百特醫療 (BAX) 2005 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Baxter International's second quarter earnings conference call. Your lines will remain in a listen-only mode until the question and answer segment of today's call. [OPERATOR INSTRUCTIONS]. This call is being recorded by Baxter and is copyrighted material. It cannot be recorded or rebroadcast without Baxter's permission. If you have any objections, please disconnect at this time. I would now like to turn the call over to Miss Mary Kay Ladone, Vice President Investor Relations at Baxter International. Miss Ladone, you may begin.

Thank you, Brooke. Good morning, everyone, and welcome to our second quarter 2005 earnings conference call. Joining me today are Bob Parkinson, CEO and Chairman of Baxter International; and John Greisch, Chief Financial Officer.

Before we get started, let me remind you that this presentation, including comments regarding our financial outlook contain forward-looking statements that involve risks and uncertainties, and of course our actual results could differ materially from our current expectations. Please refer to today's press release and our SEC filings for more detail concerning factors that could cause actual results to differ materially. In addition, in today's call non-GAAP financial measures will be used to help investors understand Baxter's ongoing business performance. These measures include gross profit, SG&A, operating profit, sundry, and earnings per diluted share. Each excluding special charges. In accordance with SEC Regulation G, 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 over the call to Bob.

Thanks, Mary Kay. Good morning, everybody.

First of all, we're pleased to be able to communicate this morning very strong operating results for the second quarter. I think by all accounts, Q2 results reflect our commitment to provide value to our shareholders through predictable sustainable growth, through improved quality of earnings, increased cash generation and the improvement in allocation of capital. In a few minutes, John's going to walk you through our Q2 results in some amount of detail, and as always we'll provide time at the conclusion of our prepared comments today for -- for Q&A.

Before doing that, however, I do want to focus at the outset of our call this morning on the announcement that we made just a little while ago regarding Baxter's COLLEAGUE Infusion Pump and various actions that we've taken and we will continue to take to address certain product performance issues. By the way, we do expect that the FDA will issue a press release. Their press release on this issue sometime today as well.

Let me -- let me start first by providing a little bit of context. As I'd mentioned over the last year, reengineering our business and administrative processes throughout the Company has been a very high priority; and among these, ensuring that we have rigorous quality and regulatory processes in place. An area of acute focus over the past year has been the establishment of what we call product improvement plans for certain products with, I will tell you, particular focus on instrumentation products such as COLLEAGUE. These product improvement plans have led us to put other instrument products on hold from time to time over the last year as we implement redesigns of software, electronics and other systems that improve the performance and reliability of these products. It was really out of this product improvement process that we identified some particular issues with COLLEAGUE earlier in the year, of which we voluntarily notified customers on March 15th of 2005. All of these issues are and have been in various phases of remediation as it relates to our installed base of COLLEAGUE devices in the field. We have now been notified by the FDA that our action on March 15th has been classified as a Class 1 recall, and as a result, we're obligated of course to issue the press release this morning communicating the agency's position in this regard. By the way, our March 15, 2005 communique to our customers is provided as an electronic link to our press release this morning.

Now in a separate field corrective action letter sent to customers late yesterday, the Company announced that it is in the process of developing an aggressive action plan to address an additional design issue with the COLLEAGUE Infusion Pump, and that the Company will voluntarily hold shipments of new COLLEAGUE pumps until the issue's resolved. This design issue involves, not to get too technical here, but to give you a sense of this, this design issue involves a -- a clocking circuit contained in the pump. It's really like a quartz crystal that we all have in our watches that can disrupt internal communications in some devices. While the incidents of this occurring is low, when it does occur, the pump alarms and the infusion of intravenous therapy stops and then the pump displays a failure code. The FDA has been informed of this action, and the Company continues to work with the agency and its customers to resolve these issues. This communique, the one I'm referring to from yesterday to our customers, is also provided as an electronic link to today's press release. And I would encourage you to access these links to develop a more detailed understanding of the specific issues that we're addressing here. I would tell you all certainly our number one priority in the Company right now is to get these issues with COLLEAGUE fixed right and fixed soon. As mentioned, we will not ship new instruments until the issue is resolved. Our plans going forward for the remainder of the year and the financial guidance that John going to provide later assume that we will not ship new COLLEAGUE devices at least through the remainder of 2005. Clearly, this is disappointing to all of us. But I think most importantly to our customers who are being inconvenienced by our actions. We'll plan on discussing this matter obviously in greater detail during the Q&A.

Now on a separate front this morning we also announced an agreement with Gambro for the distribution of hemodialysis instruments. In connection with this agreement, we're going to stop manufacturing instruments at our Tampa, Florida, facility immediately and will exclusively distribute Gambro's products. This action is consistent with our desire to optimize and improve the profitability of our hemodialysis business, and by partnering with Gambro, as you know, a leader in the hemodialysis market, we'll be in a position to provide our global renal customers with high-quality hemodialysis instruments while at the same time improve the operating margins of our HD business. More important, this arrangement will enable Baxter to focus its resources on home therapies drawing on our traditional strengths in peritoneal dialysis. As you may recall, at the recent investors conference, I discussed the fact that we would address certain portfolio issues within our Company more proactively in the coming year, all with an eye toward increasing shareholder value. And this collaboration with Gambro that we announced this morning, I think, is a good example of that.

Before turning the call over to John, I'd also like to just briefly summarize a number of key product launches, R&D milestone and new business development activities beyond the Gambro agreement which transpired during second quarter. First of all, ADVATE received regulatory approval in Australia, and we now have launched ADVATE in 14 countries with approvals in 21 countries overall. Regulatory approval was also received on liquid GAMMAGARD in the U.S. with market launch scheduled for the fourth quarter this year, and we're hopeful that the European approval will occur in early 2006. As you know, the agreement with the American Red Cross to purchase their plasma and then manufacture and market finished product took effect on July 1. Extraneal was approved in the second quarter in Mexico. As you may recall, Mexico is our third largest peritoneal dialysis market in the world. And finally, we just began shipment of the vial presentation of ceftriaxone, the generic version of Roche Pharmaceutical's Rocephin, and we're currently awaiting FDA approval for the first and only frozen premix presentation which today accounts this packaging form -- the frozen that is -- accounts for about 15% of total Rocephin today. I think these milestones illustrate the momentum that's building with our R&D programs and business development initiatives, and of course, we look forward to providing you with continued updates on our progress in these areas in future investor calls.

