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Baxter International Inc. (NYSE:BAX)

Q4 2007 Earnings Call

January 24, 2008 8:30 am ET

Executives

Mary Kay Ladone - Vice President, Investor Relations

Robert L. Parkinson Jr. - Chairman of the Board, President, Chief Executive Officer

Robert M. Davis - Chief Financial Officer, Corporate Vice President

Analysts

Mike Weinstein - J.P. Morgan

Frederick Wise - Bear Stearns

Matthew Dodds - Citigroup

Larry Keusch - Goldman Sachs

Glenn Reicin - Morgan Stanley

Kristen Stewart - Credit Suisse

Ben Andrew - William Blair

Operator

Good morning, ladies and gentlemen, and welcome to Baxter International’s fourth quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Mary Kay Ladone, Vice President Investor Relations of Baxter International. Ms. Ladone, you may begin.

Mary Kay Ladone

Thanks, Sean. Good morning, everyone and welcome to our Q4 2007 earnings conference call. Joining me today are Bob Parkinson, CEO and Chairman of Baxter International; and Rob Davis, 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 uncertainty and of course our actual results could differ materially from our current expectations. Please refer to today’s press release and our SEC filings for more detail concerning factors that could cause actual results to differ materially.

In addition, 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.

Robert L. Parkinson Jr.

Thanks, Mary Kay. Good morning, everyone and thanks for calling in this morning. We’re very pleased with our fourth quarter and full year 2007 financial results that we reported earlier today. 2007 was a great year for our company and we believe we continue to be very well-positioned for 2008 and beyond.

While we exceeded expectations on virtually all key financial metrics for the year, we’re particularly pleased with the improving quality of our earnings and the strength of our overall financial position. While Rob will provide a detailed explanation of our financial results in just a few minutes, I’d like to briefly point out a few important highlights at the outset this morning.

As you saw, adjusted EPS again exceeded guidance for the quarter, reflecting a 15% increase versus the prior year. Sales growth for the quarter after adjusting for both FX and our TT divestiture grew a very solid 7% and this despite the loss of BeneFIX sales in Europe.

Full year sales growth, again adjusting for FX and the sale of TT, was 8% and adjusted EPS of $2.79 reflects robust growth of 25% versus 2006.

For the year on an adjusted basis gross margins of 49% even improved by 260 basis points over the prior year and operating income as a percentage to sales was 20.8%, which is the highest level we’ve had in a number of years.

As we look forward to 2008 and in fact beyond, we expect both gross and operating margins to expand further as a continued result of improved product mix and business mix, intense focus on pricing opportunities throughout all of our businesses, disciplined control of manufacturing costs, and productivity improvements throughout our global manufacturing footprint.

As part of our strategic plan, we’ll continue to accelerate overall R&D spending both internally and through ongoing business development initiatives and in fact, R&D spending increased 16% in 2007 versus 2006 and exceeded $700 million on an adjusted basis for the year, which is a record level for our company.

During the year, we obtained approval for or launched a dozen new products and continued to make excellent progress advancing many of the programs in our pipeline, including our trails with IVIG for Alzheimer’s, our adult stem cell trial for cardiac myocardial ischemia, our seasonal and pandemic influenza programs, and many others.

In the fourth quarter, R&D spending exceeded $200 million and increased 14%. Some of our more recent R&D highlights include: completing the screen of patients for final enrolment in our Phase II trial using our proprietary Isolex technologies to select CD34-plus adult stem cells to improve symptoms and clinical outcomes in patients with chronic myocardial ischemia, which is a severe form of coronary artery disease.

In addition, we recently announced our support of a Phase I/IIa trial at Northwestern University’s Feinberg School of Medicine for the use of adult stem cells in patients with a condition called critical limb ischemia, or CLI, which is characterized by severely blocked arteries in the leg and sharply diminished blood flow that could result in amputation.

Secondly, we received final funding from the Department of Health and Human Services, along with our partner DVC, for the continued development of our cell-cultured seasonal and pandemic influenza candidate vaccines. In addition, we initiated a Phase III clinical trial in the U.S. using our seasonal influenza vaccine candidate. The trial, which will include more than 3,000 subjects, is expected to be completed by mid-year 2008.

Third, we initiated a Phase II study evaluating our fibrin sealant product, CoSeal, as a hemostasis agent in vascular surgery, which can ultimately lead to a broad hemostasis indication for this product.

And finally, we obtained FDA 510K clearance for V-Link, a Luer-activated device with VitalShield protective coating, the first needle-less IV connector containing an antimicrobial coating. This new device, which will launch in the first half of 2008, has been shown to kill 99.9 percent of specific common pathogens known to cause catheter-related blood stream infections, including the highly resistant bacteria called methicillin-resistant Staphylococcus aureus, or MRSA.

I am also very pleased with the acceleration of our business development activities throughout 2007, which included completing the divestiture of Transfusion Therapies, which was a significant undertaking, and establishing a dozen new alliances with companies like Halozyme, [Decka], Pfizer, Nektar, and Nycomed, to name just a few.

In the fourth quarter alone, we completed four business development initiatives, including the agreement we discussed at last quarter’s conference call with Kaketsuken for the worldwide rights to develop and manufacture and market the recombinant protein ADAMTS13.

In addition, we recently announced plans to develop both an unmodified recombinant factor IX therapy and a chemically modified longer acting version. Pre-clinical work on the longer acting version of recombinant factor nine includes an expanded partnership with Nektar therapeutics using their leading PEGylation technology in combination with Baxter's recombinant factor IX to increase the length of time that factor levels are maintained in the body and potentially reducing the number of required infusions.

In the quarter, we also completed two deals that complement our regenerative medicine business and biosurgery portfolio.

First, we announced a marketing, supply, and manufacturing agreement with Pfizer and FDA approval for GELFOAM Plus Hemostasis Kit, which contains Pfizer’s GELFOAM gelatin absorbable sponge and Baxter's Human Thrombin for the use in controlled bleeding during surgical procedures.

