Baxter International Inc.

Good morning, ladies and gentlemen, and welcome to Baxter International's third quarter 2022 earnings conference call. Your lines will remain in a listen-only mode until the question and answer segment of today's call. At that time, if you would like to ask a question, you will need to press star, then one on your telephone keypad. If anyone should require assistance during the conference, please press star, then zero on your telephone keypad. As a reminder, this call is being recorded by Baxter and is copyrighted material. It cannot be recorded or re-recorded or rebroadcast without Baxter's permission. If you have any objections, please disconnect at this time. I would now like to turn the call over to Ms. Claire Trackman, Vice President, Investor Relations at Baxter International. Ms. Trackman. you may begin.

Good morning and welcome to our third quarter 2022 earnings conference call. Joining me today are Joe Almeida, Baxter's Chairman and Chief Executive Officer, and Jade Saccaro, Baxter's Chief Financial Officer. On the call this morning, we will be discussing Baxter's third quarter 2022 financial results and full year financial outlook for 2022. With that, Let me start our prepared remarks by reminding everyone that this presentation, including comments regarding our financial outlook for the fourth quarter and full year 2022, our 2022 to 2025 long-range plans, the acquisition of Pilgrim, new product development, the potential impact of proposed pricing actions, business development, portfolio optimization, and regulatory matters contain forward-looking statements that involve risks and uncertainties. And of course, our actual results could differ materially from our current expectations. Please refer to today's press release in our SEC filing for more detail concerning factors that could cause actual results to differ materially. In addition, on today's call, non-GAAP financial measures will be used to help investors understand Baxter's ongoing business performance. A reconciliation of the non-GAAP financial measures being discussed today to the comparable GAAP financial measures is included in our earnings release issues this morning and available on our website. On the call this morning, we will be discussing operational sales growth, which adjusts for the impact of foreign exchange and the acquisition of Hill Round. Now I'd like to turn the call over to Joe. Joe?