And so with that, let me turn it over to John to take you through the numbers. John, if you would.

Thanks, Bob.

In terms of the financials, we have a lot to cover today including the impact of the second quarter charge and other one-time income items, as well as our adjusted results and our outlook for Q3 and for the full year. Let me start by reviewing the one-time items and reconciling our adjusted earnings and GAAP results for the quarter. I'll then review with you before -- I'll review these before discussing our second quarter operating results. Please refer to page 8 of our press release, which reconciles our reported GAAP earnings to our adjusted earnings.

First, Bob just provided you with an overview of where we are with the COLLEAGUE pump, and in our press release we disclosed that we recorded an after tax charge of $65 million associated with correcting this. On an earnings per share basis, this equates to $0.10 per share. We also stated that if additional remediation actions are necessary in the future, further charges may be incurred. Second, our GAAP financial results include an after tax $80 million benefit or $0.12 a share for the reversal of reserves related to our 2003 and 2004 restructuring programs. These are due to changes in estimates of the required reserves, the majority of which are the result of lower severance and other employee costs due to the fact that more of the headcount reductions have been achieved through attrition than was previously estimated. We continue to make good progress with our restructuring initiatives. However, at this time given the higher employee attrition and other reserve changes, we have lowered the remaining reserves to reflect our current estimates. As I mentioned, we remain on track to complete the restructuring by the end of this year, and generate the expected savings related to these programs. At the end of the second quarter, we have now eliminated over 3300 of the 4000 expected positions to be eliminated through the 2004 restructuring actions as planned.

Finally, during the quarter, we recorded a change in estimates to our effective tax rate due to ongoing improvements to our geographic product sourcing. We now expect our effective tax rate going forward to be approximately 22%. The estimate change resulted in a year-to-date adjustment which is reflected in our second quarter tax rate of about 20%. The total benefit in the quarter was $0.03 a share which included $0.01 benefit related to the first quarter. So to summarize, our GAAP earnings per share for the quarter were $0.51. Excluding the $0.10 charge for COLLEAGUE and the $0.12 benefit from the restructuring reserve change, second quarter earnings on an adjusted basis are $0.49 a share. Our original guidance of $0.43 to $0.45 for the quarter excluded one time items and also assumed a tax rate of 25%. So therefore, adjusting for these items, including the tax rate change, earnings would have been $0.46 a share.

Let me walk you through our adjusted results now, that you can find on page seven of today's release, excluding the special items for the quarter that I just reviewed as well as the special items and restructuring reserves from the second quarter last year. First, worldwide sales were approximately $2.6 billion, an increase of 8% over the prior year, 3 points of which were from currency. Each of our three businesses delivered very solid performances. U.S. sales were up 6%, while international sales increased 11 points, including 7% from currency. In BioScience, sales were $990 million, an increase of 11%, with currency contributing 4 points. Transfusion Therapy sales of $140 million increased 3%, while sales of our core BioScience business excluding transfusion therapies were $850 million, an increase of 12%, 4 points of which were from currency.

In our Recombinant business, we had another very solid quarter with sales of nearly $400 million, an increase of 24% including 4 points from currency. We continue to see accelerated demand for ADVATE in both the U.S. and Europe and remain very encouraged with our ADVATE conversion which is occurring across all patient groups. ADVATE accounted for more than 65% of our recombinant Factor VIII sales in Europe and more than 30% in the U.S. during the quarter. Total sales for ADVATE were $148 million, about two-thirds of which were in Europe. And this compares to about 117 million in the first quarter and 51 million in the second quarter last year. We now expect ADVATE sales for the first -- for the full year to be approximately $600 million.

Turning to the Plasma business, antibody therapy sales are 93 million, an increase of 3%, with currency contributing 2 points. Our IGIV business continues to improve, particularly in the U.S. where pricing continues to increase. However, as expected, volume was down from last year following our throughput reductions. Plasma protein sales of 266 million were flat, as strong sales of specialty therapeutics, including FEIBA and Tisseel, offset declines in plasma derived Factor VIII and lower plasma sales to third parties. And finally, our Biosurgery business, which is comprised of several wound management and tissue sealing products, increased again by approximately 20%.

In Renal, sales totaled $504 million, an increase of 5 points for the quarter. Excluding the impact of foreign exchange, sales were flat for renal. You'll recall that in the first quarter we divested our service business in Asia which had sales of approximately $20 million in the second quarter last year. Excluding the impact of this divestiture, renal sales increased 9%, or 4% on an organic basis. International sales increased 7%, lead by strong PD sales, which increased 10% for the quarter. As Bruce discussed at our investor conference in May, we continue to drive value in this business through international expansion as ESRD treatment rates in markets outside the U.S. continue to increase. And we're very encouraged thus far this year of our patient gains in Latin America, Asia as well as in Europe.

In our Medication Delivery business, sales were approximately 1.1 billion, an increase of 8%, including 3 points from currency. And in terms of specific product categories within med delivery, our IV therapy sales were 312 million, an increase of 8 points, with our base IV solutions increasing double digits during the quarter. Overall, strong international growth and growth of IV solutions was offset by lower U.S. sales of MICROMIX, our nutritional compounding machine. In our infusion systems business, sales were up 5%, basically in line with overall market growth; and our anesthesia business had sales of 282 million which were up 9%, lead by strong growth of SUPRANE, one of our proprietary inhaled anesthetics. PROPOFOL sales for the quarter were similar to the first quarter sales. And finally, drug delivery generated sales of 226 million, an increase of 12%, driven by significant growth in small volume parenterals and in our contract manufacturing business.

