百特醫療 (BAX) 2018 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Baxter International's Third Quarter 2018 Earnings Conference Call. (Operator Instructions)

As a reminder, 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 Ms. Clare Trachtman, Vice President, Investor Relations at Baxter International. Ms. Trachtman, you may begin.

Thanks, Candace. Good morning, and welcome to our Third Quarter 2018 Earnings Conference Call. Joining me today are Joe Almeida, Baxter's Chairman and Chief Executive Officer; Jay Saccaro, Baxter's Chief Financial Officer; and Brik Eyre, President, Americas.

On the call this morning, we will be discussing Baxter's third quarter 2018 financial results along with our updated financial outlook for 2018. A supplemental presentation to complement this morning's discussion can be accessed on our website. This presentation, along with related non-GAAP reconciliations, can be accessed on Baxter's external website in the Investors section under Events and News.

With that, let me start our prepared remarks by reminding everyone that this presentation, including comments regarding our financial outlook, new product development, business development and regulatory matters, contain forward-looking statements that involve risks and uncertainties.

And, of course, our actual results could differ materially from current expectations.

Please refer to today's press release and our SEC filings for more details 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, generic competition for cyclophosphamide in the U.S. and approximately 1 month of sales from the acquisition of Claris in July 2017 along with our acquisition of 2 surgical products from Mallinckrodt in the first quarter of 2018.

Now I'd like to turn the call over to Joe. Joe?

Thank you, and good morning. I will begin with some comments and perspective on our third quarter results. Jay will then walk through the financials and guidance in greater detail, and we'll close with your questions. Brik Eyre, whom may you know from our May Investor Conference, will join us for the Q&A to provide additional insights on our U.S. performance.

Baxter reported solid third quarter with sales up 2% on a reported basis, 3% on a constant currency basis and 3% operationally. On the bottom line, adjusted earnings per share were $0.80, increasing 25% year-over-year.

Our strong earnings growth demonstrates the continued power of our operational improvement initiatives, and we see more potential for these efforts moving forward. Drivers of growth in the quarter included the company's Renal Care, Pharmaceuticals, Advanced Surgery and Acute Therapies businesses; increased demand for Baxter's contract manufacturing services also contributed to the performance in the quarter. This strength helped offset declines in our Medication Delivery and Nutrition businesses.

Growth in Renal Care was primarily driven by increased patient volumes for our peritoneal dialysis products globally. In the U.S., this contributed double-digit PD therapy growth. In Asia Pacific, we continued to see strong patient growth in China. And for the first time in years, we're experiencing positive patient growth in Japan following the launch of KAGUYA earlier this year.

In Pharmaceuticals, growth was driven by strength in the U.S., where we've experienced increased demand for our premixed injectables and extended our portfolio with the addition of Claris products. Claris, which we'll now refer to as Baxter a MetaBot, continues to deliver double-digit performance growth, in line with our expectations. Increased sales of anesthesia and critical care products also contributed to the results in the quarter. Advanced Surgery achieved double-digit growth, including the contribution of $14 million from sales of RECOTHROM and PREVELEAK.

Acute Therapies also reported double-digit sales growth based on global strength across the portfolio. On Monday, this team initiated a worldwide launch of the leading-edge PrisMAX system beginning with 19 European countries. PrisMAX is our next-generation technology for CRRT, or continuous renal replacement therapy in organ support therapies. It offers ICU practitioners a broad range of advantages designed to make therapy simpler, safer, more accurate and more efficient. This is transformative innovation that builds on decades of Baxter market leadership in the acute care space. These strong results posted by this business was partially offset by performance in our U.S. Medication Delivery and Nutrition businesses, which were, frankly, disappointing.

I can assure you that steps are already being taken to address these issues. It starts with decisive action to put the right leadership in place, accountable for renewing the strategic momentum and forecast reliability that we and you expect. Overall, we remain on sound footing across a vast portfolio of products with market leadership positions.

To be certain, we are in a period of course correction in a few key areas, which we often occurs -- which rather, which often occurs from time to time in a dynamic market like ours. Let me drill down a few key areas starting with supply disruption due to Hurricane Maria.

It has now become clear that market dynamics have fundamentally shifted in a few of our market segments in the aftermath of Hurricane Maria at least in the near to midterm. While we have resumed production at prehurricane levels, the gap in bringing supply back to market ultimately caused a longer-lasting ripple effect for several products line. End customer demand has now fully resumed to prior levels.

Specifically, with respect to small volumes -- rather with respect to small volume parenterals, which include our Mini-Bag and Mini-Bag Plus lines, we have seen impacts from protocol changes such as moving to IV push for administration of drugs as well as some moves to competitive products on supply constrained codes.

While we expect to regain most of this business, we do anticipate it will take some time, particularly for the portion of the business that has moved to alternative practices for drug administration. We are continuing to reinforce the benefits of Mini-Bag Plus, emphasizing safety and reduced potential for medication errors.

We're also reinforcing the availability of supply with our customers. For select U.S. nutrition products, we've seen some market contraction as a result of hurricane-related supply constraints whether through providers delaying the start of parenteral nutrition and/or reducing dosage. We also experienced some shifts to outsourced nutrition compounding centers in competitive products. It is unlikely we'll regain all our lost sales here, particularly where we've seen market contraction at least in the near to midterm.