Thank you, Claire, and good morning, everyone. We appreciate your joining today's call. I will start with a look at our third quarter performance, including sales. some perspective on the macro environmental factors impacting our near-term trajectory. They will provide a deeper dive on our financials and outlook after which we will open up the lines for your questions. Q3 2022 represents the third full quarter since the close of our Hill Realm acquisition. Total company sales of 3.8 billion grew 17% on the reported basis and 23% at a constant currency rates. Legacy Hill Realm contributed $735 million to sales in the third quarter. Excluding the impact of Hill Realm and foreign exchange, third quarter sales rose slightly on an operational basis. On the bottom line, third quarter adjusted earnings per share of 82 cents were the higher end of the guidance range we had provided previously. Both top-line and bottom-line performance in the quarter reflect the continued impact of macroeconomic headwinds, including significant inflationary pressure, as well as ongoing global supply chain constraints, consistent with what many others are encountering globally. With further regard to the macroeconomic environment, I want to note the impairment charge in our third quarter of the nation is related to the Hill-Rom acquisition. Jay will provide additional details, but in short, this chart relates to many of the shifting market dynamics, including rising interest rates and lower valuation multiples. They have reduced equity values broadly, along with the increased supply chain-related costs that we've previously discussed. With that said, and with 10 months of progress in perspective, I want to underline our continuing confidence in the potential of the Hill-Rom acquisition. This is already playing out as an opportunity to expand the reach of both legacy portfolios geographically and across the continuum of care. It is also accelerating our connected care journey. expanding our digital footprint, and helping to unlock the next wave of innovation across our R&D pipeline. Integration of our legacy organizations is advancing swiftly, and as previously shared, we are achieving even greater value capture through cost synergies than initially anticipated. Additionally, overall demand across the Baxter and legacy Huron portfolios remains solid, but we continue to experience meaningful backorders and backlogs due to reduced access to a variety of raw materials and electromechanical components. As I have shared previously, this has resulted not only in higher cost spot purchases, but also expedited freight costs as we work steadfastly to get our life-sustaining products to the patients and clinicians who depend on us. While we see signals that some of these macro factors may begin to ease next year, our current expectation is that select supply constraints will persist into 2023, particularly as it relates to semiconductors where we continue to see high levels of volatility in supply. During the quarter, we experienced several decommits from various suppliers meaningfully impacting our overall demand planning process. We have also seen supply constraints from other raw materials, which has further impacted performance. In total, we estimate that the semiconductor and raw material constraints we've experienced negatively impacted Baxter's top line performance in the quarter by more than $100 million, or approximately 400 basis points. And on a year-to-date basis, we estimate this period to be approaching $300 million. We continue to take decisive action to help mitigate these constraints and position the company for improved future performance. Some of the actions we've already undertaken include extending the horizon of our demand forecast out to 24 months for supply constraint category. to allow our suppliers to allocate capacity and inventory to Baxter over a long horizon, validating alternate supply options to provide flexibility in sourcing, establishing direct buying relationships with critical secondary component suppliers, enhancing our manufacturing processes to further optimize mature usage and reduce waste, and meeting with the management teams of our key suppliers and select government officials to reinforce the criticality of Baxter's products. We are confident that these actions will further enhance our ability to help mitigate supply chain impacts on Baxter's near and mid-term performance. At the same time, we remain focused on improving the operational efficiency across the organization We've already implemented several initiatives that are expected to drive improved future performance, including ensuring that we have the optimal organization structure and business processes in place. In addition, we are pursuing some near-term actions to help offset the increased expenses we're experiencing. These actions, including recent restructuring initiatives, broad hiring freeze, reduced discretionary spending, and accelerating our hero integration efforts. Additionally, we do expect to realize savings this year through lower annual employee incentive bonuses, which are directly tied to business performance. Also, as mentioned last quarter, we have already passed on a portion of the incremental costs we've absorbed to our customers and are collaborating with them to finalize agreements, which include revised pricing terms to address continued cost pressures. We deeply value these relationships and appreciate the challenges our customers themselves are facing. Upon successful execution and implementation of these agreements, we anticipate the related revenues will be reflected in our results next year. We believe these actions will help underscore our unwavering commitment to our patients and customers. Collectively, these initiatives are fueled by the sustained emphasis on operational efficiency and cost-based optimization that has powered our transformation to date. And, as I will continue to stress, we will never pursue any action that compromises our fundamental mission to save and sustain lives. We are also actively advancing our strategic review of the portfolio to ensure the optimal structure to execute on our vision of transforming healthcare to improve patient outcomes, enhance workflow efficiency, and enable cost-effective care. We anticipate that we will be in a position to provide more details on these ongoing activities early next year. I want to reiterate that our strategic core and prospects remain firm as is our commitment to driving long-term value for our shareholders and the many other stakeholders we serve. Backstreet Strength is founded on our diverse, durable portfolio of essential healthcare products, which will continue to be enhanced by our focus on driving innovation in connected care and core therapies. Baxter's industry leadership and increased scale, combined with our rapidly advancing digital capabilities, create a spectrum of prospects to help advance our impact in line with our life-saving mission and, in turn, to share our success with our shareholders and other stakeholder communities. I want to recognize and thank our employees for their remarkable effort always, and especially as we navigate the current macro environment. Our global team consistently embraces our life-saving mission above all, rising to meet each new challenge with dedication, passion, and a keen focus on serving the many stakeholders who depend on us. Now, Jay will provide more details on our third quarter performance and outlook for the remainder of the year.

