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Baxter International Inc. (NYSE:BAX)

Q2 2014 Earnings Results Conference Call

July 17, 2014; 08:30 AM ET

Executives

Bob Parkinson - Chairman & Chief Executive Officer

Ludwig Hantson - President, BioScience

Bob Hombach - Chief Financial Officer

Mary Kay Ladone - Corporate Vice President, Investor Relations

Analysts

Derrick Sung - Sanford Bernstein

Larry Keusch - Raymond James

David Lewis - Morgan Stanley

David Roman - Goldman Sachs

Mike Weinstein - JPMorgan

Kristen Stewart - Deutsche Bank

Bruce Nudell - Credit Suisse

Rick Wise - Stifel Nicolaus

Operator

Good morning ladies and gentlemen and welcome to Baxter International’s, second quarter earnings conference call. Your lines will remain in a listen-only mode until the question-and-answer segment of today’s call (Operator 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. Mary Kay Ladone, Corporate Vice President, Investor Relations at Baxter International. Ms. Ladone, you may begin.

Mary Kay Ladone

Thanks Pam. Good morning everyone and welcome to our Q2, 2014 earnings conference call. Joining me today are Bob Parkinson, CEO and Chairman of Baxter International; Ludwig Hantson, President, BioScience; and Bob Hombach, Chief Financial Officer.

Before we get started, let me remind you that this presentation, including comments regarding our financial outlook, new product developments and regulatory matters contain 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 detailed concerning factors that could cause actual results to differ materially.

In addition, in 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 Bob Parkinson.

Bob Parkinson

Thanks Mary Kay. Good morning. Thank you all for calling in. As you all saw in the press release issued earlier this morning, Baxter reported strong financial results for the second quarter, which exceeded expectations and we’ve confirmed our full year 2014 outlook.

Adjusted earnings increased 5% to $1.26 per diluted share and worldwide sales advanced 16%. Excluding Gambro and foreign currency, Baxter’s sales rose 5%, driven by solid growth across our global franchises.

Positive momentum continues to build and Baxter is off to a strong start in 2014. We’re driving solid performance across our entire business portfolio in advancing care in both developed and emerging markets. This provides a strong foundation to build upon as we improve our competitive position, enhance operational, commercial and scientific effectiveness, continue to meet challenges posed by the global marketplace and regulatory environment and create value for patients, healthcare providers and other key stakeholders. I continue to be confident in our prospects for the long term and believe we are well positioned for sustained performance and success.

Our strong results reflect our strategic focus on improving access to care, as we broaden our global presence and advance the new product pipeline through both internal development and collaborations. During the quarter we announced an array of pipeline achievements and approvals; advanced R&D collaborations with our partners and made progress towards the separation into two leading healthcare companies.

First within the bioscience business, we continue to build upon our global leadership position in Hemophilia that is evidenced by a number of recent achievements, including European regulatory approval of a new manufacturing facility in Singapore for the production of recombinant proteins including ADVATE and BAX 855 upon regulatory approval.

Baxter was granted multi-year awards for ADVATE in the U.K. and in Australia, where ADVATE was named the preferred recombinant factor VIII treatment. Baxter recently received regulatory approvals for ADVATE in Turkey and Russia, supporting efforts to increase access to recombinant treatments in emerging markets. With these approvals, ADVATE is now approved in 62 countries worldwide.

In addition the FDA granted approval for the BAXJECT III reconstitution system, which reduces the number of steps in the reconstitution process for patients and caregivers and we recently received European approval for myPKFiT, which is a new web-based individualized dosing device for prophylactic treatment. This device allows physicians to calculate personalized ADVATE treatment regiments based on patient information and individual pharmacokinetic profiles.

Lastly, we’ve now completed dosing for all patients in the Phase III clinical trial for BAX 855. To-date we have no reports of inhibitors or drug related serious adverse events. We look forward to sharing the top line data in the third quarter and continue to expect to file in the U.S. before the end of the year.

In addition to our internal R&D accomplishments, we are collaborating with partners on advancing R&D programs in new disease areas with high unmet medical needs, which capitalize on our core technical capabilities, expertise and global channels.

Progress to highlight includes first, initiation of two Phase III trials for an investigational etanercept biosimilar in rheumatoid arthritis and chronic plaque psoriasis by our partner Coherus BioSciences. As you know, Baxter has obtained exclusive commercial rights for Europe, Canada, Brazil and certain other markets.

Second, the announcement by our partners CTI BioPharma, on the completion of enrollment in its PERSIST-1 pivotal trial of pacritinib, a novel oral JAK2/FLT3 inhibitor for patients with myelofibrosis, a chronic malignant bone marrow disorder. This is the first of two Phase III trials required to support regulatory approval.

PERSIST-2 began earlier this year and is evaluating patients with low platelet counts for whom no viable treatment exists today. CTI and Baxter will jointly commercialize pacritinib in the U.S. and Baxter has been granted exclusive rights for all indications outside the U.S.

And finally, we continue to augment our portfolio with acquisitions like Chatham Therapeutics, which we announced last quarter, and AesRx which we announced just last week. AesRx is a private U.S. biopharmaceutical company, focusing on sickle cell disease with its development program Aes-103. This investigational oral prophylactic treatment has clearly been evaluated in a Phase II clinical trial and has the potential to address an extremely high unmet clinical need in a community with inadequate treatment options and no recent major clinical advancements.

Moving on to medical products business, the recent highlights include the presentation of data at a European Renal conference supporting the safely and efficacy of the VIVIA hemodialysis system. As you know, the VIVIA system completed CE marking in Europe late last year, and is currently being introduced on a limited basis in 2014.

In the U.S. we continue to engage in productive dialog with the FDA regarding the design of our final clinical trial supporting a nocturnal indication and we are working towards initiating this trial before the end of the year. In addition Baxter received 510-K clearance from the FDA for our next generation SIGMA Spectrum Infusion Pump, offering an option for wireless connectivity and integration of data into hospitals electronic medical record.

