Baxter International Inc (BAX) — Q3 2022 Earnings Call Transcript

Good morning, and welcome to our third quarter 2022 earnings conference call. Joining me today are Joe Almeida, Baxter's Chairman and Chief Executive Officer; and Jay Saccaro, Baxter's Chief Financial Officer. On the call this morning, we will be discussing Baxter's third quarter 2022 financial results and full year financial outlook for 2022. With that, let me start our prepared remarks by reminding everyone that this presentation, including comments regarding our financial outlook for the fourth quarter and full year 2022, our 2022 to 2025 long range plans, the acquisition of Hillrom, new product development, the potential impact of proposed pricing actions, business development, portfolio optimization 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 and 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. On the call this morning, we will be discussing operational sales growth, which adjusts for the impact of foreign exchange and the acquisition of Hillrom. Now, I'd like to turn the call over to Joe. Joe?

Thank you, Clare, and good morning, everyone. We appreciate your joining today's call. I will start with a look at our third quarter performance, including some perspective on the macro environmental factors impacting our near-term trajectory. Jay will provide a deeper dive on our financials and outlook, after which we will open up the lines for your questions. Q3 2022 represents the third full quarter since the close of our Hillrom acquisition. Total company sales of $3.8 billion grew 17% on a reported basis and 23% at constant currency rates. Legacy Hillrom contributed $735 million to sales in the third quarter. Excluding the impact of Hillrom and foreign exchange, third quarter sales rose slightly on an operational basis. On the bottom line, third quarter adjusted earnings per share of $0.82 were at the higher end of the guidance range we had provided previously. Both top line and bottom line performance in the quarter reflect the continued impact of macroeconomic headwinds, including significant inflationary pressures, as well as ongoing global supply chain constraints consistent with what many others are encountering globally. With further regard to the macroeconomic environment, I want to note the impairment charge in our third quarter financials related to the Hillrom acquisition. Jay will provide additional details, but in short, this charge relates to many of the shifting market dynamics, including rising interest rates and lower valuation multiples that have reduced equity values broadly, along with the increased supply chain-related costs that we've previously discussed. With that said, and with 10 months of progress and perspective, I want to underline our continuing confidence in the potential of the Hillrom acquisition. This is already playing out as an opportunity to expand the reach of both legacy portfolios geographically and across the continuum of care. It is also accelerating our connected care journey, expanding our digital footprint and helping to unlock the next wave of innovation across our R&D pipeline. Integration of our legacy organization is advancing swiftly. And as previously shared, we are achieving even greater value capture through cost synergies than initially anticipated. Additionally, overall demand across the Baxter and legacy Hillrom portfolios remains solid, but we continue to experience meaningful backorders and backlogs due to reduced access to a variety of raw materials in electromechanical components. As I have shared previously, this has resulted not only in higher cost, spot purchases, but also expedited freight costs as we work steadfastly to get our products to the patients and clinicians who depend on us. While we see signals that some of these macro factors may begin to ease next year, our current expectation is that select supply constraints will persist into 2023, particularly as it relates to semiconductors, where we continue to see high levels of volatility in supply. During the quarter, we experienced several decommits from various suppliers, meaningfully impacting our overall demand planning process. We have also seen supply constraints from other raw materials, which has further impacted performance. In total, we estimate that the semiconductor and raw material constraints we've experienced negatively impacted Baxter's top line performance in the quarter by more than $100 million, or approximately 400 basis points. And on a year-to-date basis, we estimate this figure to be approaching $300 million. We continue to take significant actions to help mitigate these constraints and position the company for improved future performance. Some of the actions we have already undertaken include extending the horizon of our demand forecasts out to 24 months for supply-constrained categories to allow our suppliers to allocate capacity and inventory to Baxter over a long horizon, validating alternate supply options to provide flexibility in sourcing, establishing direct buying relationships with critical secondary component suppliers, enhancing our manufacturing processes to further optimize material usage and reduce waste, and meeting with management teams of our key suppliers and select government officials to reinforce the criticality of Baxter’s products. We are confident that these actions will further enhance our ability to help mitigate supply chain impacts on Baxter’s near and mid-term performance. At the same time, we remain focused on improving the operational efficiency across the organization and have already implemented several initiatives that I expect to drive improved future performance, including ensuring that we have the optimal organizational structure and business processes in place. In addition, we are pursuing some near-term actions to help offset the increased expenses we're experiencing. These actions include recent restructuring initiatives, a broad hiring freeze, reduced discretionary spending, and accelerating our Hillrom integration efforts. Additionally, we do expect to realize savings this year through lower annual employee incentive bonuses, which are directly tied to business performance. Also, as mentioned last quarter, we have already passed on a portion of the incremental costs we've absorbed to our customers and are collaborating with them to finalize agreements that include revised pricing terms to address continued cost pressures. We deeply value these relationships and appreciate the challenges our customers themselves are facing. Upon successful execution and implementation of these agreements, we anticipate the related revenues will be reflected in our results this year. We believe these actions will help underscore our unwavering commitment to our patients and customers. Collectively, these initiatives are fueled by the sustained emphasis on operational efficiency and cost-based optimization that has powered our transformation to date. And, as I will continue to stress, we will never pursue any action that compromises our fundamental mission to save and sustain lives. We are also actively advancing our strategic review of the portfolio to ensure the optimal structure to execute on our vision of transforming healthcare to improve patient outcomes, enhance workflow efficiency, and enable cost-effective care. We anticipate that we will be in a position to provide more details on these ongoing activities early next year. I want to reiterate that our strategic core and prospects remain firm as is our commitment to driving long-term value for our shareholders and the many other stakeholders we serve. Baxter’s strength is founded on our diverse durable portfolio of essential healthcare products which will continue to be enhanced by our focus on driving innovation in connected care and core therapies. Baxter’s industry leadership and increased scale, combined with our rapidly advancing digital capabilities, create numerous prospects to help advance our impact in line with our lifesaving mission, and in turn, to share our success with our shareholders and other stakeholder communities. Finally, I want to recognize and thank our employees for their remarkable effort always, and especially as we navigate the current macro environment. Our global team consistently embraces our lifesaving mission above all, rising to meet each new challenge with dedication, passion, and a keen focus on serving the many stakeholders who depend on us. Now, Jay will provide more details on our third quarter performance and outlook for the remainder of the year.