And lastly, through a partnership with Nycomed, Baxter has been granted exclusive rights to market and distribute the company’s TachoSil patch in the United States upon FDA approval, which is expected in 2009. TachoSil is currently available in more than 50 markets outside the U.S., including Europe and Japan, with annual sales of more than $150 million.

Before turning the call over to Rob, let me provide just a quick update on the COLLEAGUE infusion pump. Over the last several months, we’ve made significant progress with the remediation of the U.S. installed base of single channel COLLEAGUEs. Today, we’ve remediated approximately 62,000 pumps, representing more than 40% of the U.S. installed base of single channel devices. These upgraded COLLEAGUEs are performing quite well in the marketplace.

As we previously communicated, we’ve defined [the fifths] to the triple channel COLLEAGUE issue and we are in the final stages of completing our 510K which we expect to submit to the agency in the next several weeks.

As you know, in the third quarter, [Par Excel], our independent auditor notified us that our quality systems had been certified, thereby triggering an inspection by the FDA within 30 days. In December, the FDA completed their inspection and raised several questions to which we have responded. We are hoping to receive the FDA’s input shortly.

As a result of our progress to date, we believe we will be in a position to recommercialize COLLEAGUE by the middle of the year and while Rob will address our financial guidance for the year more specifically in just a moment, I’ll tell you now that we are planning sales revenue for COLLEAGUE of approximately $75 million in 2008. We can pick up on this further in the Q&A if you’d like, but in the meantime let me turn the call over to Rob for a more detailed discussion of our Q4 and full year results. Rob.

Robert M. Davis

Thanks, Bob and good morning, everyone. As Bob mentioned, we are very pleased with our financial performance for the year and for the quarter 2007. Let me start by walking you through the P&L by line item and then I’ll conclude my comments with a discussion of our 2008 outlook before turning the call back to Bob for some closing comments.

Starting with sales, our reported sales totaled approximately $3 billion and increased 9%. Currency contributed six percentage points of growth, so sales growth excluding foreign currency was 3% and in line with the guidance we provided of 2% to 3% growth for the quarter.

Excluding Transfusion Therapies from both years, reported sales increased 13% and excluding foreign currencies, sales growth was 7%, reflecting the underlying strength of our businesses globally.

Like last quarter, we faced difficult comparisons in both bioscience and medication delivery for the planned transition of marketing rights for BeneFIX and Propofol, which had a combined sales totaling more than $60 million in Q4 of last year.

Turning to full year results, worldwide sales totaled $11.3 billion and increased 9%, with currency contributing 5 percentage points of benefit. Again, excluding Transfusion Therapies from both years, reported sales increased 12% and excluding foreign currency, sales growth was 8%.

In terms of individual business performance, let me start with medication delivery, which had sales totaling approximately $1.2 billion, an increase of 11%. Currency contributed six percentage points of growth, therefore excluding currency, medication delivery sales increased 5%.

U.S. sales increased 3% while international sales increased 21%. International sales growth excluding foreign currency was the highest of the year at 8%. For the full year, medication delivery sales of $4.2 billion increased 8%, and excluding currency sales were up 4%, in line with our guidance.

I should note that this performance reflects the turnaround we’ve been discussing as medication delivery generated positive growth in 2007 for the first time in three years.

By segment, global IV therapy sales of $390 million increased 14%, with currency contributing 8 percentage points of growth. Growth continues to be driven by solid demand for our solutions globally, modest pricing improvements, and strong international growth in our nutritions business.

Global infusion system sales totaled $236 million in the quarter and increased 7%, or 2% excluding foreign currency. In the quarter, anesthesia sales totaled $126 million and increased 37% while full year sales exceeded $420 million, with growth of 33%.

Our results continue to reflect the success we’ve had with our proprietary anesthetic SUPRANE augmented by generic sales of SEVOFLURANE and importantly, reinforces our position as the only supplier of all three modern inhaled anesthetics in the global marketplace.

And finally, global injectables and pharma partnering sales of $390 million increased 4%, with currency contributing four percentage points of growth. Strong growth from our international pharmacy compounding and U.S. pharma partnering businesses offset the decline of Propofol. Excluding Propofol and currency, sales growth of global injectables was approximately 5%.

I would also like to point out, since some of you may have seen this, that we recently recalled nine lots of generic Heparin thousand unit multi-dose vials due to an unusual increase in allergic reactions. We’ve notified our customers and we are awaiting official classification of this recall by the FDA, which we do anticipate will be a class one.

Sales of this low margin product totaled approximately $10 million in 2007 and we do not expect it to materially impact our business in 2008.

To summarize, 2007 was a very solid year for medication delivery. Annual sales were in line with our expectations and the business generated positive sales growth for the first time since 2004. We continue to be very encouraged by the building momentum and the number of positive trends across the medication delivery portfolio, including the solid fundamentals in our IV therapy and anesthesia businesses, the progress we are making with COLLEAGUE, and the growth prospects of our pharma partnering business.

Now moving on to renal, fourth quarter sales totaled approximately $600 million and increased 12%, with foreign currency contributing eight percentage points of growth. In line with our expectations, renal sales for the full year totaled $2.2 billion, an increase of 8%, with currency contributing four points of growth.

Hemodialysis sales of $120 million increased 11% and excluding currency, sales increased 2%. Global PD sales totaled $481 million for the quarter and increased 12%, with currency contributing 7 points of growth. Excluding currency, sales growth was 5%.

The consistent growth in PD sales throughout 2007 can be attributed to solid growth in the U.S. where patient growth this quarter of approximately 4% is the highest it’s been in a number of years. This is further augmented by strong international growth as a result of double-digit patient gains, particularly in China, the rest of Asia, and Latin America. In fact, China was our fastest-growing country in 2007 with more than 13,000 PD patients representing a year-over-year increase of 30%.

In summary, renal demonstrated very consistent performance throughout the year. The success of our back-to-basics approach continues to strengthen our global leadership position and we continue to see solid fundamentals in this business as exemplified by our international performance.

