Baxter International Inc (BAX) — Q4 2015 Earnings Call Transcript

Thanks, Stephanie. Good morning and welcome to our fourth quarter 2015 earnings conference call. Joining me today are Joe Almeida, Baxter's new Chairman and Chief Executive Officer, and Jay Saccaro, Chief Financial Officer. On the call this morning we will be discussing Baxter's fourth quarter financial results and outlook for the remainder of 2016 before taking your questions. With that, let me start our prepared remarks by reminding everyone that this presentation, including comments regarding our financial outlook, new product development, and regulatory matters, contains 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 in our SEC filings for more detail concerning factors that could cause actual results to differ materially. In addition, on 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 Joe. Joe?

Thanks, Clare. Good morning, and thanks for joining us. Before commenting on our performance in the fourth quarter, I wanted to share a few initial impressions of what I have observed during the past several weeks and why I'm excited about the opportunities that lie ahead. Clearly, we're building on a very strong foundation. Baxter has established one of the most trusted and respected brands in the healthcare industry, and over this rich history, we have built a durable portfolio of market-leading projects with broad geography reach that spans more than 100 countries. Clearly, we have an outstanding base for expanding margins and accelerating performance. And following last year's spin-off of Baxalta, we can now devote our attention to the strategies and investments that will drive profitable growth across the business and create value as we aspire to deliver top quartile total shareholder returns for our investors. The initial steps are already well underway, which is reflected in Baxter's fourth quarter results. As you saw in this morning's release, we delivered adjusted earnings of $0.43 per diluted share, exceeding our guidance of $0.30 to $0.32 per diluted share. Operating income of 10.7% compared favorably to our guidance of 9.5% to 10%. After adjusting for the impact of foreign exchange and a generic market entrant in the U.S. for cyclophosphamide, we reported sales growth of 4% in the quarter, also ahead of our expectations. Key growth drivers in the quarter included strong performance in our U.S. fluid systems franchise where our newly launched SIGMA SPECTRUM infusion pump continues to build momentum, as well as increased demand and favorable pricing for our IV solutions. Performance was also augmented by strength in our U.S. peritoneal dialysis business, which reported the highest quarterly growth of the year. The U.S. PD business is seeing very promising early results on the recent launch of our AMIA APD cycler, which features our SHARESOURCE two-way connectivity platform, and we look forward to expanding this launch in 2016. So overall, a positive quarter and a great base to build on for the future. As for what the future looks like, we are in the process of developing a strategic framework that will shape our priorities and direct our approach and investments moving forward. I'm confident this framework will drive sustainable growth for Baxter and create enhanced value for our shareholders. Simply put, our objective is to further accelerate and increase the impact of our margin improvement plans to support our goal of top quartile shareholder return. To successfully achieve this outcome, we will execute on three distinct strategic factors, including portfolio optimization, operational excellence, and capital allocation. In terms of portfolio optimization, we have taken a passionate approach to portfolio management which includes categorizing our businesses based on their existing financial profile and future potential. Accordingly, we will reallocate investments based on the ability to drive innovation. In addition, we're intensifying our focus on both R&D velocity and productivity to support our top and bottom line growth initiatives. The second area of strategic focus is operational excellence. We are aggressively examining our cost structure in terms of how we do business from manufacturing and operations to commercial and corporate infrastructure. I'm confident we can take additional costs out of our business without compromising our commitment to quality and safety. Related to this, we will also ensure our capital expenditures are optimally allocated to projects that enhance bottom line growth and support long-term value creation. The final strategic focus area for us is capital allocation, where we are committed to deploying capital in a manner that creates value over both the short and long-term. We'll be sharing more information about our strategy at our upcoming Investor Day on May 9 in New York City. At that meeting, we will provide more specifics around our objectives along with our three and five-year aspirational financial targets. We know there's a lot of hard work in front of us, but our team is energized and well prepared for the road ahead. And with that, I will pass it to Jay for more details on our fourth quarter performance and outlook for 2016. Then we'll have time at the end for questions. Jay?