Thanks, Joe, and good morning, everyone. As Joe mentioned, our results for the quarter came in largely as expected, with some impact to sales due to select supply chain-related constraints. As discussed earlier, our teams have been and continue to identify opportunities to help mitigate the unprecedented macroeconomic headwinds we continue to face, and we remain committed to delivering on our long-term objectives. Turning to our financial performance, third quarter 2022 global sales of $3.8 billion advanced 17% on a reported basis, 23% on a constant currency basis and rose slightly on an operational basis. On the bottom line, adjusted earnings decreased 20% to $0.82 per share, falling within our guidance range of $0.79 to $0.83 per share. Earnings in the quarter reflect the increased costs of raw materials, freight, and labor, as well as the impact of rising interest rates, foreign exchange headwinds, and the higher tax rate. Before I review our financial performance for the quarter, I wanted to spend a moment discussing the non-cash impairment charge that we recorded related to the Hillrom acquisition. When we purchased Hillrom, we valued the business based on anticipated cash flows, Baxter’s prevailing cost of capital, and market EBITDA multiples at the time of the transaction. As Joe mentioned, the primary reason for the write-down was due to changes in external factors that have occurred since the acquisition date, specifically the significant increase in interest rates we have seen and the reduction in market-based EBITDA multiples. As we evaluated these environmental factors and coupled them with the supply chain impacts we've incurred, which we carry forward in our projections, we deemed it appropriate to reduce the carrying value of goodwill and certain other intangible assets associated with Hillrom. I want to reinforce Joe's earlier comment that we continue to see tremendous potential for our combined portfolios. We have accelerated our cost synergy targets, which continue to track ahead of our expectations, and our commercial leaders are driving actions to unlock the growth of the combined company. Now, I’ll walk through performance by our regional segments and key product categories. Note that constant currency growth is equal to operational sales growth for all global businesses and Baxter’s three legacy geographic regions. Starting with sales by operating segment, sales in the Americas were flat to the prior year on a constant currency basis. Sales in Europe, the Middle East, and Africa grew 3% on a constant currency basis, and sales in our APAC region decreased 2% on a constant currency basis. Quarterly sales in that region reflected a slowdown in growth in China due to the country's zero COVID policy, which we estimate impacted sales by approximately $10 million in the quarter, as well as the anticipated impact from various value-based procurement initiatives being implemented in the region. Moving on to performance by key product category, global sales for renal care were $942 million, increasing 4% on a constant currency basis. Performance in the quarter was driven by solid growth in our PD business, where we observed an increase in PD patients globally. PD growth was augmented by two discrete items totaling approximately $20 million. Performance in the quarter was partially offset by lower in-center HD sales, partially due to HD monitor supply challenges due to component availability. Sales in medication delivery of $725 million were at a similar level to prior year sales on a constant currency basis. Within the quarter, we observed strong demand for products in our IV therapy portfolio. This growth was more than offset by lower infusion system sales, as component availability remained challenged, coupled with the large hospital system order in Q3 in 2021, which created this difficult comparator to the prior year. Pharmaceutical sales of $525 million declined 3% on a constant currency basis. Performance in the quarter reflects declines in our global generic injectables portfolio due to continued increased competitive activity, which were partially offset by increased sales of inhaled anesthesia globally. Moving to clinical nutrition, total sales were $231 million, increasing 4% on a constant currency basis. Performance in the quarter was driven by demand for our broad multi-chamber product offering, partially offset by supply-related challenges for our vitamins. Sales in advanced surgery were $247 million, advancing 6% on a constant currency basis. Growth in the quarter reflects recovery of elective procedures relative to pre-COVID levels. Surgical volume recovery was strong in Europe, while procedures in the U.S. and APAC region came in slightly below our expectations. Within the U.S., we observed a slow start to July, with an uptick in August and September. Sales in our acute therapies business were $158 million, declining 9% on