We're in process of rebasing this business and expect to resume U.S. market growth of low single digits in the coming quarters. And while not directly related to the hurricane's impact on our production levels, the historic tight supply in the market for IV solutions has also impacted performance for the Medication Delivery business this year.

Sales of large-volume IV solutions spiked in the first 5 months of the year driven by increased purchased -- by increased purchases, given the protracted industry-wide supply challenges coupled with an intense flu season. Customers rushed to acquire any available IV solutions products. This resulted in growing inventory levels across our customer base.

Our forecast was built off this elevated run rate and didn't contemplate the level of inventory destocking we're currently experiencing as supply constraints have eased. In addition, the timing of adding incremental beds in nonacute customer has fallen short of our expectations. It's important to note that the end user demand for our LVPs is up approximately 2% year-to-date. We believe this is slightly ahead of the market, which we see as growing approximately 1%.

So ultimately, while our overall share has remained stable, the impact from the inventory destocking as well as the timing of bringing on new customers has clearly been slower than anticipated. As a result of these market dynamics, we are resetting expectation for these businesses in 2018. Going forward, our expectation is that the Medication Delivery and Nutrition business will grow in line with our long-term outlook.

Taken together, these learnings will help support greater predictability and forecast alignment. We have a unique portfolio of life-sustaining products, and we've implemented some necessary changes that we believe will make our prospect both stronger now and over the long run.

In summary, our diversified portfolio, accelerating innovation, strong balance sheet and relentless focus on operational efficiency give us the confidence and flexibility to deliver on our long-term financial objectives.

With that, I will turn it over to Jay.

Thanks, Joe, and good morning, everyone. As Joe mentioned, although we've experienced challenging market dynamics in select businesses, our third quarter results reflect the benefit of our diversified portfolio as well as our ongoing commitment to accelerating bottom line growth.

I'll start by discussing our third quarter results before providing our updated financial outlook for 2018. Beginning with the third quarter, Global sales of $2.8 billion increased 2% on a reported basis, 3% at constant currency and 3% on an operational basis.

On the bottom line, adjusted earnings increased 25% to $0.80 per diluted share. This exceeded our previous guidance of $0.72 to $0.74 per share driven by solid operational performance and ongoing benefit from our business transformation initiatives and a lower tax rate.

Now I'll walk you through performance by our regions and Global Business Units. Note for this quarter, constant currency sales growth is equal to operational sales growth for all businesses with the exception of our Pharmaceuticals and Advanced Surgery business. For these businesses, we will provide operational growth.

Starting first with sales growth for our 3 regions. Sales in the Americas advanced 4% on a constant currency basis and 3% operationally. Sales in Europe, Middle East and Africa grew 4%, both constant currency and operationally. And finally, sales in our Asia Pacific region were flat on both a constant currency and operational basis.

As a reminder, in the third quarter of 2017, we recorded $25 million of sales in our international compounding business due to an early contract settlement with one of our Australian hospital pharmacy customers, which impacted growth in the Asia Pacific region by approximately 4%.

Moving on to performance by Global Business Units. Global sales for Renal Care were $910 million, advancing 3% on a constant currency basis. Performance was driven by mid-single-digit growth for PD therapies globally as well as low single-digit growth globally for our in-center HD business. Sales in Medication Delivery were $652 million, down 3% on a constant currency basis driven by the business dynamics that Joe walked through earlier. Pharmaceutical sales were $519 million, increasing 5% constant currency and 5% operationally. Sales growth in the quarter benefited from strength in our anesthesia business and increased demand for Baxter's injectable premixed drugs. Sales of U.S. cyclo were $40 million in the quarter, and global Claris sales were $38 million.

Moving to Nutrition. Total sales were $218 million, down 2% on a constant currency basis. Solid growth in international markets was offset by lower sales in the U.S., which Joe commented on earlier. Sales in Advanced Surgery were $200 million, increasing 15% constant currency and 7% operationally.

As Joe mentioned, sales of RECOTHROM and PREVELEAK contributed approximately $14 million in the quarter. Sales in our Acute Therapies business were $122 million, representing growth of 10% on a constant currency basis, continuing the trajectory of delivering double-digit growth driven by increased global demand for Baxter's continuous renal replacement therapies.

Finally, sales in our other category, which primarily includes our contract manufacturing services, were $146 million, an increase of 17% on a constant currency basis. Performance in the quarter was primarily driven by increased demand for our contract manufacturing services, specifically our cytotoxic contract manufacturing services as well as incremental production volumes for seasonal vaccines.

Moving through the rest of the P&L. Our adjusted gross margin of 46.3% increased 100 basis points over the prior year, benefiting from favorable product mix and manufacturing efficiencies. Adjusted SG&A totaled $622 million, decreasing 1% on a reported basis and flat on a constant currency basis. We continue to see a positive contribution from our relentless focus on effective expense management and business transformation initiatives, which helped to offset the loss of approximately $10 million in transition service income from Shire and incremental expenses related to our recent acquisitions. Adjusted R&D spending in the quarter of $153 million increased 3% on a reported basis and 4% on a constant currency basis versus the prior year period as we continue to invest in high-impact programs to accelerate innovation at the company. Adjusted operating margin in the quarter was 18.3%, an increase of 170 basis points versus the prior year. Growth was driven by strong operational expansion as well as continued effective expense management.