Thanks, Joe, and good morning, everyone. As Joe mentioned, adjusted earnings in the quarter of $0.43 per diluted share exceeded our previously issued guidance of $0.30 to $0.32 per diluted share. Sales growth in the quarter benefited from strong operational performance in our fluid systems, PD, and acute businesses, as well as operating expense savings resulting from our disciplined management of costs and the restructuring initiative we announced last quarter. In addition, other income from foreign exchange-related gains and a favorable tax rate both contributed to our performance in the quarter. Now, let me briefly walk you through the P&L by line item before turning to the financial outlook for 2016. Starting with sales, worldwide revenues of $2.6 billion increased 2% on a constant currency basis. This performance compared favorably to our Q4 guidance of a 1% sales decline, with better than expected sales growth observed across the portfolio, particularly in our fluid systems, integrated pharmacy solutions, and renal franchises. Including the impact of foreign exchange, sales declined 7% on a reported basis, and excluding the impact of both foreign exchange and U.S. cyclophosphamide, Baxter's sales rose 4% globally. Sales in the U.S. increased 1% on a reported basis, and after adjusting for cyclophosphamide, U.S. sales advanced 7%. International sales on a constant currency basis increased 2% and declined 12% on a reported basis. Turning now to the drivers of business performance in the quarter, please note, I will be speaking to sales growth on a constant currency basis excluding any foreign exchange impact for each of the businesses and franchises to provide a clearer picture of Baxter's underlying operational performance. Starting with hospital products, global sales totaled $1.6 billion and increased 2%, and after adjusting for U.S. cyclophosphamide, sales for the hospital products business increased 5%. Within the fluid systems franchise, sales of $569 million advanced 12%. Performance in the quarter was driven by growth of more than 20% in the infusion systems business, supported by the successful launch of our next generation SIGMA SPECTRUM Pump and the related access sets pull-through. In addition, sales of IV solutions in the quarter benefited from favorable pricing and demand, particularly in the United States. Sales in the integrated pharmacy solutions franchise totaled $595 million and were comparable to the prior year period. Excluding U.S. cyclo sales, revenues in the category increased 8% driven by strength across the franchise, which includes our nutritional products, pharmacy injectables, and hospital pharmacy compounding services. Fourth quarter U.S. cyclo sales totaled $65 million representing a benefit of approximately $10 million versus our previous guidance. For the full year, U.S. cyclo sales totaled approximately $270 million. Fourth quarter revenues in surgical care, which includes our anesthesia and biosurgery products, totaled $346 million and were comparable to the prior-year period. Performance benefited from low single-digit growth of our anesthesia business and core surgical sealants and hemostasis products which both increased in line with surgical procedure volume growth. This performance was offset by lower sales of select non-core biosurgery products. Finally, sales in the biopharma solutions and other category, which is our former partnering business, totaled $109 million and as expected declined 22%. As we previously highlighted, this decline is driven by a large customer electing to self-manufacture products that were previously contract manufactured by Baxter. As we mentioned last quarter, this category also reflects sales for products Baxter is manufacturing on behalf of Baxalta, which totaled approximately $13 million in the quarter. Turning to the renal business, global renal sales totaled $984 million, representing an increase of 1%. Performance in the quarter was driven by high single-digit growth in our U.S. peritoneal dialysis business. As Joe mentioned, we're very excited about the prospects for this business which will benefit from the recent launch of our new AMIA PD cycler. In addition, we experienced low teens growth globally in our acute business driven by underlying market growth and an increased adoption of continuous renal replacement therapy as a treatment option for acute kidney injuries. Growth in the renal business was offset by lower sales in our in-center chronic hemodialysis business resulting from our previously discussed decision to forego certain lower-margin sales opportunities along with competitive pressures for dialyzers. Turning to the rest of the P&L, adjusted gross margin for the quarter was 42.6%, slightly ahead of our expectations driven by favorable product mix in the quarter. Adjusted SG&A totaled $672 million and decreased 17% on a reported basis. On a constant currency basis, adjusted SG&A declined 11%, reflecting the benefit of the initial actions we have taken to rebase our cost structure and reduce discretionary expenses, and the impact from transition service income we received from Baxalta during the quarter, which totaled approximately $30 million. Adjusted R&D spending in the quarter of $158 million increased 2% versus the prior year. On a constant currency basis, adjusted R&D expenditures increased 9% as we balance increased investments to support our new product pipeline with efforts to optimize our overall R&D spend. Consistent with our portfolio optimization priorities, during the quarter, we made the decision to discontinue the development of select programs and as a result absorbed approximately $15 million in expenses related to these decisions. Adjusted operating margin in the quarter was 10.7%, which compared favorably to our guidance of 9.5% to 10% driven by the positive gross margin mix and SG&A savings I just referenced. As Joe mentioned earlier, we'll continue to streamline our operations and control spending to drive ongoing margin expansion. Interest expense was $32 million in the fourth quarter. Last week, we executed our first transaction with respect to the retained Baxalta stake. In this transaction, we exchanged