Thanks, Joe, and good morning, everyone. As Joe mentioned, our results for the quarter came in largely as expected, with some impact of sales due to select supply chain-related constraints. As discussed earlier, our teams have been and continue to identify opportunities to help mitigate the unprecedented macroeconomic headwinds we continue to face, and we remain committed to delivering on our long-term objectives. Turning to our financial performance, third quarter 2022 global sales of $3.8 billion advanced 17% on a reported basis, 23% on a constant currency basis, and rose slightly on an operational basis. On the bottom line, adjusted earnings decreased 20% to 82 cents per share, falling within our guidance range of 79 to 83 cents per share. Earnings in the quarter reflect the increased cost of raw materials, freight, and labor, as well as the impact of rising interest rates, foreign exchange headwinds, and a higher tax rate. Before I review our financial performance for the quarter, I wanted to spend a moment discussing the non-cash impairment charge that we recorded related to the Hill-ROM acquisition. When we purchased Hillrom, we valued the business based on anticipated cash flows, Baxter's prevailing cost of capital, and market EBITDA multiples at the time of the transaction. As Joe mentioned, the primary reason for the write-down was due to changes in external factors that have occurred since the acquisition date, specifically the significant increase in interest rates we have seen and the reduction in market-based EBITDA multiples. As we evaluated these environmental factors and coupled them with the supply chain impacts we've incurred, which we carry forward in our projections, we deemed it appropriate to reduce the carrying value of Goodwill and certain other intangible assets associated with Hillrond. I want to reinforce Joe's earlier comments that we continue to see tremendous potential for our combined portfolios. We have accelerated our cost synergy targets, which continue to track ahead of our expectations, and our commercial leaders are driving actions to unlock the growth of the combined company. Now, I'll walk through performance by our regional segments and key product categories. Note that constant currency growth is equal to operational sales growth for all global businesses and Baxter's three legacy geographic regions. Starting with sales by operating segment, sales in the Americas were flat for the prior year on a constant currency basis. Sales in Europe, Middle East, and Africa grew 3% on a constant currency basis, and sales in our APAC region decreased 2% on a constant currency basis. Quarterly sales in that region reflected a slowdown in growth in China. due to the country's zero COVID policy, which we estimate impacted sales by approximately 10 million in the quarter, as well as the anticipated impact from various value-based procurement initiatives being implemented in the region. Moving on to performance by key product category, global sales for renal care were $942 million, increasing 4% on a constant currency basis. Performance in the quarter was driven by solid growth in our PD business, where we observed an increase in PD patients globally. PD growth was augmented by two discrete items totaling approximately $20 million. Performance in the quarter was partially offset by lower in-center HD sales, partially due to HD monitor supply challenges due to component availability. Sales and medication delivery of $725 million were a similar level to prior year sales on a constant currency basis. Within the quarter, we observed strong demand for products in our IV therapy portfolio. This growth was more than offset by lower infusion system sales as component availability remained challenged, coupled with a large hospital system order in Q3 2021, which created this difficult comparator to the prior year. Pharmaceutical sales of $525 million declined 3% on a constant currency basis. Performance in the quarter reflects declines in our global generic injectables portfolio due to continued increased competitive activity, which were partially offset by increased sales of inhaled anesthesia globally. Moving to clinical nutrition, total sales were $231 million, increasing 4% on a constant currency basis. Performance in the quarter was driven by demand for our broad multi-chamber product offering, partially offset by supply-related challenges for our vitamins. Sales in advanced surgery were $247 million, advancing 6% on a constant currency basis. Growth in the quarter reflects recovery of elective procedures relative to pre-COVID levels. Surgical volume recovery was strong in Europe, while procedures in the US and APAC region came in slightly below our expectations. Within the US, we observed a slow start to July, with an uptick in August and September. Sales in our acute therapies business were $158 million, declining 