UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

For the quarterly period ended June 30, 2017

For the transition period from                      to                     

Commission file number 1-4448

 

BAXTER INTERNATIONAL INC.

(Exact name of registrant as specified in its charter)

 

 

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.        ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

The number of shares of the registrant’s Common Stock, par value $1.00 per share, outstanding as of July 28, 2017 was 544,870,914 shares.

 

 

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BAXTER INTERNATIONAL INC.

FORM 10-Q

For the quarterly period ended June 30, 2017

TABLE OF CONTENTS

 

 

 

 

 

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PART I. FINANCIAL INFORMATION

Baxter International Inc.

Condensed Consolidated Statements of Income (unaudited)

(in millions, except per share data)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Baxter International Inc.

Condensed Consolidated Statements of Comprehensive Income (unaudited)

(in millions)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Baxter International Inc.

Condensed Consolidated Balance Sheets (unaudited)

(in millions, except shares)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Baxter International Inc.

Condensed Consolidated Statements of Cash Flows (unaudited)

(in millions)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Baxter International Inc.

Notes to Condensed Consolidated Financial Statements (unaudited)

1. BASIS OF PRESENTATION

The unaudited interim condensed consolidated financial statements of Baxter International Inc. and its subsidiaries (the company or Baxter) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles (GAAP) in the United States have been condensed or omitted. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the company’s Annual Report on Form 10-K for the year ended December 31, 2016 (2016 Annual Report).

In the opinion of management, the unaudited interim condensed consolidated financial statements reflect all adjustments necessary for a fair statement of the interim periods. All such adjustments, unless otherwise noted herein, are of a normal, recurring nature. The results of operations for the interim period are not necessarily indicative of the results of operations to be expected for the full year.

Certain reclassifications have been made to conform the prior period condensed consolidated statements to the current period presentation.

Accounting for Venezuelan Operations

Currency restrictions enacted in Venezuela require Baxter to obtain approval from the Venezuelan government to exchange Venezuelan bolivars for U.S. dollars and require such exchange to be made at the official exchange rate established by the government. In the first quarter of 2016, the Venezuelan government moved from the three-tier exchange rate system to a two-tiered exchange rate system and the official rate for food and medicine imports was adjusted from 6.3 to 10 bolivars per U.S. dollar. Due to a recent decline in transactions settled at the official rate or the secondary rate and limitations on the company’s ability to repatriate funds generated by its Venezuela operations, the company concluded in the second quarter that it no longer meets the accounting criteria for control over its business in Venezuela and the company deconsolidated its Venezuelan operations on June 30, 2017. As a result of deconsolidating the Venezuelan operations, the company recorded a pre-tax charge of $33 million in other expense (income), net in the second quarter of 2017. This charge included the write-off of the company’s investment in its Venezuelan operations, related unrealized translation adjustments and elimination of intercompany amounts. Beginning in the third quarter of 2017, the company will no longer include the results of its Venezuelan business in its consolidated financial statements.

New accounting standards

Recently issued accounting standards not yet adopted

In March 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, which amends ASC 715, Compensation – Retirement Benefits, to require employers that present a measure of operating income in their statements of earnings to include only the service cost component of net periodic postretirement benefit cost in operating expenses. The service cost component of net periodic postretirement benefit cost should be presented in the same operating expense line items as other employee compensation costs arising from services rendered during the period. The other components of net benefit cost, including interest costs, expected return on assets, amortization of prior service cost/credit, and settlement and curtailment effects, are to be included separately and outside of any subtotal of operating income. The company intends to adopt the standard effective January 1, 2018.  This guidance will impact the presentation of the company’s consolidated statements of income with no impact on net income.  Upon adoption of the standard on January 1, 2018, operating income for the three and six months ended June 30, 2017, will be recast to increase $8 million and $17 million, respectively, with a corresponding increase in other expense (income), net.

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which amends the existing accounting standards for revenue recognition. ASU No. 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. ASU No. 2014-09 will be effective for the company beginning on January 1, 2018. The standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption.  The company has completed an assessment of the new standard and is currently executing its detailed implementation plan and developing processes for gathering information for required disclosures.  Based on the work performed to date, the company does not expect the adoption of the new standard to have a material impact on the consolidated financial statements. The company expects to adopt the standard using the modified retrospective method.

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Recently adopted accounting pronouncements

As of January 1, 2017, the company adopted on a prospective basis ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting, which amends ASC Topic 718, Compensation – Stock Compensation. The updated guidance requires all tax effects related to share-based payments to be recorded in income tax expense in the consolidated statement of income. Previous guidance required that tax effects of deductions in excess of share-based compensation costs (windfall tax benefits) be recorded in additional paid-in capital, and tax deficiencies be recorded in additional paid-in capital to the extent of previously recognized windfall tax benefits, with the remainder recorded in income tax expense. The new guidance also requires the cash flows resulting from windfall tax benefits to be reported as operating activities in the consolidated statement of cash flows, rather than the previous requirement to present windfall tax benefits as an inflow from financing activities and an outflow from operating activities. As a result of the adoption, net income and operating cash flow for the three and six months ended June 30, 2017, increased by approximately $13 million and $30 million, respectively.  The prior periods have not been restated and therefore, windfall tax benefits of $12 million and $27 million, respectively, for the three and six months ended June 30, 2016, were not included in net income and were included as an inflow from financing activities and an outflow from operating activities in the condensed consolidated statement of cash flows.

In 2016, the company adopted ASU No. 2016-15, Statement of Cash Flows (Topic 230). The guidance requires that the cash payments for debt prepayment or debt extinguishment costs be classified as cash outflows for financing activities. As a result of the adoption, the company recast certain debt repayments and debt extinguishment costs from operating to financing activities which resulted in an increase to operating cash flow and a decrease in financing cash flows of $33 million for the six months ended June 30, 2016. The adoption of this guidance did not impact the company’s condensed consolidated statements of income, condensed consolidated statements of comprehensive income or condensed consolidated balance sheets.

2. SEPARATION OF BAXALTA INCORPORATED

On July 1, 2015, Baxter completed the distribution of approximately 80.5% of the outstanding common stock of Baxalta Incorporated (Baxalta) to Baxter shareholders (the Distribution). After giving effect to the Distribution, the company retained 19.5% of the outstanding common stock, or 131,902,719 shares of Baxalta (Retained Shares).  The Distribution was made to Baxter’s shareholders of record as of the close of business on June 17, 2015 (Record Date), who received one share of Baxalta common stock for each Baxter common share held as of the Record Date. As a result of the Distribution, Baxalta became an independent public company trading under the symbol “BXLT” on the New York Stock Exchange.

On June 3, 2016, Baxalta became a wholly-owned subsidiary of Shire plc (Shire) through a merger of a wholly-owned Shire subsidiary with and into Baxalta, with Baxalta as the surviving subsidiary (the Merger). References in this report to Baxalta prior to the Merger closing date refer to Baxalta as a stand-alone public company. References in this report to Baxalta subsequent to the Merger closing date refer to Baxalta as a subsidiary of Shire.

For a portion of Baxalta’s operations, the legal transfer of Baxalta’s assets and liabilities did not occur with the separation of Baxalta on July 1, 2015 due to the time required to transfer marketing authorizations and other regulatory requirements in certain countries. Under the terms of the International Commercial Operations Agreement (ICOA), Baxalta is subject to the risks and entitled to the benefits generated by these operations and assets until legal transfer; therefore, the net economic benefit and any cash collected by these entities by Baxter are transferred to Baxalta. As of June 30, 2017, two countries have not yet been separated.

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Following is a summary of the operating results of Baxalta, which have been reflected as discontinued operations for the three and six months ended June 30, 2017 and 2016. The assets and liabilities have been classified as held for disposition as of June 30, 2017 and December 31, 2016.

 

 

 

As of June 30, 2017 and December 31, 2016, Baxter recorded a liability of $21 million and $47 million, respectively, for its obligation to transfer these net assets to Baxalta.  

Baxter and Baxalta entered into several agreements in connection with the July 1, 2015 separation, including a transition services agreement (TSA), separation and distribution agreement, manufacturing and supply agreements (MSA), tax matters agreement, an employee matters agreement, a long-term services agreement, and a shareholder’s and registration rights agreement.