approximately 38 million Baxalta shares or approximately 28% of the total original equity stake to retire $1.45 billion of indebtedness under one of our bank lines. Over the next several months, we'll look to further deploy the remaining Baxalta equity through a combination of additional debt for equity and equity for equity exchanges, as well as make a contribution of at least $600 million worth of equity to our U.S. qualified pension plan, subject to final regulatory approval. Our goal is to exit our retained equity position prior to any shareholder vote for the Baxalta Shire transaction to minimize the risk of any potential negative tax implications, and we have an agreement in place with Shire and Baxalta to assist with the orderly disposition of the stake. For 2016, we expect these retained stake-related actions to benefit our earnings by approximately $0.15 per diluted share. In terms of key balance sheet items, after giving effect to the extinguishment of the bank line, our current gross outstanding debt balance is approximately $5 billion, and cash on hand at the end of 2015 totaled approximately $2.2 billion. Other income totaled $36 million and included a foreign exchange gain from hedges on balance sheet positions of approximately $20 million, and dividend income of approximately $10 million associated with our Baxalta equity stake. The adjusted tax rate was 16.6% for the quarter. This compared favorably to our guidance and contributed approximately $0.02 to our earnings per share in the quarter. The lower tax rate was driven by the extension of the R&D tax credit, a slight shift in our sales mix, and certain other adjustments. As previously mentioned, adjusted earnings of $0.43 per diluted share exceeded our guidance of $0.30 to $0.32 per share. Let me conclude my comments this morning by providing an update on our outlook for 2016. Starting with sales on a constant currency basis, we expect 2016 full year sales for Baxter to increase 2% to 3%, and after adjusting for the U.S. cyclo impact, we expect underlying growth of 3% to 4%. On a reported basis, including the impact of foreign exchange, we expect sales to decline approximately 1%. This is driven by growth in the hospital products business up 2% to 3% or 4% to 5% excluding U.S. cyclo. Within the hospital products franchises, we expect sales growth of 6% to 8% for fluid systems driven by strength in the U.S. business, partially offset by the international business where we continue our efforts to optimize our geographic footprint for this franchise. For the integrated pharmacy solutions franchise, we expect sales to decline mid-single digits including the impact of U.S. cyclo. For the full year 2016, we anticipate at least two additional competitive entrants, specifically one to enter mid-year and the second to enter towards the latter part of 2016. As a result, we expect U.S. cyclophosphamide sales to total approximately $180 million, representing a $90 million year-over-year decline. Sales for the category after adjusting for cyclophosphamide are expected to be comparable to prior years. I would also remind you that in 2015, we recognized approximately $40 million in government sales for PROTOPAM. Given the purchasing pattern associated with this product, we do not anticipate any sales in 2016 in IPS. Within the surgical care franchise, we anticipate sales to grow 2% to 3%. Lastly, for the hospital products business, we expect the other category, which includes our biopharma solutions franchise, to increase low-double digits as we anniversary the impact of our customer transitioning their manufacturing in-house. This also reflects an incremental year-over-year benefit of approximately $25 million associated with contract manufacturing revenues from Baxalta. For the renal business, we expect full year sales to increase approximately 3% driven by continued growth in our PD and acute businesses and a stabilization in our in-center HD business. Moving down the P&L, we expect an operating margin of approximately 11%, which compares favorably to the guidance we provided at our 2015 May Investor Conference of approximately 10%. We expect interest expense to total approximately $90 million. This reflects the recent extinguishment of our bank line along with additional debt repayment based on further utilization of the retained stake. For 2016, we expect modest other income of approximately $10 million. This represents a year-over-year decline of approximately $150 million. In 2015, we benefited from certain balance sheet hedge gains and select equity gains related to our Baxter Ventures portfolio, neither of which is planned to repeat in 2016. For the year, we expect an average adjusted tax rate of 19.5% to 20%. This represents an increase from 2015 driven primarily by the change in earnings mix. For 2016, we anticipate an average share count of approximately 540 million shares. This reduction is driven by equity-for-equity exchanges that we anticipate to execute as part of our retained stake strategy later in the second quarter. Please note that our interest expense and share count guidance reflects a preliminary base case retained stake execution plan and is subject to change as we reassess the optimal size and mix of our remaining transactions as market and other conditions evolve. We anticipate providing updates to our guidance and/or additional detail around the actual impacts of our retained stake transactions as appropriate as we move forward. Based on these factors, we expect adjusted earnings excluding special items of $1.46 to $1.54 per diluted share for 2016. Finally, for the year, we expect operating cash flow of approximately $1.4 billion and CapEx of approximately $900 million, resulting in free cash flow for 2016 of approximately $500 million. This is also favorable to the guidance we provided in May. Specific to the first quarter of 2016, we expect sales growth excluding the impact of foreign currency to increase 3% to 4%. At current foreign exchange rates, we expect reported sales to decline approximately 2%, and we expect adjusted earnings excluding special items of $0.28 to $0.30 per diluted share. With that, we can now open up the call for Q&A.