Net interest expense was $11 million in the third quarter, reflecting higher levels of interest income due to rising interest rates. And other income totaled $32 million in the quarter, primarily reflecting a benefit from the recent changes we made to our U.S. pension plan along with foreign exchange gains on balance sheet positions.

The adjusted tax rate was 17.1% for the quarter, which includes a benefit of $9 million from stock compensation. This came in favorable to our expectations driven primarily by certain discrete items recorded in the quarter.

And as previously mentioned, adjusted earnings of $0.80 per diluted share exceeded our guidance of $0.72 to $0.74 per share. During the quarter, we repurchased $247 million or 3.3 million shares of Baxter's stock. These repurchases were partially offset by option-related dilution in the quarter.

Before turning to 2018 outlook, I will briefly comment on our cash flow performance. In the first 3 quarters of 2018, we generated free cash flow of $873 million, with improvements in net income offset by higher inventory levels as we work to rebuild supply for select products to ensure adequate product availability.

Let me conclude my comments this morning by providing our guidance for the fourth quarter and full year 2018. Given the market dynamics we discussed for our U.S. Medication Delivery and Nutrition business, we've lowered our sales forecast for the year. Globally, we now expect 2018 full year sales to increase approximately 5% on a reported basis. We now expect growth of approximately 4% on a constant currency basis and approximately 3% on an operational basis.

Moving to full year guidance by business. On a constant currency and operational basis except where otherwise noted, in Renal Care, we continue to expect growth of 3% to 4%. In Medication Delivery, we now expect sales to decline low single digits. We now expect our Pharmaceuticals business to increase high single digits at constant currency. This assumes 2018 U.S. cyclo sales of $160 million, above previous guidance of $130 million.

We continue to expect full year Claris sales of approximately $145 million. Adjusting for cyclo and the first 7 months of Claris, we now expect operational sales to increase approximately 7%.

Moving to Nutrition. We now expect sales to decline low single digits. For our Advanced Surgery business, we now expect sales to increase approximately 10% on a constant currency basis. This includes a contribution of approximately $45 million related to the acquisition of RECOTHROM and PREVELEAK. Excluding the impact of these sales, operational growth is expected to be approximately 4%. For the Acute Therapies business, we now anticipate growth of 10% to 11%.

Finally, in our other business, we now expect growth of high single digits given increased demand for our contract manufacturing services.

Moving down the P&L. We now anticipate adjusted operating margin expansion of approximately 100 basis points. We expect net interest expense of approximately $45 million and other income of approximately $105 million for 2018.

For the year, we continue to expect an adjusted tax rate of approximately 17%. For full year 2018, we anticipate a diluted average share count between 545 million to 550 million shares. Based on these factors, we expect 2018 adjusted earnings, excluding special items, of $2.98 to $3 per diluted share.

Finally, for the year, we now expect to generate operating cash flow of approximately $2.2 billion, with capital expenditures of approximately $700 million and free cash flow of approximately $1.5 billion, down slightly from our previous guidance due to higher inventory levels.

Specific to the fourth quarter of 2018, we expect sales growth of approximately 1% on a reported basis and between 3% and 4% on both a constant currency and operational basis. And we expect adjusted earnings, excluding special items, of $0.71 to $0.73 per share.

That concludes my comments. We can now open the call for Q&A. As a reminder, also on the call today is Brik Eyre, President, Americas, to join us during the Q&A. Candace?

(Operator Instructions) And our first question comes from Bob Hopkins of Bank of America Merrill Lynch.

So, I guess, my concern looking at the last 2 quarters is that at least some of the issues that you're facing seem a bit structural given that you're experiencing share loss and a move to some alternative cheaper technology. So, I guess, my question is this, can you quantify for us or describe the degree to which you think you're losing share here and then help us understand how these issues could impact growth into 2019?

Okay. Bob, I'm going to pick up half of the answer here, and I'm going to pass to Brik to get a little bit more color on the question on the share. First of all, there were shifts in the market because, us not having Mini-Bags and Mini-Bag Plus and amino acids, we actually were the ones teaching our customers how to use alternative methods. Some of them will come back, and we expect in 2019 to pick up a portion of that without a problem. The other ones will take a little longer for us to convert because those are medical practices. You have a significant amount of hospitals in the country, and we have large market share. I would say that we don't see the issues that we experienced in '18 by rebasing '18 to affect, tremendously, growth rates going forward. So as a matter of fact, I would say that the full year of 2018 results are the base for the LRP that we present in May, which runs from '18 to '23. So using the projected performance of 2018 we -- that we just shared with you, we are not revising our long-term guidance for total Baxter even the top or bottom lines. So there are structural issues. They take a little longer to resolve, but we have not lost any customers at this moment. And we may have lost some temporary share in accounts where some fluids are being substituted, which we expect from the mid- to long-term to recapture. I'd like to see if Brik would like to add anything to it.