Pursuant to the TSA, Baxter and Baxalta and their respective subsidiaries are providing to each other, on an interim, transitional basis, various services. Services being provided by Baxter include, among others, finance, information technology, human resources, quality supply chain and certain other administrative services. The services generally commenced on the Distribution date and are expected to terminate within 36 months of the Distribution date. Billings by Baxter under the TSA are recorded as a reduction of the costs to provide the respective service in the applicable expense category, primarily in marketing and administrative expenses, in the condensed consolidated statements of income. In the three and six months ended June 30, 2017, the company recognized approximately $16 million and $36 million, respectively, as a reduction to marketing and administrative expenses related to the TSA. In the three and six months ended June 30, 2016, the company recognized approximately $26 million and $53 million, respectively, as a reduction to marketing and administrative expenses related to the TSA.  

Pursuant to the MSA, Baxalta or Baxter, as the case may be, manufactures, labels, and packages products for the other party. The terms of the agreements range in initial duration from five to 10 years. In the three and six months ended June 30, 2017, Baxter recognized approximately $6 million and $12 million, respectively, in sales to Baxalta. In the three and six months ended June 30, 2016, Baxter recognized approximately $14 million and $25 million, respectively, in sales to Baxalta.  In addition, in the three and six months ended June 30, 2017, Baxter recognized $50 million and $98 million, respectively, in cost of sales related to purchases from Baxalta pursuant to the MSA. In the three and six months ended June 30, 2016, Baxter recognized $48 million and $92 million, respectively, in cost of sales related to purchases from Baxalta pursuant to the MSA.  The cash flows associated with these agreements are included in cash flows from operations — continuing operations.

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Cash outflows of $49 million and inflows of $8 million were reported in cash flows from operations – discontinued operations for the six-month periods ending June 30, 2017 and 2016, respectively. These relate to non-assignable tenders whereby Baxter remains the seller of Baxalta products, transactions related to importation services Baxter provides in certain countries, in addition to trade payables settled post local separation on Baxalta’s behalf.

3. SUPPLEMENTAL FINANCIAL INFORMATION

 

Net interest expense

 

 

Other expense (income), net

 

 

Inventories

 

 

Property, plant and equipment, net

 

 

4. EARNINGS PER SHARE

The numerator for both basic and diluted earnings per share (EPS) is either net income, income from continuing operations, or income from discontinued operations. The denominator for basic EPS is the weighted-average number of common shares outstanding during the period. The dilutive effect of outstanding stock options, restricted stock units (RSUs) and performance share units (PSUs) is reflected in the denominator for diluted EPS using the treasury stock method.

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The following table is a reconciliation of basic shares to diluted shares.

 

 

The effect of dilutive securities included unexercised stock options, unvested RSUs and contingently issuable shares related to granted PSUs. The computation of diluted EPS excluded 6 million and 4 million equity awards for the second quarter and six months ended June 30, 2017, respectively, and 9 million and 14 million equity awards for the second quarter and six months ended June 30, 2016, because their inclusion would have had an anti-dilutive effect on diluted EPS. Refer to Note 9 for additional information regarding items impacting basic shares.

Stock repurchases

In July 2012, the Board of Directors authorized the repurchase of up to $2 billion of the company’s common stock. The board of directors increased this authority by an additional $1.5 billion in November 2016. During the first half of 2017, the company repurchased 1.8 million shares for $95 million in cash. During the first half of 2016, the company did not repurchase any shares. The company has $1.6 billion remaining available under the authorization as of June 30, 2017.

5. ACQUISITIONS AND OTHER ARRANGEMENTS

 

Celerity Pharmaceuticals, LLC

In the second quarter of 2017, Baxter paid approximately $10 million to acquire the rights to Clindamycin Saline from Celerity Pharmaceuticals, LLC (Celerity).  Baxter capitalized the purchase price as an intangible asset and is amortizing the asset over the estimated economic life of 12 years.

In the first quarter of 2016, Baxter paid approximately $23 million to acquire the rights to Vancomycin injection in 0.9% Sodium Chloride (Normal Saline) in 500mg, 750mg, and 1 gram presentations from Celerity. Baxter capitalized the purchase price as an intangible asset and is amortizing the asset over the estimated economic life of 12 years. Refer to Note 5 within the 2016 Annual Report for additional information regarding the company’s agreement with Celerity.

Wound Care Technologies, Inc.

In April 2017, Baxter paid approximately $8 million to acquire Wound Care Technologies, Inc., a medical technology company that develops and markets external tissue expansion devices for the wound care market.  The purchase price allocation resulted in an amortizable intangible asset of $8 million that will be amortized over its estimated economic life of 8 years.

6. GOODWILL AND OTHER INTANGIBLE ASSETS, NET

Goodwill

The following is a reconciliation of goodwill by business segment.

 

 

As of June 30, 2017, there were no accumulated goodwill impairment losses.

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Other intangible assets, net

The following is a summary of the company’s other intangible assets.

 

 

Intangible asset amortization expense was $36 million and $42 million in the three months ended June 30, 2017 and 2016, respectively, and $74 million and $82 million in the six months ended June 30, 2017 and 2016, respectively.

 

In the second quarter of 2016, the company recorded an impairment charge of $51 million, of which $41 million related to a developed technology asset, relating to the company’s Hospital Products segment synthetic bone repair products business which was acquired from ApaTech Limited in 2010. The assets of the business were written down to estimated fair value and recorded in cost of sales.

 

7. BUSINESS OPTIMIZATION CHARGES

Beginning in the second half of 2015, the company initiated actions to transform its cost structure and enhance operational efficiency. These efforts include restructuring the organization, optimizing the manufacturing footprint, R&D operations and supply chain network, employing disciplined cost management, and centralizing and streamlining certain support functions. Through June 30, 2017, the company has incurred cumulative pretax costs of $474 million related to these actions. The costs consisted primarily of employee termination, implementation costs and accelerated depreciation. The company expects to incur additional pretax costs of approximately $335 million and capital expenditures of $90 million through the completion of these initiatives by the end of 2018. The costs will primarily include employee termination costs, implementation costs, and accelerated depreciation. Of this amount, the company expects that approximately 5 percent of the charges will be non-cash.

During the three and six months ended June 30, 2017 and 2016, the company recorded the following charges related to business optimization programs.

 

 

During the three and six months ended June 30, 2017 and 2016, the company recorded the following restructuring charges.

 

 

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Costs to implement business optimization programs for the three and six months ended June 30, 2017, were $16 million and $37 million respectively, and consisted primarily of external consulting and transition costs as well as employee salary and related costs. These costs were included within cost of sales and marketing and administrative expense.

 

Costs to implement business optimization programs for the three and six months ended June 30, 2016, were $15 million and $19 million, respectively, and were related primarily to external consulting costs. These costs were included within marketing and administrative and R&D expense.

 

Costs related to the integration of Gambro AB (Gambro) were included within marketing and administrative expense for all referenced periods.

 

For the three and six months ended June 30, 2017, the company recognized accelerated depreciation, primarily associated with facilities to be closed, of $3 million and $8 million respectively. The costs were recorded within cost of sales, marketing and administrative and R&D expense.

 

For the three and six months ended June 30, 2016, the company recognized $14 million of accelerated depreciation, primarily associated with facilities to be closed. The costs were recorded in cost of sales for all referenced periods.

 

The following table summarizes cash activity in the reserves related to the company’s business optimization initiatives.

 

 

Reserve adjustments primarily relate to employee termination cost reserves established in prior periods.

Approximately 80% of the company’s restructuring reserves as of June 30, 2017 relate to employee termination costs, with the remaining reserves attributable to contract termination costs. The reserves are expected to be substantially utilized by the end of 2018.

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8. DEBT, FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

Debt Issuance

In May 2017, Baxter issued senior notes with a total aggregate principal amount of €600 million at a fixed coupon rate of 1.30% due in May 2025.  The company has designated this debt as a non-derivative net investment hedge of its European operations for accounting purposes.

Debt-for-equity exchanges

On January 27, 2016, Baxter exchanged Baxalta Retained Shares for the extinguishment of $1.45 billion aggregate principal amount outstanding under its $1.8 billion U.S. dollar-denominated revolving credit facility. This exchange extinguished the indebtedness under the facility, which was terminated in connection with such debt-for-equity exchange. There were no material prepayment penalties or breakage costs associated with the termination of the facility. Baxter recognized a net realized gain of $1.25 billion related to the Baxalta Retained Shares exchanged, which was included in other expense (income), net for the period ended June 30, 2016.

