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Baxter International Inc. (NYSE:BAX)

Q1 2008 Earnings Call

April 17 2008 8:30 am ET

Executives

Mary Kay Ladone - VP, IR

Bob Parkinson - CEO and Chairman

Rob Davis - CFO

Analysts

Mike Weinstein - JPMorgan

Matthew Dodds - Citi

Lawrence Keusch - Goldman Sachs

Glenn Reicin - Morgan Stanley

Rick Wise - Bear Sterns

Ben Andrew - William Blair

Operator

Good morning, ladies and gentlemen, and welcome to Baxter International's first quarter Earnings Call. (Operator Instructions).

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

Mary Kay Ladone

Thanks Kevin. Good morning, everyone, and welcome to our Q1 2008 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 uncertainties, and, of course, our actual results could differ materially from our current expectations. Please refer to today's press release and our SEC filings for more details concerning factors that could cause actual results to differ materially. In addition, 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 is available on our website.

Now, I would like to turn the call over to Bob Parkinson. Bob?

Bob Parkinson

Thanks, Mary Kay. Good morning, everyone, and thanks for calling in this morning. We are quite pleased with our first quarter financial results, which were reported earlier today, and we continue to be particularly encouraged 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 and outlook in just a few minutes, let me start off this morning by briefly pointing out just a few highlights at the outset.

Adjusted EPS again exceeded guidance for the quarter, reflecting a 21% increase versus the prior year. This included a charge we booked for the Heparin recall, which was offset by a differed gain for the Transfusion Therapies divesture completed a year ago.

Sales growth after adjusting for FX and the TT was 4%. However, I think it’s important to note that excluding various adjustments creating a difficult comparison to last year’s growth in our core business of 7% to 8% is consistent with how we have been running on our basis over the last several quarters and reflects the strength and the diversity of our businesses globally. We also continue to be pleased with the consistency of our improving margins. Gross margin on an adjusted basis was 49.8%, expanding by 250 basis points over the prior year. And, adjusting for the Heparin charge, gross margin was approximately 50.5%. Adjusted operating income as a percentage of sales was 21%.

As we move forward we continue to be enthusiastic about our outlook. We expect both gross and operating margins to expand further as a continued result of improving product mix and business mix, intense focus on pricing opportunities throughout all of our businesses, and disciplined control of manufacturing costs as well as productivity improvements throughout our global manufacturing footprint.

We are also continuing to make significant investments in R&D, as we advance our product pipeline across all of our businesses. We are making solid progress, and in the first quarter we achieved a number of commercial clinical and regulatory milestones, including FDA approval of our ARTISS, the first and only slow setting Fibrin Sealant, indicated for use in adhering skin grafts and burn patients.

We also launched of GELFOAM Plus, the hemostasis device for use in surgical procedures, when control of capillary, venous, and arteriolar bleeding by pressure, ligature, and conventional procedures is ineffective or impractical. The launch of our V-Link Luer-activated device, with VitalShield protective coating, the first needleless IV connector containing an antimicrobial coating, that has been shown to kill 99.9 percent of specific common pathogens that cause catheter-related blood stream infections, including MRSA.

There was also the announcement of preliminary results of the phase I/II clinical trial, in which subcutaneous infusion of GAMMAGARD LIQUID with Enhanze Technology, enabled administration of a full monthly dose via a single site to patients with primary immunodeficiency. A typical subcutaneous infusion of IVIG requires dosing one to two times per week at two to five different injection sites. And, finally I would like to announce this morning that we've submitted our IND to the FDA for the phase III study, investigating the use of GAMMAGARD for the treatment of Alzheimer’s disease and we expect to begin the study in the second half of year.

The preliminary six month phase II results will be presented later today at the American Academy of Neurology Annual Meeting in Chicago, by the lead researcher Dr. Norman Relkin of New York Presbyterian - Weill Cornell Medical Center. We are encouraged by these preliminary results and expect additional longer term data on the phase II to be presented later this year.

Now, before turning the call over to Rob, let me provide you with an update on the COLLEAGUE Infusion Pump, and you know that we took a charge this morning, which we called out in our release. Since we last spoke in January, we have made significant progress with the remediation of the US installed base of single channel devices, which represents 75% of the total US install base. Today, we have remediated almost 80,000 pumps, more than 50% of the single channel devices in the market. The submission of our 510(k) for the TRIPPLE Channel Pump continues to evolve. As was previously communicated, we did identify the fix to the Triple Channel buffer issue. However, we remain in dialogue with the FDA regarding the validation of other software modifications.

We are also in dialogue with FDA concerning observations from their December inspection and the certification of our quality systems, and we are actively addressing those issues. As a result, we don't believe that we'll be in a position to re-commercialize COLLEAGUE this year. This delay is the primary basis for the charge that we took this quarter, accounting for some additional cost for the remediation program, and again Rob will detail the elements of that charge in a couple of minutes.

Additionally, we are lowering our COLLEAGUE revenue guidance to approximately $30 million versus our original expectation of approximately $75 million. While this does not include any revenue associated with re-commercialization of new COLLEAGUE devices this year, we're in a position to recognize lower margin revenues for replacement pumps provided to existing customers as part of the remediation program.

While Rob will address our financial guidance for the year more specifically in a moment, we continue to believe that we are very well positioned, and not only for the remainder of 2008, but for the longer-term. Given the medically necessary nature of our products, our strong market positions and our accelerating pipeline further supported by our diversified healthcare model, we're confident in our ability to drive improved performance and growth.

As always, I'd be happy to address any questions you may have during the Q&A. In the meantime, let me now turn the call over to Rob for a more detailed discussion of our Q1 results and outlook for the remainder of 2008. Rob?