a constant currency basis and reflecting a tough comparison to the prior year where we had experienced elevated demand for CRRT given the rise in COVID cases. BioPharma Solutions sales in the quarter were $172 million, declining 10% on a constant currency basis, and reflecting a step down in sales of COVID vaccines compared to the same period last year. COVID vaccine sales for the quarter totaled approximately $30 million. Hillrom contributed $735 million in sales to the quarter, which included $380 million in sales in patient support systems, $279 million of sales in front line care, and $76 million of sales in global surgical solutions. Hillrom declined mid-single digits on a constant currency basis as compared to Q3 2021 when the company was a standalone entity. Performance in the quarter reflects a difficult comparison to the prior year period, as well as the impact of the semiconductor supply constraints we've discussed. We continue to experience record levels of backlog for the legacy Hillrom business. Our order book remains strong, and to date, we have not seen any significant cancellations from customers. As mentioned last quarter, we remain somewhat cautious on capital spending, as hospitals continue to assess their budgets in light of the current market environment. Moving through the rest of the P&L, our adjusted gross margin of 42.9% decreased by 110 basis points over the prior year, reflecting increased cost of goods sold primarily driven by the factors we've discussed around inflation, freight, and supply constraints. Adjusted SG&A of $821 million represented 21.8% as a percentage of sales, an increase of 200 basis points versus the prior year, driven by the addition of Hillrom as well as higher freight expenses. As mentioned earlier, we continue to tightly manage our G&A base. Adjusted R&D spend in the order of $148 million represented 3.9% as a percentage of sales, a decrease of 10 basis points versus the prior year. Both adjusted SG&A and adjusted R&D reflect a benefit from lower bonus accruals under our annual employee incentive compensation plans, which are directly tied to Baxter's performance. These factors resulted in an adjusted operating margin in the quarter of 17.2%, a decrease of 300 basis points versus the prior year. Adjusted net interest expense totaled $104 million in the quarter, an increase of $72 million versus the prior year driven by higher outstanding debt balances related to the acquisition of Hillrom. Adjusted other non-operating income totaled $2 million in the quarter compared to a $12 million loss in the prior year period, driven primarily by amortization of pension benefits. The adjusted tax rate in the quarter was 23.8% as compared to 14.8% in the prior year period. The year-over-year increase was primarily due to the mix of earnings in the quarter, which has changed following the Hillrom acquisition. In addition, during the third quarter of 2021, the company recognized the benefit in its effective tax rate from a discrete item due to a reserve release resulting from a favorable tax ruling. And as previously mentioned, adjusted earnings of $0.82 per diluted share declined 20% versus the prior period. Let me conclude my comments by discussing our outlook for the fourth quarter and full year 2022, including some key assumptions underpinning our updated guidance. We have adjusted our full year earnings per share outlook primarily to account for a strengthening U.S. dollar and the resulting foreign exchange headwind, increased interest expense assumptions given a rise in interest rates, and a higher expected full year tax rate due to earnings mix. As discussed, we anticipate electromechanical component availability will remain challenged in the fourth quarter and into 2023, which will continue to hamper sales growth for select businesses, including medication delivery, front line care, and patient support systems. For the fourth quarter of 2022, we expect global sales growth of mid-to-high single digits on a reported basis, mid-teens on a constant currency basis, and approximately flat on an operational basis. And we expect adjusted earnings, excluding special items, of $0.92 to $0.99 per diluted share. For full year 2022, we now expect global sales growth of 17% to 18% on a reported basis, approximately 23% on a constant currency basis, and low single digits operationally. Moving down the P&L, we expect full year adjusted operating margin to be between 17% and 17.5%, reflecting the impact of all of the various dynamics we've discussed today. For the year, we now expect interest expense to total approximately $400 million, given rate increases and an adjusted tax rate of approximately 20% and a diluted share count of 508 million shares. Based on these factors, we now expect 2022 adjusted earnings, excluding special items, of $3.53 to $3.60 per diluted share. With that, we can now open up the call for Q&A.