Before I turn the call over to Bob to review our financial results and outlook for the remainder of the year, I’d like to take a moment to outline the progress we are making to create two separate independent global healthcare companies.

First as you know, we’ve named Bob Hombach, Chief Financial Officer of the new biopharmaceutical company and Jay Saccaro, Chief Financial Officer of Baxter International, following completion of the transaction. I’ve had the pleasure of working directly with Bob and Jay for many years and I’m confident that both businesses are positioned for future success given their deep knowledge of these businesses, financial expertise and their leadership qualities.

In addition, last week we announced the appointment of Dr. John Orloff as Vice President and Global Head of R&D for Baxter BioScience. Dr. Orloff will be responsible for advancing the late stage bioscience pipeline, enhancing the current R&D operating model and pursuing additional innovative opportunities for the business. Dr. Orloff joins Bioscience from Merck Serono Pharmaceuticals, where he served as Global Head of Clinical Development.

We continue to work diligently to prepare the organization for the spinoff and expect to announce additional senior leadership appointments in the coming months. In addition we are currently targeting the filing of a preliminary Form-10 with the SEC before the end of the year. We’re planning to host an Investor Conference in New York in the second quarter of 2015 to provide details on both companies, and we expect to finalize the transaction by mid 2015.

As always, I’d be happy to address questions on this or any topic during the Q&A this morning, but with that I’ll now turn the call over to Bob.

Bob Hombach

Thanks Bob, and good morning everyone. As Bob mentioned, adjusted earnings per diluted share in the second quarter advanced 5% to $1.26, which exceeded our previously issued guidance range of $1.18 to $1.22 per share. This over achievement can primarily be attributed to strong sales across several franchises, including cyclophosphamide in the absence of any new competition and the favorable timing of a large (inaudible) shipment originally scheduled for the third quarter. These items each drove favorability versus our guidance of approximately $0.02 per diluted share respectively.

As we mentioned in the press release, GAAP earnings of $0.95 per diluted share included net special items totaling $172 million or $0.31 per diluted share, primarily for intangible amortization and costs associated with contingent revenue and product development milestone payments, remediation efforts related to the in-progress SPECTRUM Infusion Pump recall, integration of the company’s acquisition of Gambro, and Baxter’s planned separation into two independent healthcare companies. These charges were partially offset by the reversal of certain business optimization and litigation reserves.

Now let me briefly walk you through the P&L by line item before turning to the financial outlook for 2014. Starting with sales, worldwide sales of approximately $4.3 billion advanced 16% on both a reported and constant currency basis, driven by solid growth across our global franchises. This performance exceeded our sales growth guidance range of 12% to 13%. Excluding Gambro revenues of $408 million, Baxter sales rose 5% on a constant currency basis.

In terms of individual business performance, Global Bioscience sales exceeded $1.7 billion and advanced 7% in the second quarter. On a constant currency basis sales increased 6%. Within the product categories, haemophilia sales of $904 million increased 6% on both the reported and constant currency basis.

We continue to capitalize on our global leadership position and brand differentiation. New product launches including the new fiber prophylactic indication and Rixubis for the treatment of Haemophilia B, and increased penetration of recombinant therapies, particularly in emerging markets.

Specifically global demand for ADVATE remains very strong, resulting in double digit growth for the quarter and year-to-date. This reflects the positive patient experience with our brands and ongoing benefits derived from our prophylactic label expansion, augmented by shipments to Brazil as part of our ongoing collaboration with Hemobras to advance access to recombinant factor VIII therapy. To-date we have converted more than 35% of the 10,000 Haemophilia A patients in Brazil and continue to expect to generate sales of more than $100 million in 2014.

In addition, global demand for fiber remains robust. We are benefiting from the new prophylactic indication in the U.S., where we generated double digit growth this quarter and we recently received approval in Canada, Australia and Japan. As you may recall, only 15% to 20% of inhibitor patients globally are treated prophylactically, presenting a significant long term growth opportunity for our Haemophilia franchise.

In biotherapeutics, sales of $548 million increased 7% on a reported basis and increased 6% on a constant currency basis. This reflects sequential improvement driven by enhanced product availability and growth of immunoglobulin therapies, albumin and alpha-1 treatments.

Consistent with last quarter, the U.S. sales increased 7%, while international sales were up 4%.International growth was marked by improved growth for immunoglobulin therapies and albumin, as we’ve resumed albumin shipments to China. While the U.S. growth may moderate in the second half of the year due to tough comparisons, we expect international growth to accelerate on a sequential basis in the third and fourth quarters.

In BioSurgery, sales totaled $189 million and increased 6%. On a constant currency basis sales rose 5%, driven by increased penetration for surgical sealants like TISSEEL and FLOSEAL, particularly outside the U.S. As you know, growth of these products is tied directly to grow in surgical procedures, which remains very modest.

Finally, vaccine revenues totaled $110 million and increased 12%. Sales grew 6% on a constant currency basis, driven primarily by strong sales of the FSME vaccine, which was partially offset by lower milestone payments related to government collaborations for the development of influenza vaccines.

In medical products, global sales of more than $2.5 billion increased 24% on both a reported and constant currency basis. Excluding Gambro, medical product sales grew 4% on a constant currency basis.

Within the product categories, renal sales totaled $1 billion, which includes the contribution from Gambro of $408 million. Excluding Gambro, renal sales of $636 million declined 3% or 1% on a constant currency basis as expected.

PD patient gains in the U.S. have never been stronger, driving U.S. PD growth of 15%. However this was more than offset by lower international sales, which were impacted by the timing of certain tenders which we discussed last quarter, and the divestiture of the CRRT business. Excluding these items which totaled approximately $40 million, global renal sales increased approximately 4%.

Sales in the fluid system category of $816 million increased 8% on a reported and constant currency basis. Performance continues to be driven by favorable demand and pricing for IV solutions and other injectables, particularly for cyclophosphamide.

As you may know, to-date we have not experienced any new competition for cyclo and we’ve updated our full year guidance to reflect our new assumption. On the year-to-date basis, the U.S. cyclophosphamide sales totaled approximately $225 million.