Looking at our gross margin, margins for the quarter were 43.2%, an improvement sequentially by over 2.5 points due to margin expansion across all three of our businesses. Compared to last year, our gross margin's improved by 1.8 points, driven by higher margins in BioScience, largely the result of improvements in the plasma business and the benefits of accelerated ADVATE conversion. SG&A of $537 million increased 13% over 2004. Nearly the entire increase was due to higher pension expenses, increases in reserve for bad debts and litigation, and the impact of exchange rates, all of which more than offset the expected savings achieved from our restructuring efforts. Excluding the increases in reserves for bad debts and litigation, SG&A growth was about 7%. And as a percent to sales, SG&A for the quarter was 20.8% compared to 20.1% last year, and 20.3% in the first quarter this year.

R&D spending totaled 133 million, which was an increase of about 3 points. This growth reflects accelerated spending, primarily in our BioScience business, which was offset by savings on discreet projects that have been terminated as part of our R&D rationalization process. So as a result of our strong sales growth and gross margin expansion, our operating margin of 17.2% improved sequentially by nearly 2.5 points and improved 1.3 points compared to last year. This the strongest operating margin we've seen in Q2 since 2002 and reflects our commitment to continue to improve our margins going forward. As expected, interest expense totaled $33 million, an increase of 8 million over last year as a result of higher interest rates and the impact of our net investment strategy. And similar to the first quarter, sundry expense was an expense of 25 million which includes the translation impact of foreign exchange, minority interest, and various other miscellaneous items. So as you've seen, with strong operational performance and the tax rate change, adjusted earnings totaled $0.49 for the quarter.

Turning to cash flow, we had another great quarter. Cash flow from operations totaled $508 million compared to 305 million last year. While year-to-date cash flow from operations of 779 million was improvement of over $500 million compared to last year. Capital spending totalled 98 million, down from 139 million in the second quarter last year. And we now expect CapEx for the full year to be approximately $550 million. Free cash flow this quarter was 410 million compared to 166 million last year, which represents an improvement of nearly $250 million. As was the case in the first quarter, the most significant change in our free cash flow is our improved working capital management where we continue to make great progress. DSO of 58.4 days improved by more than 2 days over last year, and cash flow from our securitization programs has again been reduced with an outflow of $34 million during the quarter. Our inventory turns improved to 2.9 compared to 2.6 last year. We continue to make substantial progress in reducing our plasma inventories which declined by approximately $60 million during the quarter. This represents a cumulative reduction of nearly $350 million since we began our plasma inventory reduction efforts in June of 2003. However, as we mentioned last quarter, we do expect plasma inventories to increase in the back half of this year as the new American Red Cross agreement takes effect. Net debt of $3.1 billion is $813 million lower than this time last year. It's also down over $400 million from the end of the first quarter this year. We ended the quarter with a net debt to cap ratio of just over 30% at 30.1. This is down over 10 points from a year ago.

Finally, let me provide you quick update on the status of our net investment hedges. The net liability at the end of the second quarter was about $730 million, a reduction of approximately $160 million during the quarter. And a reduction of $439 million since the end of 2004. This reduction is a result of both movements in currencies and the settlement of $308 million so far this year. The remaining 2005 maturities of $70 million will be paid off later this year. And as of today, approximately 55% of the remaining liability is fixed through our mirror hedge strategy. So in summary, we're pleased with the year-to-year improvement in our cash flow. We continue to make progress in terms of improving the quality of our cash flow from operations, and by intensifying our focus and discipline in this area, we expect to continue to see further improvements in the future. Lastly, as we mentioned last quarter, we were in the process of finalizing our plans with respect to potential actions under the American Jobs Creation Act and will be communicating our specific plans in that regard during the third quarter.

Let me conclude my comments this morning by providing our outlook for the third quarter and full year 2005. Given some the issues that I just reviewed, I know this is complicated, so let me start by commenting on several key drivers. First, for the full year we expect organic sales growth to be in the 2 to 4% range. Strong sales performance to date will be offset somewhat with the assumed loss of COLLEAGUE sales in the second half, PROPOFOL generic competition in the second half, and difficult comparisons to last year, particularly in the fourth quarter.

Now let me comment on each of these items briefly. First, as began with COLLEAGUE, we're assuming our COLLEAGUE Infusion Pump will be on hold at least through the end of 2005. COLLEAGUE sales in the second half of last year totalled approximately $120 million, while full-year sales of COLLEAGUE in 2004 were about $170 million. With respect to PROPOFOL, as we anticipated, a generic competitor has entered the U.S. market and we do expect lower PROPOFOL sales compared to 2004 in the third and fourth quarters. PROPOFOL sales in the second half of last year also totalled approximately $120 million. And lastly as we've mentioned previously, our fourth quarter growth comparisons will be challenging due to very strong drug delivery growth last year driven by the one-time purchase by the U.S. Government of approximately $35 million. So by business, given the issues just discussed, we now expect full-year organic sales growth for medication delivery to be flat to down slightly. Again, this assumes the loss of COLLEAGUE sales in the second half and the anticipated decline in anesthesia sales due to lower sales for PROPOFOL.

In renal, we expect organic sales to be flat as strong international PD sales will be offset by the expected decline in HD due to the divestiture of the Asia service business from the first quarter. And finally, we expect BioScience organic sales growth to be up in the mid single digits driven by strong recombinant demand and continued penetration of ADVATE. In addition, we expect increased antibody therapy sales as result of improved pricing, the launch of WinRho in the U.S., and the benefit of the American Red Cross agreement which became effective July 1. As we previously communicated, we expect other plasma sales to be down approximately 10% as we exit third party plasma agreements and lose the contract manufacturing revenue from the Red Cross. We also expect transfusion therapy sales to be down year-over-year for the full year.