Now turning to bioscience, bioscience delivered another outstanding quarter with record sales of approximately $1.2 billion, an increase of 16%. This growth includes six percentage points of benefit from foreign currency. Excluding foreign currency, sales growth in bioscience was 10%.

U.S. sales increased 14%, driven by double-digit increases in virtually all product categories, while international sales growth, which was again impacted by the difficult comparison for BeneFIX, increased 18% or 6% excluding currency.

For the full year, bioscience sales reached approximately $4.6 billion, reflecting an 18% increase versus 2006. Excluding foreign currency, full year sales increased 13%. As a side note, bioscience sales growth excluding BeneFIX and foreign currency was 15% in the quarter and 16% for the full year.

Recombinant sales of $463 million increased 14% in the quarter and totaled $1.7 billion for the year, a 13% increase versus 2006. Throughout 2007, we continued to see conversion to Advate, with global sales for Advate now exceeding $1.2 billion on an annual basis.

On a global basis, conversion to Advate, which was 60% in 2006, expanded to approximately 70% by the end of 2007. While conversion in Europe remains at over 90%, we’ve now converted 55% of our patients in the U.S. and 65% of our patients to Advate in other markets. This continues to reflect the strong demand for Advate which we have differentiated with various dosage forms, making it easier for patients requiring higher does to administer Advate by reducing the number of vials needed, as well as the total infusion time.

In addition, we expect to continue to drive growth in this business with our focus on increased compliance, establishing prophylaxis as the standard of care, and continuing to support global penetration of the therapy.

Turning to the plasma business, in the quarter plasma protein sales of $301 million increased 15% with currency benefiting sales by seven percentage points. Performance continues to be driven by growth of our specialty therapeutics like FEIBA, FLEXBUMIN, and ARALAST, as well as increased demand and improved pricing across the portfolio.

Antibody therapy sales increased 35% and totaled $280 million, with currency benefiting sales by five points. Growth was once again driven by continued demand for and conversion to liquid gamma guard and price improvements in the U.S. and Europe. I should note liquid conversion of approximately 40% in 2006 is now at approximately 60%.

Sales of our regenerative medicine business totaled $95 million and increased 22%, with currency contributing five points of growth. This continues to be a result of strong growth of FloSeal and CoSeal.

Finally, revenues in the other category totaled $70 million as the difficult comparison for BeneFIX, which had sales of approximately $45 million last year, once again offset strong vaccine growth, which was a continued result of increased demand for our FSME Encephalitis and Meningitis vaccines. For the full year, vaccine sales exceeded $300 million.

As you know, bioscience had a great year with sales reaching a record level and exceeding our original expectations. We continue to believe that this business will exhibit solid to improving market fundamentals and is well-positioned for 2008 and beyond.

As a result, we expect increased sales and continued gross margin expansion in bioscience driven by strong underlying demand, continued conversion to higher margin products like Advate and Liquid IVIG, as well as specialty plasma therapeutics and continued growth in our regenerative medicine and vaccine businesses.

Turning now to gross margin, gross margin in the quarter of 49.4% improved 1.8 points versus last year. The primary driver of this expansion continues to be improved business and product mix, particularly in bioscience given conversion to Advate and Liquid Gamma Guard, growth of our specialty plasma therapeutics, and continued yield improvements. These improvements were partially offset by $20 million of discretionary expenses related to both COLLEAGUE remediation costs and certain customer accommodations for U.S. customers and the impact of lower higher margin vaccine sales versus last quarter. Adjusting for these two items, gross margins would have exceeded 50%.

For the full year, gross margin of 49% improved by 2.6 points versus last year’s margin of 46.4%. As we’ve mentioned in the past, the majority of this improvement can be attributed to business and product mix upgrades and cost and yield improvements with approximately 20% of the improvement resulting from favorable price, particularly in the bioscience and plasma business.

In the fourth quarter, SG&A of $654 million increased 7% compared to prior year. This growth includes approximately five points of growth from foreign currency. SG&A as a percentage of sales was lower sequentially and improved to 21.7% from 22.1% in the fourth quarter of last year.

We continue to make investments in select marketing programs as we redirect our promotional focus towards higher margin, higher growth products while tightly managing general and administrative costs.

R&D spending of $206 million increased 14% on an adjusted basis, driven by double-digit increases in all three businesses for new product launches, clinical trials, and milestone payments to partners.

As we reinvigorate across the -- innovation across the company and accelerate R&D spending, I think it’s important to note that we continue to do so with disciplined project and milestone management, increased productivity, as well as program prioritization, while balancing our pipeline with both short and long-term product opportunities.

Turning now to operating margins, our operating margin in the quarter was 20.8%, an improvement of 1.9 percentage points despite increases in both SG&A and R&D. And for the full year, our operating margin of 20.8% improved by 2.3 points compared to the 2006 full year margin of 18.5%.

Other expense of $4 million was similar to last year and interest expense was $12 million compared to $1 million in the prior year period.

The tax rate in the quarter of 19.9% was in line with our expectation and finally, as we mentioned earlier, on an adjusted basis earnings per diluted share of $0.76 increased 15% and compares favorably to the earning guidance we previously provided of $0.72 to $0.74 per share.

The adjusted results exclude after-tax charges totaling $10 million or $0.02 per diluted share for in-process R&D associated with recently announced collaborations with Nektar Therapeutics and Nycomed.

Moving to cash flow, cash flow from operations for the quarter totaled $751 million and for the full year, we generated cash flow from operations of approximately $2.3 billion, in line with our expectations. This was after a net outflow of more than $150 million as a result of our decision in the fourth quarter to exit our accounts receivable securitization facility in Europe, given that the economics of this type of program have deteriorated.

Our total DSO, which ended the quarter at 53 days, is in line with last year as a lower DSO in the U.S. was offset by a higher international DSO due to changing geographic mix.