Hi. Good morning, everybody. Thanks for taking the question. I guess, Jay, just to start out, bridging the gap on the changes of the 2022 guidance would be helpful, but more importantly, we'd love to see if you would provide some initial thoughts on 2023 if you'd commit to some level of earnings growth off the $3.60 for next year and still at 75 basis points of margin expansion as before?

Sure. Travis, I missed the first part of the question.

So the 2022 bridge for the EPS guidance.

Okay, great. So yes, let's walk through the different pieces. I think all of these are starting to set up well for 2023. But it starts with the third quarter. Overall, Q3 came in largely in line with our expectations. We were pleased to put $0.82 in the books. And really the commercial operations were off a couple of cents, in large part related to shortfalls in sales driven by supply constraints in certain areas. The tax rate and FX came in a little bit worse than our expectations. But offsetting this, and I think this is important to know, was better than anticipated performance in our supply chain. As you know, this has been an area of extreme volatility for us as we've navigated the complicated macro environment. So it was really nice to see our supply chain team deliver in the quarter and set the stage for the fourth quarter and beyond. Now, as we go to Q4, with respect to EPS, we now expect roughly a $0.05 headwind from foreign exchange, tax, and interest relative to our previously issued guidance. On a year-over-year basis, these items impact us roughly $0.15. And so we expect a continued supply constrained environment on the sales line. This is an area that we're navigating very carefully. But overall, the real driver in the fourth quarter relates to this headwind from these non-operational items. So now as we transition to next year, what I previously shared with you all is a template which says 4% to 5% compounded sales growth, minimum 75 basis points of operating margin expansion in a given year. As we thought about 2023, the sales growth will come in on the lower end of the range closer to 4%, in large part because of lower levels of COVID vaccines emanating from our BPS business. But as it relates to margin, through continued focus on costs, through execution of our Hillrom synergies, along with a real and significant impact of value improvement programs in our plans, we can confirm at this point the 75 basis points of margin expansion. Now, of course, we're going through our plan as we speak. And I will tell you that the world has been extremely volatile. But it's very nice to be able to share that with you at this point in time. And a lot of this comes down to stability coming out of our supply chain organization. Now the one thing I will say is part of the reason we're not seeing accelerated sales growth is, as we look at 2023, there are continued headwinds from a supply constraint standpoint. So we're going to expect to see component challenges through parts of 2023 and other areas. And so from a supply and semiconductors will continue to be challenging as we move through next year. So that's going to be something that we have to live with for a while. We're hoping that rehabilitates over the course of next year and certainly provides a tailwind as we move to 2024. Now, moving to some other items, as we look at foreign exchange, that's going to be fairly neutral to operating margin, but it will be roughly $0.15 headwind year-over-year, and a lot of that will be concentrated in the first half of the year. Because we've seen rates really deteriorate in Q3 and Q4. And then from an interest expense standpoint, we're looking at approximately a $0.15 headwind. So this is a – before that - and the interest rate will start to become a tailwind later on in this long-range plan. And so I think for us as we sit here today, we feel really good about the prospects going into 2023. And so we've been dealing with a lot of volatility, and I think really putting controls in place to navigate some of that. And I think our ability to confirm that 2023 is an important step as we move forward. Joe, I don’t know if you'd want to add anything to that.

No, you have covered it all.

Thanks, Travis.

Thanks. A quick follow-up just to make sure, I think putting that all together, it still sounds like earnings can be up next year versus 2022. And on the 75 basis points, what’s assumed on the $1 billion inflation, assume that’s stable and does it assume Novum IQ?

Okay. So as it relates to EPS, I think there's a little bit of EPS growth as we look at it based on some of the non-operational items impacting us, but we do expect some level as we look at it. And then I'm sorry, I missed the second part of your question. I couldn't quite hear that.