Specialty pharmaceuticals, which includes our inhaled anesthetics and nutritional therapies posted sales of $404 million, reflecting an increase of 10%. Sales rose 9% on a constant currency basis, driven primarily by increased penetration of Suprane in markets outside the U.S. and high single digit growth of our global nutrition franchise.

Finally, sales in BioPharma Solutions, which is our pharma partnering business totaled $249 million and declined 3% on a reported basis or 4% on a constant currency basis. Performance can be attributed primarily to the timing of shipments and lower third party demand, which was partially offset by strong pharmacy compounding revenues.

Turning to the rest of the P&L, gross margin in the quarter was 50.7% compared to 53.0% last year. Margin expansion in the base Baxter business resulting from mixed benefits was more than offset by the impact of the lower margin Gambro business and foreign currency, which collectably reduced the rate by approximately 250 basis points.

SG&A totaled $961 million and increased 18% with the Gambro acquisition accounting for the vast majority of the growth. Excluding Gambro SG&A increased 4%, as leverage close to arise from benefits associated with our business optimization initiatives. This was partially offset by select investments and promotional end marketing initiatives for new product launches and with the international market to enhance our global presence, and the incremental expedited freight charges to support the strong demand we are seeing in the U.S. medical products business.

R&D spending in the quarter of $292 million increased 15% versus the prior year. Excluding Gambro R&D spending rose 2%. We continue to advance the new product pipeline and accelerate investments in a number of areas, including programs in our leading hemophilia franchise, those leveraging our expertise in the therapeutic areas of hematology, oncology and immunology and investments in renal therapies aimed at improving patient outcomes across the continuum of care.

The operating margin in the quarter of 20.3% is lower than last year’s operating margin of 23.8%. Excluding Gambro, the operating margin with 23.5% as positive mix was offset by foreign currency and investments in SG&A and R&D. Interest expense was $42 million in the second quarter, which reflects debt issuances to fund both the Gambro acquisition and the Covington plasma manufacturing site.

Other income totaled $70 million, driven primarily by the favorable foreign exchange impact on balance sheet positions. The tax rate was 21.8% for the quarter, in line with our expectations and as previously mentioned adjusted earnings per diluted share advanced 5% to $1.26.

For the first half of 2014, cash flow from operations was strong and totaled approximately $1.2 billion, reflecting an improvement versus last year. DSO ended the quarter as 56.7 days and excluding Gambro, Baxter’s DSO was 53 days, slightly lower than the prior year.

Inventory turns of 2.2 are comparable to the prior year period and lastly in the first half of the year we repurchased approximately 6.4 million shares for $450 million dollars or on a net basis, 2 million shares for $218 million, in line with our full year objective.

Finally, let me conclude my comments this morning by providing our financial outlook for the third quarter and full year 2014. For the full year, we now expect adjusted earnings of $5.10 to $5.20 per diluted share. We continue to provide a wider guidance range than our historical practice, as the number of factors and assumptions impact the outlook in the second half for the year, particularly potential headwinds related to cyclophosphamide competition in foreign currency.

As mentioned earlier, we have updated our assumptions for cyclophosphamide competition. While this has resulted in a transitory benefit, it also provides the opportunity to accelerate investments that will better position both BioScience and the medical products businesses for sustained success going forward.

For the full year the cyclo benefit is currently estimated to be more than $0.20 per diluted share. This benefit will largely be offset by incremental investments we are making across the portfolio, and by absorbing a foreign currency impact of almost $0.25 per diluted share in 2014, which is approximately $0.10 per share higher than our original expectations.

Specifically by line under the P&L, starting with sales, we now expect sales growth, excluding the impact of foreign currency of approximately 10% to 11%, which includes annual sales of more than $1.6 billion for Gambro. At current foreign exchange rates, we expect reported sales growth of approximately 9% to 10%. Excluding Gambro, we expect the base Baxter business to grow approximately 3% on a constant currency basis.

For the full year we continue to expect gross margin for the company to decline by approximately 150 basis points from the 2013 margin of 52%. Positive sales mix in the base Baxter business is more than offset by Gambro and the full year foreign currency impact of approximately 100 basis points.

In terms of expenses, we continue to invest and support the elevated level of sales reflected in our guidance, as well as accelerated spending in sales and marketing to support new product launches and R&D investments, primarily related to recent business development activity within BioScience, while making incremental investments in our medical products operations to enhance our operational effectiveness. As a result, we now expect R&D and SG&A to grow in high single digits for the full year, representing an increase of approximately $200 million versus our original 2014 expectations. This includes an incremental impact from foreign currency of approximately $50 million dollars.

We expect interest expense to total approximately $160 million, and we now expect other income of approximately $70 million for the full year, the vast majority of which has already been recognized in the first half of the year. We expect a tax rate of approximately 21.5% and we expect a full year average share count of approximately 547 million shares, which assumes approximately 300 million in net share repurchases.

From a cash flow perspective, we continue to expect to generate cash flow from operations of approximately $3.5 billion, which excludes the cash cost associated with the spin-off of the biopharmaceuticals business. We expect capital expenditures of approximately $1.8 billion, which includes Gambro and the investments we are making to enhance our plasma manufacturing footprint in Covington, Georgia.

Let me move to sales and expand on our assumptions for the two businesses and the major product categories. Beginning with medical products, on a constant currency basis, including the contribution of Gambro, we now expect sales growth of approximately 14% to 15%. Excluding Gambro, we expect sales for medical products to grow 1% to 2%. Specifically we expect renal sales to grow approximately 40%, including the benefit of continued PD penetration, and the incremental revenue contribution from Gambro.

We now expect Fluid Systems sales to be flat to up 2%, reflecting a benefit of approximately $150 million relative to our original guidance. We are now assuming that we experience competition for cyclophosphamide later this year, reducing sales by approximately $50 million to $75 million compared to sales in the second half of 2013. We continue to expect specialty pharmaceutical sales, which includes our nutritional therapies and inhaled anesthetics to grow in the 3% to 5% range and we expect our BioPharma solution sales to be flat for the full year.