Inventory turns of 2.5 turns are slightly lower than 2.7 turns last year. As in previous quarters, this is primarily due to inventory builds in medication delivery for the COLLEAGUE remediation efforts. As we move through 2008, inventory turns are expected to improve as we begin to work down the COLLEAGUE inventory.

Capital expenditures for the year totaled $692 million compared to $526 million in 2006, and as we continued to invest in appropriate capacity across our businesses to support our growth, you will see a continued growth in capital expenditures into 2008.

And lastly, for the year we repurchased 34 million shares of common stock for $1.9 billion. On a net basis, we repurchased 17 million shares for $1.2 billion. This is consistent with our stated capital allocation strategy and focus on returning value to shareholders through both share repurchases and dividends.

Overall, I am particularly pleased with our ongoing ability to generate strong cash flow. We were able to return significant value to our shareholders as a result of progress in rebuilding our financial flexibility, continuing with our capital allocation and financial management discipline, while investing in R&D and accelerating business development activities that will position us for future growth.

Finally, let me conclude my comments this morning by providing our financial outlook and guidance for 2008. As you saw in the press release this morning, we expect earnings of $3.10 to $3.18 per share. This reflects continued expansion of gross and operating margins, select investments in marketing and promotional activities to support our growth going forward, and accelerated R&D spending. More specifically, we expect sales growth excluding the impact of foreign exchange to be in the 5% to 6% range. On an apples-to-apples basis, excluding Transfusion Therapies revenue in both 2007 and 2008, our full year sales growth excluding foreign currency would approximate 6% to 7%. I will expand on this in more detail in just a moment.

For the full year, we expect gross profit as a percentage of sales to improve by 100 to 150 basis points, reflecting continued expansion in bioscience and improved profitability in medication delivery and our core PD business.

Given our margin expansion, we have the flexibility to accelerate investments in R&D and therefore expect annual R&D growth in the low to mid teens.

We expect SG&A to increase in mid-single-digits as we continue to control general and administrative expenses and selectively invest in marketing and promotional activities to support new product launches and our higher growth, higher margin products.

We expect to continue our trend of year-over-year operating margin improvement as operating margins in 2008 improve by approximately 100 basis points to approximately 22%. We expect interest and other expenses combined to total approximately $130 million.

We expect interest expense to increase by more than $50 million as a result of our decision to exit the remaining net investment hedges that mature in 2009, as well as generate a lower level interest income due to the assumption of lower U.S. interest rates and lower cash balances.

We expect our tax rate to approximately 19.5% and finally, we expect a full year average share count of 640 million to 645 million shares, assuming share repurchases of at least $1 billion on a net basis.

From a cash flow perspective, we expect cash flow from operations to exceed $2.5 billion and capital expenditures to total approximately $850 million as we continue to invest to expand capacity for certain medication delivery products and plasma therapeutics.

Now, to expand on our sales assumptions for the full year, first, we expect foreign currency based on current exchange rates to impact the sales by approximately two to three points for the full year. Therefore, our reported sales growth is expected to approximate 8%.

Second, as Bob mentioned earlier, we continue to make good progress with the COLLEAGUE infusion pump and our 2008 guidance now includes approximately $75 million in COLLEAGUE revenues.

Third, we expect Transfusion Therapies associated with transition services to decline throughout 2008 and to total approximately $130 million versus $223 million in 2007.

And lastly, as a reminder, bioscience and medication delivery will face difficult comparisons in the first half of 2008, given the impact of BeneFIX and Propofol, with sales in 2007 totaling $100 million and $35 million respectively.

Turning to the three businesses, for 2008 we expect renal sales excluding foreign currency to be approximately flat. This is primarily the result of lower PD sales growth due to the recent loss of a major government tender in Mexico. If you adjust for the Mexico tender, renal sales growth would have been in mid-single-digits, demonstrating the ongoing strong fundamentals of the core PD franchise across the other markets.

For medication delivery, we expect sales excluding foreign currency to grow in the 5% to 7% range. This will be driven by several factors. First, anesthesia growth will be in the mid-teens due to strong end user demand for our proprietary anesthetic SUPRANE and additional market launches of SEVOFLURANE.

Second, we expect the global injectables business to grow in low-single-digits. Consistent with 2007 trends, strong growth in the pharma partnering business is expected to offset declining revenues in generic injectables, primarily due to the tough year-over-year comparisons for Propofol.

Lastly, IV therapy sales are expected to grow in line with overall market growth of mid-single-digits and infusion systems is expected to grow in the 8% to 10% range, including the contribution from COLLEAGUE.

Finally, for the bioscience business, we expect sales growth of 8% to 10%, driven by strong growth across the portfolio. First, we expect recombinant growth in high-single-digits, including Advate sales approaching $1.4 billion. Second, we expect plasma protein and antibody therapy sales to grow in the low teens, given solid demand and improved pricing. Third, we expect growth in our biosurgery business to once again be in the mid-teens. And finally, we expect the other category to decline by approximately 15% to 20% as the impact of BeneFIX offsets strong vaccine sales.

Vaccine sales are expected to total at least $380 million in 2008 versus $300 million I highlighted for 2007 as a result of continued demand for our encephalitis and meningitis C vaccines, as well as revenues related to our influenza advanced purchase and stock pile agreements.

For the first quarter, we expect earnings per diluted share of $0.71 to $0.73, and sales growth excluding the impact of foreign currency of approximately 3%. This equates to approximately 5% growth excluding Transfusion Therapies, which was divested at the end of the first quarter of 2007.

In summary, throughout 2007 we’ve generated strong cash flow, delivered solid revenue and earnings growth, and improved the profile of the P&L. We believe our 2008 [volumes] are realistic and achievable, reflect the benefits of our diversified healthcare model, and continue to track well with our long-term expectations.

Now I would like to turn the call back over to Bob.

Robert L. Parkinson Jr.