On March 16, 2016, the company exchanged Baxalta Retained Shares for the extinguishment of approximately $2.2 billion in principal amount of its 0.950% Notes due May 2016, 5.900% Notes due August 2016, 1.850% Notes due January 2017, 5.375% Notes due May 2018, 1.850% Notes due June 2018, 4.500% Notes due August 2019, and 4.250% Notes due February 2020 purchased by certain third party purchasers in the previously announced debt tender offers. As a result, the company recognized a net loss on extinguishment of debt totaling $101 million and a net realized gain of $2.0 billion on the Baxalta Retained Shares exchanged, which are included in other expense (income), net for the period ended June 30, 2016.

Securitization arrangement

The following is a summary of the activity relating to the company’s securitization arrangement in Japan.

 

 

The impacts on the condensed consolidated statements of income relating to the sale of receivables were immaterial for each period. Refer to the 2016 Annual Report for further information regarding the company’s securitization agreements.

Concentrations of credit risk

The company invests excess cash in certificates of deposit or money market funds and diversifies the concentration of cash among different financial institutions. With respect to financial instruments, where appropriate, the company has diversified its selection of counterparties, and has arranged collateralization and master-netting agreements to minimize the risk of loss.

The company continues to do business with foreign governments in certain countries, including Greece, Spain, Portugal and Italy that have experienced a deterioration in credit and economic conditions. As of June 30, 2017, the company’s net accounts receivable from the public sector in Greece, Spain, Portugal and Italy totaled $148 million.

Global economic conditions and liquidity issues in certain countries have resulted, and may continue to result, in delays in the collection of receivables and credit losses. Governmental actions and customer-specific factors may also require the company to re-evaluate the collectability of its receivables and the company could potentially incur additional credit losses. These conditions may also impact the stability of the Euro.

Derivatives and hedging activities

The company operates on a global basis and is exposed to the risk that its earnings, cash flows and equity could be adversely impacted by fluctuations in foreign exchange and interest rates. The company’s hedging policy attempts to manage these risks to an acceptable level based on the company’s judgment of the appropriate trade-off between risk, opportunity and costs.

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The company is primarily exposed to foreign exchange risk with respect to recognized assets and liabilities, forecasted transactions and net assets denominated in the Euro, British Pound, Chinese Yuan, Korean Won, Australian Dollar, Canadian Dollar, Japanese Yen, Colombian Peso, Brazilian Real, Mexican Peso and New Zealand Dollar. The company manages its foreign currency exposures on a consolidated basis, which allows the company to net exposures and take advantage of any natural offsets. In addition, the company uses derivative and nonderivative instruments to further reduce the net exposure to foreign exchange. Gains and losses on the hedging instruments offset losses and gains on the hedged transactions and reduce the earnings and equity volatility resulting from foreign exchange. Financial market and currency volatility may limit the company’s ability to cost-effectively hedge these exposures.

The company is also exposed to the risk that its earnings and cash flows could be adversely impacted by fluctuations in interest rates. The company’s policy is to manage interest costs using a mix of fixed- and floating-rate debt that the company believes is appropriate.

To manage this mix in a cost-efficient manner, the company periodically enters into interest rate swaps in which the company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional amount.

The company does not hold any instruments for trading purposes and none of the company’s outstanding derivative instruments contain credit-risk-related contingent features.

All derivative instruments are recognized as either assets or liabilities at fair value in the condensed consolidated balance sheets and are classified as short-term or long-term based on the scheduled maturity of the instrument. Based upon the exposure being hedged, the company designates its hedging instruments as cash flow, fair value, or net investment hedges.

Cash Flow Hedges

The company may use options, including collars and purchased options, forwards and cross-currency swaps to hedge the foreign exchange risk to earnings relating to forecasted transactions and recognized assets and liabilities.

For each derivative instrument that is designated and effective as a cash flow hedge, the gain or loss on the derivative is accumulated in accumulated other comprehensive income (AOCI) and then recognized in earnings consistent with the underlying hedged item. Option premiums or net premiums paid are initially recorded as assets and reclassified to other comprehensive income (OCI) over the life of the option, and then recognized in earnings consistent with the underlying hedged item. Cash flow hedges are classified in net sales, cost of sales, net interest expense, and other expense (income), net, and primarily relate to forecasted third-party sales denominated in foreign currencies, forecasted intercompany sales denominated in foreign currencies, and anticipated issuances of debt, respectively.

The notional amounts of foreign exchange contracts were $673 million and $561 million as of June 30, 2017 and December 31, 2016, respectively. There were no outstanding interest rate contracts designated as cash flow hedges as of June 30, 2017 and December 31, 2016. The maximum term over which the company has cash flow hedge contracts in place related to forecasted transactions as of June 30, 2017 is 17 months.

Fair Value Hedges

The company uses interest rate swaps to convert a portion of its fixed-rate debt into variable-rate debt. These instruments hedge the company’s earnings from changes in the fair value of debt due to fluctuations in the designated benchmark interest rate. For each derivative instrument that is designated and effective as a fair value hedge, the gain or loss on the derivative is recognized immediately to earnings, and offsets the loss or gain on the underlying hedged item. Fair value hedges are classified in net interest expense, as they hedge the interest rate risk associated with certain of the company’s fixed-rate debt.

The total notional amount of interest rate contracts designated as fair value hedges was $200 million as of June 30, 2017 and December 31, 2016

Net Investment Hedges

In May 2017, the company issued €600 million of senior notes due May 2025. The company has designated this debt as a hedge of a portion of its net investment in its European operations and, as a result, mark to spot rate adjustments of the outstanding debt balances have been and will be recorded as a component of AOCI.  As of June 30, 2017, the company had accumulated pre-tax unrealized translation losses in AOCI of $31 million related to the Euro-denominated senior notes.

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Dedesignations

If it is determined that a derivative or nonderivative hedging instrument is no longer highly effective as a hedge, the company discontinues hedge accounting prospectively. If the company removes the cash flow hedge designation because the hedged forecasted transactions are no longer probable of occurring, any gains or losses are immediately reclassified from AOCI to earnings. Gains or losses relating to terminations of effective cash flow hedges in which the forecasted transactions are still probable of occurring are deferred and recognized consistent with the loss or income recognition of the underlying hedged items.

There were no hedge dedesignations in the first six months of 2017 or 2016 resulting from changes in the company’s assessment of the probability that the hedged forecasted transactions would occur.

If the company terminates a fair value hedge, an amount equal to the cumulative fair value adjustment to the hedged items at the date of termination is amortized to earnings over the remaining term of the hedged item. There were no fair value hedges terminated during the first six months of 2017. In March 2016, the company terminated a total notional value of $765 million of interest rate contracts in connection with the March debt tender offers, resulting in a $34 million reduction to the debt extinguishment loss.

Undesignated Derivative Instruments

The company uses forward contracts to hedge earnings from the effects of foreign exchange relating to certain of the company’s intercompany and third-party receivables and payables denominated in a foreign currency. These derivative instruments are generally not formally designated as hedges, and the change in fair value, which substantially offsets the change in book value of the hedged items, is recorded directly to other expense (income), net. The terms of these instruments generally do not exceed one month.

The total notional amount of undesignated derivative instruments was $756 million as of June 30, 2017 and $822 million as of December 31, 2016.

Gains and Losses on Hedging Activities

The following tables summarize the income statement locations and gains and losses on the company’s derivative instruments for the three months ended June 30, 2017 and 2016.

 

 

 

The following tables summarize the income statement locations and gains and losses on the company’s derivative instruments for the six months ended June 30, 2017 and 2016.

 

 

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For the company’s fair value hedges, equal and offsetting losses of $1 million were recognized in net interest expense in the second quarter of 2017 and equal and offsetting losses of $4 million and $26 million were recognized in net interest expense in the second quarter and first half of 2016, respectively, as adjustments to the underlying hedged item, fixed-rate debt. Ineffectiveness related to the company’s cash flow and fair value hedges for all periods presented were not material.