For BioScience, we are also raising our guidance and now project sales growth excluding foreign currency of 4% to 5%. Our outlook includes sales growth in our global hemophilia franchise of 5% to 6%. While we continue to expect increased competition for recombinant factor VIII therapies in the second half of this year, performance will be fueled by underlying global demand for ADVATE, convergent to recombinant therapy in Brazil, new tender awards and continued benefits from new product launches, including RIXUBIS and FEIBA prophylaxis.

For the BioTherapeutics franchise, we continue to expect growth of approximately 4%, with sales of immunoglobulin therapies and albumin in China ramping up in the second half of the year.

And finally for our BioSurgery and vaccine businesses, we now expect growth in the low to mid single-digits.

As mentioned in our press release, for the third quarter we expect earnings per diluted share excluding special items of $1.28 to $1.32. We expect sales growth excluding the impact of foreign currency of 12% to 13%. Excluding Gambro, we expect the base Baxter sales at constant currency rates to grow approximately 4% to 5%.

Thanks. I’ll now open up the call for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). I would like to remind participants that this call is being recorded and a digital replay will be available on Baxter International’s website for 30 days at www.baxter.com.

Our first question comes from Derrick Sung of Sanford Bernstein. Your line is now opened.

Derrick Sung - Sanford Bernstein

Hi, Good morning. Thank you for taking my questions and congratulations on a strong quarter. I wanted to get right to kind of the key [controversies] [ph] surrounding the stock right now, which is the sustainability of your hemophilia franchise. You’ve raised hemophilia guidance for the back half of this year. At the same time you are starting to see the competition now coming from the longer acting factor VIII.

Just wondering if you could kind of comment on, is that hemophilia guidance raise coming from kind of the confidence in sustainability of your ADVATE franchise in the face of competition or is it coming more from some of these other growth drivers that you mentioned. Just give us a little bit more color on how you’re thinking about that business moving forward? Thank you.

Bob Parkinson

Bob and Ludwig, you want to respond to Derrick’s questions.

Ludwig Hantson

Sure. Hi Derrick, this is Ludwig. So overall we are very pleased with our hemophilia performance. As Bob was saying, we are increasing our sales guidance. I think the confidence is coming from different angles. First of all we feel that our ADVATE gold standard position is a strong position and that we believe that we will be able to continue to grow our ADVATE position through different factors.

In addition to that we have new products coming in, we have RIXUBIS. In addition to that the fiber prophy indication is also a strong growth driver. In addition to that we have geographical expansion playing a role. So overall we feel good about the guidance that we gave you and we believe it’s coming from different angles here.

Derrick Sung - Sanford Bernstein

Could you perhaps give us, quantify a little bit more for us the opportunity from the recent OUS tender wins and the launches in Russia and Turkey of ADVATE, as well as maybe Bob, if you can give us a sense for how much Brazil is contributing this quarter?

Bob Parkinson

Sure Derrick. The tender wins in Australia and the U.K., we really will start ramping up activity here in the back half of 2014. So relative to our expectations and we did have a good line of sight on one of those two to begin with, so relative to our expectations, not much of an incremental contribution here in 2014.

But as we move into ‘15 and beyond, these are multi-year tender awards and I think position us to significantly increase our market share in the U.K. where it had gotten down to below 10% at one point here and as you know we were completely out of the Australian market and now we have the preferred position. So we’ve not specifically quantified that opportunity at this point, but for both of them, it will be a meaningful opportunity to grow internationally and a key franchise for us.

As it relates to Brazil, as I’ve mentioned before, we are going to experience some lumpiness here as we continue to ramp-up conversion and continue to open up the opportunity for different segments within Brazil, and so again we are projecting more than $100 million of sales here. The contribution in the second quarter was fairly modest. We do expect that to ramp up throughout the course of the back-half of this year, so more than half of that $100 million is going to happen in the back-half.

Derrick Sung - Sanford Bernstein

May be one final follow-up to Ludwig’s comments. Ludwig can you may be just give us a little bit more detail now that the Biogen longer acting is in the market and that you’ve seen the label. Could you just may be give us a little bit more detail on sort of your expectations for the impact from that versus what you were thinking before as you’ve seen the label and any additional color on the early progress of their launch and how you’re specifically detailing against that competition? Thank you.

Ludwig Hantson

Yes Derrick, I think that their label is not much differentiated from the ADVATE label. If you look at the ADVATE label, it has very strong annual bleed rate data in there which is unsurpassed, and which is still from a patient perspective the most important thing. We also have individualized PK in our label. We have every three day dosing in the label and when you look at the use of ADVATE, our ADVATE prophy patients are on an every three day or longer dosing regimen already.

And so the data that we’ve shared with all of you are survey data that comes from patients and healthcare providers, tells us that yes the interest of the community is there for a longer acting. The definition of a longer acting for hemophilia A is one per week or longer dosing regimen.

So our expectation is the same as the guidance that we gave you and that is we expect a single digit impact on our ADVATE to market share till 855 comes on board. Bob talked about the fact that we’ve completed the enrollment, we completed all the assessments, we are on track to share 855 data with you third quarter and we are still on track for a submission by the end of this year.

Operator

Thank you. Our next question comes from Larry Keusch of Raymond James. Your line is now open.

Larry Keusch - Raymond James

Yes hi, good morning. For Bob Hombach and then I have one for Bob Parkinson. Just again, I just want to want to make sure I’m understanding the cyclo updated guidance. So are you saying now that you obviously haven’t seen any competition yet and now you’re thinking later in this year and on top of that I think you had been initially anticipating about a $0.25 impact. Are you now saying it’s $0.20? Again, I just want to make sure I’m getting that all correct.

Bob Hombach

We are now expecting competition to enter late Q3 to early Q4. We had previously guided to a potential negative impact of $0.20 to $0.30 that we baked into our initial guidance and from that initial guidance we are saying that’s going to get a little bit more than $0.20 better. So we are going to have improvements relative to our expectation around cyclo. Our original expectation is a little more than $0.20.