Thanks, Rob. Before we open up the call to Q&A, let me make just a few brief closing comments. Obviously 2007 was a very successful year for us on multiple fronts -- financially, operationally, and strategically, and we accomplished a number of important achievements that will support continued improvement not only into 2008 but beyond.

First, as further evidenced by our 2007 performance, our organization is increasingly effective in operational execution as measured by our ability to improve margins and increased cash flow.

Second, these improvements have enabled us to move into Phase II of our turnaround, characterized by the accelerated level of R&D spending and the pace of business development initiatives, both of which are critical elements to accelerate revenue growth in the years ahead.

Third, our company continues to benefit from the power of our diversified healthcare model with each of the businesses making significant contributions in 2007, whether through product development, strategic partnerships, geographic expansion, or a combination of the three. And we are committed to sustaining this momentum in the months and years ahead.

And lastly, while we are not without our challenges, of course, we continue to be very well-positioned with respect to the changing macro environment, given the medically necessary nature of our products, our strong market positions, further supported by our global brand and presence, we’re confident in our ability to drive improved performance and growth, despite a changing economic and political environment.

Our 2008 outlook is aligned with our long-range strategic plans and we remain committed to meeting our short-term financial guidance while continuing to invest in innovation and business development activities that position the company for enhanced growth in the future.

In the meantime, we begin 2008 positioned for continued success. We look forward to providing all of you with continued updates throughout the year.

So with that, we’ll now open up the call to Q&A. Mary Kay.

Mary Kay Ladone

Sean.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mike Weinstein with J.P. Morgan.

Mike Weinstein - J.P. Morgan

First question, Rob, I was hoping you could just spend another minute on the $20 million in incremental expenses in the COGS line that you identified, so we understand that.

Robert M. Davis

Yeah, no, I’m happy to do that. A couple of things; first, in the quarter, as you know we have been in the process of remediating our single channel pumps throughout really most of 2007 and in the fourth quarter, we did have one customer, an important customer, where we did give some concessions in the form of really lower margins on some products that we put into that chain. And as a result, that did drive down the margin in the quarter for medication delivery. That’s one piece of it.

And then as we continued to evaluate where we are with our total remediation costs, we saw the opportunity in the quarter to take a little bit extra for some of the charges we’ve seen over time as we’ve been continuing to do the remediation, so that was a portion of it as well.

Mike Weinstein - J.P. Morgan

And Bob, if we listen to the 2008 guidance and we look at what’s in our model and think back to last year’s analyst meeting, you laid out a base case LRP for 2011 which talked about gross margins in that base case going north of 50% and operating margins of roughly 23%. And here we are looking at 2008 and we’re already talking about gross margins north of 50 in ’08 and operating margins of 22%. So pretty quickly in your LRP you are going to blow through that 2011 plan. Do you want to update the LRP today?

Robert L. Parkinson Jr.

We’re just giving you guidance for ’08 and now you want guidance for -- you know, our outlook base case stays the same. Obviously we’re pleased with the progress to date. You know, we are -- the facts are what they are. We are moving ahead, given our guidance for ’08, slightly faster than that base case that we presented to all of you back last March, I guess, at our investor conference. But we’ll see how things go before we become more definitive beyond that. Rob, I don’t know if you have anything you want to add.

Robert M. Davis

No, the only thing I would add is I think to be clear, what we’ve consistently said is we always expected to exceed the 50% gross margin. We were just never willing to quantify it by how much, so we are continuing to track obviously well to our own expectations long-term, but this in no way implies that we’ve robbed the later years of margin improvement and brought it in earlier.

All of the growth drivers that we’ve talked about consistently through 2007 of our margin will continue beyond, well beyond 2008.

Mike Weinstein - J.P. Morgan

The renal business, the Mexican contract that you guys gave up this year, I assume it’s a lower margin contract?

Robert L. Parkinson Jr.

Well, it would have been at the prices we probably would have had to bid. And you hate to walk away from business but I think in many ways, it exemplifies the discipline that we’ve tried to maintain in all of our businesses over the last few years. But that’s a big impact on the revenue line so we wanted to get it out there to make sure that everyone was aware of it.

As Rob pointed out in his comments, and I guess I want to reemphasize, however, adjusting for Mexico, this back-to-basics strategy in our core PD business, which is really the area of strategic focus, continues to be very effective and we continue to see both patients and revenue associated with our core PD business ramp-up very nicely. But we wanted to call that out especially so you all knew what was going on there.

Robert M. Davis

I think it’s important to note, just to give you a sense of the perspective, that was about a percentage point on our total company sales, so that also, to Bob’s point, did have an impact on sales but we still think it was the right decision to make.

Mike Weinstein - J.P. Morgan

Okay. Lastly, I’m just listening to the difference pieces relative to our model, the ups and downs. Anesthesia is going to be very strong, which is a high margin business. The specialty therapeutics within bioscience, FEIBA, ARALAST, obviously the plasma proteins all very strong for 2008. And then [inaudible] is going to be pulling off, obviously the transfusion therapies revenues was low margin business. This Mexican contract would have been low margin business. There’s still a lot here that if you are talking about the mix of what’s driving your revenue growth, is still a big shift to higher margin products, fair?

Robert L. Parkinson Jr.

Yes.

Mike Weinstein - J.P. Morgan

Okay, great. Thank you, guys.

Operator

Rick Wise of Bear Stearns.

Frederick Wise - Bear Stearns

COLLEAGUE, just to clarify for me, the $75 million that you mentioned for COLLEAGUE, is that a worldwide number that you all were suggesting for ’08? Was that an OUS only number? Because my impression is, if I’m remembering correctly, you’re already generating something like $60 million, $70 million internationally.

Robert M. Davis

To be clear, that is just a U.S. number, so effectively what we are saying is in the U.S., we expect $75 million of sales from COLLEAGUE and that -- so really, we gave no explicit guidance to OUS because we really were just focusing on getting the product back in the U.S. market.

Mary Kay Ladone

Although OUS COLLEAGUE sales are about $25 million to $30 million in ’07 and will be in that similar range in ’08. That’s our current plan.