Thank you. Good morning, everybody.

Good morning.

Good morning.

Good morning, David.

Hi, Joe. Good to hear your voice again here. I want to just start with one strategic question and then one follow-up on the financial side. And, Joe, I imagine you'll get into this in more detail come May, but maybe you could just start from a top-down perspective on where you ultimately hope to take Baxter. As I sort of think about the profile of the business today, relatively low-single digit top line growth, room for margin expansion, how do you want the business to be perceived, and where do you ultimately want to take the story over time?

David, I don't want to preempt our meeting in May, but I will give you a few things that we're considering very seriously. First of all, from the top down, we need to alter the weighted average market growth rate of our businesses. By doing that, we will look at some organic programs that can help us get into some adjacent markets and also some acquisitions. When we look at execution, we need to continue to improve our execution on a global basis and make sure that we are in the right businesses around the globe. Being global is not to be all over the place, so we need to ensure that we're focusing on countries and geographies for businesses that make sense. All this work is in process as we speak. When I look at the cost base and expense, we want to take the company to a rebase exercise, cost rebase, and determine what the appropriate level of support is to maintain our company and provide for continuous improvement and operational excellence programs that will deliver better results than we have discussed in terms of operating income back in May last year. So we are working very diligently right now in creating this strategic framework. We're working on our portfolio initiatives. But we understand some of these initiatives on the top line take a little longer, and I have no issues augmenting that with some acquisitions. I also have no problems accelerating our cost reduction to rebase the cost of the company to create momentum until we can ignite the innovation machine again.

That's very helpful. Thank you. And then just on the financial side. Jay, maybe you can sort of help us talk through the difference between the 10% operating margin guidance that you provided at last May's analyst meeting and the 11% that you're presenting today for 2016? What are some of the factors that influenced the 100 basis point better performance?

Great. So there are a number of different variables that have impacted our performance since we sat together in May. I'll highlight maybe the four most significant. As David pointed out, we guided to an operating margin of 10% for 2016. Obviously, we're very pleased to report our expectations now are an 11% operating income margin. One of the key drivers relates to foreign exchange. The foreign exchange environment since May has moved very significantly. We can talk later about EPS impacts, but from an operating margin impact relative to our May expectations, we're down about 1.4% in terms of margin impact due to foreign exchange. As you'll recall, in the second half of the year, many of the emerging markets' currencies moved while the developed markets' currencies stabilized, and for us, because we don't hedge emerging market currencies, it had a 1.4% impact on our overall margin. We did have higher than expected cyclo in 2016. So as I pointed out in my prepared remarks, we'll achieve about $180 million of cyclo sales in 2016. That's roughly 1 percentage point higher than we expected. We also have positive pension impacts. There are a number of impacts that we have with respect to our pension, some of which we had anticipated in part related to the contribution of the retained stake, but some of which we did not anticipate, and that's about a 60 basis point improvement as we move to 2016. But I will tell you the area that's most important as we look at the stability of the operations from my perspective relates to the operational performance and OpEx savings, which contribute about a point of margin improvement relative to our May investor conference expectations. So those are the four factors. With cyclo and pension essentially offsetting FX and then the overachievement really, in my view, coming from operational strength.

Thanks for all the detail.

Good morning, David.

Good morning, Joe, just a couple of questions here. I'll start with strategic for Joe and then a follow-up maybe for Jay. Joe, just – I know we're not going to get a lot of commentary before May, but just very broadly, I know you've only been there a short period of time, kind of a couple of questions for you. The first is how do you see the balance of pursuing large M&A in the near term versus delivering your organic margin plan? And if you think specifically about your hospital business and the four segments there, do you have a sense of which segments are likely to see further investment versus which ones are likely to be optimized for return or cash? And then a quick follow-up for Jay.

Yeah, David. We are completing that analysis. We've put our portfolio through about five different filters, and we actually have a pretty good idea of the things that we will invest in for top line growth versus those that are managed more for return on invested capital and those that are strategic bets and ones that we're going to manage more for cash. I would say, to you, we have a very good IPS business; the integrated pharmacy solutions is a very good business, and it's something that we probably can double down on, as an example. We will be making organic investments, possibly inorganic investments. I just want to circle back to your comment about large-scale M&A. When we go down this path and consider inorganic opportunities, size is not what matters but the ability to change the weighted average market growth rate of our businesses is key to us. Those acquisitions will be singles and doubles, they will not be big things in one shot. We're going to make the right decisions with our shareholders' money. We need to balance that well, but we need to ensure that we can successfully integrate and generate a step change in how we grow that business that we acquired. So we'll be focusing a great deal of our attention on the value the business brings to us strategically, but IPS is a good place to start.