Rob Davis

Thanks, Bob, and good morning everyone. As Bob mentioned, we reported solid financial results today that favorably compare to the earnings guidance we previously provided. The quality of our performance is the result of continued gross and operating margin expansion, which again allowed us the flexibility to selectively invest for the future in sales and marketing programs, as well as R&D.

As Bob mentioned, our GAAP results included an after-tax charge of $45 million, or $0.07 per diluted share for additional COLLEAGUE remediation cost. The various components of the charge include additional customer accommodations, including extended warranties and the other remediation costs associated with the delay in our re-commercialization timeline. Excluding this charge, adjusted earnings per diluted share of $0.74 increased 21% and compared favorably to our earnings guidance of $0.71 to $0.73 per share.

I will now walk you through the P&L by line item, before updating you on our financial outlook for the remainder of the year. Starting with sales, our reported sales totaled approximately $2.9 billion and increased 8%. Currency contributed 6 percentage points of growth, so sales growth, excluding foreign currency, was 2%. Excluding Transfusion Therapies from both years, reported sales increased 10%, and, excluding foreign currency, sales growth was 4%.

Like last year, we faced difficult comparisons of both BioScience and Medication Delivery for the transition of marketing rights for BeneFIX and Propofol, which had combined sales totaling over $65 million in the first quarter last year. In addition, we plan a lower PD growth in Renal, due to the loss of a major tender in Mexico, which impacted our sales by approximately $25 million in the quarter.

In terms of individual business performance, let me start with medication delivery, which had sales totaling approximately $1.1 billion, an increase of 8%.Currency contributed 6 percentage points of growth. Therefore, excluding foreign currency, Medication Delivery sales increased 2%.

International sales increased 18%, driven by double-digit increases in our IV therapy, nutrition, global injectables, and anesthesia businesses. International sales growth, excluding foreign currency, was a solid 8%. US sales were down 2%, due to the unexpected loss of two contracts in our pharma partnering business and continued channel inventory reductions in anesthesia.

By segment, global IV Therapies sales of $371 million increased 16%, with currency contributing 8 percentage points of growth. Growth continues to be driven by solid demand for our IV Solutions globally, pricing improvements, and strong growth in our nutrition business.

Global Infusion Systems sales totaled $220 million in the quarter, and increased 5% or 1%, excluding foreign currency. (inaudible) continued to grow in line with overall market growth. And, US remediation revenues for COLLEAGUE offset a decline internationally, as we faced a tough comparison to last year for shipment of COLLEAGUE devices to customers in Canada and the UK.

In the quarter, anesthesia sales totaled $99 million, and increased 11%, driven by significant international growth. International sales increased 28% on constant currency basis, due to continued penetration of both SUPRANE, our proprietary anesthetic, augmented by growth of SEVOFLURANE, which we launched in multiple geographies during the quarter. In the US, anesthesia sales were down by 3% year-over-year. As I mentioned a moment ago, this is a result of a tough comparison to last year and the reduction in inventory levels by wholesalers. On a positive note, we continue to see end-user growth and our shipments have picked up in the second quarter. Therefore, for the full year, we continue to expect mid-teens growth in this business, driven by growth of more than 20% internationally, and mid to high-single digit growth in the US.

Finally, Global Injectables and pharma partnering sales of $368 million increased 2%, with currency contributing 4 percentage points of growth. Strong growth from our international pharmacy compounding business was more than offset by two factors; the decline of PROPOFOL, and as I mentioned earlier, the loss of sales in our pharma partnering business due to the failure of our customer’s product in the clinic and another client’s decision to market a new presentation of a particular product and shift manufacturing in-house.

Moving now to Renal, first quarter sales totaled more than $550 million and increased 6%, with foreign currency contributing 8 percentage points of growth. US sales increased 1% and international sales increased 7%. Global PD sales totaled $445 million, and increased 6%. In the US, PD sales growth was driven by solid patient growth of approximately 5%, the highest growth we have experienced in a number of years.

In international markets, PD patient gains continue to grow in the double-digits in Asia, led by consistent patient growth in China of approximately 30%, and mid-to-high single digit patient growth in other developing countries around the world. Excluding the impact of the loss tender in Mexico, that I mentioned earlier, international PD sales were up approximately 6% at constant rates and global PD sales increased 5%.

Hemodialysis sales of $113 million increased 7%, and excluding currency sales, were down 2%.

Now, turning to BioScience; BioScience is off to another great start this year with sales of approximately $1.2 billion, an increase of 13%. This growth includes 5 percentage points of benefit from foreign currency. Both US and international sales increased 13%, excluding the benefit from foreign currency, international sales increased 3%, as strong growth across the portfolio more than offset loss to BeneFIX sales. International sale increased approximately 13% at constant rates, excluding the impact of BeneFIX.

Recombinant sales of $436 million increased 12% in the quarter, as we continue to see increased demand and conversion to ADVATE. Global sales of ADVATE totaled approximately $325 million, which now represents almost 75% of our total recombinant sales. While conversion in Europe remains at over 90%, US conversion continues to advance. In fact, we've now converted almost 60% of our US patients to this therapy. Our outlook on this business reflects continued strong demand for ADVATE, increased compliance, and improved penetration and standards of care globally, further augmented by a differentiation of the therapy with various dosage forms making it more convenient for patients by reducing the number of vials needed, as well as the total infusion time.

Turning to the plasma business; in the quarter, Plasma Proteins sales of $260 million increased 16%, with currency benefiting sales by 6 percentage points. Performance continues to be driven by our 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 29% and totaled $286 million, with currency benefiting sales by 4 percentage points. Growth was once again driven by continued demand for and conversion to GAMMAGARD LIQUID, and price improvements in the US and in Europe.