So the 75 basis points, what’s assumed on inflation in Novum IQ?

Okay. So from an inflationary standpoint, I think we're looking at kind of consistent levels today. So we're not anticipating significant price up in any commodities. We're anticipating some slight improvement in certain areas, but also some negatives related to utilities, for example, in Europe. Joe, you want to address the Novum question.

I will. So we always preface any conversation on products that are not approved, that we do not, I speak on behalf of the FDA. We believe that we have successfully resolved the issue that was the primary subject of the FDA’s last additional information request. We referenced this on the Q2 call. We will submit data and we believe demonstrates successful resolution of the interest as part of our response. Since that time, we have identified additional software changes we're planning to implement proactively in consultation with the FDA. We're in the process of updating our response. And because of that, we're doing everything we can to submit our response as quickly as possible. While we hope to be in a position to submit those responses by late Q4, it may spill over into a couple of weeks of January, maybe half of January. So we're doing the best we can to pull this together. We are very comprehensive in how we answer the FDA. We work very collaboratively with them. And we want to make sure that the product has all the information before we send it to them. So there's no further request for information. That's our objective.

Really helpful color. Thanks a lot for taking the questions.

Thank you.

Great, thanks. Maybe I could start off on capital allocation, how you're thinking about the business mix. We saw some reports in the news about potential sales or divestitures of some of the assets within renal that were low to no growth and low to negative margin. Maybe just give us a sense of how you're thinking about your portfolio here in the environment to get deals done, whether it's additive or subtraction?

Robbie, good morning. I'm not going to address the market rumors directly, but I want to share what we are currently doing. We are actively reviewing our company’s portfolio and will be prepared to discuss it in early January, although I can't provide full details right now. However, I can give you some insights into our activities. We are examining every opportunity within the company to align with the vision we established during our Investor Day in May, which focuses on connected care, areas that can enhance gross margins, and prospects for higher revenue growth, particularly in software, as well as facilitating better connections for clinicians and institutions. As we evaluate our portfolio, some products will be retained while others will not. Our goal is to optimize our offerings, and we are about three quarters of the way through this assessment. We will collaborate with our Board of Directors to determine what we believe will constitute Baxter's new portfolio moving forward, as I mentioned, by early January. I also want to emphasize that any adjustments to our portfolio, including asset sales or any transactions, will fundamentally prioritize creating shareholder value. This is always our main focus, along with improving returns on invested capital and increasing value through discounted cash flows. The process is intense, and we aim to present our new business structure and outline how we will fulfill our mission and vision by early January.

Great. Maybe just as a follow up, Jay, you talked about something like $100 million, and I guess theoretical lost sales in the quarter from supply chain issues, but also about how the supply chain was a positive in the quarter and helped the margins. How should we think about those two reconciling next year? And in that 4% growth and 75 bips of margin, how should we think about what's being resolved in the backlog and how much improvement we'll be seeing in the supply chain? Thanks a lot.

Robbie, I'll let Jay really comment on the numbers. I'll tell you about a couple of aspects. While we are seeing supply chain is performing well against the very difficult sets of circumstances, as we said, labor inflation and material inflation have been significant to Baxter, and they're doing a great job navigating through that. Our procurement group is doing a great job getting the products to us. What is happening is there is a significant amount of backlog and backorder for the company on products depending on semiconductors. And it's not one company or two; it is several. It's a plethora of companies that produce products for us, and we source semiconductors from them. A couple of things that we are doing that I feel more confident that throughout 2023, the situation will be better is that we are developing long-term relationships directly with the manufacturers of the chips instead of going to distributors or going directly to board assemblers. The second thing is, the amount of decommits that companies are coming forward during the quarter makes sometimes very difficult for us to predict what we can assemble and ship at the end of the quarter is getting better into 2023, as our supply chain now has a full view of commitments into 2023 of what we need to make our growth. Business has been very effective by the use of front line care, which is our business under our acquisition Hillrom, our patient support systems, the ability to make more funds, we have very good demand for our current pump, our SIGMA Spectrum pump, we can’t make more because we’re missing two or three key components that are in shortage in the marketplace due to high demand from other sources, in the automotives and other areas. So what I can tell you is we are doing everything we can, and the supply constraint is really what has impacted Baxter’s performance on the top line.