Okay. That's very helpful. And then Jay, just on fluid systems, it was the driver obviously in the quarter, and it does seem to be the principal driver for next year's acceleration. Can you give us a component right now, what principally is driving the success? I know it's capital and consumable, but can you give us a sense of how large of a role capital sales are playing in 2016 and any sense of backlog in terms of sustainability of those capital sales over the next couple of years? Thank you.

Fluid systems has two main growth drivers for the fourth quarter and as we head into next year, we anticipate similar performance levels from them. The first is our infusion systems business, which experienced over 20% growth in the U.S. This growth has two components: the sale of the recently relaunched SPECTRUM Pump, which is capital-related, and strong performance in set sales, also well into double digits. On the IV therapy side, we previously mentioned marketplace conditions, our actions taken, and ongoing demand for this significant product, which led to solid growth in the IV therapy business, also into double digits. Together, these factors contributed to a 27% growth in fluid systems in the U.S., which is a positive outcome for us. We expect this to continue, though not at the same rate as in Q4. There will be some moderation as we progress with our 2016 plan, but overall we are pleased. Some of this is tied to capital spending, and many hospitals have lacked appealing pump alternatives for several years, indicating a potential pent-up demand. We have a clear view of the sales plan for 2016, making this sector a key growth driver for Baxter in the coming years.

Great. Thank you very much.

Thank you, and good morning, everybody. Jay, just want to circle back to a couple of the line items in the guidance. The share count guidance seems to imply that you're going to use $1 billion of the retained – the remaining Baxalta stake in the stock-for-stock exchanges. Is that about right in terms of – is that about what you're applying in your assumptions for 2016? And if so, why is that the right mix in terms of what remains?

Yeah, Mike, maybe I'll take a step back and address the retained stake overall to address your question in totality. From the retained stake standpoint, two things are very clear to us today: First, as you know, we're in the process of finalizing the bank line transaction, which is going to reduce our gross debt by $1.45 billion. That will be completed imminently. The second item is, in this quarter, we expect to contribute more than $600 million in equity to our pension plan. That, of course, is subject to Department of Labor approval. So those things are very definitive. As we move on to the remaining transactions, our preliminary plan is to pursue two additional transactions. One is an equity-for-debt exchange, and the second is an equity-for-equity split-off. We currently expect to pursue the debt exchange early in Q2 and the equity exchange closer to mid-year. There are a number of factors that will lead us to finally size these transactions, but you're right: from a placeholder standpoint, our current view is that we will use, at Baxalta's current price, a little more than $2 billion to retire debt and a little less than $1 billion to retire equity. But as I said before, these transactions are subject to market conditions, optimal pricing, and our objective is to maximize long-term value and optimize economics with respect to these transactions. So from a definitive plans perspective, I can tell you these are our very preliminary plans, but by no means definitive. We're evaluating what the optimal mix is, so there may be changes to these transactions as we move forward based on the receptivity of the market and a number of other factors. As we finalize plans and execute transactions, clearly we'll update guidance. But we have enough information today to share with you these preliminary estimates which provide some balance around the guidance range that we've given. In combination, we expect about a $0.15 benefit this year. There will be some increase to next year in part because the equity-for-equities transaction would occur very close to mid-year in this plan assumption, and also the equity-for-debt exchange we'd have at least a quarter more of benefit rolling into 2017.

That's a great overview, Jay. Thanks very much. And, Joe, let's just talk strategy for a minute. So you touched on a number of the themes that you talked about in San Francisco, including portfolio optimization, improving R&D productivity, enhancing the overall growth mix of the business, and being in the top quartile of shareholder returns. A big part of that is putting this Baxalta stake in your balance sheet to work to create value. You talked about doing more likely a series of smaller deals to achieve those objectives. As you think about that, is the number one priority to accelerate the overall mix of growth in the company's end markets, or should we look at it as more ROIC-driven, more margin-driven? Maybe just help us think about if you're looking – if you have targets and if you're looking to do something in particular for the company, is it accelerating the top line? Or how do we think about that mix?

Well, we're going to, Mike, take a look at this as a three to five-year horizon. What can we do to change the trajectory of the company's top line growth and bottom line? What comes first? We already have embarked on this extensive operational excellence program to cut costs. We're going to double down on that and become a little bit more aggressive. That will create some momentum as we continue to look for the opportunities at the top line. When we talk about capital allocation at the top line, we have about four to five businesses that will likely receive a significant amount of investment on the organic arena. I'm going to talk more about that in May. I don't want to preempt that now. But we're also going to invest inorganically in opportunities for those businesses. When we talk about executing well, we want to buy businesses that are growing faster than our current base business, which is pretty obvious. The second thing is, if we can combine that with a good synergistic deal, we'll do it as well. And why do I bracket large deals? Because very large deals are very difficult to find. We can keep looking for such a deal, but it will take a couple of years versus just creating a good strategy by looking at adjacencies and pairing good businesses with acquisitions that make sense. I don't disregard the possibility of larger size deals, but I'd just say it's much more difficult to encounter than something else that can create value almost instantly that you can execute a little faster. So I'm looking at this whole strategy as a journey where we ensure our costs are in place while we augment our internal innovation and supplement it with some well-thought-out acquisitions.