Sales of our Regenerative Medicine business totaled $94 million, and increased 15%, with currency contributing 5 points of growth. This continues to be the result of strong growth of FloSeal and CoSeal.

Finally, revenues in other categories totaled $134 million, as the difficult comparison for BeneFIX with sales of over $45 million last year, offset strong vaccines growth, which was the continued result of increased demand for our FSME encephalitis vaccine. For the quarter, vaccine sales totaled more than a $100 million.

Turning to the rest of the P&L, and starting with gross margin. Gross margin in the quarter of 49.8% improved 2.5 points versus last year. Partially impacting the year-over-year improvement is a $19 million charge related to the recall of our Heparin sodium injection vials in the US. As we have previously mentioned, while this matter has and will continue to receive significant media attention, financially this issue has been manageable. We will be happy to take further questions on this topic during the Q&A.

Excluding the Heparin charge, our gross margin in the quarter was 50.5%, an improvement of 320 basis points. The primary driver of this expansion continues to be improved business and product mix particularly in BioScience, given conversion to higher margin products like ADVATE and GAMMAGARD liquid, as well as favorable pricing in BioScience and Medication Delivery, and continued cost and yield improvements.

Turning to SG&A, SG&A of $640 million in the quarter increased 10% compared to prior year. This growth includes approximately 5 percentage points of growth from foreign currency. Excluding currency, SG&A growth was in the mid-single digits and was the continued result of investments we are making in select marketing programs directed to our higher growth, higher margin businesses particularly in BioScience. And, we continue to entirely manage other general and administrative costs.

R&D spending of [$190 million], increased 19% driven by double digit increases across all three businesses for new product launches, clinical trials, and milestone payments to partners. As we reinvigorate innovation across the company and accelerate R&D spending, 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.

Our operating margin in the quarter was 21%, an improvement of 1.4 percentage points even after increases in SG&A and R&D. Interest expense was $17 million, compared to $5 million in the prior year, as a result of settling net investment hedges during the quarter and lower interest income due in part of faster than planned share repurchases. And, other income was $1 million, as various expenses were offset by the benefit of $16 million for the deferred gain that Bob mentioned earlier, related to the transfusion Therapies divestiture.

Finally, the tax rate in the quarter was 19.3%, in line with our expectations. And, adjusted EPS of $0.74 exceeded the guidance we previously provided. As we have discussed, these adjustments results include both the HEPARIN charge and gross profit of $19 million, and the gain of $16 million in the other expense line, which virtually offset one another, and overall had an immaterial impact on our performance.

Moving to cash flow, cash flow from operations for the quarter totaled $362 million, an improvement of approximately $150 million versus prior year. Our total DSO which ended the quarter at 56 days, it's slightly higher than the first quarter last year, as a lower DSO in the US was offset by higher international DSO, resulting from our change in geographic mix.

Inventory turns of 2.3 turns are lower than 2.6 turns last year. This is primarily the result of higher inventory levels in BioScience, as we continue to build plasma inventory for a transition to the new LA fractionation facility and extend safety stock levels from just under two weeks to approximately four to six weeks.

Capital expenditures for the quarter totaled $157 million, compared to $93 million in the first quarter of last year, as we continue to invest in appropriate capacity across our businesses to support our future growth.

And lastly, during the quarter, we repurchased 9 million share of common stock for $545 million. On a net basis, we repurchased 6 million shares for $433 million. In addition, the Board of Directors approved a new $2 billion share repurchase authorization, which is consistent with our stated capital allocation strategy, and our focus on returning value to shareholders through both shares repurchases as well our dividend.

Finally, let me conclude my comments this morning by providing an update on our financial outlook for 2008.

As you saw in the press release this morning, we raised our earnings guidance to $3.18 to $3.24 per share. This reflects continued year-over-year expansion of gross and operating margins, select investments in marketing and promotional activities to support our growth accelerate R&D spending, and a benefit from favorable foreign exchange. More specifically, we expect sales growth, excluding the impact of foreign exchange to be in the 5% to 6% range. Foreign currency for the fully year is expected to benefit sales growth by approximately three points, so our reported sales growth is expected to be in the 8% to 9% range. On an apples-to-apples basis, excluding Transfusion Therapies revenues in both 2007 and 2008, our full year sales growth, excluding foreign currency, would be approximately 6% to 7%. Transfusion Therapies sales are now expected to total approximately $150 million for the full year.

For the full year, we expect gross profit, as a percentage of sales, to improve by 100 basis points to 150 basis points, SG&A growth to be in the 6% to 8% range, and R&D growth to be in mid-teens. This will result in operating margin improvement in 2008 of a 100 basis points to approximately 22%. We expect interest and other expense combined to total approximately $130 million.

Interest expense is expected to increase year-over-year and total approximately $70 million or $75 million for the year, as a result of our decision to exit the remaining net investment hedges, as well as due to lower interest income and lower cash balances. We expect our tax rate to be approximately 19% to 19.5%. And finally, we expect a full year average share count of 635 million shares to 640 million shares assuming share repurchases of at least $1 billion on a net basis.

From a cash flow perspective, we now expect cash flow from operations to total approximately $2.6 billion, and capital expenditures to total approximately $1 billion. I should note the change in our CapEx guidance from approximately $850 million is largely due to the impact of foreign currency translation.

Turning to the three businesses, for 2008, we continue to expect Renal sales, excluding foreign currency, to be approximately flat. This is primarily the result of lower PD growth due to loss of the PD tender in Mexico. Adjusting for this, Renal sales growth would be in mid-single digits demonstrating solid progress in the core PD franchise across the other markets.