As of June 30, 2017, $5 million of deferred, net after-tax losses on derivative instruments included in AOCI are expected to be recognized in earnings during the next 12 months, coinciding with when the hedged items are expected to impact earnings.

Fair Values of Derivative Instruments

The following table summarizes the classification and fair values of derivative instruments reported in the condensed consolidated balance sheet as of June 30, 2017.

 

 

The following table summarizes the classification and fair values of derivative instruments reported in the condensed consolidated balance sheet as of December 31, 2016.

 

 

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While the company’s derivatives are all subject to master netting arrangements, the company presents its assets and liabilities related to derivative instruments on a gross basis within the condensed consolidated balance sheets. Additionally, the company is not required to post collateral for any of its outstanding derivatives.

The following table provides information on the company’s derivative positions as if they were presented on a net basis, allowing for the right of offset by counterparty.

 

 

Fair value measurements

The following tables summarize the bases used to measure financial assets and liabilities that are carried at fair value on a recurring basis in the condensed consolidated balance sheets.

 

 

 

As of June 30, 2017, cash and equivalents of $3.8 billion included money market funds of approximately $1 billion, and as of December 31, 2016, cash and equivalents of $2.8 billion included money market funds of approximately $1 billion. Money market funds would be considered Level 2 in the fair value hierarchy.

For assets that are measured using quoted prices in active markets, the fair value is the published market price per unit multiplied by the number of units held, without consideration of transaction costs. The majority of the derivatives entered into by the company are valued using internal valuation techniques as no quoted market prices exist for such instruments. The principal techniques used to value these instruments are discounted cash flow and Black-Scholes models. The key inputs are considered observable and vary depending on the type of derivative, and include contractual terms, interest rate yield curves, foreign exchange rates and volatility.

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Contingent payments related to acquisitions consist of commercial milestone payments and sales-based payments, and are valued using discounted cash flow techniques. The fair value of commercial milestone payments reflects management’s expectations of probability of payment, and increases as the probability of payment increases or expectation of timing of payments is accelerated. The fair value of sales-based payments is based upon probability-weighted future revenue estimates, and increases as revenue estimates increase, probability weighting of higher revenue scenarios increase or expectation of timing of payment is accelerated. The change in the fair value of contingent payments related to Baxter’s acquisitions, which use significant unobservable inputs (Level 3) in the fair value measurement, were primarily driven by payments of approximately $8 million in the first half of 2017.

The following table provides information relating to the company’s investments in available-for-sale equity securities.

 

 

In the first quarter of 2017, the company recorded a net $4 million other-than-temporary impairment charges within other expense (income), net based on the duration of losses related to one of the company’s investments. In the second quarter and first six months of 2016 the company recorded $1.1 billion and $4.4 billion, respectively, of net realized gains within other expense (income), net related to exchanges of available-for-sale equity securities, which represented gains from the Retained Share transactions.

Book Values and Fair Values of Financial Instruments

In addition to the financial instruments that the company is required to recognize at fair value in the condensed consolidated balance sheets, the company has certain financial instruments that are recognized at historical cost or some basis other than fair value. For these financial instruments, the following table provides the values recognized in the condensed consolidated balance sheets and the approximate fair values as of June 30, 2017 and December 31, 2016.

 

 

The following tables summarize the bases used to measure the approximate fair value of the financial instruments as of June 30, 2017 and December 31, 2016.

 

 

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Investments in 2017 and 2016 included certain cost method investments.

In determining the fair value of cost method investments, the company takes into consideration recent transactions, as well as the financial information of the investee, which represents a Level 3 basis of fair value measurement.

The estimated fair values of current and long-term debt were computed by multiplying price by the notional amount of the respective debt instrument. Price is calculated using the stated terms of the respective debt instrument and yield curves commensurate with the company’s credit risk. The carrying values of the other financial instruments approximate their fair values due to the short-term maturities of most of these assets and liabilities.

9. STOCK COMPENSATION

Stock compensation expense totaled $28 million and $32 million in the second quarter of 2017 and 2016, respectively, and $46 million and $54 million for the six months ended June 30, 2017 and 2016, respectively. Approximately 70% of stock compensation expense is classified in marketing and administrative expenses with the remainder classified in cost of sales and R&D expenses.

In March 2017, the company awarded its annual stock compensation grants which consisted of 5.4 million stock options, 0.7 million RSUs and 0.6 million PSUs.

10. RETIREMENT AND OTHER BENEFIT PROGRAMS

The following is a summary of net periodic benefit cost relating to the company’s pension and other postemployment benefit (OPEB) plans.

 

 

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11. ACCUMULATED OTHER COMPREHENSIVE INCOME

Comprehensive income includes all changes in shareholders’ equity that do not arise from transactions with shareholders, and consists of net income, CTA, pension and other employee benefits, unrealized gains and losses on cash flow hedges and unrealized gains and losses on available-for-sale equity securities. The following table is a net-of-tax summary of the changes in AOCI by component for the six months ended June 30, 2017 and 2016.

 

 

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The following is a summary of the amounts reclassified from AOCI to net income during the three and six months ended June 30, 2017 and 2016.

 

 

 

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Refer to Note 8 for additional information regarding hedging activity and Note 10 for additional information regarding the amortization of pension and other employee benefits items.

12. INCOME TAXES

Effective tax rate

The company’s effective income tax rate for continuing operations was 13.7% and 0.5% in the second quarters of 2017 and 2016, respectively, and 15.3% and (1.1%) in the six months ended June 30, 2017 and 2016, respectively. The company’s effective income tax rate differs from the U.S. federal statutory rate each year due to certain operations that are subject to tax incentives, state and local taxes, and foreign taxes that are different than the U.S. federal statutory rate. In addition, the effective tax rate can be impacted each period by discrete factors and events.

The effective income tax rate for continuing operations increased during the six months ended June 30, 2017 principally due to the absence of the tax-free net realized gains associated with the Baxalta Retained Share transactions, which included debt-for-equity exchanges, the contribution of Baxalta Retained Shares to the company’s U.S. pension plan and the exchange of Baxalta Retained Shares for shares of the company, as well as benefits attributable to closing an IRS and German income tax audit that were all reflected during the six months ended June 30, 2016.  The effective income tax rate for continuing operations during the six months ended June 30, 2017 was favorably impacted by approximately 4.7 percentage points due to tax windfall benefits realized from stock option exercises and vesting of RSUs and PSUs associated with the company’s stock compensation programs.

13. LEGAL PROCEEDINGS

Baxter is involved in product liability, patent, commercial, and other legal matters that arise in the normal course of the company’s business. The company records a liability when a loss is considered probable and the amount can be reasonably estimated. If the reasonable estimate of a probable loss is a range, and no amount within the range is a better estimate, the minimum amount in the range is recorded. If a loss is not probable or a probable loss cannot be reasonably estimated, no liability is recorded. As of June 30, 2017, the company’s total recorded reserves with respect to legal matters were $19 million and there were no related receivables.

Baxter has established reserves for certain of the matters discussed below. The company is not able to estimate the amount or range of any loss for certain contingencies for which there is no reserve or additional loss for matters already reserved. While the liability of the company in connection with the claims cannot be estimated and the resolution thereof in any reporting period could have a significant impact on the company’s results of operations and cash flows for that period, the outcome of these legal proceedings is not expected to have a material adverse effect on the company’s consolidated financial position. While the company believes that it has valid defenses in these matters, litigation is inherently uncertain, excessive verdicts do occur, and the company may incur material judgments or enter into material settlements of claims.

In addition to the matters described below, the company remains subject to the risk of future administrative and legal actions. With respect to governmental and regulatory matters, these actions may lead to product recalls, injunctions, and other restrictions on the company’s operations and monetary sanctions, including significant civil or criminal penalties. With respect to intellectual property, the company may be exposed to significant litigation concerning the scope of the company’s and others’ rights. Such litigation could result in a loss of patent protection or the ability to market products, which could lead to a significant loss of sales, or otherwise materially affect future results of operations.

General litigation

On July 31, 2015, Davita Healthcare Partners, Inc. filed suit against Baxter Healthcare Corporation in the District Court of the State of Colorado regarding an ongoing commercial dispute relating to the provision of peritoneal dialysis products. A bench trial concluded in third quarter 2016 and the parties are awaiting the court’s decision.