Yes. Thanks, Joe. Bob, let me talk about a couple of segments of the business. So first, our small-line parenterals. So these are 50-, 100-, 150-milliliter bags that are used to administer, infuse medication to patients. In that segment, when there were no products to be -- that our customers could find, about 25% of the doses that have historically been used or been administered through infusion, using our Mini-Bag and Mini-Bag Plus products, had to find other ways to administer those drugs. A portion of that went through a new practice, which is IV push. Now to be clear, IV push happens in every hospital every day across the country typically in OR drugs, et cetera. But in this particular case, when there was no product, specifically cephalosporins, penicillins, those anti-infectives, were moved to an IV push. This practice is the nurse literally takes a syringe and dilutes the drug into 5, 10 mls worth of diluent and then injects it into a port that is at the set at the hand, where there is access to the vein, and then they will do that over a period of time. There are some safety concerns, et cetera, that we are talking with our customers, but some customers have moved to IV push. And in so doing, they have to change their protocol. They change their protocol, they change their system, et cetera. So while we do believe we will get this back, it's taking a little bit more time than we had anticipated. Other customers went to competitive products. We actually feel very confident that we will get those products back, and we're working with our customers now to ensure that they understand that we have capacity, supply, et cetera. Now the other component of this is nutrition that was impacted from a -- the hurricane perspective. The nutrition business actually did contract. The market contracted. Whereas Joe mentioned in his -- in the opening comments, when customers didn't have product, they delayed start times, et cetera. So believe the overall nutrition market has contracted about 7%. We have also lost some share because we didn't have product, and we are working again with customers to get that share back. So while we don't think it's a long-term piece, certainly over the next few quarters, we anticipate seeing a ramp-up of bringing those products back to us. But anything that required a change in protocol will take a little bit more time.

Just a very brief follow-up. Joe, is now the right time to be more aggressive with the balance sheet-related to buyback given your confidence that these things will be temporary?

I would say that with the capacity that we have, and we're going to look at the sentiment of the investors, it's always a good time at this moment to look at some buybacks. But also we continue to use a significant amount of efforts inside Baxter in the M&A space. So we want to make sure that we have capacity to do all of the above, continue to increase our dividends annually and buy back shares and have plenty of capacity to go after M&A targets, which has a renewed and very focused effort at Baxter.

And our next question comes from Vijay Kumar of Evercore.

And maybe just going back to Bob's question on some of the disruptions you guys have had. And this is a little unusual for you guys, where The Street's got used to stellar execution. So I just want to understand the dynamics, right? So you had -- I think, Joe, you mentioned LVPs. So if I'm understanding what happened on the LVP side is, customers prebought as in they built up inventories. One, how long does it take for them to work through those inventories? Should we still be expecting impacts in first half of '19? And then back to, I guess, Brik's sort of -- explanation on the push syringe impact. But I would think like, I mean, for 50 ml to 100 ml bags, someone pushing in using an IV push, that's a lot of inconvenience from a time -- use of time perspective in the hospital for the nurse. I'm just trying to think whether all of that comes back, or the assumptions around why some of that may not come back?

So I'm going to have Brik answer 95% of your question. Just want to go back to the LVP. We now have a very good understanding of what happened in terms of stocking and destocking. As I said, we haven't lost a customer. But what we learned from this whole thing was that there was a pattern of purchases that were for many years in place, due to the product allocation that customers would buy whatever was available for them to buy because it was usually a little less than they would wish to purchase. We have created significant flexibility in the supply chain. And for the first time, we are in the market with no allocation, which creates flexibility for us, not to sell in U.S., but sell the product in other parts of Latin America, like we just did the other day in Mexico, extremely well-executed flexibility of supply chain. So we are going into a new era of LVPs where not only our plant in North Cove has done extremely well remediating and improving the output of the plant. So, at the same time, we resolved long-lasting quality issues. Things of the past have been resolved effectively. That plant is also now surpassing capacity plants because it's doing so well. We have capacity in Mexico, Ireland. So we now have the ability to really put the product to work. And this will be fundamentally important for us to resign customers that were -- we've signed in the past. When we talk about execution, we had an execution issue in the short term by having a team that did not understand what was happening with the difference between inventory in distributor and demand at the end of the day. It didn't change the dynamics. We did not see the signal, and we should have seen that and communicated more effectively. But to that end, we are relentless in execution. That's why we made significant changes in the U.S. team and have replaced people -- and plus we're replacing people who did not understand how we operate. I want to pass on to Brik to speak specifically about the push and how this business can come back in terms of market share as well.