Larry Keusch - Raymond James

Okay, and then you mentioned the investments that you’re going to make against that, so how do we sort of think about the net impact of all of this.

Bob Hombach

Well, the net impact is as you know we didn’t change our overall guidance. So I talked a little bit about a pretty significant ongoing currency head-wind that we’re incurring here of an incremental $0.10 to our expectation as well, so that’s largely half of it. The rest of it relates to incremental investments that we’re making and as you know, we did a couple of business development deals here recently in gene therapy for haemophilia A, as well as an acquisition for sickle cell anemia treatment.

Those are going to come with R&D burns with them and so that is going to ramp up our R&D spend. That and a few other things, about $50 million for the rest of this year and then we’re making internal investments to support numerous new product launches, primarily in BioScience and SG&A. Those two make up the bulk of the difference between the $0.20 benefit from cyclo and the $0.10 downside related to FX.

Larry Keusch - Raymond James

Got you. And then I guess for Bob and may be for Ludwig, obviously post the Medtronic and Covidien deal and some of these other ones that are getting announced, clearly scale is something that seems to be dramatic out there. You guys obviously are going to innately get smaller with the spin off. So, I’m wonder if you could sort of discuss a little bit about how you guys think in the individual businesses, the needs to get better and to get bigger and sort of perhaps the strategy behind that.

Bob Parkinson

Let me make some, may be some general comments for both businesses and then more specifically regarding new BAX and if Ludwig wants to comment on new bio going forward. Stating the obvious, we are consumed right now with activities associated with the spin. So it’s not about -- at this stage thinking about getting bigger, it’s about really moving forward to executive effectively the spin.

Of course one of the strategic motivations behind the decision itself was to increase the focus in both businesses. I can tell you from the new BAX perspective if you will, we feel there is significant opportunities to grow earnings at a faster rate than sales as a result of a number of things, but one of which is to your question, I think aggressively managing portfolio, whether that’s business product, geographic portfolio and so on and I think you can anticipate post-spin activity in that regards.

That also sets the stage then, I think to be proactive in term the acquisitions and so on to kind of reshape if you will the portfolio that comprises the new Baxter going forward. But again, those are the things we’re evaluating right now, but not spending a lot of time on given the focus of the energy slurries is really on the spin.

Ludwig, I don’t know, from a new bio perspective if you want to add anything to that. I think probably it describes the intention of your organization right now as well.

Ludwig Hantson

Correct. I think the question is not, how do we bigger here. I think the question is finding the right opportunity within the disease area that we are focusing on, which is immunology and hematology, oncology. And I think the question, can we make the difference in the patients’ life and how can we bring value.

Bob Parkinson

Yes, I think that’s a great summary, in fact. I think you said it’s not about getting bigger at this stages, it’s about getting better and the spin, and its heart was really about intensifying the focus in each of the businesses so that we can be better, both from an innovation point of view, as well as how we launch and commercialize our products and manage the portfolios in both business. So the question of getting bigger is something we always think about, but I would tell you right now, it’s not really front burner.

Operator

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

David Lewis - Morgan Stanley

Good morning. Bob Hombach, I just want to come back to the margins here for a second. I understand the discretionary spending in the back half of the year, but it’s released the second quarter. Were some of these discretionary spending items present in the second quarter, because obviously we would expect a little more up-side here in the second quarter, relative to our expectations, given the very strong revenue.

And then Bob, some of the things you described are discretionary in nature in the back half of the year. How much do those carry forward into next year, because some of these you described are more base line spending on some of the new JV initiatives and some I imagine you can modulate pretty good heading into ’15. So if you can give us a sense of whether these items are kind of ’14 discretionary or linger into ’15 and then I have a quick follow-up.

Bob Hombach

Okay. Yes, as it relates to second quarter, there was a fairly significant impact of gross margins. We did see some incremental SG&A, not so much in R&D yet. As I mentioned the two new acquisitions really are just going to start impacting BioScience from our R&D run rate perspective in the second half of this year.

But from a gross margin perspective, the impact was pretty significant in the second quarter, primarily from FX, and the driver there really is the euro and as you know, as we’ve talked about in the past, given our global footprint, we have significant sales in Europe in the base Baxter business. Gambro had more than 50% of their sales in Western Europe as well. So that actually increased our exposure on the sales line, which is a good thing.

But on the cost side, historically we’ve been able to mute most of Euro fluctuations at the gross margin line through a combination of our manufacturing footprint and financial hedging that we do. But as we’ve added Gambro into the mix, Gambro actually has a disproportionate amount of their manufacturing footprint in Europe and so their cost relative to revenue was much higher in Europe.

So in fact the very strong Euro that we saw in the second quarter was a pretty meaningful negative to gross margin, because sales were higher related to the FX translation. But costs were even higher and so there’s pretty meaningful gross margin impact as we mentioned between that and Gambro, a 250 basis point negative on gross margin. So the lack of drop during the second quarter more is related to gross margin, primarily FX and less to do with these incremental investments, which again are primarily back half.

And then as it relates to discretionary, clearly the R&D run rate for those two acquisitions is going to be their going forward. The SG&A and new product launches, those certainly can be modulated and that’s what we are doing now. We do have a platter of new products to position in the market over the next six to 12 months and we are going to make sure we make the right investment there, but we do have a bit more flexibility on that.

David Lewis - Morgan Stanley

Okay, helpful, thanks Bob. And then Bob Parkinson, just as you think about the spin heading into next year, obviously one of the biggest drivers of the medical products business will still be Gambro and then the broader Renal franchise. So maybe you can give us an update here over the last six months. Where do you think you stand as it relates to the organic growth profile you expected at Gambro? There’s capacity coming back on line and some of the cost opportunities that you saw. How would you give us sort of a summation of where Gambro sits across some of those metrics? Thank You.

Bon Parkinson

Sure Dave. I would say first of all, at a high level we are tracking very well with the original expectations. More specifically in terms of the cost synergies, again tracking just may be a little bit behind in the short term, but longer term we feel that the target we communicated to you is more than achievable.