For Medication Delivery, we now expect sales excluding foreign currency to grow approximately 4%. This change is primarily the result of lower Infusion Systems growth, due to the change in our COLLEAGUE revenue guidance and lower growth in our global injectables business. For the full year we now expect growth in the Infusion Systems business to be in the 5% to 7% range. We expect flat sales versus the prior year in our global injectables business, due to continued generic competition and the two customer losses we discussed in our pharma partnering business.

We continue to be optimistic about the growth in our anesthesia business. With growth in the mid-teens, due to strong end-user demand for our proprietary anesthetic SUPRANE and additional market launches and increased penetration of SEVOFLURANE. And lastly we expect IV therapy sales to grow in mid-single digits, driven by solid growth of our IV solutions and nutrition business.

Finally, for the BioScience business we now expect sales growth of approximately 10%, driven by strong growth across the portfolio. This compares to our original expectation of 8% to 10% growth at constant currency rates. First, we continue to expect recombinant growth in high-single digits, including ADVATE sales of more than $1.4 billion.

Second, we now expect plasma protein and Antibody Therapy sales to grow in mid-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 in the low double-digits, as the impact of BeneFIX offset strong vaccine sales. Vaccine sales are expected to total more than $400 million for the full year, representing an increase of more than 20% versus 2007.

For the second quarter, we expect earnings per diluted share of $0.81 to $0.83, and sales growth, excluding the impact of foreign currency of 4% to 5%.

In summary, we believe our 2008 plans are realistic and achievable, and reflect the benefits of our diversified healthcare model. And we believe, we continue to track well with our long term expectations.

Now, let me turn the call back to Bob for his closing comments before we open it up to Q&A. Thanks.

Bob Parkinson

Thanks Rob. One more item that I'd like to update you on, before we open the call to Q&A this morning, is the expansion of John Greisch's responsibility. John, as you know, has served as President of International for the past two years and has been instrumental in establishing a strong regional organization that is supporting our efforts with geographic expansion in all of our businesses. I recently broadened John's responsibilities to include the manufacturing and supply chain operations associated with Baxter's Medication Delivery and Renal businesses, as part of our ongoing efforts to improve operational efficiencies and further accelerate margin expansion. John's oversight and leadership in the areas of optimization of Baxter's global manufacturing footprint, global capacity planning and supply chain will allow us to take our operational effectiveness to the next level.

In closing, let me simply say that we are very pleased with our start to the year, well obviously not without some challenges, everyone has those, but we are on track to have another very solid year at Baxter. And importantly our financial strength allows us to invest in ways to sustain growth in the coming years. So with that, let's open up the call for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Mike Weinstein of JPMorgan. Your question please

Mike Weinstein - JPMorgan

Hi, guys, thank you for taking the questions. Let me start with the guidance commentary for the year. You had a good quarter here. Obviously, you topped your guidance for the first quarter. But you raised your guidance for the year momentarily, so I would like, if you could just give us a little bit more color on where that excess is coming from, obviously very strong gross margin, but if you could talk about within the business, the driver, your thoughts relative to balance of the year, thanks?

Bob Parkinson

Okay. That is pretty open ended, Rob why don’t you add on.

Rob Davis

Good morning. If you look at what we are really looking at for the full year, obviously it’s really a reflection of what you saw in the first quarter. Obviously as I highlighted, BioSience started the year very strong, which we are very pleased with. And we continue to expect good momentum in that business through the rest of the year. And I think, to Bob’s comments about the confidence we have despite some of the challenges we faced, it’s important to note that in first quarter and frankly for the full year, we were able to absorb the Heparin charge. We were able to absorb the lost revenue from COLLEGUE and the situation in (inaudible), which is really due more to a few large customer accounts, and that is what’s overall going on in that business, and still deliver on expectations and frankly little bit ahead of expectation for quarter. That is largely what’s going to carry to the full year. So, again for the full year it’s going to be BioScience strength, offsetting for the full year of COLLEGUE impact, as well as the weakness we do expect in the full year in our pharma partnering businesses and some benefit from foreign currency. So, that really is the driver of both the quarter and the full year guidance.

Bob Parkinson

Mike, I would just add to that, I think the theme is really one we've established -- and continued opportunity for margin improvement for the foreseeable future certainly, and it's driven by things we've talked about before. First of all business mix, it's encouraging that our BioScience business continues to do so well, it's a higher margin business as you know. So, as it grows faster than the other businesses, the profile benefits from that. But in addition, product mix within all the business units, the fastest growing categories right now, I think Medication Delivery and Renal to some degree are result of higher margin product categories. Productivity, which we continue to focus on, and pricing, and we continue to get pricing in most of our business, encouragingly in Medication Delivery as well as BioScience. So I think, as those elements continue to manifest themselves that continues to be, I think the basis for our confidence, as we look to the rest of the year.

Mike Weinstein - JPMorgan

Bob, as I look at it, top line really is not a great indicator, as your performance, and I'd say that because if we think about some of the decisions you made, obviously the BeneFIX distribution agreement was relatively lower margin business, that went away middle of last year. The decision on Transfusion Therapies…

Bob Parkinson

Right.

Mike Weinstein - JPMorgan

The decision within Renal…

Bob Parkinson

Right.

Mike Weinstein - JPMorgan

On the Mexico contract, these are all, obviously lost revenue opportunities, but so lower margin opportunities, and so they end up translating it into a higher gross margin piece. It seems like really the best measure of this company's performance pretty consistently as of being the gross profit line fair statement?