In November 2016, a purported antitrust class action complaint seeking monetary and injunctive relief was filed in the United States District Court for the Northern District of Illinois. The complaint alleges a conspiracy among manufacturers of IV solutions to restrict output and affect pricing in connection with a shortage of such solutions. Similar parallel actions subsequently were filed. In January 2017, a single consolidated complaint covering these matters was filed in the Northern District of Illinois. The company filed a motion to dismiss the consolidated complaint in February 2017.

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In April 2017, the company became aware of a criminal investigation by the U.S. Department of Justice, Antitrust Division and a federal grand jury in the United States District Court for the Eastern District of Pennsylvania.   The company and an employee received subpoenas seeking production of documents and testimony regarding the manufacturing, selling, pricing and shortages of IV solutions and containers (including saline solutions and certain other injectable medicines sold by the company) and communications with competitors regarding the same.  The company is cooperating with the investigation.  As previously disclosed, the New York Attorney General has requested that Baxter provide information regarding business practices in the IV saline industry. The company is cooperating with the New York Attorney General.  

Other

In December 2016, the company received a civil investigative demand from the Commercial Litigation Branch of the United States Department of Justice primarily relating to contingent discount arrangements for, and other promotion of, the company’s TISSEEL and ARTIS products. The company is cooperating in this matter.

14 SEGMENT INFORMATION

Baxter’s two segments are strategic businesses that are managed separately because each business develops, manufactures and markets distinct products and services. The segments and a description of their products and services are as follows:

The Renal business provides products and services to treat end-stage renal disease, or irreversible kidney failure, along with other renal therapies. The Renal business offers a comprehensive portfolio to meet the needs of patients across the treatment continuum, including technologies and therapies for peritoneal dialysis (PD), hemodialysis (HD), continuous renal replacement therapy (CRRT) and additional dialysis services.

The Hospital Products business manufactures intravenous (IV) solutions and administration sets, premixed drugs and drug-reconstitution systems, oncology injectable drugs, IV nutrition products, infusion pumps, inhalation anesthetics, and biosurgery products. The business also provides products and services related to pharmacy compounding, drug formulation and packaging technologies.

The company uses income from continuing operations before net interest expense, income tax expense, depreciation and amortization expense (Segment EBITDA), on a segment basis to make resource allocation decisions and assess the ongoing performance of the company’s business segments. Intersegment sales are eliminated in consolidation.

Certain items are maintained at Corporate and are not allocated to a segment. They primarily include most of the company’s debt and cash and equivalents and related net interest expense, foreign exchange fluctuations (principally relating to intercompany receivables, payables and loans denominated in a foreign currency) and the majority of the foreign currency hedging activities, corporate headquarters costs, stock compensation expense, nonstrategic investments and related income and expense, certain employee benefit plan costs as well as certain nonrecurring gains, losses, and other charges (such as business optimization, integration and separation-related costs, and asset impairments). Financial information for the company’s segments is as follows.

 

 

 

 

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The following is a reconciliation of segment EBITDA to income from continuing operations before income taxes per the condensed consolidated statements of income.

 

 

15. SUBSEQUENT EVENTS

On July 27, 2017, Baxter completed the acquisition of Claris Injectables Limited (Claris), a wholly owned subsidiary of Claris Lifesciences Limited, for total consideration of approximately $625 million. Through the acquisition, Baxter added capabilities in production of essential generic injectable medicines, such as anesthesia and analgesics, renal, anti-infectives and critical care in a variety of presentations including bags, vials and ampoules. As the acquisition of Claris was completed after June 30, 2017, Baxter’s condensed consolidated financial statements do not include the financial condition or the operating results of Claris in any of the periods presented herein.  At the time of issuance of the company’s condensed consolidated financial statements as of and for the three and six months ended June 30, 2017, the initial accounting for the acquisition of Claris, including the purchase price allocation, was yet to be completed.

 

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Refer to the company’s Annual Report on Form 10-K for the year ended December 31, 2016 (2016 Annual Report) for management’s discussion and analysis of the financial condition and results of operations of the company. The following is management’s discussion and analysis of the financial condition and results of operations of the company for the three and six months ended June 30, 2017.

RESULTS OF OPERATIONS

Baxter’s income from continuing operations for the three and six months ended June 30, 2017 totaled $264 million, or $0.48 per diluted share, and $537 million, or $0.97 per diluted share, compared to $1.2 billion, or $2.19 per diluted share, and $4.6 billion, or $8.33 per diluted share for the three and six months ended June 30, 2016. Income from continuing operations for the three and six months ended June 30, 2017 included special items which decreased income from continuing operations by $84 million and $129 million, respectively, or $0.15 and $0.23 per diluted share, respectively, as further discussed below. Income from continuing operations for the three and six months ended June 30, 2016 included special items which increased income from continuing operations by $1.0 billion and $4.1 billion, or $1.73 and $7.51 per diluted share, as further discussed below.

Special Items

The following table provides a summary of the company’s special items and the related impact by line item on the company’s results of continuing operations for the three and six months ended June 30, 2017 and 2016.

 

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Intangible asset amortization expense is identified as a special item to facilitate an evaluation of current and past operating performance and is similar to how management internally assesses performance. Additional special items are identified above because they are highly variable, difficult to predict and of a size that may substantially impact the company’s reported operations for a period. Management believes that providing the separate impact of the above items on the company’s results in accordance with GAAP in the United States may provide a more complete understanding of the company’s operations and can facilitate a fuller analysis of the company’s results of operations, particularly in evaluating performance from one period to another. This information should be considered in addition to, and not as a substitute for, information prepared in accordance with GAAP.

 

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NET SALES

 

 

 

 

 

 

Foreign currency unfavorably impacted net sales by one percentage point during the second quarter and two percentage points during the first half of 2017 compared to the prior periods principally due to the strengthening of the U.S. Dollar relative to the Euro, Mexican Peso, British Pound, Chinese Yuan, as well as certain other currencies.

The comparisons presented at constant currency rates reflect comparative local currency sales at the prior period’s foreign exchange rates. This measure provides information on the change in net sales assuming that foreign currency exchange rates have not changed between the prior and the current period. The company believes that the non-GAAP measure of change in net sales at constant currency rates, when used in conjunction with the GAAP measure of change in net sales at actual currency rates, may provide a more complete understanding of the company’s operations and can facilitate a fuller analysis of the company’s results of operations, particularly in evaluating performance from one period to another.

During 2016, the company made a strategic decision to exit select products in certain markets including Venezuela, India and Turkey.  Overall, these items had a negative impact to the company’s net sales growth rate of one percentage point during the second quarter and first half of 2017, respectively.  The company is also presenting the impact of generic competition for U.S. cyclophosphamide to enhance comparability between periods and better identify operating trends.  

Franchise Net Sales Reporting

The Renal segment includes sales of the company’s peritoneal dialysis (PD), hemodialysis (HD) and continuous renal replacement therapies (CRRT) and additional dialysis services.

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The Hospital Products segment includes four commercial franchises: Fluid Systems, Integrated Pharmacy Solutions, Surgical Care and Other.

The following is a summary of net sales by commercial franchise on a reported and constant currency basis along with the impact of significant non-operational items.

 

 

 

Net sales in the Renal segment during the second quarter and first half of 2017 were comparable to the prior periods. Excluding the impact of foreign currency, sales increased 3% and 2% in the second quarter and first half of 2017, respectively, driven by continued growth of PD patients and adoption of the company’s new Automated Peritoneal Dialysis Cyclers (APD) AMIA in the U.S. and HomeChoice CLARIA in international markets.  Increased sales globally of the company’s CRRT products also contributed to growth in the second quarter and first half of 2017.  Sales growth in the second quarter and first half of 2017 was partially offset by lower sales of HD products internationally, driven by reduced volumes and increased pricing pressures.  Certain international strategic market exits negatively impacted the Renal segment’s net sales by 1% during the first half of 2017 and are expected to negatively impact full year Renal segment net sales by approximately $50 million as compared to 2016.