Perfect. That's helpful, Joe. Thanks. I'll let someone else jump in.

Thank you, Mike.

Oh, thank you, and good morning.

Good morning, Bob.

Good morning.

Good morning, Joe. Great to hear your voice. A couple of quick questions. First of all, can you start out with Jay on the operating margin guidance for 2016? You're exiting the year at just below 11%, and you're guiding for 2016 at 11%. It sounds like cyclo pension FX are kind of a wash. So can you give us a sense as to what kind of underlying operating margin improvement you're assuming for 2016 relative to where you're exiting the year?

Yeah, there's an important point to make which is – and you know this about our business, Bob. We have seasonality, which typically the second half of the year is stronger than the first half. The fourth quarter is typically one of the strongest margin quarters that we have, in large part because of incremental sales performance that naturally occurs. As we think about margin performance next year versus this year, I do think it's important to look at the entire year holistically. For the full year 2015, we were at approximately 9% margin going to the 11% that we've guided. So it is a substantial step change improvement in margin. The other point I will make is our Q1 guidance does have the lowest margin of the year. Again, due to the fact that Q1 sales are typically the lightest because of all the fixed costs we have in place, there is some absorption that does not occur due to the lower sales level. So I think those are a couple of important points. By and large, we're very pleased with the margin improvement that this plan indicates. The second half of the year was very important for us, in large part, because it gave us confidence that we could give solid guidance for 2016, and that we could operate effectively on a standalone basis. I do think it's important to consider the seasonality and the trending in margin when we think about 2016.

Right. So maybe just year-over-year then, ex the things that are affecting margins like cyclo pension and FX, what kind of year-over-year underlying margin improvement are you assuming with the 11%?

Yeah, essentially we're talking about, as I said, 200 basis points from 2015 to 2016. Let me highlight a few items for you that impact that. Cyclo is about an 80 to 90 basis point drag relative to 2015. PROTOPAM is another item that we've discussed previously, which is approximately a 30 basis point item. Foreign exchange is about a 1.6 point year-over-year margin drag. So relative to May, it's less. On a year-over-year basis, it's even more than that. The pension, again, is about a point of improvement year-over-year. But then there are a number of other critical items— SG&A savings, we're talking about a two percentage point improvement in SG&A. R&D savings, we're talking about a 60 basis point improvement. Then, operationally, due to many of the initiatives we are putting in place from a mix volume standpoint, along with some of our pricing and economic value capture initiatives, along with general business growth, yields approximately a little more than one percentage point of margin improvement. I walked you through a number of items there, and there are a lot of moving pieces that take us from the 9% to 11%. But there are a number of important items that we can point to operationally that are really driving this improvement that we have confidence in, as we've seen from the second half of this year as we move forward.

Great. Thank you for that. And then, Joe, just real quickly, one of the questions that we're getting a lot from investors is you're articulating a plan to drive faster growth for the company on a top line basis. People are I think very curious about how the balance will look, what the balance will look like in terms of the need to invest in the business incrementally to drive that top line growth versus what investors are looking for in terms of operating leverage in the business as you look forward over the next couple of years. How do you respond to that kind of question about the need to invest to get top line growth, but the desire for people to see real operating leverage progress here?

Bob, we need to look at this in phases. We need to bring leverage at the same time that we invest, meaning we need to accelerate some of our cost reductions. Secondly, our spending in R&D today is adequate for the portfolio as we see it for the near and midterm. This does not require us to spend more money than we are spending today. If we need to spend more, we need to self-fund that and ensure that this does not impact our earnings. This is not an investment story where we have an R&D budget that is completely underfunded to deliver innovation. We just need to do a better job in allocating capital to the right franchises that have the chance to grow faster. For instance, regarding IPS, we'll double down to get more molecules to the marketplace, and we're working on plans like this very rapidly. But that is a reallocation of resources. I want to make sure our investors are clear that as we work to accelerate our cost reductions to provide for improved bottom line, we will create a mix change in our spend to invest in the right things and concurrently look at some good acquisitions that will come in and create momentum and change in our weighted average market growth rate.

Great. Thank you very much.

Thank you.