Encouraging earlier returns, I think on commercial synergies. So when you look at the size of the business, in terms of revenue what’s becoming increasingly evident is the way to really monitor and this business is more broadly what we call Baxter Gambro Renal now, because we are seeing in the market place the expectation that the full complement of products would lever the legacy Baxter businesses, Peritoneal Dialysis and obviously home haemo going forward. In fact, if you look at our total Renal business revenue growth continues to perform very well and so in that sense, in terms of the revenue line, we continue to be very optimistic that we will achieve, if not exceed the original expectations.

Having said that, on the legacy Gambro business, we continue to focus on ramping up capacity specifically in the dialyzer area, which is going to continue to be a challenge over the next year or two. Simply stated there’s more demand right now than our ability to deliver. You know some of the historical issues that the previous owners of Gambro were dealing with in that regard and so on. But we are moving forward to expand capacity. Our two primary dialyzer facilities in Hessiga, Germany and Opelika, Alabama, and it’s just a matter of time before we get that capacity ramped up, so that we can accelerate the growth of the dialyzer business.

The acute business in the hospital is growing very nicely and the monitor business, we are pleased with how the monitor business is performing, specifically some of the reliability improvements and so on. So without getting more granular, I would say again back where I stated at a high level, things are tracking very nicely with our expectations.

Operator

Thank You. Our next question comes from David Roman of Goldman Sachs. Your line is now opened.

David Roman - Goldman Sachs

Thank You. Good Morning everybody. I wanted to start with, I think the announcement was, it was yesterday and you highlighted it today on the call, the initiation to the Phase III trials in an Etanercept. May be you could just talk a little bit more about what you see the U.S. regulatory pathway being for your biosimilar program and how we should sort of expect that to unfold over the next couple of years.

Ludwig Hantson

Hi David, it’s Ludwig. I think as you said, its evolving and I don’t think everybody has the answers here. But for us it’s critical that this is an opportunity to create access to these molecules. We are building a portfolio. We believe that a portfolio approach for us is critical, so we are building this portfolio and at this moment we have three molecules; one vertigo here and then there’s two with Momenta.

I think there is an opportunity within the regulatory pathway to go for interchangeability. Of course that’s going to depend on finalizing those regulations, as well as what are the product characteristics. So we believe that we are in a strong situation, at least with one of the approaches that we have to shoot for interchangeability.

I think you’ve seen that some of those, at least one of molecules is in Phase III. The other molecules continue to advance in the development. So stay tuned, we’ll know more as we move forward here.

Mary Kay Ladone

And David, specifically related to Etanercept, remember we have OUS rights in Europe and several markets outside the U.S., so it’s not a product that we will have the rights for in the U.S.

David Roman - Goldman Sachs

Got it, thank you. And then just a follow-up may be to Bob Parkinson’s comment. I think in response to one of the earlier questions about leverage in the business and you did reference the potential for the remaining Baxter International to generate revenue growth and earning with earning growth pacing at a faster rate. Could you maybe just talk about the opportunity set there, because one of the things that stands out to us, at least when I look at your quarterly or annual filings, is the extent its current medical product margin sits below peers and I assume we’ll see more in the From 10. But maybe you sort of just preview for us some of the opportunities that exist there to close the gap in your mid products margin versus peers that has the potential to drive the outsized earnings growth for some period of time.

Bob Parkinson

Sure David. Well first of all, kind of at a high level, everybody focuses on the creating of the BioScience spin off at the new public company, but I will tell you, our mindset is we are creating two new companies here. The spinoff of BioScience provides the legacy Baxter business, which as you know I will run going forward. I think an opportunity to reevaluate anything and everything that we do and I think that’s really healthy and that’s the mindset that we are embracing.

First of all, I think intensifying focus on higher margin growth areas, product categories like anesthesia, parenteral nutrition, certainly the BioSurgery business, which while we’ve developed that market very nicely in the U.S., it continuous to be very undeveloped in many markets outside the U.S.

Also infusion pumps. With the approval of the SIGMA Spectrum a month or so ago and the anticipated launch later this year with that, it’s going to put us in a position to play offence in infusion pumps for the first time really in many years. If you look at the margin accretion opportunity over the next five years or so in the infusion pump business for us to regain the share that we lost over the years in the U.S. due to the calling situation, and then be able to expand outside the U.S. there’s probably $0.30, $0.35 of EPS equivalent associated with margin accretion opportunities just in the infusion pump area. So anesthesia, nutrition, infusion pump, BioSurgery, all higher margin areas will benefit from intensified focus and as I mentioned, infusion pumps benefiting from now the ability to play offense with the recent approval.

I commented earlier then on the opportunities in terms of portfolio and I think that there is significant opportunities to evaluate. As an example, core businesses like IV’s. In certain markets the IV business where we can bundle with the contract that includes the disposable sets, the infusion pumps, the secondary, the mini bags, the pre-mixes and so on, continues to be a very attractive business from a return on investment.

In certain markets in IV’s where we’re contracting separately for IV’s, these are largely international markets, I think we really need to be more aggressive in terms of evaluating what is the sustainable value of these businesses, and so that’s the kind of example from a portfolio, geographic in that sense. The kind of things that I think we will be much more proactive in.

I also think in terms of this new mindset and I’m challenging the organization to evaluative, really new paradigms in a lot of different areas. This recent IV shortage in the U.S. I think has sensitized a lot of people to the value of these products; products that largely have been taken for granted historically, which are essential to saving and sustaining lives and I described it as always the best deal in healthcare, to be able of pay for half a liter or a liter of IV at lower price than a bottle of water at Seven-Eleven, that kind of puts it in perspective and I think there’s opportunity there in terms of taking prices up and really getting value commensurate with the value that those products serve clinically and so on.

So I’ll stop there. I would just tell you, I’m very excited to really lead this new organization and I think focus on those areas for margin accretion that exists. So this will be a subject we’ll talk a lot about in the coming months and certainly post-spin as we crystallize more specifically, but there’s fertile ground here I believe, to support my earlier comment about being able to drive earnings growth at a much faster rate than revenue growth in this new business.