With respect to margins with continued gross margin expansion particularly within BioScience, together with accelerated growth in R&D in the 5 to 7% range for the full year, we continue to expect gross margin and operating margin to improve in the second half. However, we now expect our operating margin to be somewhat lower than our original expectation and to average between 17 and 17.5% for the full year, primarily due to the loss COLLEAGUE sales in the second half. With sundry and interest expense totaling more than $200 million together and with the lower tax rate of 22%, we now expect adjusted earnings per diluted share for the full year to be in the $1.86 to $1.90 range. Our guidance also assumes current foreign exchange rates, which are expected to benefit sales by approximately 1% in the second half. However, our guidance does not include the following items. First, the $0.02 per diluted share impact from the second quarter charge and restructuring benefit. Second, in connection with the Gambro agreement and the decision to discontinue hemodialysis instrument manufacturing, we expect charge -- a charge in the future totaling 40 to $50 million which is not included in our guidance. And lastly, again, our guidance excludes the cost associated with the repatriation of foreign earnings under the American Jobs Creation Act later this year. We now expect cash flow from operations in 2005 to exceed $1.6 billion with free cash flow of at least $1 billion compared to $814 million last year and up from our previous guidance. As I stated earlier, we now expect CapEx for the full year to be approximately $550 million. And as you saw in today's release for the third quarter, we expect organic sales growth to be between 2 and 4% with earnings per share to be in the range of $0.45 to $0.47 per share.

With that, let me turn the call back over to Bob.

Thanks, John.

Very briefly, in summary we've met or exceeded our financial commitments in the first half of the year with strong operational performance. We've also continued to deal with several historical issues as we focus on establishing a stronger foundation for the Company going forward. While the situation with the COLLEAGUE pump is challenging, we're working quickly to address the issues. Of course, quality of our product is absolutely our highest priority. We remain committed to enhancing quality systems and processes across all of our businesses. And with that, we'll now open up the call for questions and answers.

[OPERATOR INSTRUCTIONS]. Rick Wise, Bear Stearns.

Couple questions. First, in terms of the COLLEAGUE, Bob, it sounds like the process of fixing the -- the issues began earlier this year if not before. Maybe you can help us understand more clearly what needs to be done, and so we can better gauge -- we can better gauge the conservatism or optimism of your thought that it won't be on the market at all in the second half.

Sure. Let me -- let me back up in time. As I commented in my prepared comments, Rick, this notion of product improvement programs is something we embrace going back well over a year ago. With, as I said, particular focus on instrumentation. And so the notion of continued improvement and product improvement enhancement and so on on virtually all of our electronic infusion devices began then. So we've had a series of product improvements that we've been implementing on and off, going back at least for a year. In March of this year, we went out with a field corrective action and communique to our customers that cited three different product improvements, or fixes, or upgrades that we were in the process of implementing. And again, I would encourage you, that's one of the links on the website. You ought to read that, because it details them all. And we've continued to move ahead to do that throughout the year. As I indicated, we learned earlier this week that upon evaluation, the FDA had decided to classify those actions that we took in March as a Class 1 recall, there by really necessitating the communication of the press release this morning.

The latest issue, and I'll expand on this a little bit, the latest issue where we issued a field corrective action and communique to our customers yesterday has to it with this timing unit I referenced. And this more of a physical issue than it is a software issue. And let me just take a minute to describe the failure mode. Under certain very low level conditions, the crystal which is in the unit can lead to a malfunction of the device. And the malfunction of the device is described as follows. If it is running, it stops administering the medication. It alarms to call back the nursing professional. And the device, in essence, shuts down, and as I say, it's designed and programmed to stop administering medication. At that point in time, the nurse needs to intervene in one of a couple ways. It's what's referred to in the field corrective action letter as a contingency plan, somewhat euphemistically. But really what that means is two things, which is if the pump malfunctions and it can't be restarted to administer the medication, there ought to be another pump there to put the patient on. The second, probably even more obvious contingency plan, if you will, is the sets, of course, all have roller clamps and the meds can continue to be administered with the adjustment of the manual roller clamp to ensure the critical meds can be -- continue to be administered until another pump can be obtained. So that's the failure mode.

Now, the fix, and this gets back to your question in terms of timing, we have couple of different approaches to fix this which were encouraged that we're going to be able to do. The challenge, of course, is making sure that we validate those fixes. We want to fix this quickly, but we most assuredly want to fix it right. And we're in the process of validating that -- the best option to fix that. It will involve some type of physical change to actually one of the boards of the circuit -- print circuit boards of the unit. The basis of the charge that we took represents a couple things. It assumes that we are going to go out aggressively, proactively when we validate the fix in an essence over a -- as short a period of time as possible, in essence upgrade every pump that's in our installed base which in the U.S. is over 200,000 pumps, okay? Regardless of how low level the occurrence may be and how infrequent this failure is, we've adopted the comprehensive fix.

The other reason we've done that as it relates to some of the earlier field corrective actions that have been communicated such as those reflected in the March 15th letter by going out proactively with the fix of the crystal and this particular issue that I just described, it will also enable us to accelerate the implementation in a comprehensive way of other product upgrades and product fixes that we communicated earlier. It's not infrequent. In fact, it's common for us and all manufacturers in this area when there's a product modification or a product fix, however you want to term it in some form or fashion, frequently those get done when the devices rotate through periodically for normal service. That was, frankly, a path that we have gone down in a number of our product improvements with COLLEAGUE over the last year or so. But given this most recent issue which we've more fully characterized and understand that can lead to the shutdown phenomenon that I described hence we made the decision to go out aggressively in the fashion that I described. Take the charge and in the process also accelerate some of the other fixes.

So, I covered a lot there, Rick, but I wanted to -- now how long is it going to take? I'm not going to define that specifically. John and I both referenced in terms of our plans for not reselling COLLEAGUE at least through the end of the year. I'll limit it at that at this point. But this is the most important priority in our Company and we are going to, like I say, if we believe we have a fix, we can get that validated shortly and hopefully before long we can commence fairly soon with the upgrades of the devices that are in the field.

Okay. One follow-up at a slightly different topic. The -- ADVATE sales are great. I believe I saw that Bayer was announcing, if I understood it correctly, sort of a third generation product. Maybe you could update your -- our thoughts on competitive situation and I think Baxter has a new program for a new generation product as well. Just refresh our memories there. Thank you.

Yes, I think Bayer's announcement speaks for itself. They went out with an announcement of an, I think, initiation of a Phase 1 trial and beyond that -- beyond that again, I think it really speaks for itself. As we've discussed previously, in fact, I think Joy Amundson touched on this briefly at the investor's conference. We, as well, have some -- a couple different options. Obviously one of the things we all aspire to achieve with recombinant Factor VIII is an extended half-life on this. We have initiatives underway, perhaps different approaches. Whether it's us or Bayer, this is -- this is long-term.