So, Vijay, thank you. I want to just make sure I'm clear. In the package insert for administration of a ceph or a pen, for example, there's a couple of ways that they can do that. They can put into a Mini-Bag and infuse it over 30, 45 minutes of an infusion or -- and that would be like 100 ml. Or you can inject it through IV push with 5 to 10 mls of diluent. And so it's not -- they're not doing an IV push of 100 mls. It is 5 to 10. Now they will do that over 3- to 5-minute period of time. It will say in the package insert how long they should wait. The practical reality is studies have shown that a lot of times, they don't wait that long to push it and so there could be an overprescription or overdosing, and there could be a medication error. And that's one of the things we're talking to our customers about. So IV push, the issue really is they're comfortable with IV push for certain drugs, but those drugs that can be infused, cephs, pens, et cetera, really the best way to administer that drug is through Mini-Bags. And that's what we're talking to our customers about. Now I might take just a moment on LVPs to add just a little bit of color. This has been a business that's been highly successful for us for a number of years and has driven tremendous, tremendous growth. And the vast majority of that comes from new customer sign-ups. As you know, over the last 5 or 6 years, we've actually signed up to 3- to 5-year contracts, about 100,000 beds. So tremendous market shifts over the last 5, 6 years in our business from an LVP perspective. And that has been -- that coupled with an industry challenge in supply, our customers virtually purchased almost everything we could produce. In fact, these products have been on allocation. So we allocated a number of units that each customer could buy based on historical performance because we had to do that to make sure that we got product to every customer. As we discussed and as Joe just discussed, we brought more product from Latin America. We were able to increase the allocation to customers above their historical usage and ultimately, to remove that. As we did that, the demand for our products was tremendous in the first half of the year, particularly in the first quarter as customers were concerned and distributors as well were concerned about the hurricane disruption of the market in general as well as products that had just been on allocation for a long time exacerbated with a larger flu impact that we had in last quarters or last -- earlier this year. So there was tremendous, tremendous demand for our product. And then our U.S. team took that run rate on product that has always been able to -- whatever we manufactured, people purchased over the last 5 years because of allocation and used that for our forecast of the back half of the year. And they did so not realizing that distributors and customers purchase significantly over the end user demand the first half, most notably in the first quarter as I mentioned. Now the good news is, that those distributors have worked through that inventory caused a significant impact in the third quarter, but we believe that we are close to being back into equilibrium. We've been in contact with our distributors, our wholesalers. We know our end user demand. We get tracings from our distributors. So we are -- we've really improved our analytical capabilities, and certainly we will be at equilibrium over the next couple of months.

That is extremely helpful, Brik. And maybe, Jay, just on the margin front, that was a stellar standout rate in terms of the positives. Irrespective of what the top line was, I mean, you guys have executed on margins, but as we -- it looks like maybe Q4, maybe there are some below-the-line items impacting. I'm having a little bit of a hard time getting to the low end of an EPS guide range. And when we look at '19, just qualitatively, should we be assuming some of these revenue headwinds persist, but on the margin front, the guide that you guys laid out at the Analyst Day, nothing changes on the margin front?

Sure. Vijay, let me talk a little bit about Q4 and our expectations there. Because to your point, while in second half of the year, we were pleased to be able to confirm the overall guidance at the high end of the range, you point out very accurately that the Q4 implied guidance is down relative to what we previously shared. There's a few factors in play here, the largest of which is this issue that we've highlighted and discussed extensively about Medication Delivery and Nutrition. Overall, as we think about the impact in the fourth quarter relative to our prior expectations, that's about $0.06 of impact. Now offsetting that is savings initiatives that we have in place, roughly $0.01; cyclophosphamide impacts, approximately $0.03; and then there are a couple of financial adjustments, or financial items, I should say, related to foreign exchange and tax. We have taken -- we reduced our expectations with respect to FAS123R. So you do see a bit of a tax uptick. But in combination, foreign exchange and other financial items impact us roughly $0.04 in the quarter. So in combination, all of those items take us roughly down $0.05 midpoint to midpoint in the fourth quarter. As it relates to 2019, we'll stop short of giving guidance for that today. We do believe that there's real opportunity to recover, and I think Brik has discussed that extensively as has Joe. But as far as specific guidance for 2019, we'll stop short of that. We have reiterated confidence in the long-range plan that we shared, which shares through 2023 with also 2020 numbers.

And our next question comes from Robbie Marcus of JPMorgan.

Great. I wanted to ask about some of the businesses that did well in the quarter, particularly Acute Therapies and Pharmaceuticals. These are ones where we've seen trends progressing positively each quarter. Can you help us understand Pharmaceuticals, what's driving that, how sustainable it is? And then in Acute Therapies, there were some new product launches recently. Can you help us understand the impact from those going forward?

Can you repeat the second part of the question? I understood the Pharmaceuticals. I missed...

Acute Therapies in new product launches.

Acute Therapies, okay. Robbie, we had an extraordinary performance in the Pharmaceuticals business. Some of that is our capability of producing products that others can't and being there all the time. Cyclophosphamide is one of them despite the fact there's the new competitor that was authorized by the FDA to produce. We haven't seen the product coming out of this manufacturer yet. It's a very difficult product to make. We're not saying that we're the only ones who can because there's another competitor in the markets, and those has their product out there. But at the end of the day, we can make oncolytics and cytotoxics extremely well, one of the best in the market. We have BREVIBLOC that we do well and also TDS, which we source and be able to -- have the product for our customers. We don't see these products repeating the same performance all the time because as the nature of the business being when we can produce then people can't, people sometimes come back to the market. The BREVIBLOC is one that now has a couple of other manufacturers on the market, but we are always hedging our capabilities. So the performance of the Pharmaceuticals have been driven primarily by our ability to execute versus others who can't. I will give a little bit of a mid- to long-term view of Pharmaceuticals, which is our ability to continue to look into acquired molecules, which we've been doing. Second is our commitment to deliver on the LRP that Brik had presented at the Investor Day. We are still on track for all of that. Moving to the Acute Therapies, and I just want to say that we just launched PrisMAX, great product, launched in Europe. It's going to launch in the U.S. following. We are very excited. We're #1 in this therapy around the globe. You can see by the performance of this business and the performance of a competitor that just released earnings the other day, specifically yesterday, that we continue to be very successful in gaining share and also creating adoption for this technology. This just proves this is a structurally sound business, and we're very happy with the execution. I just also want to take the opportunity, you mentioned things that are going well, to underscore our launch of PD business and relaunch of our PD business in Japan with great success. And a 10% growth overall in China on all of our businesses combined. So we have some really good stuff happening. The unfortunate part is that we missed some of the market signals in the U.S. that created a headwind for us in Q3, will create in Q4 and we'll recover probably through '19 into '20. So we have some really good businesses within the company. They are really good cash generators and also we have a good and sound pipeline coming out on the company in '19 and '20.