Frederick Wise - Bear Stearns

Thank you. Very helpful. Coming back to gross margin, Mike detailed a lot of the issues that are improving but maybe you could help us understand in a little more clarity, the gross margin improvement issues, many people are concerned, a frequent concern that Baxter is running out of gas on margins. It clearly sounds like that’s not at all the case, but maybe Bob, just you could expand more broadly on why you are so confident. You highlighted product mix, business mix -- maybe get into a little more, add a little more color on the pricing and productivity side of things so we can help appreciate the improvement.

Robert L. Parkinson Jr.

Let me just comment on several of those things. I’ll try not to get into too much detail but I think one of the misconceptions that I commonly run into on the outside is this margin improvement story is associated with plasma proteins and that’s it. And of course, as you know, Rick, there’s much more going on here than just that. Every one of our businesses continues to improve its gross margins. And it’s a by-product of really business unit product mix upgrade. Net delivery is a good example of that.

With the turnaround in this business and the accelerating revenue growth, which is encouraging, within that is higher growth, as was commented on with Mike’s question previously, accelerated growth in anesthesia, which is very high margin, nutritional products, our B2B business, and so on. So it’s really an upgrade in business unit mix even within the other businesses.

The comment on pricing, we continue to get favorable pricing across most of our businesses, not all of our businesses. You know, a great example of that would be in the core IV business where historically, the pricing environment has just been very difficult. We’re finding right now that there is pricing improvement in the marketplace, the U.S. market, in our core IV business.

So it really is about pricing across the board, obviously to varying degrees. Certainly a business mix in terms of bioscience growing at a faster rate than med delivery in renal and it has higher margins, but within med delivery and renal, business unit mix or product line mix upgrade, if you will, on promoting categories or promoted businesses that are at a higher margin.

And then, of course, underlying all that, which is really the historic strength of this company, is leveraging I think our focus on managing manufacturing costs; offsetting inflationary increases, which have been more significant, on select raw materials, oil-based materials and so on, resins; continuing to offset those with cost reduction and what we call value improvement programs.

So it really is a combination of all those things which is why, Rick, we continue to be encouraged that there continues to be legs on this margin improvement story.

Frederick Wise - Bear Stearns

Okay, one last question; international growth ex currency, if I think I’m reading the number right, was up only 2% or so. I appreciate that there are a number of drags, BeneFIX, et cetera, but maybe just give us a little more perspective on growth opportunities internationally and why we might be more confident? Again, ex currency we might see accelerating growth. Any big drivers there? Or maybe the question is what’s John up to anyway out there, or internationally?

Robert L. Parkinson Jr.

Well, you pointed BeneFIX, which is a big hit internationally. The Mexico tender going forward, if you’re talking ’08 versus ’07, clearly the $100 million in this Mexico tender is a big impact. Also, if you’re looking ’08 versus ’09, we had some very strong vaccine sales in Europe as well, which are not going to grow at the same rate in ’08.

But really, a strength of our company has been the sales that are in our international markets -- you know, 57%, 58% of the sales of the company are outside the U.S. We’ve talked previously about geographic expansion being a very important element of our growth going forward, so we continue to be very confident as to the growth prospects internationally.

Rob, I don’t know if you have anything you want to add to that.

Robert M. Davis

I just want to make sure, to clarify, actually if you look at our constant international sales growth into ’08, it’s 6%, Rick, so Mary Kay can give you the details of that but to Bob’s point, medication delivery is improving year-on-year, bioscience continues to be strong international year-on-year. We mentioned the renal issue. Absent the Mexico tender I mentioned, we would have continued to see the exact trend we’ve seen in our core PD business, driving at about the same rate we’ve seen throughout 2007.

So it’s really more of the same of what we had in 2007 with probably a little bit of acceleration in medication delivery. But again, that 6% constant we feel very good about the fundamental underlying growth that we are seeing internationally.

Frederick Wise - Bear Stearns

Okay. Thanks for another great quarter, guys.

Operator

Matt Dodds is on the line with a question, from Citigroup.

Matthew Dodds - Citigroup

I’m going to go back to plasma. A couple of questions on that area; for the IVIG growth, the last couple of quarters, even if you look at it organically, the growth has been accelerating. It doesn’t seem to be price, so are you ready to say yet the unit growth is on the increase, at least double digits in that business?

And then the second question, more for ’08, is on ARALAST. Now that you have higher supply, are you going to make a more concerted effort to go after new patients to try to grow that business? What’s the plan for accelerating ARALAST? Because that should be a very profitable product for you.

Robert L. Parkinson Jr.

Let me take a stab at both of those and then Rob, you can add to my comments. Relative, Matt, to IVIG, the growth is very encouraging. It is more than price. As you know, it continues to be mix upgrade from lypholized to liquid in certain markets where we get value there.

To your point, the reality is the underlying market growth for IVIG I think continues to be quite robust, frankly. And we’re also seeing fairly significant price increases in even developing markets and so on where historically there was a bigger price gap but with the global supply situation, you are seeing really a more accelerated pricing favorability in select geographies around the world.

So you’ve got that dynamic, overall strength in pricing, robust underlying volume growth, and continued mix upgrade from lypholized to liquid. And so it’s really the confluence of all those things that lead to the kind of positive growth that you’ve seen.

Mary Kay.

Mary Kay Ladone

I was just going to add, Matt, for 2007, volume growth wasn’t at low double digits.

Matthew Dodds - Citigroup

Okay. Did that accelerate through the year?

Mary Kay Ladone

I don’t have that but I can follow up with you later.

Matthew Dodds - Citigroup

Okay.

Robert M. Davis

I think the other important point, Matt, too is and to your question, we did put out for antibody therapies and our plasma proteins, low teen sales in 2008 so we are reflecting the fact that versus that 10% long range volume price number we’ve continued to quote, some of the positive trends we’ve seen in ’07 we expect in ’08, you know, we’ll deal with beyond ’08 when we move forward with our revised long-range outlooks.