Thank you very much.

Thanks, Rick.

Glenn Novarro, Banc of America Securities.

Sure, a couple things. One, I was hoping you can touch a little bit on the -- the PD business. So international business continues to go very well for you guys, but the U.S. business continues to lag. Can you talk about the strategy in the U.S. to get the PD business back to a growth driver for the Company. And then, John, just quickly, what -- what should we think about the tax rate for 2006? Thanks.

Okay, Glenn. Thanks. Let me address the -- the renal PD questions, and then John can address the tax situation. Bruce McGillivray covered this at some length in the May investors conference. Yes, you're right. We continue to be very encouraged by the expansion of our PD business outside the U.S., particularly in developing emerging markets. And so on the question, of course, is how do we get this thing back on track and accelerate growth in the U.S.?

First and foremost it starts with focus and execution. I would say that the Gambro deal that we announced this morning is a major first step in that regard. Frankly, in a number of markets including the U.S., I think we have been distracted in some ways with historical issues in the hemodialysis business. Now through the partnership with Gambro it will allow us to focus on really what is the core franchise that we built, which is PD. There has been recently some more encouraging developments in terms of reimbursement which should be helpful, vis-a-vis HD -- PD versus HD, that is, Glenn, in -- in the U.S. And the other thing I will tell you is we're in the process of making some changes in terms of our commercial leadership, our sales and marketing leadership domestically in the U.S. which just comes back to the point I made about execution. I'm not suggesting that through the increased focus different leadership commercially in the U.S. and the like is going to have a dramatic difference in the short-term. But I am confident that over the next year or two we're going to begin to exhibit growth rates that are accelerated from what we've experienced in the U.S. over the last few years.

Bob, just a -- just a quick follow-up. Are you still -- years ago the push back from nephrologists was always not wanting to give up the patient. By having him undergo HD they'd see the patient several times a week. Is that still the major push back for higher adoption for PD?

I think there's a lot of factors. The periodic contact with the -- face-to-face with the patient during the week from, certainly, a clinical point of view has merits. I think there are economic merits, as you well know. For economic considerations that also are drivers in that -- in that selection. I will tell you our view is long-term. We see a continuing trend to the home. Patient convenience being the key driver. Potentially in the long term more home hemodialysis in the U.S. market as well, which longer term could be a nice byproduct of our collaboration with Gambro. We leverage our expertise in the home, from a delivery, from a service, from a high-touch perspective, if you will, which we do better than anyone and that potentially is something we might look to work with our new partner Gambro down the line. So we think the long-term driver will be toward the home. But as you know, you've got infrastructure established, capacity established for traditional hemodialysis and so there are those real barriers to conversion. So, it is a -- it is a multifaceted answer to your question, Glenn. So I'll have John address the tax question.

Thanks.

Glenn, on the tax rate, as I said in my comments, we expect 22% going forward and that's 2005 and beyond.

Okay. And just can you quickly remind us what the litigation charges were -- or reserves were for -- that you were -- that you took in 2Q?

There was nothing big. It was a number of small issues. I think the one thing we announced was the Haemonetics settlement, which at the time that was announced we indicated it was not material and it was not material. But that and a few other smaller things collectively resulted in several million dollars of charges.

Okay. Great. Thank you.

Nothing big.

Thanks.

Glenn Reicin, Morgan Stanley.

Good morning, folks. Actually two questions, one for Bob, one for John. First on, Bob, can you tell us what you're doing to preserve the franchise -- the COLLEAGUE franchise in the next six months to keep customers happy so in fact COLLEAGUE sales can bounce back when this is all said and done? And then, John, I'll try to get a bunch in questions in one. If I look at -- if I back out the reserves that you said you took on the SG&A line, I think it sounds like it's like 30 million which is $0.04 a share. And if I take into account that reserve that's in the P&L and I look at -- you only have one competitor in PROPOFOL right now, and the lower tax rate, the 186 to 190 looks extremely conservative unless the hit from COLLEAGUE is extremely large. So I'd love for you to give us a little bit of break down what you think the COLLEAGUE hit is actually going to be on the P&L. Thanks.

Okay, Glenn, Let me address the first part in terms of -- in terms of COLLEAGUE. First and foremost it starts with open and forthright communication. The easiest thing to do in these kinds of situations is not intentionally but unconsciously may perhaps create expectations in terms when issues are going to get resolved sooner than perhaps they might. And so we went out last night with a very comprehensive communication program to our sales force who in turn are probably in the process as we speak right now sitting down with their customers explaining the situation and so on. The one operation that will continue is we'll continue to receive service pumps in from the field and be able to -- to process service improvements and so on and get those pumps back out. First and foremost, the most important thing is and it gets back to Rick's question, is the timetable that's associated with -- with managing this. I hate to acknowledge, this but I will. I mean, this is not the first time that customers have had to wait for COLLEAGUEs. Typically it's been because of backorder situations and supply constraints and so on. And generally with these kinds of capital instruments and so on, there is some ability for customers to have some patience and wait and so on. But as I said in my prepared comments, this is disappointing for a lot of reasons but most importantly our customer. So this is where our sales force comes to bear and -- and builds upon the trust in the relationships that have been established over the years and that's really -- that's really the mode we're adopting at this point.

I think the other thing that I should emphasize which is really apparent is this is a popular pump. This is the leading brand of infusion pump in the U.S. market. And it is for a reason. Patient -- customers, medical professionals, nurses and so on like the COLLEAGUE pump and they will wait with us and work with us as long as we're able to execute in a fairly short timeframe. As I say, that's why it's the top priority in the Company, so.

What -- just two follow-ups on that. Is this a basis for a hospital to nullify an existing contract? Could Premier reexamine the contract with you? And also what does the hospital do if they need a replacement pump right now? Can you give them a loaner? Can you do anything to help them in the meantime?

Well, as I said, if they have -- usually most hospitals have excess capacity of pumps for -- to accommodate surge in hospital activity and so on for starters. Secondarily, pumps that need to be serviced we're going to do everything to accelerate the service of those pumps when they come in and out so we don't -- we don't disrupt -- disrupt the supply.