Hi. Thanks for taking our questions. I wanted to just clarify a question, Jay, on Q1 guidance. You mentioned the sort of puts and takes and I think some seasonal effects that may show for a little—the weakest quarter of the year in terms of margins and a touch below where we were expecting. Was there anything else other than just absorption, or was there any FX impact there that you can quantify?

Yeah, sure. Just a couple of comments in terms of Q1. Historically for Baxter, Q1 has been the weakest quarter of the year, with approximately 23% to 24% of full-year sales occurring in the quarter, and 2016 is no different for us. The result of that is you have a lower drop through both in terms of margin and then ultimately in terms of EPS. And then there is another factor, which is we do have a slightly larger FX impact in the first quarter than we do in later quarters in the year. Roughly 40% of the FX impact on a full-year basis occurs in the first quarter. So really those would be the two items that I would point to. There's nothing specific beyond that as we look at sales and performance in 2016.

That's great. Thank you. And then one follow-up on one of the things that are driving much of your growth in the current portfolio of businesses is around pumps. Really impressive number in Q4. Stepping back and thinking about that business, as we all know, it has had its challenges in the past as a category. I just look to get an update on how you feel you're positioned with the new business coming in from SIGMA, with some of the new FDA actions and guidelines on cybersecurity and some of the competitors that have had problems with those kinds of new category requirements. How are you positioned going forward to help mitigate the risks of other kinds of problems that you've had in the past as a group in pumps, not just Baxter, obviously.

Matt, this is Joe. I can only speak about the Baxter product. In terms of the industry, you outlined well. There's always a concern. But this is not only the only programmable pump that you have in that category. You have pumps; you have all kinds of different things that fall into that category. But speaking specifically about our business, we have launched a really good product, and you can attest to—the testament to it is the sales growth and how we are gaining back market share and how that business is performing. The team is executing very, very well. Our objective is to continue to improve the operation of the pump. We have new versions coming up in a couple more years. We are very excited about the prospect of creating some new features within this pump, and we think in terms of cybersecurity, our pump has performed well. You can't guarantee 100% in this area. We're doing the best we can to ensure the platform we have is safe and secure for the clinicians who are programming it for the patients who are receiving the fluid.

That's great. Thank you.

Oh, hi. Good morning, everyone.

Morning, Larry.

Good morning. Joe, I'm wondering if we could start out perhaps just talking a little bit about how you see the health of the emerging markets as you look into 2016. I'm not so much talking about FX rates, but just more about the baseline fundamentals within the various regions.

Well, as you read the same headlines I do, there is a contraction in some of the major—the larger emerging market economies. Very different in nature between China and Brazil and Russia, but nonetheless, we do 25% of our business in those regions. I think one particular thing about our business is that we are not a physician-preferred product in those regions, we are a hospital necessity. So we're talking about infusion, we're talking about dialysis, and those products are needed. We have seen price pressure in those markets, but we probably saw that ahead of many people because of the necessity of our products. I feel that the risk of those markets deteriorating further for Baxter is pretty low. With all that said, it is our responsibility to look at our portfolio in those countries and make sure that we're selling the right products to the right markets. We're going through that process as we speak. But in terms of the headlines for Baxter, those are necessity products in hospital settings, and we've seen most of the contraction already. I'm not saying that we won't see it in the future, but we are not a physician-preferred product company in those markets. I feel very comfortable that our strategy at the moment is solid. But going forward, rest assured we're going to look at every region and country to make sure that the businesses we have are profitable and have good prospects going forward.

Okay. Terrific. And then I wanted to, Joe, perhaps get at again the growth question a little differently. In your prepared comments you talked about reigniting the innovation engine at Baxter. You discussed reallocating resources to drive inorganic, and you talked about potential organic opportunities. But as you've been there, and I know it's a short time, what do you really need to do to change the ability of Baxter to innovate? Do you need to change the culture? Do you need to hire folks into these various categories to really drive the innovation? What needs to happen to get that engine ignited?

So just a comment on how new I am. I can tell you I know where the cafeteria is because I eat there almost every day. The culture of the company is one of innovation for many years. I think by not having Baxalta as part of Baxter today really puts the spotlight on how we take those franchises that have been trusted for a long time around the globe and make them more innovative, creating adjacencies within our own capabilities, our four walls here for organic growth. The culture that I'm passing on to our employees is very clear: it’s about having a strategic direction, and that's about 10% of the conversation. Ninety percent of the conversation is execution. It's about making sure that once we allocate capital to the right programs, our people deliver on time or better than that. That's all about execution. That's what I'm watching very closely, because I believe we have very, very smart people at Baxter. I'm not surprised but I'm very pleased with what I found here, and I want the Baxter team to understand that from this point forward when we get this strategy going, it's all about execution. I think I have everybody behind me when it comes to that.