Sure. Robbie, as we move to next year, we continue to assume a constrained top line due to semiconductors and availability of other components. So that does not fully resolve next year. We do expect to see some improvement and no deterioration relative to today's level. But we will live with this throughout most of next year. As we think about the margin improvement, really that's emanating from a significant improvement in value improvement programs, things like automation initiatives that we have going on in the plan. And that really helps support the 75 basis points improvement that we've discussed. We'll see lower than expected freight. And we are only targeting roughly 75 basis points or in excess of 75 basis points because we don't have a big commodity easing assumption in the numbers that we're sharing. To the extent that materializes, certainly that could be an upside, but we're not banking on that at this point. We're banking on living in a challenging commodity world for 2023 for the most part, along with a supply-constrained world. Those two items are very big uncertainties. I'm hopeful that we take a conservative decision and those break our way over the course of the year. But we'll have to watch that very carefully.

Great. Thanks a lot.

Thank you.

Good morning, Joe. Hi, Jay. I wanted to focus on Hillrom, which you mentioned is down mid-single digits. First, I want to understand the decline. If I consider Hillrom as a mid-single digit growth company, what has caused the decline? To what extent are the integration challenges with Baxter a factor, and how much has it been related to component supply? I’d like to clarify that. Also, Joe, based on what you know today, when do you think Hillrom can return to its previous performance? Will it take until 2024, or do you believe it could be in the second half of next year? I have a follow-up question related to Hillrom as well.

Rick, I'm going to have Jay answer that. And I'll close answering the question, but Jay should start.

Yes, sure. Overall, Rick, Hillrom did decline in the quarter, roughly 5% and was down roughly 1% year-to-date. And what's interesting is that the demand for Hillrom products remains incredibly strong. We've seen historic levels of backlog in our front line care business. We've seen backlog in our PSS business as well. So as we look at the portfolio of products, the innovation, the complementarity with the Baxter portfolio, we're incredibly excited. And the environment for their orders has been fairly strong throughout the year; it's been fairly consistent. But we've had severe supply constraints. And so without supply constraints, Hillrom would have been probably flat in the third quarter, and on a year-to-date basis would be growing close to mid-single digits, which I would characterize as kind of where we would have hoped it would have been. But with these supply constraints that have been extremely challenging, in particular, in the case of front line care, it's been hard to get to the sales level that we hoped for. So Joe, maybe you want to add to that.

Yes. Rick, we have done as a company a very thorough integration job here. Our synergies are coming higher, much higher than we had estimated in the first year of the integration. Our supply chain people had to come into Hillrom and do a lot of work to reestablish lines of supply into the business. When the semiconductor prices hit, Baxter was better prepared to handle the Hillrom loss. And what we did is we put our best to handle issues primarily on front line care. The supply chain really came through for us and today is doing a much better job as a matter of fact. We had better performance than we planned in front line care in the third quarter because we're able to get the products out of the door. We also have extremely competent management in both businesses. We have Reaz Rasul, the Head of Front Line Care. We have Andy Frye, the Head of GSS and PSS. So we are very confident in the business we purchased. The business has the ability to perform. We will fix the supply chain issues as we're currently doing. And we'll be able to get back to the Hillrom that we made assumptions to buy. As you heard from Jay, our growth would have been ex-supply chain what we had expected to be. So I think Baxter brought to Hillrom a combination of a great portfolio. Hillrom brings great management and discipline, and Baxter has to replace the team that was there and is able probably to do in the long term a better job of this combination.

Got you. Maybe I'll change the topic, but for my follow-up you talked about passing on the cost pressures and you're in the process or you're well along signing new price agreements. Can you help us think through if this applies to your entire business? How should we consider the impact, and how do we factor that into our thinking as we look ahead to '23, considering you could have another 50 basis points of price on half the portfolio? Any additional insights or perspectives would be appreciated. Thank you so much.

Those are excellent questions. I want to clarify that while Jay and I will handle different aspects of this discussion, it's important to note that we generally do not comment on pricing as part of our business operations. However, due to substantial increases in input costs over the past two years, we are keen on recovering some of those costs where feasible. We have already implemented price actions throughout the year. Beyond what I've shared, I won't provide specific details about our pricing discussions or agreements with customers. What I can emphasize is our preference for building long-term relationships with our customers to find the best way to share the increased costs associated with product delivery. These costs have risen significantly due to oil prices, logistics, raw materials, and labor, among other factors. We have made notable progress in this area, but if we are unable to reach agreements with any customer, we will explore our options to recover these increased delivery costs while fulfilling our mission to serve patients, which is vital to us. Baxter's mission is at the heart of our company, and I’ve been continually impressed by our employees' dedication since I joined nearly seven years ago. We've absorbed a considerable increase in input costs recently, and while our supply chain has worked hard to mitigate this, it shows in our margins that these efforts aren’t sufficient. We hope to maintain strong partnerships with our suppliers, as continued collaboration is essential for us to provide our products and innovations effectively. I’ll stop there and turn it over to Jay.

