okay, so we pull things forward. But we also have come across a significant amount of opportunities that we initially did not anticipate.

So, I see us building a lot of confidence in probably over achieving our targets, and I say that with no hesitation. I would say also that there is a portion of our restructuring that is more complex, which is the outsourcing and labor arbitration that is involved in changing our back-office profile.

But based in what I did in my past and looking at what we're doing today, there is a vast difference in our approach, and I truly believe that our people will be able to do what we set forth to do at the savings that we've set or even better. So, things are coming together very well.

One thing I want to give credit to Baxter and the Baxter management and Baxter employees is once we set our compass to the right direction here, they really execute very quickly, I was surprised how much momentum we got out of simplification and savings.

So, the folks of our company have done a phenomenal job embracing this change, and those are not easy changes to make. So, in summary, we are happy with the result and satisfied by the way. And it does give us confidence that probably we will over achieve on our long-range plan targets..

Thank you for that. I appreciate that. And then, Jay, a little more short-term oriented question around the fourth quarter guidance. You characterized the fourth quarter margin guidance as a slight downtick from Q3, but unless I'm doing my math wrong, it looks like operating margins will come down 200 basis points to 300 basis points in Q4 versus Q3.

So, I guess I'm just curious, one, do I have my math right? And two, were there any onetimers in Q3 in that 16% or is that a clean number? And then, maybe if you could just talk a little bit more about the increase in spending in R&D from Q3 to Q4. Thank you..

Yeah, I mean, look, 16%, great quarter, we were really happy with it. The full year, we expect, to be around 13%. And so, while there weren't onetimers in place, we do expect to see a, what I call, downtick, you call 200 basis points to 300 basis points of deterioration in the fourth quarter, which I think is fair.

And as I said, there's a couple of factors, right? It's probably split roughly evenly between R&D and SG&A. From an R&D standpoint, one of the areas we really want to accelerate and we recognize investments today will yield dividends in a couple years relates to biosurgery. So, we've started to accelerate spending there.

There were a number of programs that will begin in earnest in the fourth quarter that will facilitate that. And then to Joe's comment earlier, this point-of-care, another very exciting development for us. It's got a lot of benefits for the patients. It's a great program for us.

It also allows us to run a capital-light model relative to the historic way of delivering PD solutions to patients. So, very exciting developments, but they have a cost associated with them. We do expect to see that impact on margin by 1 point roughly. And then, SG&A, it's maybe a little bit more than that. For us, Q3 was a low level of SG&A spending.

The Q4 number, we're expecting to move back up to roughly the Q2 level. We would historically expect to see a Q4 uptick. Q3 is typically a lower SG&A spend quarter in part because of the August month, which is a holiday in many parts of the world. So, for us, we're being prudent and thinking about an uptick in spending to occur in the fourth quarter.

But then to the last point, we've got to accelerate the top line. That is a clear charge of our entire company and that takes some investment as well. We have empowered our international organization to begin spending on a number of initiatives. There's no impact on the sales line related to these of note in 2016.

But these investments will start to pay dividends and self fund in 2017 and 2018. So, very exciting development there. Good investments to make. We track and monitor these investments on a monthly and quarterly basis, but in combination, these elements lead to a deterioration, slight deterioration from this 16% level.

Having said all of that, to Joe's point, we shared some projections in May of 2016, for margin in 2018, we said 14% to 15%; in 2020, we said 17% to 18%. We have a higher likelihood of over achieving those numbers as we sit here today. That's clear..

Very helpful. Thanks, guys..

Thank you. And our next question comes from Brooks West of Piper Jaffray. Your line is now open..

Hi. Thanks.

Can you hear me?.

Yes. Hi, Brooks..

Great. Good morning. So, I had a question, trying to tease out organic growth opportunities more on the Hospital Products side of the business, and I'm specifically looking at the difference in performance between the U.S. and international businesses.

So, Jay, I wonder, can you – do you have a sense for the underlying growth rate if you back out either the product lines or the geographies that you're exiting in that business? And then secondly, if you look at organic growth opportunities within Hospital Products, can you talk about even just getting the entire portfolio approved in all geographies, can you help us understand kind of the organic growth opportunity within, and I guess I'm thinking more injectables and nutrition? That's question number one..

Yeah, sure. Look, the overall Hospital business – as far as the exits that took place, it actually was slightly tilted towards Renal. So, we looked at the India business, we made some decisions related to IVs and PD. In Turkey, we looked at our clinics business along with the IV business there.

But on balance, I would say slightly more of an impact in Renal than it was in the Hospital business. And to be clear, we've had outstanding performance in the U.S. Hospital business, right? The 6% growth has been quite good, and internationally the growth is below that.

And so, you ask a great question which is, how do we accelerate growth outside the U.S.? The U.S. has benefited from a number of factors which are not quite present internationally. We've had the benefit of a new product launch, the SIGMA SPECTRUM pump.

We've had very solid performance coming from our nutrition business, and we've seen sort of adequate performance coming out of our Surgical Care business. But the real standout performance comes from the U.S. Fluid Systems business.