The other thing I should emphasize is the -- the occurrence of this incident is extremely low. So while we've asked -- and if you read the field corrective actions and the instructions that went out to the customer, there are certain pumps that should be taken out of service and we denote the certain codes through the diagnostics that can be -- that need to be assessed here and then taken out of service. This is a very, very, very low incident rate. So we don't anticipate as a practical matter the number of pumps that are going to be taken out of service, Glenn, daily to -- to not only be significant at all. It's going to be a very low level. I think the practical issue is that if you had hospitals that were in the process of either upgrading some of their older devices or hospitals that for some reason were expanding the number of devices because of hospital activity and so on, frankly, those are the ones that are going to be more problematic to deal with. But I don't want to leave anyone with the conclusion that, gee, if a pump's -- if a hospital has 400 infusion devices -- COLLEAGUE devices, as a result of the ones we're asking them to take out of service, 100 of those 400 are going to be taken out of service. It isn't anything close to that. It's like single digits or something -- or less. So that's what we're dealing with, to give you maybe a more specific context.

And Premier?

Pardon me?

And what about the Premier contract?

I don't anticipate any issue with the -- the Premier contract. I -- specifically I can't comment on is there or is there not a provision on this. But to change infusion pump systems, of course, is a very, very big deal. It also -- it's a big deal for hospitals to have two different types of brands or two systems. It's -- from a nursing training and so on, standardization of one brand of pumps is very, very critical. So there are some -- some barriers there to conversion. But having said that, the end of the day we have to be responsive -- as responsive as possible to our -- to the customer needs and we'll do that.

Glenn, just to get back to your other questions. You quantify the SG&A issue reasonably accurately. And with respect to PROPOFOL, even though there's only one new competitor in the market, the net dynamics in the overall PROPOFOL market are shaping up to be pretty well in line with what our expectations were. On COLLEAGUE, the next impact that we expect in terms of earnings impact is about $0.07. So it is not insignificant. Obviously, it's a high margin product for us.

The other item -- couple other comments, I think if you look over the past few quarters, the guidance that we've given, we've been pretty accurate with what we've delivered quarter after quarter. And we expect to continue that certainly for the second half of the year. The only other item I think you've seen in the first half of this year our sundry expense has averaged about $25 million per quarter which isn't inconsistent with -- with last year either. And that expectation for the second half of the year and it's a whole hodgepodge of stuff between FX, minority interest and various other odds and ends. I would expect that level to continue for the third and fourth quarters as well.

And the $0.07 hit, how quickly do you think that could be reversed if, in fact, you start putting out product in the first of next year? Does that $0.07 carry over to next year? Or does that go away pretty quickly once you start shipping out?

As soon as we get the product back on the market and assuming we retain our share, which we certainly would assume we would, that -- that'll turn around immediately.

Right.

It's all about getting the product back on the market following the remediation that Bob articulated.

Great. Hats off to you guys on the quarter. Thank you.

Thanks, Glenn.

Mike Weinstein, J.P. Morgan.

Hi, there. Good morning, guys.

Hey, Mike.

Just to be clear relating to your comments on PROPOFOL, John. Is that for pricing it like a generic?

I'd rather not comment on specific competitive pricing, Mike. But as I said, between the competitive actions -- or the number of competitors and where pricing is shaking out generally, it's pretty well in line with what we expected to happen which is not inconsistent with a typical generic trend.

Okay, perfect. And then I just want to understand a little bit more about what's driving the drop in the tax rate, if you could flush that out a little bit.

Yes, as you know, historically the Company has been very efficient with setting up a very tax efficient manufacturing footprint around the world. And the biggest change over really the past quarter or two is the accelerated sales of ADVATE in Europe. And when we built the Neuchatel, the tax advantages that we enjoy from ADVATE particularly in Europe with the accelerated sales rate in Europe this year, that's really been the primary driver for the change in estimates of the tax rate.

Okay. If you -- is there -- as you're thinking about your portfolio and I obviously don't want you guys to jump ahead of yourselves here, but if you end up exiting a business that has a tax advantage manufacturing, could that end up reversing on us a year from now or is that unlikely?

I think that's unlikely.

Okay. Just trying to think ahead here.

Yes.

And then --

Obviously, Glenn -- or Mike, excuse me. What one comment that we made about the whole portfolio issue is our objective is to make whatever actions we make around our lower margin opportunities whether it's hemodialysis or the service business or something else. So to the extent we take portfolio actions around lower margin businesses obviously the impact on our overall earnings is going to be positive and the impact on the tax rate, I don't see to be an issue at all.

And then last question, would you just flush out the impact of the Gambro agreement on the Company's gross and operating margins?

Yes, it'll be relatively modest impact because our instrument business is not a huge part of our hemodialysis business to begin with. But by eliminating the fixed cost of manufacturing in our Tampa facility and getting a -- a product -- a quality product in the marketplace, our overall service costs around instruments are expected also to decline. But in terms of material changes to Baxter overall, it's going to be relatively insignificant.

And just to be clear, you're continuing to manufacture the dialyzers?

No, we're not manufacturing any dialyzers, so this action is really consistent with what we did with dialyzers. I think we stopped manufacturing dialyzers --

With Gambro back --

Pardon me?

When was that? A couple years ago?

End of '03 I believe when we shut that down out of our Mountain Home, Arkansas, so all of the dialyzer sales that we have today which is the largest product within our hemodialysis segment are distributed products.

Okay. Okay. That's very helpful. Thanks.

Ted Huber, Wachovia Securities.

Thanks. Good morning. I just wanted to go back to COLLEAGUE for a minute if I could. It sounds as if even though this is a full Class 1 recall, there's just a small number of pumps that will initially come off the market, and then in time you'll swap out the boards on these other 200,000 or so pumps. Is there any chance that the FDA is going to want a much quicker withdrawal of this product from the market that could cause some customer issues given that you are sole source for a lot of these sites?