Sure. Rick, I don't want to get into too much detail on specifics around price and what pieces of the portfolio and so on. But it's safe to say we expect price will be a positive contributor to our numbers next year in 2023. The other thing I would say is it is something that we look at in every single market, in every product line. Why? Because in every one of our areas, we have been challenged with very high levels of inflation and very high levels of incremental costs. So from our perspective, we really have to challenge every sale to make sure that we're garnering enough profit from it and offsetting some of the significant costs that we've had.

Thank you very much.

Thanks.

Good morning, guys. Thanks for taking my questions. You mentioned that you haven't seen any cancellations due to hospital CapEx pressures and that the backlog remains full here. How do you look at new orders on that backlog versus supply issues sort of keeping that backlog high? And are you seeing any impact to new sales versus stroke levels as hospitals struggle with lower margins and lower cash flows?

We have noticed occasional order cancellations from smaller institutions facing labor challenges in executing capital expenditure projects, which can be sizable. However, generally, we haven't observed a significant decline in capital program investments. In fact, if we were able to produce three to four times more infusion pumps, I am confident we would have sold them. Similarly, if we had manufactured twice as many monitors, they would have sold as well. The situation is somewhat different for beds; their implementation is larger, and features like nurse call systems and telephones tend to be more complex. These are the areas where we sometimes see delays, not due to pricing but primarily due to labor shortages. Currently, I don’t believe we are witnessing a major change in the ordering patterns for capital equipment. This observation should not be compared to 2021, which saw unusually high rental revenue for Hillrom largely due to the impacts of COVID-19, especially around the Omicron wave in late October and November of last year.

Okay, fair enough. And then a follow up on the supply chain, can you breakout the $100 million of impact to revenues in Q3 on semiconductors versus the other raw materials? Out of curiosity, what are the other raw material shortages? And then on the semiconductor side, the macro data shows that the pressure peaked sort of into Q2, has been improving sort of during Q3. So curious if you see any semiconductor shortage improvement from July versus October?

Sure. So a couple of things I would say related to this question. First, the vast majority of the sales impact relates to semiconductors. I would say that over 90% of the challenges that we've faced relate to semiconductors. There are other select areas where we have seen meaningful impact. For example, in our nutrition business, there are certain ingredients and vitamins that we're unable to secure due to supplier challenges, and that's had an impact as well, but the majority relates to semiconductors. Now, as it relates to your semiconductor question, the type of semiconductor used in medical devices is a little bit different than standard semiconductors that are used in the highest tech products available today. And so while there has certainly been a curtailment of demand for some of these consumer products, the size of the semiconductor that we use does not benefit from this curtailment of demand and normalization of supply. And I would even say, for some semiconductor manufacturers, they are seeing inventory levels build of the super thin semiconductor. And so we just have not yet seen this normalize in our case where we are all hands on deck working to secure the components that we need. And we'll continue to do that. But this is something that, as I've said, we don't have a pathway for this getting resolved in the immediate term. Joe, I don't know if you'd like to add anything to that.

What we're experiencing is related to the challenges with semiconductor manufacturers, as not all chips are the same. For example, Intel's sales have decreased significantly in PCs, but that doesn't impact our chips since we don't rely heavily on Intel products. Our chips are focused on the Internet of Things, utilizing thicker chips with superior software. These chips represent about 12% of the semiconductor industry's output. Consequently, we are collaborating closely with select companies that are performing well with us. Additionally, we have initiated a redesign program for our boards. We've pinpointed critical components and started redesigning 30 of our boards with one of our suppliers. We also implemented front-line care programs to replace six essential semiconductors that may face constraints in the next 18 months through board redesigns. Redesigning boards is more complex than it seems; it requires adjustments due to changes in the form, fit, and function of the semiconductors, and sometimes we need to revalidate and clinically revalidate the boards. Therefore, simply stating that we are redesigning boards does not capture the full scope of the effort. We are exploring new solutions with our current suppliers, sourcing directly from them, and utilizing brokers worldwide to find available inventory. This has made our company much more adept in managing semiconductors and boards, despite the challenges involved. We have had to develop significant expertise in this area, which will yield benefits in the future.