Robert L. Parkinson Jr.

On ARALAST, your second question, we have been obviously constrained from a supply point of view as it relates to being as proactive promotionally as we’d like to be. We are approaching the position now where we can open up the throttle a bit from a promotional point of view.

ARALAST represents a great opportunity, a great example of a specialty therapeutic within the plasma protein category and so on, so I think that you can assume that as the supply situation improves, you will see us be much more proactive in the marketplace promotionally.

Matthew Dodds - Citigroup

Thanks, Bob. Thanks, Rob.

Operator

Larry Keusch from Goldman Sachs is on the line with a question.

Larry Keusch - Goldman Sachs

Just a couple of quick things here, and I’m going to come back to plasma as well; first off, can you just give us an update on the timing for the presentation for that Phase II data on Alzheimer’s?

Robert M. Davis

We continue to expect it in the first half of the year. There are a couple of different conferences that the lead investigator, Dr. Relkin, is looking to get to so I don’t want to commit for him a date but there are several conferences coming up here in the coming months that I know he’s looking at. So we do believe you’ll see it before we get to mid-year.

Larry Keusch - Goldman Sachs

Let me ask another way -- is February out now thought?

Robert M. Davis

To be honest with you, I can’t say for certain.

Larry Keusch - Goldman Sachs

Okay, and then just two sort of longer term questions for you; Bob, what are you doing with the fractionation facility or what are the plans for the facility in L.A., the older facility over the next several years? Is that going to be mothballed? Do you keep it around if you should need it? So if you could help us think about what --

Robert L. Parkinson Jr.

Well, fundamentally, we’re obviously winding it down now. I mean, the long-term plan is to take it out of commission. In the meantime, we continue to support the conversion from the old to the new in L.A. frac and we also look at our operations in Vienna and Rieti in Italy to look for where there’s opportunity to get either more productivity through yield enhancements, yield improvements, or a modest capacity expansions that enable us in terms of our global manufacturing footprint in fractionation to make sure that we can stay attuned to the underlying market demand.

Larry Keusch - Goldman Sachs

Okay, and then lastly, are you noticing any difference or making any assumptions for the supply characteristics dynamics as you think in ’08, particularly amongst the competitors?

Robert L. Parkinson Jr.

Are you talking about in the plasma business?

Larry Keusch - Goldman Sachs

Yes, please.

Robert L. Parkinson Jr.

No. I mean, I think our position is consistent with what we’ve communicated with all of you. We don’t see any dramatic change, necessarily. Obviously we’re not as familiar with our competitors as we are with our own situation, but it would seem that people are doing what they need to do to ensure that the global demand can be met collectively by the industry.

Larry Keusch - Goldman Sachs

Okay, terrific. Thanks, guys.

Operator

Glenn Reicin of Morgan Stanley.

Glenn Reicin - Morgan Stanley

Two questions; if I look at your guidance, at least relative to my expectations, the biggest variance for 2008 was really on the vaccine line. And ever since you guys bought North American Vaccine I sort of have seen a bumpiness with respect to that business. Has that changed and should we sort of expect straight-line growth going forward? That’s the first question.

Robert M. Davis

No, I don’t think you should expect straight-line growth. I think the key is based on improving fundamentals in that business, obviously with FSME and our meningitis C vaccines and what’s been going on in the markets for those products, we expect to see good growth in those from ’07 to ’08. Obviously we saw good growth in those from ’07 versus ’06.

Beyond that, it really is more focused on near-term on the pandemic opportunities and while we do expect to continue to have those and that’s part of why we gave the growth expectations we gave, it’s one of those things where they come in fits and starts. We do believe, given how long product will last on a shelf and the fact that there will need to be restocking, every couple of years there is more out there for this, so that is something we see.

But I think more importantly than that, long-term, given the technical success we’ve had with our [Verasol] platform, now we’re starting to think strategically about other opportunities in the vaccines business as well.

So it will be a growth vehicle for the company but just given the nature of it, it’s hard to say that it’s going to be a straight-line growth.

Glenn Reicin - Morgan Stanley

Let me ask you a different way -- the tenders that you have, and I assume this is a tender business, do you think there’s a high probability of retaining those tenders from year to year?

Robert M. Davis

On the base business, FSME and [Nyspec], yes.

Glenn Reicin - Morgan Stanley

Okay, good. Second question, which hopefully will cap the whole discussion about pricing on plasma, just from my back-of-the-envelope calculations I was estimating for 2007 that it contributed around $120 million pretax, or around $0.15 a share. I would love to hear whether you can confirm that number or not, and I’m talking about solely on the plasma and antibody businesses.

And then, while you don’t really want to talk about the industry, what are you assuming in terms of pricing for 2008?

Robert L. Parkinson Jr.

What do we have -- I think in terms of pricing, around like mid-single-digit pricing, thereabouts?

Robert M. Davis

What we’ve continued to communicate and I don’t think we want to necessarily deviate from that is mid-single-digits on price, low to mid, probably edging towards mid for ’08, and then the rest being volume to get to that low teens number. I’d have to go back and quantify the dollar impact of pricing.

I can tell you that generally, as we quoted in the script, and this is something we continue to track, it runs about 20% of the total across all of the plasma and protein business. So I could do the math but that’s probably the easiest way to --

Robert L. Parkinson Jr.

Explain the 20%.

Glenn Reicin - Morgan Stanley

Well, I was just thinking --

Robert M. Davis

The 20% was price improvement in ’07 versus ’08 -- I’m sorry, ’06 versus ’07 in margin, so the margin contribution --

Robert L. Parkinson Jr.

Twenty-percent of the improved margin is resulting from price. I just want to be clear. Not 20% price increases, okay? I think everybody knows that but it’s really important to clarify.

Robert M. Davis

Good point. The margin contribution.