Well, I'm not going to speculate on what the FDA may or may not do, Ted. I think -- first of all your understanding of the issue as you described it is absolutely right. The number of pumps as I mentioned -- I think Glenn Reicin asked the question, but to reiterate the number of pumps that will technically be taken -- or practically will be taken out of service, quote-unquote, out of services, if you will, in other words those that exhibit a -- a tendency or predisposition toward these certain error codes that are referenced in our field corrective actions are -- it's very, very low. So we don't see this as having a practical and certainly not a significant impact on the installed bases that are out there, okay? Relative -- so all of the other devices will continue to operate and so on. The issue, of course that was communicated this morning is that -- is that we have -- and by the way, I'll emphasize. We voluntarily took the position to stop shipping devices until we were able to address the latest issue, the -- the physical issue that I described, as well as accelerate the implementation of some of the -- the earlier things that we had communicated in March.

Now, the practical realities of displacing 200,000-plus devices in the U.S. marketplace, I think, speaks for itself. I mean, we -- I don't know how many pumps. I'm not going to quote a number that we ship every year. But it's only a fraction of that. That installed base has been built over 8-plus years since COLLEAGUE was first launched. And it's -- and it's the largest installed base of any model of pump in the U.S. market by far. So, these are -- I think it's important for everybody to understand. I think you do -- this installed base of devices delivers hundreds of millions of IV medications annually without any problem at all. It's a low level issue that -- that we voluntarily wanted to address. The agency took the position in retrospect to classify our action we took four months ago in March as a Class 1 recall. But as a practical matter, to fill the void if many pumps came out of that installed base would be virtually impossible to do, I guess, either by us or the other manufacturers.

But, Bob, just to clarify. The FDA at this point is only requiring you to replace this small subset or are they basically saying -- is that right?

Well, what we've asked, to be very clear, it's a very small subset that is being taken out of service of the installed base. All right? And -- and that's what actually we have voluntarily decided to do, okay? They're not requiring us to do anything so far.

But ultimately you are going to replace all 200,000 or at least bring --

Well, we we're going to -- we -- based upon the fix that we validate and the approach that we take, we will -- we will modify I think is a better way to say it, every one of the 200,000-plus devices in the field.

Okay, and then --

Hence, the basis of the charge that we took.

Got you. And just quick follow-up. Comment what you plan to do on the international side and how many COLLEAGUEs are out there. And then secondly, I saw on the release that there's been three deaths reported to date. Given where we are in this process, do you expect there's going to be more news on that front? Will there be more deaths related to --?

Two different questions. I mean, we're taking the same posture internationally as we are domestically. It's a global issue. Obviously, there's many, many fewer COLLEAGUE devices outside the U.S. Less than 20% of our installed base of devices is outside the U.S. So -- but the actions that we're taking in terms of the whole launch shipment and asking customers to take out of service this low incident level of pumps that exhibit these certain tendencies, those actions are going to be global in nature. So it's totally consistent, all right?

Relative to -- to the -- to the reported deaths and injuries that were spelled out in the -- in the press release, I mean, you understand it's very difficult to establish some kind of causality in these situations. I would say having said that we don't rule out that there was an association. We obviously take these kinds of things very seriously. I would tell you that we have a very robust process in place for receiving information on all of our products from the field, evaluating that information, communicating with the FDA, and certainly on any product investigating death/serious injury reports. And -- and these investigations involve teams that include medical professionals and so on. So having said that, any adverse incident, of course, is a basis for concern. And I would emphasize again the failure codes involved in these field corrective actions, both those in March and the one that we announced yesterday, represent an extremely small percentage of what I said before. Really hundreds of millions of medical infusions that are safely delivered by COLLEAGUE pumps every year.

Okay. That's helpful color. Last question from me. On the HD move, to a distributed strategy, can you comment on what impact that might have on the -- the revenue growth trajectory for that franchise, and what, as much as you can tell us, is the -- is the margin impact? It sounds like it's a positive EBIT impact for the business.

Not to be real specific. I mean, the hemo segment if you strip it down, certainly in the machines and so on has not been really growing. So the impact on growth is virtually nil. Relative to profitability, as I think John referred to, we're not going to get specific, but directionally this has been a very low margin business for us and so we can see this as a margin enhancement opportunity. But again, on the total scheme of things for the Company it's not that material financially. I think the more relevant issue, which I mentioned and I'll re-enforce again, is disability to focus. I think it's fair to say you go back over the years. We've gotten distracted away from PD because of HD. And that's for a lot of reasons. Product quality issues and things of that nature. So this collaboration with Gambro will now set the stage that will enable us to truly focus on the franchise that we think is the future of our renal business.

Makes sense. Thanks -- thanks very much.

Okay, Ted.

Steve Hamill, Piper Jaffray.

Thanks, good morning.

Hey, Steve.

I was wondering if you could talk a little bit more about the SUPRANE strength and what's causing that, since this really isn't a new product for you guys, per se. What are you doing to get this growing as well as it is right now?

Well, one of the things we're doing is we're intensifying our promotional focus on this. I mean, this is a -- this is a branded proprietary product that -- I'll be very candid. When I came here a year ago, I said I can't believe we're not doing more with this product. And we have, over the last year, thrown more promotional resources behind it. We've done that selectively and in a disciplined way. But this is a product that has some -- some legs to it and we're starting to see some the benefit of that.

And to what extent does it help pull through other portfolio products in the anesthesia portfolio?

SUPRANE? Not -- not to a great degree. Obviously we manufacture isoflurane -- generic isoflurane. And so it positions us as having a family of inhalation products and relationship with the anesthesiologist, vaporizer placement support and so on and so on. So there's -- I guess you'd describe that as a little bit of kind of horizontal synergy in that regard, Steve.

Okay. And then I was wondering if you could give a little bit more color in terms of the gross margin strength. You did comment that it was strong across all three businesses. I'm wondering to what extent you view that as mix and how much of it was by what was a solid revenue growth quarter and good absorption?