Operator

Thank you. Our next question comes from Mike Weinstein of JPMorgan. Your line is now opened.

Mike Weinstein - JPMorgan

Thank you for taking the questions. First one, Bob Hombach, when you had the late March call to announce the separation, it sounded like you still had a fair amount of work to do to put some numbers behind the separation costs. Have you had any additional work done on what you think the dilution from the spin will be; meaning really, for you guys will be all the incremental overhead that will have to be created, and I think you said at that time you didn't expect any tax leakage. So has there been any change there? Thanks.

Bob Hombach

Yes, and no change on the view on tax leakage as I mentioned. I think transactionally we as create legal entities and move assets and people in various countries around the world, there may be small amount which will call out as separate special items, but in terms of ongoing tax rate for the two businesses, no change in prior view. Nothing significant we see for either business here at this stage.

As it relates to synergy, we’re certainly working diligently internally to estimate what gross synergies are going to be and then how we’re going to go about mitigating them, how much before the spin occurs and how we will be able to get out the cost position over the first year or two. Again, we’re not seeing anything significant or different than what our consultants would say the benchmarks look like, so nothing has popped up and no red flags from what I said before that I think we are largely going to be in line with the type of operational, this synergy you’ve seen from other spin-offs.

I would say though that our international footprint, which represents 60% of our sales on an annual basis, we are very integrated, it will be very complicated to separate the two businesses, but I think as we create a new biopharmaceutical company in an international framework, we’ll be able to do that in a fairly streamlined way. So again, there may be a little bit of extra dilution on day one related to international, but nothing significant.

Mike Weinstein - JPMorgan

Okay. And then can you give us an update on maybe – well, it maybe two items. One, you haven't talked about recently the plans for the vaccine business. Has there been any progress there? And then two, we've got the [IQVU] (ph) panel coming up at the end of the month. Can you set expectations for what we'll see that will be new in the panel pack, and how you expect the language from the FDA to read in the panel pack? Thanks.

Bob Parkinson

Bob, you want to handle the vaccines and…

Bob Hombach

Yes, certainly. As we mentioned earlier this year, we did take the strategic decision to look at, first a couple of development programs within R&D, particularly flu and our line program and see if those would be better served to be partnered or divested and we also were open potentially to our two inline vaccines to divesting those as well, depending on the preference of the partner.

So we’ve gone through a process, talked to a lot of different interested parties and that process is ongoing, so not appropriate to comment further now. We are very focused on optimizing the value of the overall vaccine portfolio and as we make progress, we’ll certainly share that as appropriate, so still working on it, but nothing to update at the moment.

Ludwig Hantson

With respect to the [IQVU] (ph) panel scheduled for July 31, the team is getting ready for the interaction, the dialogue. No new questions. It’s still the same as we discussed, the four questions or the questions related to long term safety of the antibodies related to a pH20 and specifically neuronal development in fertility, so nothing new there.

I’m very pleased that you will be able to see all our data and we believe that our data is clean and that we have a positive benefit risk, but as you will be there most likely, we’ll have a great dialogue with the FDA.

Mike Weinstein - JPMorgan

Thank you Ludwig.

Operator

Thank you. Our next question comes from Rick Wise of Stifel Nicolaus. Your line is now opened.

Rick Wise - Stifel Nicolaus

Good morning Bob, how are you doing?

Bob Parkinson

Hi.

Rick Wise - Stifel Nicolaus

Bigger picture first. You're clearly investing heavily on the biosciences side pre-spin, seemingly on the surface a little less though in medical devices, although obviously Gambro is a big investment that you're integrating. So definitely you're actively supplementing biopharma ahead of the spin.

Should we expect that Medical Product business development opportunities could come before the spin too or are you going to focus on that post-spin? And maybe just as part of that, as long as I'm laying it all out here, it sounds like you're interested in M&A. What areas are you likely to be thinking about? Something directly related to the existing business or broadening the scope of the post-spin med device company? Thanks.

Bob Parkinson

Okay Rick, thanks for the questions, several things. Yes, I mean obviously when Gambro is the largest acquisition in the history of the company, so that really expresses an investment I guess in the new batch, but I think may be what is under appreciated is much is in the R&D area. The nature of the investments have been really in new systems; home hemodialysis, the VIVIA system, which we’re really excited about has been a five year investment. Likewise the AMIA system which is our next generation home choice and so on. So those don’t jump out in the way that our bio pharmaceutical investments do, but we have been making meaningful investments in internal R&A, those being just a couple of examples.

Relative to business development activity going forward, I mean we continue to be open to that, despite as you say, and we all know our primary focus is the spin. I’m not suggesting we won’t do anything, but if we do, it will be of the smaller nature.

Longer term, look we think there continue to be opportunities within the two core areas, which are the treatment of end stage renal disease, as well as the hospital channel. With the movement of the BioSurgery business over to the new Baxter going forward, very few companies can represent the breadth and diversity of products that are sold in the acute care hospital and so from an acquisition business development point of view going forward, that will continue to be I think a major area of focus to further solidify the channel.

I’m not sure what percent of all healthcare dollars are either spent or driven through the acute care channel, but it’s a very high percentage and as I say, very few companies have a strong over presence in platform from a channel perspective there as we do. So I think it’s fair to say, at a very high level that will drive our business development, including acquisition efforts going forward.

Ludwig Hantson

And Rick, I would just point out that I did mention in my prepared comments that in addition to the SG&A and R&D investments, we are making investments in operations within medical products. We’re seeing very strong demand, particularly in the U.S. for IV’s and PD and we’re seeing the regulatory environment raising the bar on everything from production through logistics, so there are incremental investments going in to that as well.

Rick Wise - Stifel Nicolaus

Right, and just to follow up quickly on renal, Bob Hombach as you said, PD gains are very strong in the quarter, up 15% in the U.S. Is that kind of growth sustainable? May be help us understand that and help us understand a little bit more about the timing issues OUS. I mean, do they swing back positive in the second half? It didn’t happen in the second quarter, but now they have happened. I’m not sure I fully understood what was going on there. Thank you.