Glenn Reicin - Morgan Stanley

Well, let me press you on that; while you don’t want to go back and look at the numbers, mid-single-digit pricing, just your gut, does that compare with double-digit pricing this year or upper-single-digit pricing, sorry, in 2007?

Mary Kay Ladone

It depends on the product, Glenn, but yes, in some cases we did see double-digit pricing.

Robert L. Parkinson Jr.

I think across the plasma proteins, it’s probably high-single-digits, so I think the takeaway is we think the year-to-year price improvement, ’08 versus ’07, will modulate certainly versus ’07 versus ’06 but continue to be at least in that kind of mid-single-digit year-to-year increase level. Does that help?

Glenn Reicin - Morgan Stanley

Yes, very much so. Thank you very much.

Operator

Kristen Stewart of Credit Suisse.

Kristen Stewart - Credit Suisse

I was just wondering if you guys could expand a little, to the extent you can, on healthcare associated infections? I know you mentioned V-Link as one of the products that you recently introduced in that area. Anything else that you believe you can bring to the table over the near-term?

Robert L. Parkinson Jr.

Well, beyond the product that we’ve announced that we are launching in ’08, we are evaluating a number of other things. There won’t be any other products in this area. Obviously this is a pronounced need that exists in the acute care hospital environment and especially as reimbursement changes. I mean, one of the things that you probably are all aware of is that Medicare and other reimbursers now are focusing on either mediation errors or hospital acquired infections in hospitals for not reimbursing going forward, which is clearly getting the attention of the acute care hospital system throughout the U.S.

So the marketplace is becoming increasingly responsive to these kinds of products and technologies that can be instrumental in reducing rate of infection.

So beyond the product we’ve announced, we don’t have anything specific we’re prepared to talk about now, but given this market need and really expanding market opportunity that exists, clearly it’s an area of strategic focus for our medication delivery business.

Kristen Stewart - Credit Suisse

And then can you just remind us again where you stand on generic biologics and how you are viewing that, if your thoughts have changed at all?

Robert L. Parkinson Jr.

It hasn’t been really a priority for us. We continue to monitor obviously the ongoing discussion and debate on regulatory pathways and what the implications of that may be. It isn’t at all evident that this is something that’s going to get well defined in the near term and so while we are in the generic multi-source business with other therapeutics, frankly we continue to observe and stand on the sideline a bit is maybe the best way to describe it and monitor this whole area of either generic biologics or what people refer to bio-similar.

So it isn’t -- I guess what I would say is it isn’t self-evident to us at this stage that business can really be a big opportunity for us.

Kristen Stewart - Credit Suisse

Okay. Thanks very much.

Mary Kay Ladone

Sean, we have time for one more question.

Operator

Our final question comes from Ben Andrew with William Blair.

Ben Andrew - William Blair

I just wanted to follow-up on one last plasma question -- I promise, just one; what have you seen historically in terms of off-label use of Alzheimer’s -- of IVIG in Alzheimer’s and what have you baked into your plan? So the real question becomes what impact could we see if in fact the data from the Phase II study are positive?

Robert L. Parkinson Jr.

We haven’t really baked anything in our plan. It isn’t evident to us that there is use of any significance. There may be a few people who are trying it in a very selective basis but again, our visibility into that is quite limited and it clearly is not a dimension that we’ve dialed in our forecast for 2008.

Robert M. Davis

I think it’s safe to say, Ben, we’ve talked about this on several occasions, that because of the fact that currently this is an un-reimbursed therapy, and it is a fairly expensive therapy, we just don’t see a huge influx of off-label use coming as we announce trial results, so this continues to be a great long-term opportunity for the company but not something that we believe has a material short-term impact of any kind.

Ben Andrew - William Blair

Okay, and the second question is on the PD side -- really kind of three topics there. Other international tenders or concerns that we might be looking at other impacts? And why is the competitive dynamic changing so dramatically there that there’s this $100 million hit in Mexico? As well as why are you seeing below market growth still in PD in the U.S.?

Robert L. Parkinson Jr.

Okay, a number of questions. First of all, I think the situation in Mexico is pretty much what I would describe as a one-off. What I’m saying by that is we don’t see other markets around the world at this stage that appear to be going down a centralized tender pathway that Mexico has, so that’s the first piece, Ben.

Secondly, the reason the impact is so significant is about 80% of all dialysis patients in Mexico are on PD, so it’s one of our biggest markets, as you know. As a result, it’s also a big expenditure for the government.

We feel that the quality of our products, and not just our CAPD products but our APD products with home choice cycler and so, frankly deserve a premium above and beyond what we were willing to bid, or it may have taken to bid to get the volume. This conversion takes place within just a couple of weeks, actually, the first of February. So we’ll see how this whole thing plays out but I think at this stage, if I can kind of think about your question and really what you are getting at here is don’t conclude that what’s happening in Mexico is happening around, necessarily going to domino around the world. I don’t think that’s the case at all.

Ben Andrew - William Blair

Is that a long-term contract or is that a one-year tender?

Robert L. Parkinson Jr.

It’s a one-year contract.

Ben Andrew - William Blair

So do you think you’ve got a shot to get it back?

Robert L. Parkinson Jr.

Yes, and there will be a lot of experienced gained in the meantime by docs, patients, the government, and the like, so stay tuned.

On the U.S. piece, you’re right. Our growth in PD patients in the U.S. is lower than the rest of the world. It is also higher today than any time it’s been in 10 years and we expect our PD patient growth to begin accelerating even into ’08.

There’s a lot of reasons for this. I’m not going to take everybody’s time this morning to get into detail but I think that we’ve made great progress really in the last 12 months or so in kind of cracking the code, so to speak, in terms of how we think we can over time accelerate patient growth in the U.S.

You are obviously aware of the concentration of providers with folks like [Presenias] and [Vedida] and so on, so while it is lower than the rest of the world, your observation is correct. The gap is closing and we think we are making progress there.

Ben Andrew - William Blair

Thanks, Bob.

Operator

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

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Source: Baxter International Q4 2007 Earnings Call Transcript
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