Yes. It was probably more product mix, Steve. Which is not a one time event. I mean, as I mentioned, it was particularly driven by BioScience in the quarter with accelerated ADVATE conversion certainly helping that. The improvements we've made in the plasma business continuing to progress our margins and expand our margins. The SUPRANE expansion that you just asked about is a high margin product for us, as is our contract manufacturing business. So all of our businesses demonstrated improvements in the quarter and there was no one time -- one time item or anything that stood out other than BioScience with the strength we've seen in the first half of the year really across all of our portfolio within BioScience being the biggest of the three businesses in terms of being a contributor to the margin expansion.

Okay. And -- and then just last in terms of the change to your operating margin guidance for the year. It basically looks like a 50 basis point trim. Is that attributable basically to the gross margin than you'll lose on COLLEAGUE? Is that the best way to view that?

That's what it is. As I said earlier to an earlier question, it's about a $0.07 impact which is almost exactly a half a point of margin.

Okay. Thank you.

No other changes.

Operator, we'll take two more questions.

Katherine Martinelli, Merrill Lynch.

Great. Thank you. Just first question for John regarding the increased SG&A tied to bad debt and litigation. When will that start to normalize? Should we assume that happens through the remainder of this year and is then at adequate levels for next year?

Yes, I think so, Katherine.

Okay. And then with respect to -- Bob, you mentioned this COLLEAGUE issue came out of the improvement process. Where are you in that in terms of evaluating and the look back, if you will, so we can get a comfort level that there's not more of this type of event yet to come?

Well, this is -- not to dodge the question, but frankly, Katherine, I mean, this is about continuous improvement, okay? I mean, if you look at -- if you look at quality history of Baxter, I mean, the reality is we're -- we're proud of our quality record at Baxter. I always use the example of our North Cove, North Carolina, facility which is -- which is perhaps the largest and most complex IV solution facility in the world. We're going back 15 years. We haven't had a single 483 observation with repeated inspections. So we have a very strong quality track record in this Company.

Having said that, as I mentioned in my comments, the area of instrumentation devices that incorporate hardware, electronics, software and the like, is an area that we have high focus on. But it really gets back to at the most basic level the notion of design. And quality of engineering competencies and the robustness in the design. And I take you there because -- and answer your question how long and so on that gets back to organizational issues. To connect the dots, we just brought in Peter Arduini, who I think you met at the May conference, who joined us from GE Healthcare. And one of the things I was looking for in bringing someone into this position beyond the obvious things you look for in a senior line executive is someone who had a familiarity and a comfort level with technical issues and engineering issues and the like. And so to a large degree, we are managing through things that emanated from a history here of -- of -- not necessarily our strongest technical core competencies in the area of instrumentation, and so we understand what we need to do. We have the right people in place at a leadership level to implement it. And -- and we will do that. But when you think of quality on any product, but certainly instrumentation, devices like COLLEAGUE and others, it gets back to, how do you design these products and how robust is the design and the reliability? How do you validate various applications and uses of the product through the design process, and so on.

We have -- I will tell you, have implemented in the last year a very rigorous product design process to do exactly that. And we have a very demanding screening process for all new products, instrument-type products that are in development right now, whether that's in medication delivery or renal or transfusion therapy. So again, I'm confident we have the processes in place. I'm confident we know what we need to do. I'm confident we have the right leadership in place now. And -- and we are going to improvement improve. But when you have an array of products -- infusion products that have been in the marketplace for a long time that emanated from a different environment in terms of the development, it is what it is, and we're doing our best to manage it.

But I guess just to push you a little bit on this, that's kind of what I'm specifically trying to get at is, are you at the process -- the point now where the initial review of those designs has taken place and this is one of the corrective actions? Or is that still ongoing in terms of --

Yes, the answer is yes. Going back last year I think we did a good job of stripping down all our devices, understanding where there may be issues, implementing corrective and preventative action programs. We've implement more CAPAPs on various products in the last year than we have in a long time. And that was a direct byproduct of this very thorough, disciplined approach. We're in process of implementing a number of those corrective and preventative action programs right now.

Okay. That's very helpful. And just one product question. You mentioned increasing investment activities for your branded anesthesia product. When you look at ADVATE and your recombinant business, have you been increasing any promotional activities, vis-a-vis prophylaxis dosing? You mentioned that at the analyst meeting as a potential growth driver. Just wondering if that is something that you've started to allocate the resources to or if that was any part of the uptick in growth for ADVATE?

Yes, I don't know -- no, I don't think that's the case. The uptick in ADVATE I can tell you was not a direct result of increased promotional focus on prophylaxis, okay? Now having said that, clearly, that's an area that we have been focusing on since the launch of ADVATE. John, correct me. I'm not aware of any new things that have been implemented specifically for those kinds of uses in recent months that it's been accelerated.

Yes, I don't think there's anything new, Katherine, but it's an evolving focus where we continue to dedicate some promotional dollars. And I think our belief is the prophylaxis improvement you're going to see is going to be evolutionary as it has been for the past several years, and going to continue to slightly improve driven by the promotional activities from ourselves and the industry, generally. Great. Thank you.

Thanks.

Matthew Dodds, Citigroup.

Thank you. For John. On the gross margin, when foreign exchange starts to turn in your favor, isn't there a benefit to the gross margin line? I'm just wondering if that's true. How long does it take to flow through when the rates change? When could we see that?

Yes. We won't see a huge change from the rate change itself, Matt. As I think you know, the biggest foreign exchange impact on our margins going forward is the removal of some of the underwater cash flow hedges that we have in place and we'll start to see some of that benefit manifest next year. Then this year it's roughly a 50 to $60 million hit to our margins and next year it's going to be about half of that. And then -- then these hedges are gone.

And then one product question, John. For albumen, should we assume that's similar to what's going on in IGIV, even if the pricing starts improving there in the U.S. and Asia/Pacific, the volume's going to be down?

Yes. The albumen volumes should not be expected to be increasing given our throughput decisions that we've made over the last year and a half. So, yes, that's correct.

Thanks, John.

Pricing's a little stronger on that today than it was a year ago. But the volumes will be pretty consistent going forward. Other than the impact of the American Red Cross volume that will be bring in.

You got -- you got the albumen from the American Red Cross as well, right?

Yes. We'll have the ability to sell that albumen, exactly, to the -- to the market with the Red Cross and currently with their previous customers.

Thanks, John.

Okay, see you, Matt.

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