Net sales in the Hospital Products segment increased 1% and 4%, respectively, during the second quarter and first half of 2017 compared to the prior period on a reported basis. Excluding the impact of foreign currency, sales increased 2% and 5% in the second quarter and first half of 2017, respectively. Certain international strategic market exits negatively impacted the Hospital Products segment net sales by 1% during the second quarter and first half of 2017 and are expected to negatively impact full year net sales by approximately $50 million as compared to 2016.  In addition, reduced U.S. sales of cyclophosphamide negatively impacted net sales by 1% during the second quarter of 2017.  The principal drivers impacting net sales were the following:

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Gross Margin and Expense Ratios

 

 

Gross Margin

The special items identified above had an unfavorable impact of approximately 1.8 and 1.9 percentage points on the gross margin ratio in the second quarter and first half of 2017, respectively. The unfavorable impact was 6.2 and 4.0 percentage points in the second quarter and first half of 2016, respectively. Refer to the Special Items caption above for additional detail.

Excluding the impact of the special items, the gross margin ratio increased due to improved pricing in select areas of the portfolio, favorable manufacturing performance and a benefit from the company’s business transformation initiatives aimed at simplifying the portfolio to drive efficiency and reduce costs.

Marketing and Administrative Expenses

The special items identified above had an unfavorable impact of approximately 1.3 and 0.8 percentage points on the marketing and administrative expense ratio in the second quarter and first half of 2017, respectively. The unfavorable impact was 1.8 and 1.3 percentage points in the second quarter and first half of 2016. Refer to the Special Items caption above for additional detail.

Excluding the impact of the special items, the marketing and administrative expenses ratio in the second quarter and first half of 2017 declined due to the actions taken by the company to rebase its cost structure and focus on expense management. These savings were partially offset by decreased benefits to the marketing and administrative expenses ratio from lower transition service income as the agreement with Baxalta for these services continues to wind down.  

Research and Development

 

 

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The special items identified above had an unfavorable impact of approximately 1.7 and 0.9 percentage points in the second quarter and first half of 2016. Refer to the Special Items caption above for additional detail.

 

Excluding the impact of the special items, the research and development expenses ratio increased in the second quarter of 2017 as a result of the company’s increased investment in new product development.

Business Optimization Items

Beginning in the second half of 2015, the company initiated actions to transform its costs structure and enhance operational efficiency. These efforts include restructuring the organization, optimizing the manufacturing footprint, R&D operations and supply chain network, employing disciplined cost management, and centralizing and streamlining certain support functions. Through June 30, 2017, the company has incurred pretax costs of $474 million related to these actions. The costs consisted primarily of employee termination costs, implementation costs, and accelerated depreciation. The company expects to incur additional pretax costs of approximately $335 million and capital expenditures of $90 million related to these initiatives by the end of 2018. These costs will primarily include employee termination costs, implementation costs, and accelerated depreciation. The company expects that approximately 5 percent of the remaining charges will be non-cash. These actions in the aggregate are expected to provide future annual pretax savings of approximately $950 million. The savings from these actions will impact cost of sales, marketing and administrative expenses, and research and development expenses.  Approximately 85 percent of the expected annual pretax savings are expected to be realized by the end of 2018, with the remainder by the end of 2020.

Refer to Note 7 in Item 1 for additional information regarding the company’s business optimization initiatives.

Net Interest Expense

Net interest expense was $13 million and $27 million in the second quarter and first half of 2017, respectively, and $11 million and $39 million in the second quarter and first half of 2016, respectively. The increase in the second quarter was primarily attributable to lower interest capitalized on assets under construction.  The decrease in the first half of 2017 was primarily driven by lower outstanding debt as a result of the first quarter 2016 debt-for-equity exchanges which extinguished $3.65 billion of debt as well as reduced coupon rates related to the third quarter 2016 debt issuance, partially offset by lower interest capitalized on assets under construction. See Note 8 within Item 1 for additional details about the debt extinguishments.

Other Expense (Income), Net

Other expense (income), net was expense of $20 million and $22 million in the second quarter and first half of 2017, respectively, and income of $1.2 billion and $4.3 billion in the second quarter and first half of 2016, respectively. Special items during the periods presented included the $1.1 billion and $4.4 billion net realized gain on the Baxalta Retained Shares transactions in the second quarter and first half of 2016, respectively, the $101 million debt extinguishment loss in the first quarter of 2016, and the $33 million loss on the deconsolidation of the company’s Venezuelan subsidiary in the second quarter of 2017.  Excluding the impact of special items, other expense (income), net was unchanged during the second quarter of 2017 and decreased $29 million in the first half of 2017 as compared to 2016.  In the second quarter of 2017, higher income from foreign currency fluctuations principally related to intercompany receivables, payables and monetary assets denominated in a foreign currency was offset by the dividend received from Baxalta with respect to the Retained Shares in 2016.  The decrease for the first half of 2017 was attributable to the dividends on the Retained Shares received from Baxalta in 2016 and recognized investment impairment losses in 2017.

Segment EBITDA

The company uses income from continuing operations before net interest expense, income tax expense, depreciation and amortization expense (Segment EBITDA), on a segment basis to make resource allocation decisions and assess the ongoing performance of the company’s business segments. Refer to Note 14 within Item 1 for a summary of financial results by segment. The following is a summary of significant factors impacting the segments’ financial results.

Renal

Segment EBITDA was $224 million and $423 million in the second quarter and first half of 2017, respectively, and $158 million and $280 million in the second quarter and first half of 2016, respectively. The increase in 2017 was driven by lower research and development costs as the company realigned allocations of research and development costs based on project spend attributable to segments, higher gross margins due to product mix and lower marketing and administrative expenses as the Renal segment benefited from the company’s business optimization programs and continued focus on reducing discretionary spending.  This growth was partially offset by unfavorable foreign currency.

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Hospital Products

Segment EBITDA was $604 million and $1,168 million in the second quarter and first half of 2017, respectively, and $576 million and $1,085 million in the second quarter and first half of 2016, respectively.  This increase was driven by higher net sales, principally in the Fluid Systems and Surgical Care franchises, and lower marketing and administrative expenses as cost savings were realized from the company’s business optimization programs and continued focus on reducing discretionary spending. This growth was partially offset by higher research and development costs as the company realigned allocations of research and development costs based on project spend attributable to segments and unfavorable foreign currency.

Corporate and other

Certain income and expense amounts are not allocated to a segment. These amounts are detailed in the table in Note 14 within Item 1 and primarily include net interest expense, foreign exchange fluctuations (principally relating to intercompany receivables, payables and loans denominated in a foreign currency) and the majority of the foreign currency hedging activities, corporate headquarters costs, stock compensation expense, non-strategic investments and related income and expense, certain employee benefit plan costs as well as certain nonrecurring gains and losses and other charges (such as business optimization, integration and separation-related costs and asset impairments).

Income Taxes

The company’s effective income tax rate for continuing operations was 13.7% and 0.5% in the second quarter and 15.3% and (1.1%) for the first half of 2017 and 2016, respectively.  The company’s effective income tax rate differs from the U.S. federal statutory rate each year due to certain operations that are subject to tax incentives, state and local taxes, and foreign taxes that are different than the U.S. federal statutory rate. In addition, the effective tax rate can be impacted each period by discrete factors and events.

 

The effective income tax rate for continuing operations increased during the six months ended June 30, 2017 principally due to the absence of the tax-free net realized gains associated with the Baxalta Retained Share transactions, which included debt-for-equity exchanges, the contribution of Baxalta Retained Shares to the company’s U.S. pension plan and the exchange of Baxalta Retained Shares for shares of the company, as well as benefits attributable to closing an IRS and German income tax audit that were all reflected during the six months ended June 30, 2016.  The effective income tax rate for continuing operations during the six months ended June 30, 2017 was favorably impacted by approximately 4.7 percentage points due to tax windfall benefits realized from stock option exercises and vesting of RSUs and PSUs associated with the company’s stock compensation programs.  

Income from Continuing Operations and Earnings per Diluted Share

Income from continuing operations was $264 million and $1.2 billion for the three months ended June 30, 2017 and 2016, respectively, and $537 million and $4.6 billion for the six months ended June 30, 2017 and 2016, respectively. Income from continuing operations per diluted share was $0.48 and $2.19 for the three months ended June 30, 2017 and 2016, respectively, and $0.97 and $8.33 for the six months ended June 30, 2017 and 2016, respectively. The significant factors and events contributing to the changes are discussed above.