Bob Parkinson

Yeah. I think that's fair, and again there continues to be, as I've said momentum in gross margin. Yes, I mean in the other new line, we have over the last couple of years been impacted by I think the right business decisions we have made to pair lower margin businesses. So we continue to report top line sales growth on organic basis net of exchange that clearly is not indicative of what I think is the overall revenue growth ability of our portfolio businesses, which is why as you look at the BeneFIX, the loss of BeneFIX, the divestiture of TT, the Propofol over the last couple of years, getting rather some of the plasma business, and so on plasma sales and so on third party plasma sales. But we are working our way through that. Now the TT comparisons are largely out of our base, we have one more quarter on the BeneFIX comparison. So, as we move in the third, fourth quarter this year. Net of exchange, what you're going to see is top line revenue growth that I think is more indicative of really the revenue fire power, if you will the portfolio of businesses that we are in. But to your point, we are going to continue to see gross margin improvement throughout. And that is I will tell you, singularly the most important financial metric that I look at and it's where I hold my line business executives too in terms of accountability and that really is the proper metric to focus on.

Mike Weinstein - JPMorgan

May I ask you one business that was -- like this quarter it was anesthesia and you guys talked about channel reductions in that business and I think that was down 3% domestically. Could you just help us quantify what the size of those inventory reductions might have been? And actually more broadly if you could comment, it seems like the report from the few companies this week, that hospitals in different degrees were reducing inventories in certain products during the first quarter, distributors were as well, can you just add any color or thoughts on that?

Bob Parkinson

I don’t know that we have any insight relative to hospitals reducing inventories, any anecdotal or factual information frankly on that. I know, one of the questions that has been raised, and other companies as they have reported this week, is the underlying growth in surgical procedures. Frankly, we haven’t seen any discernable change in that either. So in terms of the anesthesia Rob, you want to take that, let's go over to you.

Rob Davis

Mike if you look at it, it’s about $10 million that we saw in the quarter. And again, as you know, we do expect, as I highlighted in my prepared comments to see that recover. It's already showing the comeback in the second quarter. And it really was, wholesalers carrying a little bit less inventory than we expected, based on that we track what they have as far as on hand inventory, and they were a little low. But again, it's nothing in our channel checks, so we are talking with our business people in ACC and in Medication Delivery, or our BioSurgery business, support the fact that it's due to anything other than just timing of purchases by some wholesalers.

And as you know, we saw the same volatility last year. We expected it to be less, as we went to the free-for-service. Most of the volatility, I just talked about, came from the one remaining big wholesaler that we haven’t really got into the free-for-service model yet. But end-user demand, which to me is the real measure, continues to grow and look good. And as you see for the full year, we continue to be very optimistic about the total growth of this business, in the US, but also importantly outside the US we are seeing extremely robust growth. So, that's the way we are looking at it, and we feel good about it.

Mike Weinstein - JPMorgan

Okay.

Mary Kay Ladone

Next question?

Operator

Matthew Dodds with Citi is on the line with the question. Please state your question.

Matthew Dodds - Citi

Hey good morning, couple of questions. First, on vaccine, generally I've always thought it is mostly FSME primarily in Germany, has that expanded, as its number now continues to get bigger and you are looking at 20% growth, where is the majority of that coming from? And then the second question is for IVIG, for the nerve indication, can you tell me were you are with the MMN or any other indications that potentially promotes the neuro indications in the US?

John Greisch

This is John. Good morning Matt, I will answer your first question. Yes, the answer to the question. FSME is growing. We are seeing that. That actually is doing better in the market and it is a big part of what happened in Q1, and it is a big part of the full year, and the guidance change, as you know we did raise our guidance a little bit on our total vaccines business. We also continue to expect our NiceVAX vaccine to continue to be very strong this year. And there is a nominal amount of pandemic from some older contracts, but really the growth of what we are focusing on in this guidance is what's going on in those two franchises.

Matthew Dodds – Citi

And that mostly is still Germany or has it broadened out?

John Greisch

It’s mostly still Germany, but it has broadened out a little bit, but Germany is still the key driver of it.

Matthew Dodds – Citi

You are making any progress in MMN indication.

Mary Kay Ladone

No, on MMN, we are not expecting accrual for that indication until probably 2010, 2011. We are still in the clinic and Matt I believe it is in Phase II trial.

Matthew Dodds – Citi

Okay. Thanks Mary Kay.

Mary Kay Ladone

Next question?

Operator

Lawrence Keusch of Goldman Sachs, is on the line with the question. Please state your question.

Lawrence Keusch - Goldman Sachs

Yeah. Hi, good morning everyone.

Rob Davis

Good morning Lawrence.

Lawrence Keusch - Goldman Sachs

Couple of things, just turning to Heparin, Bob, clearly people understand that the financial impact from the specific product is not that large, really immaterial for you guys, but certainly what concerns people is the potential liability and how you guys get caught up in all of this. Would you mind just going through, just the most recent data, relative to your review of where you guys think you may be associated with some of these deaths? And then the second part of the question is, philosophically, and specifically related to Heparin, do you want to get back in this market and a broader question, it doesn't make sense to be in these types of markets where there are relatively small sales, but touch a lot of people and you can potentially have some issues?

Bob Parkinson

Yeah. Okay, Larry, let me weigh into that. I mean and stating the obvious, this has been a very difficult situation overall, in terms of first and foremost, starting with the patients, into the degree that Baxter products led to any untoward outcomes, certainly any patients deaths or serious injuries. We obviously very much regret that, we are disturbed by that, and it continues to be a significant challenge from a number of different perspectives. Let me start with the question you asked, in terms of potential liability, and so on. I think everyone knows that the fact that someone reports an adverse event does not necessarily mean that the specific drug caused that medical event. I would tell you that our medical assessments today indicate that in only four cases of reports that we've received, a death may be related to an allergic type of response to Baxter Heparin, and I would also say that in no cases had this been confirmed as the cause. So, the Heparin issue hasn’t produced evidence of medical outcomes of a kind or scope, I guess I would say, that we would expect to generate any kind of material patient litigation. Today we have had about a dozen lawsuits, including the few that I guess would call themselves class actions, and in none of this do we think there is a credible medical assessment linking a fatality to Baxter Heparin.