Outside the U.S., we have not had the benefit of a product launch like we've had in the U.S., and so for us, how do we address some new products perhaps from a business development standpoint outside the U.S., for example, in the Fluid Systems business? That's a real challenge and opportunity for us as we look to accelerate performance outside the U.S.

In addition, our nutrition business, which in the quarter in the United States grew in double digits, grew in low single digits outside the U.S.

And so, for us, another real area of focus has been accelerating the nutrition performance outside the U.S., and that will continue to be an area where we'll invest some of the investment initiatives are targeting nutrition growth outside the U.S. So, those are a few of the factors.

I mean it's kind of a difficult question to answer in a sense that it really is multi-product, multi-geography but it's safe to say that accelerating performance – Renal outside the U.S. has seen outstanding performance. 5% for the quarter, that was a very solid performance for us.

Accelerating the Hospital outside the United States becomes a core area of focus for us, in particular, as we move to 2017..

That's helpful. And then, I guess as a follow-up, you've talked about M&A but really haven't pulled the trigger on anything yet.

And I know Joe mentioned earlier some of that is internal timing, but can you talk about the barriers that you see to doing M&A? I mean, is it scarcity of assets? Is it pricing? What's the opportunity and what's really holding you back from pulling the trigger? Thanks..

We have targets that are probably in the number of between 10 and 15 that we have in front of us at any given time. So, it's not a scarcity of targets. And now, we have a strategy that is driving our seeking companies and seeking businesses and technologies. So now, we have the right construct here which is a strategy-driving M&A.

We are extremely disciplined when it comes to how we look at our shareholders money. And the ability to drive value is fundamentally important to us. So, at the moment, we are looking at three specific targets that we think have good value for the company. The competition sometimes is irrational about how people are paying for some of the targets.

And we don't go there. We don't want to be part of that group. We want to make sure that everything that we pay for has a way of paying back to the company and to the shareholders. So, we are very diligent. I meet with the team every month, every other week we've got updates. We just hired our new head of M&A.

He started with us about a week and a half ago. Very talented. We'll not – I want our investors to understand that we are very focused on that, but we will never forget our responsibility in managing our shareholders' money. We don't see it is as our money, it's our shareholders'.

So, we're going to make sure that investments we make are very well thought out. I also challenge our team internally to think a little broader when people look at acquisitions and make sure that we understand all the value is being captured. So, this has been a learning curve for Baxter.

We have not done that in the past and I think it is a good practice. So, as we get more mature, we're probably going to see some things happening in the future..

That's helpful. Thanks, guys..

Thank you..

Thank you. And our final question comes from the line of Larry Biegelsen of Wells Fargo. Your line is now open..

Good morning. Thanks for taking the question. I heard the comment earlier about getting to 4% to 5% growth in a couple of years, but I just wanted to focus first on 2017.

Can you talk about some of the headwinds and tailwinds investors should think about? We estimate that cyclo and exiting low-margin sales could be about a 200-basis-point headwind next year. Are in the right ballpark? And the 2016 to 2018 sales CAGR you provided at the May Investor Meeting was 3% to 4%, I believe.

Is there any reason why you can't do 3% to 4% in 2017? And I did have one follow-up. Thanks..

We're not going to talk about 2017 today. What I want to tell you is that we will remove sales from the top line, which are unprofitable today. And that is our responsibility. So, we do have the long-term objective of growing the business and the underlying business will grow 3% to 4%. The thing is, we will need to remove some sales.

We're doing business in locations that we should not be doing business. We've been there for a long time but has not panned out to be a good business. And the worst thing that we can have is to keep a business afloat that is on the marginal contribution is eroding value to the company.

So, we will take the measures that we want to take and make sure that anything that we do will have the intentions of making the company stronger in the future. So, for us, to deliver our bottom line, we will have to take some of this business off line, and I have no problems with that.

But at the same time, we are very focused in investing in the right R&D programs to be able to create the momentum to bring the top line to the 3% to 4%, eventually 4% to 5%.

So, this is our job, number one right now is to work on top line growth, but we will revamp and repurpose our portfolio, so we are not here sitting three, four years from today with massive unwanted businesses that we should have taken action before..

Very clear, Joe. Just a follow-up on capital allocation. You've talked about bringing your net debt-to-EBITDA level to about 2 times in the next couple of years.

Is there any timeline on when you expect to be at 2 times? And how do you strike the balance between waiting for the right deal to come along versus returning cash to shareholders via share repurchases? Thanks for taking the questions..

Thank you. We're very happy with our progress on free cash flow. And we see with better management of our capital, we will see probably a better performance than we have spoken to our investors back in May. With that said, it gives us a good ability to deploy this capital in acquisitions. So, we will have not a timeline fixed to get to a 2.0 times.

We will get there when we get there. I tell you, it can be in one shot. It can be in several shots.

But we are really focused in bringing our balance sheet to a place that we can either do two things, choose to deliver capital to our shareholders in form of buyback, and I think that is a very possible avenue, combined with a healthy M&A strategy because we are very happy with how our free cash flow and our capital spending is progressing..

Thanks for taking the questions..

Ladies and gentlemen, this concludes today's conference with Baxter International. Thank you for your participation, and have a great day..