9% on a constant currency basis and reflecting a tough comparison to the prior year where we had experienced elevated demand for CRRT given the rise in COVID cases. Biopharma solution sales in the quarter were $172 million, declining 10% on a constant currency basis and reflecting a step down in sales of COVID vaccines compared to the same period last year. COVID vaccine sales for the quarter totaled approximately $30 million. Kilron contributed $735 million in sales to the quarter, which included $380 million of sales in patient support systems, $279 million of sales in frontline care, and $76 million of sales in global surgical solutions. Kilron declined mid-single digit on a constant currency basis as compared to June 3, 2021, when the company was a standalone entity. Performance in the quarter reflects a difficult comparison to the prior year period, as well as the impact of the semiconductor supply constraints we've discussed. We continue to experience record levels of backlog for the legacy Hillrond business. Our order book remains strong, and to date, we have not seen any significant cancellations from customers As mentioned last quarter, we remain somewhat cautious on capital spending as hospitals continue to assess their budgets in light of the current market environment. Moving through the rest of the P&L, our adjusted gross margin of 42.9% decreased by 110 basis points over the prior year, reflecting increased cost of goods sold primarily driven by the factors we've discussed around inflation, freight, and supply chain constraints. Adjusted SG&A of $821 million represented 21.8 as a percentage of sales, an increase of 200 basis points versus prior year, driven by the addition of Hill-Rom as well as higher freight expenses. As mentioned earlier, we continue to tightly manage our G&A base. Adjusted R&D spend in the quarter of $148 million represented 3.9 as a percentage of sales, a decrease of 10 basis points versus prior year. Both adjusted SG&A and adjusted R&D reflect a benefit from lower bonus accruals under our annual employee incentive compensation plans, which is directly tied to Baxter's performance. These factors resulted in an adjusted operating margin in the quarter of 17.2%, a decrease of 300 basis points versus the prior year. Adjusted net interest expense totaled $104 million in the quarter, an increase of $72 million versus the prior year. driven by higher outstanding debt balances related to the acquisition of HILROM. Adjusted other non-operating income totaled $2 million in the quarter compared to a $12 million loss in the prior year period, driven primarily by amortization of pension benefits. The adjusted tax rate in the quarter was 23.8% as compared to 14.8% in the prior year period. The year-over-year increase was primarily due to the mix of earnings in the quarter, which has changed following the HILROM acquisition. In addition, during the third quarter of 2021, the company recognized a benefit in its effective tax rate from a discrete item due to a reserve release resulting from a favorable tax ruling. And as previously mentioned, adjusted earnings of 82 cents per diluted share declined 20% versus the prior period. Let me conclude my comments by discussing our outlook for the fourth quarter and full year 2022, including some key assumptions underpinning our updated guidance. We have adjusted our full-year earnings per share outlook primarily to account for strengthening U.S. dollar and the resulting foreign exchange headwind, increased interest expense assumptions given rising interest rates, and a higher expected full-year tax rate due to earnings mix. As discussed, we anticipate electromechanical component availability will remain challenged in the fourth quarter and into 2023. which will continue to hamper sales growth for select businesses, including medication delivery, frontline care, and patient support systems. For the fourth quarter of 2022, we expect global sales growth of mid to high single digits on a reported basis, mid-teens on a constant currency basis, and approximately flat on an operational basis. And we expect adjusted earnings, excluding special items, of 92 to 99 cents per diluted share. For full year 2022, we now expect global sales growth of 17 to 18% on a reported basis, approximately 23% on a constant currency basis, and low single digits operationally. Moving down to P&L, we expect full year adjusted operating margin to be between 17 and 17.5%, reflecting the impact of all of the various dynamics we've discussed today. For the year, we now expect interest expense to total approximately $400 million, given rate increases and adjusted tax rate of approximately 20% and a diluted share count of 508 million shares. Based on these factors, we now expect 2022 adjusted earnings, excluding special items, of $3.53 to $3.60 per diluted share. With that, we can now open up the call for Q&A.

