Baxter International Inc. — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018; unaudited. Comparisons are with the corresponding 2017 periods unless stated otherwise. Amounts are in U.S. dollars.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net sales | $2.767B | $2.707B | $8.286B | $7.787B |
| Gross margin | $1.236B | $1.130B | $3.589B | $3.306B |
| Gross margin percentage | 44.7% | 41.7% | 43.3% | 42.5% |
| Operating income | $385M | $300M | $1.201B | $1.000B |
| Income from continuing operations | $544M | $248M | $1.276B | $785M |
| Diluted EPS from continuing operations | $1.00 | $0.45 | $2.33 | $1.42 |
| Cash from operations | Not stated quarterly | Not stated quarterly | $1.341B | $1.343B |
- Sales increased 2% in Q3 and 6% year to date at reported currency rates; at constant currency, growth was 3% and 4%, respectively. Currency reduced Q3 sales growth by about one percentage point and added about two points to nine-month growth.
- Q3 segment sales: Americas $1.497B, EMEA $707M, APAC $563M. For the first nine months, sales increased in all three regions, led by EMEA.
- By business unit, nine-month growth was strongest in Pharmaceuticals (+13% reported), Acute Therapies (+15%), and Advanced Surgery (+12%). Medication Delivery declined 1%.
- Operating cash flow was essentially unchanged year over year. Capital expenditures were $468M versus $410M; operating cash flow less capital expenditures was approximately $873M, calculated from the reported figures.
- Cash and equivalents were $2.860B at September 30, down from $3.394B at year-end 2017. Debt and lease obligations totaled $3.488B, including $3.485B long term; cash exceeded current maturities but was below total debt.
Changes, drivers, and unusual items
- Reported earnings growth substantially reflected tax and other favorable items. The effective tax rate was (34.0)% in Q3 and (2.2)% for the first nine months, versus 14.5% and 15.0% in 2017. Q3 included a $200M release of a valuation allowance on U.S. foreign tax credit deferred tax assets. Year-to-date tax benefits also included a U.S.-Germany transfer-pricing settlement and other discrete items.
- Q3 and nine-month 2018 continuing-operations income included special items that increased income by $108M and $31M, respectively; comparable 2017 special items reduced income by $108M and $237M. These included tax effects, restructuring, acquisition costs, and other items.
- Claris-related claim settlements generated an $80M benefit in the first quarter. Hurricane Maria insurance recoveries reduced costs by $23M in Q3; Baxter said additional recoveries were not yet realizable.
- Gross margin improved, with management citing favorable product mix and manufacturing efficiencies, partly offset by foreign exchange, supply-chain costs, and Hurricane Maria-related lost sales. Q3 gross margin included a 1.6 percentage-point adverse effect from identified special items.
- Medication Delivery and Clinical Nutrition remained affected by Hurricane Maria-related supply constraints. Medication Delivery also faced U.S. large-volume parenteral distributor destocking. Management cited some customer protocol changes and switching to competitors.
- Business optimization charges were $90M in Q3 and $175M year to date. Baxter had incurred $751M cumulatively and expected about $130M of additional pretax costs plus $50M of capital expenditures through completion. Management expected approximately $1.2B in annual pretax savings, with about 80% expected by the end of 2018 and the remainder by the end of 2020.
- Share repurchases were $1.028B for the first nine months, compared with $275M in 2017; dividends paid were $274M. The company reported $1.6B remaining under its repurchase authorization.
- Remaining performance obligations on qualifying contracts were $7.9B at September 30; Baxter expected to recognize about 5% in 2018 and approximately 20% in each of 2019–2022, with the balance thereafter.
Liquidity, outlook, and risks
- Baxter reported $2.9B of cash, access to a $1.5B U.S. revolving credit facility and an approximately €200M euro facility, and compliance with facility covenants. Management said available liquidity and expected cash generation should support obligations and investment needs.
- The filing does not provide a clear numerical full-year revenue or earnings forecast. Management did identify expected optimization savings and remaining restructuring costs as described above.
- Regulatory exposure includes an FDA Warning Letter issued in July 2018 concerning Claris’ Ahmedabad facilities; Baxter was implementing corrective actions and had a regulatory meeting scheduled for November 6, 2018. The filing also notes an earlier FDA Warning Letter concerning North Cove and Jayuya facilities and an October 2018 regulatory meeting.
- The company was cooperating with a U.S. Department of Justice antitrust investigation and New York Attorney General inquiry concerning IV solutions manufacturing, pricing, and shortages. A related private antitrust complaint was amended after dismissal without prejudice.
- Other material risks include product quality and patient safety, manufacturing capacity and supply continuity, competition and generic entry, foreign exchange and interest-rate movements, customer and government receivable collection, and litigation. Public-sector receivables in Greece, Spain, Portugal, and Italy totaled $141M. Legal reserves were $30M; Baxter said some potential losses could not be estimated and outcomes could materially affect a period’s results or cash flows.
Most important facts for investors to verify
- How much earnings growth is sustainable after excluding the large tax benefits and other special items, particularly the Q3 tax allowance release.
- Whether Baxter achieves its stated $1.2B annual optimization savings and completes the remaining program within the projected cost and timing.
- Whether Hurricane Maria-related supply constraints, customer switching, and IV-solution availability continue to affect sales and margins.
- Progress on FDA corrective actions at Claris, North Cove, and Jayuya, and any consequences for approvals, production, or product availability.
- Developments in the DOJ and state antitrust inquiries and the amended IV-solutions class action, including any effect on reserves or exposure.
- Inventory growth, cash conversion, and capital allocation: inventories rose to $1.718B from $1.475B, while share repurchases materially exceeded the prior-year level.