Loss from Discontinued Operations

 

Discontinued operations were insignificant for both periods presented.  Refer to Note 2 within Item 1 for additional information regarding the separation of Baxalta.

LIQUIDITY AND CAPITAL RESOURCES

The following table is a summary of the statement of cash flow for the six month periods ended June 30, 2017 and 2016.

 

 

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Cash Flows from Operations — Continuing Operations

Operating cash flows from continuing operations increased during the first half of 2017 as compared to the prior year period. The increase was driven by the factors discussed below.

Accounts Receivable

Cash inflows from accounts receivable were $43 million in the first half of 2017 compared to an outflow of $38 million in the prior year as days sales outstanding decreased from 56.3 to 53.4 days period over period.  This decrease was primarily driven by improved timing of collections in Europe and Latin America.

Inventories

Cash outflows relating to inventories increased slightly in 2017 as compared to the prior-year period. The following is a summary of inventories as of June 30, 2017 and December 31, 2016, as well as annualized inventory turns for the first half of 2017 and 2016, by segment.

 

The increase in inventories was driven primarily by timing of purchases and longer sourcing lead times for certain products within the Renal segment portfolio, coupled with planned inventory build in the Hospital Products segment during the second quarter in anticipation of plant line maintenance.

Other

The changes in accounts payable and accrued liabilities were a $112 million outflow in the first half of 2017 compared to a $343 million outflow in the first half of 2016. The changes were primarily driven by a first quarter 2016 non-recurring $303 million tax settlement payment to partially settle a U.S. Federal income tax audit as well as the timing of supplier payments.

Payments related to the execution of the company’s business optimization initiatives increased from $45 million in the first half of 2016 to $80 million in the first half of 2017. The company made payments of $21 million in the first half of 2016 related to the execution of the COLLEAGUE infusion pump and SIGMA SPECTRUM infusion pump recalls. Refer to Note 7 within Item 1 for further information regarding the company’s business optimization initiatives.

Changes in other balance sheet items include an outflow of $94 million and an inflow of $61 million in the first half of 2017 and 2016, respectively, primarily driven by the collection of a tax receivable in the second quarter of 2016.

Cash Flows from Investing Activities — Continuing Operations

Capital Expenditures

Capital expenditures were $279 million and $352 million in the first half of 2017 and 2016, respectively. The company’s capital expenditures in 2017 were driven by targeted investments in projects to support production of PD and IV solutions.

Acquisitions and Investments

Cash outflows relating to acquisitions and investments of $36 million in the first half of 2017 were driven primarily by the acquisition of the rights to Clindamycin Saline from Celerity and the acquisition of Wound Care Technologies, Inc. Cash outflows relating to acquisitions and investments of $42 million in the first half of 2016 were driven primarily by the acquisition of the rights to Vancomycin from Celerity.

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Divestitures and Other Investing Activities

Cash outflows from divestitures and other investing activities in 2017 and 2016 were not significant.  

Cash Flows from Financing Activities

Debt Issuances, Net of Payments of Obligations

Net cash inflows related to debt and other financing obligations totaled $633 million for the first half of 2017 primarily related to the issuance of €600 million of senior notes at a fixed coupon rate of 1.30% due in May 2025.

Net cash inflows related to debt and other financing obligations totaled $309 million for the first half of 2016 primarily related to $481 million for the issuance of commercial paper, partially offset by a $190 million repayment of the company’s 0.95% senior unsecured notes that matured in June 2016 as well as other short-term obligations.

Other Financing Activities

Cash dividend payments totaled $141 million and $126 million in the first half of 2017 and 2016, respectively. The increase in cash dividend payments was primarily due to an increase in the quarterly dividend rate from $0.115 to $0.13 per share for quarterly dividends declared between May 2016 and May 2017.   In addition, the company increased the quarterly dividend rate from $0.13 to $0.16 per share for quarterly dividends declared beginning in May 2017.

Proceeds from stock issued under employee benefit plans increased from $168 million in the first half of 2016 to $200 million in the first half of 2017, primarily due to increased option exercises in the first half of 2017.

As authorized by the Board of Directors, the company repurchases its stock depending upon the company’s cash flows, net debt level and market conditions. In July 2012, the Board of Directors authorized the repurchase of up to $2.0 billion of the company’s common stock. The Board of Directors increased this authority by an additional $1.5 billion in November 2016. The company paid $95 million in cash to repurchase approximately 1.8 million shares pursuant to this authority in the first half of 2017 and had $1.6 billion remaining available under this authorization as of June 30, 2017. In the first half of 2016, the company executed an equity-for-equity exchange of Baxalta Retained Shares for 11.5 million outstanding Baxter shares.

Credit Facilities, Access to Capital and Credit Ratings

Credit Facilities

As of June 30, 2017, the company’s U.S. dollar-denominated revolving credit facility and Euro-denominated senior revolving credit facility had a maximum capacity of $1.5 billion and approximately €200 million, respectively. As of June 30, 2017, the company was in compliance with the financial covenants in these agreements. The non-performance of any financial institution supporting either of the credit facilities would reduce the maximum capacity of these facilities by each institution’s respective commitment.

Access to Capital

The company intends to fund short-term and long-term obligations as they mature through cash on hand, future cash flows from operations or by issuing additional debt. The company had $3.8 billion of cash and equivalents as of June 30, 2017, with adequate cash available to meet operating requirements in each jurisdiction in which the company operates. The company invests its excess cash in certificates of deposit and money market funds, and diversifies the concentration of cash among different financial institutions.

The company’s ability to generate cash flows from operations, issue debt or enter into other financing arrangements on acceptable terms could be adversely affected if there is a material decline in the demand for the company’s products or in the solvency of its customers or suppliers, deterioration in the company’s key financial ratios or credit ratings or other significantly unfavorable changes in conditions. However, the company believes it has sufficient financial flexibility to issue debt, enter into other financing arrangements and attract long-term capital on acceptable terms to support the company’s growth objectives.

The company continues to do business with foreign governments in certain countries, including Greece, Spain, Portugal and Italy, which have experienced a deterioration in credit and economic conditions. As of June 30, 2017, the company’s net accounts receivable from the public sector in Greece, Spain, Portugal and Italy totaled $148 million.

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While these economic conditions have not significantly impacted the company’s ability to collect receivables, global economic conditions and liquidity issues in certain countries have resulted, and may continue to result, in delays in the collection of receivables and credit losses.

Credit Ratings

The company’s credit ratings at June 30, 2017 were as follows.

 

 

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. A summary of the company’s significant accounting policies is included in Note 1 to the company’s consolidated financial statements in the 2016 Annual Report. Certain of the company’s accounting policies are considered critical, as these policies are the most important to the depiction of the company’s financial statements and require significant, difficult or complex judgments, often employing the use of estimates about the effects of matters that are inherently uncertain. Such policies are summarized in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section in the 2016 Annual Report. There have been no significant changes in the company’s application of its critical accounting policies during the first six months of 2017.

LEGAL CONTINGENCIES

Refer to Note 13 within Item 1 for a discussion of the company’s legal contingencies. Upon resolution of any of these uncertainties, the company may incur charges in excess of presently established liabilities. While the liability of the company in connection with certain claims cannot be estimated with any certainty, and although the resolution in any reporting period of one or more of these matters could have a significant impact on the company’s results of operations and cash flows for that period, the outcome of these legal proceedings is not expected to have a material adverse effect on the company’s consolidated financial position. While the company believes that it has valid defenses in these matters, litigation is inherently uncertain, excessive verdicts do occur, and the company may in the future incur material judgments or enter into material settlements of claims.

CERTAIN REGULATORY MATTERS

The U.S. Food and Drug Administration (FDA) commenced an inspection of Claris’ facilities in Ahmedabad, India on July 27, 2017, immediately prior to the closing of the Claris acquisition.  FDA completed the inspection on August 4, 2017, at which time FDA issued a related Form-483 (Claris 483).  The Claris 483 includes a number of observations across a variety of areas. The company is preparing its response to the Claris 483 and intends to fully implement corrective and preventive actions to address FDA’s concerns.

In January 2014, the company received a Warning Letter from FDA primarily directed to quality systems for the company’s Round Lake, Illinois, facility, particularly in that facility’s capacity as a specification developer for certain of the company’s medical devices. This Warning Letter was lifted in February 2017.