Bob Parkinson

Well, let me, Rick I’ll comment on kind of what I’ll call the market trends and then if Bob wants to add some color in terms of specifically the financial flow and so on, he can do that. It’s fair to say that globally, not just the U.S. but globally there is a movement in tumor treatment in the home, okay, whether that’s peritoneal dialysis or over time home hemodialysis and you see a number of countries, Thailand being one, Taiwan being another.

In the case of Thailand, what they called PD first, which says, look as we provide access to treatment of in-stage renal disease, the government policy is going to drive treatment in home. There is this general feeling that its lower cost, it certainly is greater convenience for patients and in some cases and we believe very strongly in terms of home hemodialysis we are going to be able to demonstrate advancing clinical outcomes in a terms in a meaning full way, such as life expectancy and so on.

So when you see the same dynamics going on in the U.S. and so in response to the first part of question Rick, yes I think the strength that we’re seeing in the U.S. market for PD, clearly is going to continue. I think it’s driven by kind of a rebalancing of the reimbursements, so now there are economic incentives for the providers to be in PD and ways in the past there were not and then of course with our launch over time of a home hemodialysis, I think it further accelerated to grow.

So simply stated in the U.S., I think the strength you’re seeing is not a transient effect. I think it’s a representation of some more longer-term environmental trends and give us confidence that that kind of growth is sustainable.

Bob you want to comment maybe more specifically on the numbers part of it.

Bob Hombach

Yes, so as it relates to PD patients in the U.S., I mean we’ve seen a pretty consistent trend over the last five or six quarters of high single digit, low double digit PD patient growth. So that demand is there with the harmonization around reimbursement. We are certainly seeing a very strong move in the U.S. in particular. So I don’t think 15% necessarily is sustainable, but certainly high single digit, low double digit PD patient growth here in the near term is certainly a possibility.

And OUS, given the mix of revenue that we get per patient in different markets, whatever the renal sales number we are reporting, you can be assured that the patient growth is probably a little faster for all the reasons that Bob just mentioned. So we are globally seeing very strong PD patient growth, but particularly in the U.S.

Bob Parkinson

The other think that I would mentioned again from a macro perspective is that in many emerging markets and developing markets you have a lot of patients that aren’t even being treated today. So it’s one of the reasons we made the investment in Gambro that we did. This is a large market, it’s going to continue to growth. By virtue of the Gambro acquisition we have established a leadership position in this market, augmented by the existing launch system, new products such as VIVIA in the home and I think it’s a good bet that we made long term.

Bob Hombach

Yes, last think I’ll add, the second quarter is somewhat depressed because of the timing of our tender as we talked about in Q1 related to renal, so I’d really look at year-to-date sales as being more indicative of the trend.

Bob Parkinson

Yes good point.

Mary Kay Ladone

Sam, we have time for two more questions.

Operator

Certainly. Our next question comes from Kristen Stewart of Deutsche Bank. Your line is now open.

Kristen Stewart - Deutsche Bank

Hi, thanks for taking the question. I just wanted to check, just with the respect to the spin-off, at the time of the announcement, you guys had commented that you do not anticipate being able to redomicile the BioScience businesses. Is that still the case or have your thoughts changed at all?

Bob Parkinson

No change. I mean certainly just as a function of a spin out. That is not an opportunity to do a tax-free redomiciling. So that’s not on the radar.

Kristen Stewart - Deutsche Bank

Okay. And then just on the IG business, can you comment just a little bit about what you’re seeing in terms of the dynamic between price and then the supply in the marketplace, because it sounds like price has been a little less favorable than what it has been historically, particularly within the U.S.

Bob Parkinson

Yes, I would say we’ve had very modest expectations on price in the U.S. over the last couple of years and our longer range outlook assume that as well. So I think that remains largely consistent. We are looking forward to having enhanced supply here as we go forward. We are able to support market growth here in ‘14 and ’15 with our current footprint and we continue to work with Sanguine to bring flexible capacity online, which we expect in 2015, to be able to provide not only for the U.S. potentially, but certainly for Europe and other markets.

So we are pleased with where we are at from a capacity standpoint and the flexibility we are going to have going forward and again, from a price perspective, I think largely in-line with our expectations.

Operator

Thank you. And our final question comes from Bruce Nudell of Credit Suisse. Your line is now opened.

Bruce Nudell - Credit Suisse

Good morning. Thanks for taking the question. Ludwig, one question for you. Just to clarify, you kind of framed the (inaudible) impact as kind of high single digits in the U.S. I guess just to clarify, is that high single-digit market share in the second half or is that average over the whole year or is that actually in fact a worldwide impact?

Ludwig Hantson

The single digit market share impact is for the U.S. and that is between now and the launch of 855.

Bruce Nudell - Credit Suisse

Perfect, that's great. And Bob, one of the things, that just looking at the numbers and it's not a very insightful observation, but when you look at the renal business, it is so heavily ex-US. So could you just broadly speak about the opportunities in the U.S., now that Gambro is part of the fold?

Bob Parkinson

Yes. Bruce, some of this is consistent with my response earlier. It was to Rick Wise’s question. For the first time over the last year or so, largely as a result of reimbursement changes and so on, we are seeing really a boost to our PD business. We look forward to that being augmented by the home HD launch, but there is a lot of things that now for the first time in the U.S. are actually driving consideration of treatment in the home, whether that is PD or HD, which is very exciting, because frankly the U.S. business as you know for us has been pretty lack luster over the last number of years, but as has been demonstrated, I think Bob Hombach cited some of the growth numbers for PD patients. We are really seeing that business get re-energized and again as I commented in my response earlier to Rick, we think that’s going to be sustainable.

Bruce Nudell - Credit Suisse

Thanks so much

Operator

Thank you. Ladies and gentlemen, this concludes today’s conference call with Baxter International. Thank you for participating and have a wonderful day.

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