Baxter International Inc. — Q3 2019 Form 10-Q
Business context and reporting period. This quarterly report covers the three and nine months ended September 30, 2019. Baxter supplies healthcare products and therapies across its Americas, EMEA and APAC segments. The filing was submitted on March 17, 2020 and includes restated 2018 comparative financial statements.
Financial performance and position
Amounts below are in millions of dollars, except per-share amounts and percentages.
| Metric | Q3 2019 | Q3 2018 restated | Nine months 2019 | Nine months 2018 restated |
|---|---|---|---|---|
| Net sales | $2,851 | $2,761 | $8,323 | $8,266 |
| Gross margin | $1,230; 43.1% | $1,232; 44.6% | $3,463; 41.6% | $3,576; 43.3% |
| Operating income | $503 | $382 | $1,236 | $1,193 |
| Net income attributable to Baxter stockholders | $369 | $518 | $1,024 | $1,241 |
| Diluted EPS | $0.71 | $0.95 | $1.97 | $2.26 |
| Operating cash flow, continuing operations | Not provided for quarter | Not provided for quarter | $1,281 | $1,308 |
Q3 sales increased 3% at reported rates and 5% at constant currency; nine-month sales rose 1% and 4%, respectively. Currency reduced reported sales growth by 2 percentage points in Q3 and 3 points year to date. Q3 operating income improved despite slightly lower gross profit; corporate and other costs declined. Net income and diluted EPS fell in both comparisons, reflecting, among other factors, unusually large tax benefits in 2018.
At September 30, 2019, cash and equivalents were $3,009, total current assets $7,210 and current liabilities $2,611. Short- and long-term debt and finance lease obligations totaled $5,065; operating lease liabilities were a further $592. Nine-month cash flow included $679 used in investing, including $505 of capital expenditures, and $614 provided by financing. Financing included $1,661 of debt issuance, offset in part by $1,029 of share repurchases and $310 of cash dividends. Cash ended the period $1,171 above year-end 2018, at $3,009.
Q3 sales growth was broad across most product groups; Medication Delivery and Advanced Surgery grew 8% and 9% at reported rates, respectively. For the first nine months, Advanced Surgery grew 10% reported and 13% at constant currency, while Clinical Nutrition declined 3% reported. Segment operating income declined year to date in Americas and EMEA but increased in APAC.
Restatement, material changes and unusual items
- Restatement and controls: Baxter corrected a longstanding foreign-exchange accounting convention that did not comply with U.S. GAAP. The company said certain intercompany transactions, undertaken after exchange rates were known, were used to generate non-operating FX gains or avoid losses; the practice had occurred for at least ten years. Restated Q3 and nine-month 2018 net income decreased by $26 million and $35 million, respectively, and diluted EPS by $0.05 and $0.07. The December 31, 2018 restatement reduced retained earnings by $551 million. Other immaterial corrections were also made. The company continued to cooperate with the SEC.
- Management identified a material weakness in internal control over financial reporting. Disclosure controls were ineffective as of September 30, 2019, and the weakness remained unremediated at that date. Actions included adopting GAAP exchange rates, automated daily rate feeds and comparisons, stronger approvals and documentation for intercompany transactions, and additional treasury personnel. Management said the interim statements fairly presented the periods shown; the independent accountant performed a review, not an audit.
- Gross margin declined year over year, which management attributed, excluding special items, to unfavorable product mix, inventory write-downs and added costs to address manufacturing issues at a U.S. dialyzer facility. Nine-month results included a $31 million intangible-asset impairment. Business optimization charges were $131 million in the first nine months; cumulative program costs since 2015 were $927 million.
- Other operating income included $40 million of Hurricane Maria insurance recoveries in Q3 and $37 million of insurance proceeds from a legacy product matter during the first nine months. A further $60 million of Hurricane Maria claims approved in October 2019 was expected to be recognized in Q4. The company reported a $755 million non-cash pretax pension settlement charge expected in Q4 after transferring approximately $2.4 billion of U.S. pension liabilities to an insurer in October.
Outlook, risks and contingencies
The filing does not provide a clear full-year sales or earnings guidance figure. Baxter expected approximately $100 million of additional pretax costs to complete its current business optimization program, with cumulative annual pretax savings of approximately $1.2 billion once remaining actions were complete; approximately 95% of expected savings were anticipated by year-end 2019, with the remainder by the end of 2023.
Management highlighted foreign-exchange exposure, competition and generic entry, manufacturing and supply continuity, product quality and regulatory compliance, litigation, and the material weakness and potential for further financial-statement corrections. It also described potential COVID-19 effects on supply chains, operations and demand as uncertain and not significant to date. Legal matters included IV-solutions antitrust litigation, opioid-related claims, securities litigation related to the FX investigation, and SEC cooperation. Recorded reserves for legal and environmental matters were $55 million at September 30, 2019; the company said it could not estimate losses for certain matters, while not expecting the proceedings to materially adversely affect consolidated financial position.
Most important facts for investors to verify
- Whether the FX-related material weakness has been fully remediated and whether additional restatements or SEC actions arise.
- Underlying sales and margin trends after separating currency effects, temporary competitor supply disruption, special items and insurance recoveries.
- Progress and realized savings from the optimization program, alongside remaining costs and manufacturing remediation at the dialyzer facility.
- Cash generation, debt and lease obligations, and the effect of the Q4 pension settlement and subsequent acquisitions on liquidity.
- Developments in regulatory matters, product and supply risks, and pending litigation, including the potential financial impact of claims that are not currently estimable.