Okay, great. And I know there've been a couple of questions on Medication Delivery. But just to look at it from a different angle, I haven't heard anything on in terms of how infusion systems have done in the quarter, year-to-date. Maybe how that's playing out with the system 8 launch. And then also can you comment on large volume pricing? I know you've said that volumes were up 2% year-to-date. How does the pricing situation look first half and then versus third quarter?

Robbie, just want to amend my answer on Pharmaceuticals that are premixes, which are replacements for -- we would sell premixes every day of the week in favor -- in detriment of Mini-Bag Plus, okay? Because premixes get a higher margin and they're up 18%, 18%. And they're reflected in Pharmaceuticals. They're not reflected in SVPs. Just want to highlight that because I missed that in my answer to you. So to the folks on the call, premixes has done extremely well. This is the GALAXY product, and those were ones that we told the customers to substitute for when we did not have Mini-Bag Plus available after the hurricane. So this is the positive side that we did not talk about. Let me pass on to Brik to answer the rest of your question.

So, Robbie, relative to pricing, with LVPs, nutrition, et cetera, the reality is these are products that are on longer-term contracts that have modest price increases built into those contracts. So pricing remains in line with our expectation across all of those product lines. Relative to infusion pumps, we continue to believe that we will pick up approximately 1% of market share this year in the United States with our SIGMA SPECTRUM pump. We have found that as more customers desire to have auto programming, one of the key features of our new pump that we've recently launched, our Spectrum IQ, which we sometimes refer to as version 9 and other integrated features that the selling cycle has lengthened a little bit. And so IT is now involved at a much higher level, at a hospital level -- or at a hospital, in each of our hospitals. And so we did reduce our pump number a little bit in the back half as products slip out into next year. But overall, we anticipate picking up the 1 percentage point as we had suggested earlier on with the new launch of SIGMA SPECTRUM.

And our next question comes from David Lewis of Morgan Stanley.

Maybe, Jay, just start with -- just start, Jay, with your question on free cash. So just free cash flow growth reversed a bit second quarter, third quarter. So I imagine there's been some supply chain reinvestment. Can you just sort of walk us through second quarter to third quarter? And as you think about sort of next year, do you think free cash flow gets back to that historical double-digit growth rate?

Yes. Look, thinking about overall performance from a free cash flow, year-over-year, I think we're still talking about north of 20% growth, so very solid growth from 2017 to 2018. You'll recall earlier in the year, we raised free cash flow guidance. We had subsequently lowered it. And really what that has to do with is a couple of the factors that we discussed during this call. One is to the extent that you fall short on a sales forecast, I mean, it's very difficult to adjust your supply chain planning such that there is not an inventory build that takes place. The second thing is, we're very pleased with the performance coming out of our North Cove manufacturing facility, but that has been overproducing in terms of getting fully back up to speed ahead of our expectations, which is another factor contributing a bit to the inventory build. And then as we said earlier, when we look at year-over-year performance, we did make some strategic decisions to make select product inventory builds. So really, those are the 3 factors that we see. We do not see this as a structural issue. And frankly, once we kind of tighten up our forecast going into next year, this will be an opportunity for us to claw this back. So this year was -- if we think about the progression of free cash flow, we've gone from $300 million in 2015 to $1.5 billion in 2018. Inherently, when you see that kind of extraordinary growth, there will be some volatility and some puts and takes. We wanted to make sure we share the, obviously, the most updated thinking in terms of where we see this landing. But like I said, I don't believe this is a structural issue that we're faced with, and we will plan accordingly, as we look to next year.

And just maybe 2 quick follow-ups. The first is for Joe or for Brik. We haven't heard a lot about the SVP manufacturing dynamics in Puerto Rico. How do they trend here in the third quarter, and what's the pathway to approval? Then, Jay -- sorry, just for the fourth quarter assumptions. We have 2 different dynamics, inventory and some of these customer changing dynamics. Inventory is you could look at tracing data and get relatively comfortable. Just basically trying to ask as it relates to customer recapture rates, how risk-adjusted are these fourth quarter numbers? And I'll jump back in queue.