The company received a Warning Letter in December 2013 that included observations related to the company’s ambulatory infuser business in Irvine, California, which previously had been subject to agency action.  This Warning Letter was lifted in May 2017.

In June 2013, the company received a Warning Letter from FDA regarding operations and processes at its North Cove, North Carolina and Jayuya, Puerto Rico facilities.  The company attended Regulatory Meetings with the FDA in November 2015 (concerning the Jayuya facility).  The company also requested and participated in a Regulatory Meeting regarding both facilities in July 2017.  The Warning Letter addresses observations related to Current Good Manufacturing Practice violations at the two facilities.

In June 2010, the company received a Warning Letter from FDA in connection with an inspection of its McGaw Park, Illinois facility, which previously supported the Renal franchise. The company’s Round Lake facility now provides the related capacity for the Renal

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franchise. The Warning Letter pertains to the processes by which the company analyzes and addresses product complaints through corrective and preventative action, and reports relevant information to FDA. This Warning Letter was lifted in February 2017.

On October 9, 2014, the company had a Regulatory Meeting with FDA to discuss the Warning Letters described above. At the meeting, the company agreed to work closely with FDA to provide regular updates on its progress to meet all requirements and resolve all matters identified in the Warning Letters described above.

Please see Item 1A of the 2016 Annual Report and Item 1 of Part II of this quarterly report for additional discussion of regulatory matters and how they may impact the company.

FORWARD-LOOKING INFORMATION

This quarterly report includes forward-looking statements. Use of the words “may,” “will,” “would,” “could,” “should,” “believes,” “estimates,” “projects,” “potential,” “expects,” “plans,” “seeks,” “intends,” “evaluates,” “pursues,” “anticipates,” “continues,” “designs,” “impacts,” “affects,” “forecasts,” “target,” “outlook,” “initiative,” “objective,” “designed,” “priorities,” “goal,” or the negative of those words or other similar expressions is intended to identify forward-looking statements that represent our current judgment about possible future events. These forward-looking statements may include statements with respect to accounting estimates and assumptions, litigation-related matters including outcomes, future regulatory filings and the company’s R&D pipeline, strategic objectives, credit exposure to foreign governments, potential developments with respect to credit ratings, investment of foreign earnings, estimates of liabilities including those related to uncertain tax positions, contingent payments, future pension plan contributions, costs, discount rates and rates of return, the company’s exposure to financial market volatility and foreign currency and interest rate risks, potential tax liability associated the separation of the company’s biopharmaceuticals and medical products businesses (including the 2016 disposition of the company’s Retained Shares in Baxalta), the impact of competition, future sales growth, business development activities, business optimization initiatives, cost saving initiatives, future capital and R&D expenditures, future debt issuances, manufacturing expansion, the sufficiency of the company’s facilities and financial flexibility, the adequacy of credit facilities, tax provisions and reserves, the effective tax rate and all other statements that do not relate to historical facts.

These forward-looking statements are based on certain assumptions and analyses made in light of the company’s experience and perception of historical trends, current conditions, and expected future developments as well as other factors that the company believes are appropriate in the circumstances. While these statements represent the company’s current judgment on what the future may hold, and the company believes these judgments are reasonable, these statements are not guarantees of any events or financial results. Whether actual future results and developments will conform to expectations and predictions is subject to a number of risks and uncertainties, including the following factors, many of which are beyond our control:

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Actual results may differ materially from those projected in the forward-looking statements. The company does not undertake to update its forward-looking statements.

 

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Currency Risk

The company is primarily exposed to foreign exchange risk with respect to revenues generated outside of the United States denominated in the Euro, British Pound, Chinese Yuan, Korean Won, Australian Dollar, Canadian Dollar, Japanese Yen, Colombian Peso, Brazilian Real, Mexican Peso and New Zealand Dollar. The company manages its foreign currency exposures on a consolidated basis, which allows the company to net exposures and take advantage of any natural offsets. In addition, the company uses derivative and nonderivative financial instruments to further reduce the net exposure to foreign exchange. Gains and losses on the hedging instruments offset losses and gains on the hedged transactions and reduce the earnings and stockholders’ equity volatility relating to foreign exchange. Financial market and currency volatility may limit the company’s ability to cost-effectively hedge these exposures.

The company may use options, forwards and cross-currency swaps to hedge the foreign exchange risk to earnings relating to forecasted transactions denominated in foreign currencies and recognized assets and liabilities. The maximum term over which the company has cash flow hedge contracts in place related to forecasted transactions as of June 30, 2017 is 17 months. The company also enters into derivative instruments to hedge certain intercompany and third-party receivables and payables and debt denominated in foreign currencies.

As part of its risk-management program, the company performs sensitivity analyses to assess potential changes in the fair value of its foreign exchange instruments relating to hypothetical and reasonably possible near-term movements in foreign exchange rates.

A sensitivity analysis of changes in the fair value of foreign exchange option and forward contracts outstanding at June 30, 2017, while not predictive in nature, indicated that if the U.S. Dollar uniformly weakened by 10% against all currencies, on a net-of-tax basis, the net asset balance of $8 million with respect to those contracts would decrease by $23 million, resulting in a net liability position.

The sensitivity analysis model recalculates the fair value of the foreign exchange option and forward contracts outstanding at June 30, 2017 by replacing the actual exchange rates at June 30, 2017 with exchange rates that are 10% weaker to the actual exchange rates for each applicable currency. All other factors are held constant. The sensitivity analysis disregards the possibility that currency exchange rates can move in opposite directions and that gains from one currency may or may not be offset by losses from another currency. The analysis also disregards the offsetting change in value of the underlying hedged transactions and balances.

Interest Rate and Other Risks

Refer to the caption “Interest Rate and Other Risks” in the “Financial Instrument Market Risk” section of the 2016 Annual Report. There were no significant changes during the quarter ended June 30, 2017.

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Evaluation of Disclosure Controls and Procedures

Baxter carried out an evaluation, under the supervision and with the participation of its Disclosure Committee and management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of Baxter’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of June 30, 2017. Based on that evaluation the Chief Executive Officer and Chief Financial Officer concluded that the company’s disclosure controls and procedures were effective as of June 30, 2017.

Changes in Internal Control over Financial Reporting

There have been no changes in Baxter’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2017 that have materially affected, or are reasonably likely to materially affect, Baxter’s internal control over financial reporting.

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Review by Independent Registered Public Accounting Firm

A review of the interim condensed consolidated financial information included in this Quarterly Report on Form 10-Q for the three and six months ended June 30, 2017 and 2016 has been performed by PricewaterhouseCoopers LLP, the company’s independent registered public accounting firm. Its report on the interim condensed consolidated financial information follows. This report is not considered a report within the meaning of Sections 7 and 11 of the Securities Act of 1933 and therefore, the independent accountants’ liability under Section 11 does not extend to it.

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Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and Shareholders of Baxter International Inc.:

 

We have reviewed the accompanying condensed consolidated balance sheet of Baxter International Inc.  and its subsidiaries as of June 30, 2017, and the related condensed consolidated statements of income and of comprehensive income for the three-month and six month periods ended June 30, 2017 and 2016 and the condensed consolidated statements of cash flows for the six-month periods ended June 30, 2017 and June 30, 2016. These interim financial statements are the responsibility of the Company’s management.

 

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

 

Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

 

We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2016, and the related consolidated statements of income, of comprehensive income, of cash flows and of changes in equity for the year then ended (not presented herein), and in our report dated February 23, 2017, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2016, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ PricewaterhouseCoopers LLP

Chicago, Illinois

August 7, 2017

 

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PART II. OTHER INFORMATION

The information in Part I, Item 1, Note 13 is incorporated herein by reference.

The following table includes information about the company’s common stock repurchases during the three-month period ended June 30, 2017.

(1)In July 2012, the company announced that its board of directors authorized the company to repurchase up to $2.0 billion of its common stock on the open market or in private transactions. The board of directors increased this authority by an additional $1.5 billion in November 2016. During the second quarter of 2017, the company repurchased 0.8 million shares for $45 million under this program. $1.6 billion remained available as of June 30, 2017. This program does not have an expiration date.

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Exhibit Index:

 

 

 

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Signature

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

 

 

 

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