So, I will tell you this has been and continues to be despite the materiality from a financial point of view, Heparin to Baxter has been and continues to be the number one priority in the company. I can't tell you the amount of time and effort, and appropriately so that’s been dedicated to this. I think it's well established at this point that the source of this contaminant, if you want to call it that, was in fact further back in the supply chain. And we have also learned that it has impacted at this point now a number of companies throughout the world, in Japan and in Europe, and it is a broader, more general issue. The one thing I will say, I am very proud of work that was done by Baxter scientists. Working hand-in-hand with the FDA to develop what I would just describe as next generation analytical test methods, that going forward can detect this particular contaminant that was introduced further back in the supply chain. As a practical matter what that means is all Heparin, from all manufactures, every where in the world that’s been a fill finished and introduced into the market place, the bulk material has now and will continue to be tested by those next generation test methods. So, we are actually very proud of that scientific accomplishment and contributions that our Baxter scientists have made in that regard. So we will continue to update you.

The second part of your question, we haven’t made a decision whether or not we are going to reenter with Heparin, it is fair to say, and clearly our priority continues to be understanding the issues that got us to this point. The technical issues as well as the supply chain management issues, which given the nature of this product as a biologic, everyone understands by now, if you didn’t know before, that it's source is pig intestines and so on , that is a complex and difficult supply chain. So, first and foremost, we need to ensure that that supply chain is controlled as effectively as possible. That we really truly understand the cause of this, and those are the necessary things we need to assess before we would then get to a position to decide whether or not we want to reenter. You are right in pointing out that this is a critical medication, used thousands of times, everyday, saving lives, in very critical procedures from Hemodialysis procedures to coronary bypass procedures and so on. And as we said here today, there is largely one supplier or manufacturer to the US market who also by the way sources bulk Heparin out of China. So, it is a, and continues to be a complex situation, but we'll address the second question you asked about the prospects of reentering it later once we dealt with some of the near term more frontal issues okay?

Lawrence Keusch - Goldman Sachs

Okay, terrific. And then just quickly, the R&D spending, obviously 20%, impressive number, can you just remind us again, just quickly the sort of top projects that is being allocated towards outside of IVIG and Alzheimer's?

Bob Parkinson

Yeah, well. I think the probably the biggest spent project continues to be our adult stem cell program for a number of indications, which yes, we are very excited about that. That's really our largest spent program in the company. We continue to spend money on our vaccines programs both our pandemic flue as well as the seasonal flu vaccine, which continues to progress nicely. Obviously, we are moving now, as we announced into the phase III study for IVIG with Alzheimer’s, subcutaneous administration of IVIG with our (inaudible) technology. What else Mary Kay, Rob help me out.

Rob Davis

With generic medicine, across all -- obviously we have talked in past about our partnerships with several companies. If you look at, probably, it is not one single large program, but it’s a number of programs which, I think offers good promise in the future. And then outside of BioScience, we are very focused on Renal, getting spending to bring out next generation cyclers horizon and continuing to make sure we remained the franchise leader in that space.

Bob Parkinson

That’s why it was the primary objective, as well as the Home Hemo Program, which continues to be a major spend area in Renal. So, I think, at a high level without getting too granular here, we have and we continue to be committed to growing R&D at a faster, perhaps a much faster rate than sales. That’s a strategic imperative for our company. I think our pipeline overall continues to evolve, become more robust. And encouragingly the pipeline is really representative of all three of our core businesses and has increasingly a nice blend of near term initiatives, which can have impact in the short term, as well as increasingly early stage and in some cases, preclinical kinds of activities, which I think is the right balance and right portfolio of R&D initiatives, that are going to be necessary to drive and hopefully accelerate growth in years to come.

Lawrence Keusch - Goldman Sachs

Okay. Great, thanks guys.

Operator

Glenn Reicin of Morgan Stanley is on the line with the question. Please state your question.

Glenn Reicin - Morgan Stanley

Good morning, folks, thanks for taking my call.

Bob Parkinson

Good morning.

Glenn Reicin - Morgan Stanley

Couple of questions here, can you maybe just quantify, what do you think would be the impact due to FX for this year and incrementally what is the change from, say when your initial guidance was made versus today? I'm really saying my bottom line, not top line.

Rob Davis

Yeah. I don't really want to get into trying to estimate for the full year FX and the numbers, because obviously, I don't want to pretend to and say what rates are going to do, but we did get some benefit in the quarter from our own expectations. I think one of the main reasons we wanted to highlight it, is we have been very vocal in the past that due to the manufacturing footprint in the location of how we produce, sell, do our R&D and SG&A, all things we talked about in the past that we have historically had a portfolio effect that has created a natural hedge position where frankly de minimis impact to pretax from FX, that has changed a little bit. I think as I talked to a lot of you about that. It used to be due to the interplay of a various currencies, obviously when every currency is strengthening versus the dollar that breaks down a little bit. So we still are seeing some muting from that natural hedging effect we have. But it did have a modest impact into the quarter and it will benefit us on here.

Glenn Reicin - Morgan Stanley

Are you willing to tell us the exact change in guidance what percentage of that was attributable to currency?