So let me first talk a little bit about SVPs, David. Our production level is back to where we want, need it to be, et cetera. We were able to put Mini-Bags back in the channel kind of mid-July, so midsummer. And we're starting to see an impact of having that back in the channel, which is a good thing as customers can buy from their primary distributors. Mini-Bag Plus just went back into the channel in September. We are healthy on most codes of Mini-Bag Plus. We've got 1 or 2 codes that we're still getting healthy on, but the vast majority of our business, we're very healthy now from a inventory perspective. And we are working, again, diligently with our customers relative to ensure that they have confidence in our ability to supply.

And then, David, from a fourth quarter financial forecast, we've spent a lot of time with a bonds up build up trying to be appropriately conservative as we look across the portfolio, and that includes LVPs. That includes SVP recapture and so on. And so I think we've got the right number as we look to Q4 in the guidance that we shared.

The only other thing I might add, David, is we have launched a new product which is sourced out of Castlebar, which is a single-pack Mini-Bag Plus product, which we're really excited about. From an operational efficiency perspective in the hospital, it's been very, very well received. And so this continues to diversify our risk as we have other sites manufacturing this Mini-Bag Plus product that is such a great product for us.

And our next question comes from Larry Biegelsen of Wells Fargo.

One on the P&L, one on capital deployment. So, Jay, in the past, you've been very helpful in pointing out kind of headwinds in the subsequent year, and you guys have been very good at being able to overcome those headwinds on the P&L. So for 2019, you have currency, cyclo, BREVIBLOC maybe on other income and tax potentially as headwinds. And in the aggregate, by our math, it could reduce 2019 EPS by about $0.40. So can you walk us through some of the P&L headwinds next year and help us understand if you can still grow EPS at a double-digit reported rate in 2019? And I had one follow-up.

Yes, sure. Larry, stay tuned. Come join us on, I think, January 31 or February 1 for guidance for 2019. At this stage, I think it's premature. What we've said is we've shared financial guideposts for 2020 and 2023. There are numerous puts and takes, of which we've confirmed and feel confident in. There are numerous puts and takes as we look at any given year, I mean, our objective is to do as well as we possibly can do in any given year. And so certainly things like new product launches are things that we'll highlight as we come to our earnings call at the beginning of next year. But like I say, it's too premature to give 2019 guidance at this point.

Understood. And Joe, regarding M&A at our health care conference, Jay, not to get you in trouble, but you said Baxter is agnostic to deal size, which surprised me a little bit. So Joe, I thought you had a strong preference for smaller deals because it was hard to get a good ROIC from larger deals. So my question is, has anything changed?

Thank you. Trying to figure out if Jay and I are on the same page, and we are actually. Jay called me right before he said this and asked, "can I say that." And I authorized him to say that without [Bernie] present. We are looking at any opportunity that we have either adjacent to the core or completely outside of the core in terms of another leg to the stool. And why do we take the constraint of size? Because that creates an issue in selecting targets, not necessarily that we will execute on that but not -- but being agnostic of size. What Jay meant to say was that we have -- we are looking at every opportunity that is -- that will get us what we need to do, which is to refresh the portfolio of Baxter, to create momentum on the gross margin line, augment growth on the top line and be accretive to the bottom line. We're doing this. And by taking the size from the restriction, we can see better what's available to us. But let me also put a commentary that was implied in Jay's response to your question during your conference, that is, we will push the boundaries of our debt ratio to the limit of investment grade, but not -- or below that. So that creates a size limitation of what we can do, okay? Secondly, I have to say to you that what Baxter has done in terms of its business transformation and what we're able to bring to the company when I first started about -- exactly 3 years ago yesterday, we had 9% of operating income, and now we are above 18% of operating income. That transformation of a company is difficult to achieve. But once you know and learn how to do it, it is paramount upon the acquisition. So if you think about when we talk about sizes and how we do it, it's not about integration per se, but it's our ability also to go in with that mentality, with that trademark and get the savings out of the target independently if the synergies are all in terms of connecting systems and doing the stuff that more traditionally people think about. I'm coming from a different angle that said that is doable, but the first thing we'll do, we'll put a business transformational office identical to what we have in Baxter at that company. And we're going to remove the cost and the fat that companies usually have in the medical technology and generics, pharmaceutical business. So it's a long answer to you to say that we are looking at multiple size deals. We're looking for in also adjacencies and outside of our space within the health care, but also we have the ability to really be a cost-driven organization, that can extract value from a target even if it's not core or highly synergistic to us.

And our next question comes from Larry Keusch of Raymond James.

Yes. Just wanted to -- we've already spent a lot of time on LVPs and SVPs, but wanted to come back to nutrition and just get some thoughts as it relates to sort of the protocols changing in terms of delayed starts for nutritional products. How do you influence that to kind of go back to where it was? Because, I guess, my concern is that could become a bit more permanent.

So, Larry, let me take that if I can. Certainly, it's more problematic when protocols change. But ASPEN, the American Society for Parenteral and Enteral Nutrition, wrote some guidelines to help people when they were in conservation mode. There are guidelines for feeding. And while these patients are typically really, really sick, they don't have gut function. That is why they're on parenteral nutrition. So it's very difficult to be able to track specifically what the clinical outcome is to -- there are so many different inputs. But if you take a step back, we do know there's good data that would suggest that outcomes are better when a patient is nourished appropriately and effectively. So we are working with all of the societies now that there's an appropriate supply to see if we can help customers go back to feeding protocols that have been established by ASPEN here in the U.S., by ESPEN, which is in Europe, to help make sure that patients are fed appropriately. We'll continue to work with those societies, continue to work with our customers. But as you mentioned, when a protocol changes in the hospital, it just takes a little bit more time to get it back. We're working very closely with our customers, and they do recognize the importance of feeding. And we just have to make sure that they're confident in our supply chain and the supply chain to the market in total. And to your point or just from a framing perspective, about 7% of the market contracted, and we will be working over the next several quarters to bring that back.