Okay. Terrific. Thanks very much for the comments.

Thank you.

Good morning, and nice quarter. It's good to hear your voice on a conference call again, Joe.

Thank you.

A couple of things. First of all, we haven't heard in a while where you are on home hemodialysis, and if you can give us an update on that, that would be great. And then in no particular order, second question: is there a way to quantify the $600 million pension impact on gross margins? And last but not least, M&A clearly is going to be a theme here. Big picture thoughts on adding additional legs to the stool and how you think about that. Thank you.

Thanks, Joanne. How are you? Listen, I'm very, very excited about home hemodialysis, first of all. It is, what I call, a blue ocean for the company. It is a great clinically needed innovation. It is not an easy market to get into because the technology has to be absolutely perfect for bringing this therapy to the home. We think we have the right technology and are working very hard to refine it. Right now we already have kicked off our U.S. clinical trial for VIVIA, and we're excited about that. In Europe, we have early patients and we're learning very quickly about our VIVIA platform; the use of this device is proving to be well received in Europe. So we like our technology. It is an area that I call a strategic bet. Why is it strategic? Because it's high-end market growth, potential for good revenue per patient, but more so, the therapy itself is absolutely fantastic for the hemodialysis patient to be able to do this at home. We're going to continue to improve our technology, and we will try to put some momentum behind accelerating the U.S. trial as much as we can and work with the agencies and CMS to see if we can get this technology to a different level.

Joanne, you asked a question about pension and quantifying; you commented on $600 million. I hope I didn't say that. That's an overstatement in terms of the impact on operating margin. On plan, it's about 60 basis points, which is closer to $60 million of unplanned benefit. But maybe taking a step back to talk about the overall impact of pension, we expect approximately a $0.14 benefit year-over-year from pension. About $0.07 roughly of that relates to the retained stake contribution that we plan to make in the coming month or so. The remaining portion has a few different pieces. First, the actual discount rate used to measure the liability has increased, and the result of that is approximately a $0.035 benefit. Second, as we've evaluated our accounting for our pension plan, we've made three adjustments. One is we updated the mortality table that we're using. The second is we are employing the recently approved methodology for accounting for the discount rate, and that is a benefit. The return on asset assumption is another item that we've lowered. So those three accounting changes that we've made impact us positively by about $0.02. We have some amortized losses rolling off that are about $0.01. In combination, we're talking about a $0.14 year-over-year impact, and importantly, this counters some of the negatives like the lack of sundry income that we experienced in 2016 along with the significant headwind on foreign exchange. But overall, the pension impact is in that order of magnitude.

Thanks. And the last question: Add a leg of the stool.

We will continue to work on inorganic and organic areas. I would say to you that a leg of the stool may be just enhancing a franchise that we have. We spoke about IPS and I'm very, very excited about that. I like our specialty injectable business today, and I think augmenting that can become a real good business. In terms of white space, it's a little early. We need to kind of get our capital allocation going well, and once we have that well segmented within our population and our management objectives, then we can do a white space analysis, and we will proceed on that path. But we really have enough opportunities right now to augment the current businesses, and their adjacencies are also viable. Thank you.

Hi. Good morning, guys. Two questions: One, in the fourth quarter, your surgical business grew low single digits and you said it grew in line with the market. For 2016, you're talking about the surgical business growing 3% to 4%. Are you saying that you expect surgical volumes and utilization to pick up in 2016? Or are you just saying the better rates are more specific to Baxter? Any thoughts on utilization rates, especially the U.S. And then my second question has to do with the U.S. renal business specifically with PD. I know PD did better in the fourth quarter, that was from some of your new products. But are you also seeing an increase in penetration in the U.S. with PD? Thanks.

Glenn, how are you? So listen, the utilization that we see, I just want to clarify, next year's growth is 2% to 3%, right?

For surgical care.

For surgical care. So the utilization remains at a good point in the U.S. I would say the U.S. has shown really good resilience, and we're happy about that. There are a couple of things about the surgical business: one, our anesthesia gases are performing very well, and we need to do a better job in our biosurgery business. We're going to be coming up with some specific actions in terms of execution, but also how we're going to manage that business on a global basis. This is an area that we probably should be looking to augment our portfolio. It's a great area of opportunity. Baxter has fantastic franchises within that category, and we want to ensure we don't miss the opportunity for market growth. Speaking about the PD business, we are growing our patient base. That is market share growth. Our new technology, the AMIA platform, is fantastic, and we're having some really early successes. We're looking for a very good 2016 in that arena.

Okay. Great. Welcome back, Joe.

Thank you, Glenn.

Thank you. This will conclude the call.