Rob Davis

No, because then it gets into, again, there is so much estimation on what's going to happen to the full year. I'd say we're confident that we'll deliver those numbers, whether the euros outwards or weakens a little bit, so it's not what's all driving that, but I don't want to estimate because it goes down that path.

Glenn Reicin - Morgan Stanley

Okay. And that was my simple question. My two more difficult questions really are can you talk a little bit about the transition to LA for active how that impacts the P&L over the next 12 months? And I'll get the other one in there, so you can decide which one you want to start with. When we look at the COLLEAGUE pump situation, we are in a market where your competitors are still innovating and looking for new ways of embedding technology into their pumps. During this whole period of time you have been trying to repair situation, at what point is this business impaired, because of what has transpired over the last two years?

Bob Parkinson

First of all, while the focus is on COLLEAGUE, Glenn, and appropriately so it doesn’t mean as part of business development efforts, and so on, we don’t continue evaluate other things that will allow us to participate in the kind of technological evolution that you have described. The fact of the matter is COLLEAGUE is still, if not the leading, the number two pump in the market place in the US today. And it is very well established. So I mean we are long ways away from the second part of your question. Obviously this has been a challenge and frustrating to all of us, but the notion of saying we got an impaired position with this product. We are not even close to that and as I suggested we are also evaluating other initiatives as well in the infusion pump area.

Glenn Reicin - Morgan Stanley

That’s intriguing.

John Greisch

I think the other thing I would point out to that, if you look at, we can talk about the market share. Our market share position we still have only lost about 3% to 4% of market share, that’s down a little bit from where we were last quarter. So, while it's eroding very slightly, just think that, I guess almost over two years out from when we started and it reinforces the strength of Bob’s point, which is this pump is still liked and used in the market and obviously we are also focused on next generation type products. But it continues to be about protecting the installed base, and helping the customers that have stayed with us, we are focused on that first and foremost. But that does include considerations around next generation products. Obviously, in a day when you are announcing a charge, I don’t think we need to get into a lot of detail of that, but needless to say it is out there and it's something we feel good about.

I'll take your first question, Glenn, on what's going on with LA front. As you look at it, as you know, the transition, we won't really be fully transition to that new facility until 2009, we are approved in for our liquid and lyophilized form of IVIG. And we are in the midst of doing that transition, but we also still are registering in various countries around the world to bring that up. We are now reflecting the depreciation from that facility, but fortunately it is largely offset by some of the positive variances we get, from a total volume of production as we have always indicated. Our intention is to replace the capacity that is coming out of our old facility with our new facility. Long term, we do expect that capacity to grow, as we get up the learning curve and believe we will continue to see margin benefits, longer term. But in the near term, it's neutral or slightly negative, due to the depreciation offset by the grants that I talked about. And then I did mention obviously as we transition, we are making sure we carry enough inventory, so we don’t allow for any disruption in the market. And that's I think the prudent thing to do, as we transition, but it's not a huge number and it’s a transitory situation until we are fully up and running. Mary Kay, would you add anything to that?

Mary Kay Ladone

No.

Glenn Reicin - Morgan Stanley

And would you care to try to quantify the ultimate contribution on the gross margin line from this new facility, without any timelines attached to it.

John Greisch

No, not right now.

Glenn Reicin - Morgan Stanley

Okay.

Mary Kay Ladone

It won’t really have a positive impact until 2010.

Glenn Reicin - Morgan Stanley

Okay, thank you.

Operator

Thank you. Our next question comes from Rick Wise of Bear Sterns & Co. Please state your question.

Rick Wise - Bear Sterns

Okay. Can we talk a little bit about first quarter organic sales growth, I had just went back and checked the first quarter transcript, and if I understood it correctly you were guiding to 3% organic growth for the first quarter, and it came in at 2%. That is not all anesthesia, so can you give us a perspective on that? And maybe follow it up with, help us why, I understand why we are going to see now 4% to 5% organic growth in the second quarter, maybe just some of the driving factors that are going to help us year-over-year? Thank you.

Bob Parkinson

Yeah, Rick, let me just kind of take you through, the organic growth net of exchange in the first quarter was 2%. The TT effect in the first quarter was about 1.8%, BeneFIX cost 1.9%, and Propofol 0.7%. So, adjusting for those items, it would come up with an adjusted organic growth of about 6.5%. Okay? And so, as those events change in the subsequent quarters, that is really the bases of our guidance.

Rick Wise - Bear Sterns

Okay. If finally, a bigger picture question, help us understand, just maybe update us Bob on your latest thinking on in terms of what’s next, I mean, obviously continued solid, organic sales growth. It seems like we are going to see more margin improvement as you detailed with mixed volume, efficiencies etcetera. But maybe talk a little bit more about your business development plans, your acquisition or joint-venture thoughts? And maybe just even more strategically, you are continuing to be aggressive in buying back shares, does that mean you are less inclined to go out and do deals, and leverage the P&L that way.

Bob Parkinson

First of all, I don't think that our position on our share buyback program in anyway should be, one should interpret that as changing our intent in terms of business development, and the kinds of acquisitions that we've talked about previously. And frankly, given the magnitude of the share buyback, given our strong cash generation position, it provides us ample latitude to do the kinds of things and the kind of scope that we've talked about before.