Okay, great. And Joe, just to sort of follow up on the first question just to make sure I have this right. You're saying that new orders for capital equipment in the last 90 days in 2022 is in line or better than it was at this time in 2021 for new orders? Thanks so much.

In 2021, at this time last year, we did not own Hillrom, but their orders were very high, mainly due to elevated rental demands linked to COVID. What I'm indicating is that we have not experienced any impact on our business due to capital constraints. Currently, we notice some delays with certain accounts, primarily because of labor shortages affecting large installations. However, we are maintaining communication about our orders. In fact, I anticipate a significant installation in U.S. hospitals in the first quarter of next year. So, we don’t observe a notable change in the order patterns for capital equipment at this time. I’m not making a comparison to 2021, which had unusually high rental revenue for Hillrom due to the COVID situation, particularly as we transitioned from summer to Omicron in October and November of last year.

Great. Thanks so much, guys.

Thank you.

Thank you for taking my question. Briefly, it sounds like you have significant back orders and backlogs. What is happening to those orders? Are they being fulfilled by somebody else? Are they just piling up so that at some stage in the future, they get met? And I'll toss my second question at the same time? It sounds like you're also working to get better expense synergies out of Hillrom. Is there a way to quantify what you think those may be now versus what you thought they would be before? Thank you.

Sure. So from a backlog standpoint, overall, we are seeing those orders for the most part stay in place. We're not seeing others take share as a result of these constrained supply environments that we have in place. Frankly, a number of manufacturers have similar challenges. Now, the question is how long will those orders remain? In some cases, if they're short-term needs, then those are things that perhaps might be impacted. But as we think about longer term for the most part, I think that these sales will represent some level of opportunity in the future. As it relates to Hillrom, we feel very good about where things are trending with the exception of the constraints that we have in place. And so we highlighted increased incremental cost capture at the May Investor Day, and we're still trending along those lines, very much in line with that with increasing confidence. I think it's important because we have some big step-ups as we move to 2023 and 2024 in terms of incremental cost synergies. What's great at this point is, as we sit here today, we feel we have clear line of sight and continue to make progress towards those numbers. So I think, as far as that goes, it's a very good story.

Thanks.

We have time for one more question.

Good morning. Thank you. Joe, I wanted to ask about connected care initiatives and any updates you can provide on progress after the Hillrom acquisition regarding the development of connected care technologies or programs. How should we expect to receive updates and track this progress? Additionally, for Jay, I'm curious about the goal of reducing net leverage to 2.75 times in 2020. Can you help us understand the factors involved and your confidence in achieving that target? Thank you for addressing these questions.

Josh, good morning. So we are seeing several programs where we are working across divisions in the connected care. We established a new group that is actually under Andy Frye, one of our executives who is also the Head of GSS and PSS, patient support systems. And we are seeing several programs from basic creating unified portals to access EMR systems in hospitals, to features that can be enabled by commonality and connecting the devices. So there's a lot going on. I think we should give an update to investors probably in the first quarter of 2023 about where we are with this connected care programs. So we have a brand new group that is now across Baxter that is looking at this and creating opportunities. So we're making good progress in this area. I’ll pass on for Jay for answering the other question.

Sure. As you know, we're really focused on maintaining solid investment grade credit ratings. We define that as BBB. So the rating that we currently have is one that we're maintaining. And in order to do that, we want to make very good progress towards the 2.75 net debt to EBITDA which is our objective. I would say that from a cash flow standpoint, this year has fallen short of our expectations. And I would say that, of course, we've had some challenges on the income statement. But as we look at inventory, we've had a fairly substantial inventory build over the course of the year, which is interesting because of what's happening is you have a pump, which is lacking one critical component. And so you're unable to sell that pump until you get that critical component. For example, we also saw extended shipping lane times over the course of the year and increases in the cost of our inventory due to our suppliers. And so for all those reasons, we've had a very challenging year from an inventory standpoint. I would note that in the third quarter, we did see a decline in inventory, and we are expecting a fairly substantial improvement in free cash flow in the fourth quarter, as is typically the case. But here's the interesting thing. While net income growth next year is low, free cash flow growth we expect to be substantial. And so we're still finalizing our plans. But you're going to start to see a very significant acceleration of free cash flow growth as the inventory situation normalizes over the next one to two years. And that will really support some of the work that we're doing to get to 2.75x net debt to EBITDA which, again, is a clear focus for our entire management team.

Thanks a lot.

Thank you very much.