Okay. Perfect. And then 2 other perhaps quick ones. I think, Joe, you may have mentioned in your prepared comments about some management changes following some of the forecasting missteps, if you will, relative to the business. So, again, I want to make sure I heard that and kind of what the plans are there. And then for Jay, just on the gross margin expansion year-over-year, which was clearly impressive, just trying to understand the components that drove that expansion, if there any onetimers there.

We always look at execution at Baxter in a way that is pretty straightforward. Some stuff we expect from people to accomplish at a certain level. Understanding their market is the first one. So when people don't understand their markets or they have been complacent in doing their jobs, it's our responsibility as leaders to identify that, either correct with the personnel that we have or just replace. So that's what we did, and we do that all the time in all businesses. We have significant changes. For instance, we made significant changes in the international business at Baxter, was really under managed, to be honest with you. And we brought some really good people in, and we started seeing the performance going up. Brik had issues with the performance in the hospital business in the U.S., and we just did the same thing. So it's pretty straightforward. No different than it would have been in any other prior jobs, but we take performance very seriously. We take performance as the #1 criteria, only second to ethics and compliance.

As it relates to gross margin, which was a bright spot in the quarter, the lion's share of the improvements relate to cost initiatives and business transformation. As Joe mentioned, we're -- the margin journey that we're on is something that initially was focused primarily on SG&A as that was the fastest area to take out. But now under the leadership of Scott Pleau, we've been able to make changes to our operation network, to facilities, to optimizing within facilities. So probably 75% of our margin improvement year-over-year relates to some of these cost initiatives. And perhaps 25% or so relates to mix and operational growth that took place in the quarter. So on balance, as we look from 2018 to 2023, you can expect to see more progress on driving cost out with a lot of that coming from the gross margin line in the coming years.

And our final question comes from the line of Joanne Wuensch of BMO Capital Markets.

There are a number of new products that you're launching right now in the second half that should benefit you in 2019, Spectrum IQ, Evo IQ, PRISMAFLEX, PrisMAX. Can you give us a brief update on how those products are rolling out the door? And how we should think about them ramping into next year to possibly offset some of the continued nutritionals and Medication Delivery recovery?

Yes. Joanne, clearly, we are looking into '19 to be a year that we're going to have growth. The question that we're going to tell you how much growth it's going to be is going to be a conversation in January. Those products will contribute, and we're counting on them to help because as you see some of this change that Brik just mentioned in nutrition is several quarters in the making to recoup that kind of a sales volume. So those new products will be key. We're counting on PrisMAX. I think dex -- that is one that we are very excited. Once we launched dex, it's actually doing very well. We have 4 new molecules launching next year as well. So we -- one thing we have proven is the ability to really ramp up quickly to big sales on those molecules. If I'm not mistaken dexmed will -- peak sales will go into '19. We'll get into '19 pretty quickly. So we need those products. We're counting on KAGUYA next year to be a driver in Japan because the profitability -- not as much as sales growth as much as the profitability. That product has shown that the patient in Japan are highly profitable in terms of our reimbursement. So we are counting on those products without a doubt. And for me, and this is the message that I give to Brik, to Cristiano who runs Europe, Middle East and Africa and Andy Frye. It's all about executing on those new products. They have the message. They know what needs to be done, and we're counting on them. Thank you.

And as my follow-up question, you mentioned that you're a little bit more revitalized on the M&A focus, and you gave a great answer earlier to what you're looking for in terms of size. But is there anything in particular that has made you revitalized? Is it the business as we're seeing it today? Or is it just opportunity or something else?

If you think about the transformation, Joanne, I put that in 3 different phases, and some of them are all in parallel. But the M&A was the -- and the portfolio revamping and transformation of the portfolio is one that had to come after 2 things that we had to do. We needed to put the house in order in terms of organizational structure, finance, balance sheet and culture. Once we get those things done, and we have our own organic programs, now we have a team that is working diligently on finding opportunities for us to tag along. So if we don't have those things in place, we couldn't do the other. We couldn't come up 6 months into this job and say we're going to buy this company and that company. We didn't have the balance sheet. Now we do. Not only that, we have the strategy, and we have competent leaders, for the most part, that we're making sure that we can execute on this. So as we make adjustments to our organization, I have to say that the people and employees of Baxter have done a significant amount of heavy lifting due to so many headwinds that we had with this hurricane, anticipated and unanticipated, because some of this stuff caught us by surprise not because we didn't prepare but because the long-lasting effect. But the people of Baxter has worked -- have worked relentlessly and get this done. Now it's time for us to really get the M&A going as these things are starting to get behind us.

And that was our question and answer session for today. Ladies and gentlemen, this concludes today's conference call with Baxter International. Thank you for participating. Everyone, have a great day.