We continue to look at a number of things. Obviously, you can't get specific on any of those, but we continue to look at a number of things, as you know our approach I think is very disciplined, I mean we're in a position where, especially with our accelerating investment and R&D, and our evolving internal product pipeline, as we look out on the coming years, we're not in a position where we really have to do anything of a significant magnitude that often times has with it a certain amount of risk. We're actually, I would say, more encouraged about where our pipeline sits today than a year ago, as I said it continues to evolve and become more robust. And with our continued ability to grow R&D spending at the levels that we are, I would fully anticipate a year from now that pipeline is even going to be stronger, so the kinds of deals that we've done over the last quarter or two of a specific product nature or a specific technology, certainly we're going to continue to do those kinds of deals. We continue to be open minded to something of larger proportions, but again nothing as you know of other major magnitude, things that we have described previously as either bolt-ons or adjacencies to existing businesses. But you are not going to talk about deals until they are done, that isn’t to suggest that the fact that we haven’t done this, is not to suggest that we don’t continue to look. But again we are doing it with a high degree of discipline and from a perspective that we are not going to bad deals, and we are not going to do risky deals, especially given the very strong underline foundation of our businesses that we are in today.

Glenn Reicin - Morgan Stanley

Okay.

Rob Davis

Can I just add something to that Rick?

Glenn Reicin - Morgan Stanley

Sure.

Bob Parkinson

I think it’s important also to note that if you go back to the capital allocation framework we laid out, going back to our Investor Conference. In that we set aside almost a $1 billion a year and it actually will grow to be more than that in the later years, especially some cash flow generation which was if you recall that 30% of discretionary investments. So the pace of our share repurchases are marginally in line with that plan we laid out. We continue to have more than enough access cash, as well as borrowing capacity to do any deal that we would want to do, and that's an important part of the framework. So I don't want people to believe that we have changed our stance for share purchases, it's exactly the same. And if I could loop back to your prior question, just quickly, Rick, one another point just to make gets to, I think, your question of versus our original expectations. We did come in a little low, part of that was, what was going on in anesthesia. And also there, if you look at it we had in the month of March, several shipments and it was actually in many of our businesses that were pushed into the second quarter. So, there is a timing element of what caused us to come in just below the expectation in Q1, that’s also in part of why you are seeing that strength in Q2, because of some of that's going to be flipping into that quarter. So, I think Bob's point is really the core growth of our business continues to be strong and very consistent with our long range view, but specifically the swing from Q1 to Q2 is a timing issue.

Rick Wise - Bear Sterns & Co

That’s very helpful. Just last, going back to COLLEAGUE, Bob, obviously very disappointing instance of timing but, can you give us any more concrete sense on the specific tasks ahead or timing on anything in terms of filing resolutions or inspections and is it literally impossible that COLLEAGUE, the Triple Channel issue gets resolved this year? Thanks very much.

Bob Parkinson

Okay. Rick, look there are several different moving parts on this, and I am not going to get into specific milestones going forward other than the direction that we provided this morning in terms of sales guidance for the year. And as we said, fundamentally taking out any sales associated with re-commercialization of the device. There are a number of parts of this, we continue to work actively with the agency regarding some of the observation they made, regarding the COLLEAGUE systems in their December inspection. There are other software modifications that we would like to address as well, through the process. And finally we are still working through what I call a testing protocol. In other words, when we get the device to where we need it with the 510(k) and so on, how do we in essence do fill clinical of this device, that we'd like to conduct before a broad scale rollout of the Triple Channel. We clearly want to avoid the kind of situation that took place last year, with this particular issue on the Triple Channel and this buffer overload. And one other things we believe is prudent to do is to make sure that we have a rigorously tested the device in the field, under a clinical-like situations before we more broadly rolled it out. So, those are three different elements of this, which in aggregate led us to take the position in terms of the guidance for the year that we provided this morning.

Rick Wise - Bear Sterns & Co

Thanks so much, Bob.

Mary Kay Ladone

We have time for one more question.

Operator

Ben Andrew of William Blair, is on the line with the question. Please state your question.

Ben Andrew - William Blair

Just briefly on the peritoneal dialysis side, can you talk about any other major tenders that are coming up for international markets that we should keep an eye on? And what's your longer term prospects are there for faster patient growth for PD?

Bob Parkinson

Yeah, Ben, this is Bob. It’s actually very good question in light of the Mexico experience, because it raises the question gee do you have many Mexico’s. Other Mexico is on the heels of this and I would indicate to you that we don’t, as you know, historically it has been a very big business for us in Mexico, and they have moved in the last two years to this tender process. Unfortunately that was a negative surprise that we incurred. But, I think, going forward, Mexico represents an opportunity for growth, as we move into 2009 and beyond. But there really are not any other countries or markets Ben that have similar characteristics. So, we don’t believe. It’s a situation where every year there is going to be one or two countries like this. I think it was very much of a one-off. Having said that, PD growth continues to be most robust in markets outside the US, including the emerging markets, we have talked about China previously. It continues to be our largest growing market. And frankly we don’t see anything horizon that would suggest that that is going to slowdown. And Ben, closer to home in the US, while it's still a single-digit growth in PD on a year-to-year basis, we are starting to gain some momentum in the US market that frankly has been a flat-to-down market for Baxter going back close to ten years now. So, we are encouraged with emerging momentum in the US. We continue to be optimistic about growth for PD outside the US, driven largely by emerging and developing markets like China, and despite the disappointment with Mexico, we don't see any comparable situations like that on the horizon going forward.

Ben Andrew - William Blair

And just briefly, can you give us an update on the status of the home product with DEKA, when you might enter the clinic with them?

Bob Parkinson

Have we communicated Mary Kay, I mean the project is moving ahead very nicely with DEKA, but I don’t know whether we are going to take…

Mary Kay Ladone

And we're not accepting Home Hemo to market or launch the product, not until by 2011.

Ben Andrew - William Blair

Okay. Thank you.

Bob Parkinson

Thank you.

Operator

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

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Source: Baxter International Inc. Q1 2008 Earnings Call Transcript
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