Thank you. We will now begin the question and answer session.

If you have a question, please press star then one on your telephone keypad. If you wish to remove yourself from the queue, press star then one again. If you are using a speaker phone, please lift the handset to ask your question. So that we may be respectful of everyone's time, please limit your comments to one question with one follow-up question if necessary. We appreciate everyone's patience and would like to provide as many of you as possible the opportunity to ask a question. We will pause for a moment while the list is being compiled. I would like to remind participants that this call is being recorded and a digital replay will be available on the Baxter International website for 60 days at www.baxter.com. Our first question comes from the line of Travis Steed of Bank of America Securities. Your question, please.

Hey, good morning, everybody. Thanks for taking the question. I guess, Jay, just to start out, bridging the gap and the changes in the 2022 guidance would be helpful, but more importantly, we'd love to see if you would provide some initial thoughts on 2023, if you'd commit to some level of earnings growth off the 360 for next year and still at 75 basis points of margin expansion as before?

Sure. Travis, I missed the first part of the question. 2022 for the ETF guidance. Great. So, yeah, let's walk through the different pieces. I think all of these are starting to set up well for 2023, but it starts with the third quarter. Overall, Q3 came in largely in line with our expectations. We were pleased to put 82 cents in the books, and really the commercial operations were off a couple of cents, in large part related to shortfalls in sales driven by supply constraints in certain areas. The tax rate and FX came in a little bit worse than our expectations, but offsetting this, and I think this is important to note, was better than anticipated performance in our supply chain. As you know, this has been an area of extreme volatility for us as we've navigated the complicated macro environment. So it was really nice to see our supply chain team deliver in the quarter and set the stage for the fourth quarter and beyond. Now, as we go to Q4, with respect to EPS, we now expect roughly a five cent headwind from foreign exchange tax relative to our previously issued guidance. On a year-over-year basis, these items impact us roughly 15 cents. And so, we expect a continued supply-constrained environment on the sales line. This is an area that we're navigating very carefully. But overall, the real driver in the fourth quarter relates to this headwind from these non-operational items. So now, as we transition to next year, What I previously shared with you all is a template which says 4% to 5% compounded sales growth, minimum 75 basis points of operating margin expansion in a given year. As we thought about 2023, the sales growth will come in on the lower end of the range, closer to 4%, in large part because of lower levels of COVID vaccines emanating from our BPS business. But as it relates to margin, through continued focus on costs, through execution of our HILRON synergies, along with a real and significant impact of value improvement programs in our plans, where we can confirm at this point the 75 basis points of margin expansion. Now, of course, we're going through our plan as we speak. And I will tell you that the world has been extremely volatile, but it's very nice to be able to share that with you at this point in time. And a lot of this comes down to stability coming out of our supply chain organization. Now, the one thing I will say is part of the reason we're not seeing accelerated sales growth is as we look at 2023, there are continued headwinds from a supply constraint standpoint. So we're going to expect to see component challenges through parts of 2023 and other areas. And so that's from a supply and semiconductors will continue to be challenging as we move through next year. So that's going to be something that we have to live with for a while. We're hoping that rehabilitates over the course of next year and certainly provide the tailwind as we move to 2024. Now, moving to some other items, as we look at foreign exchange, That's going to be fairly neutral to operating margin, but it will be a roughly 15 cent headwind year over year. And a lot of that will be concentrated in the first half of the year because we've seen, you know, rates really deteriorate in Q3 and Q4. And then from an interest expense standpoint, you know, we're looking at approximately a 15 cent headwind. So, this is a, before that, and the interest rate will start to become a tailwind later on in this long-range plan. And so I think for us, as we sit here today, we feel really good about the prospects going into 2023. And so we've been dealing with a lot of volatility, and I think really putting controls in place to navigate some of that. And I think our ability to confirm the 2023 is an important step as we move forward. Joe, I don't know if you'd want to add anything to that.

You'll cover it all.

Thanks, Travis.

Yeah, thanks. A quick follow-up just to make sure. I think putting that all together, it still sounds like earnings can be up next year versus 2022. And on the 75 basis points, what does that assume on the ability and inflation? Does it assume that's stable and does it assume no nibble in my queue?

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

Well, the seven basis points, what's assumed and not on inflation and WMIQ?

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

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

Really helpful caller. Thanks a lot for taking the question.

Thank you.

Robbie Marcus of JP Morgan is on the line with a question. Please state your question.

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

Robbie, good morning. We are actively looking for, first of all, I'm not going to comment on the rumors from the market, but I'm going to tell you what we're doing. We are actively looking at portfolio at the company. We will be ready to speak about that by early January, not at the moment. But I can tell you some bits of information, what is going on. We are looking at every opportunity at the company to focus on the vision that we had set forth during our investor day back in May, which is connected care, the areas that will drive higher gross margin, areas of higher top line growth, software, and the ability to be ahead of connecting the dots for clinicians and institutions. So when we look at that, we look in our portfolio, some products will make sense for us to retain, some products will not. So we are looking to optimize our portfolio. We are at about three quarters of of the way there in terms of understanding and we will make a decision with our board of directors and then come forward with what we think is going to be the new portfolio of Baxter going forward as I said earlier January. So I want to just also underscore that any portfolio movement which implies sale of assets or any kind of transaction always, always takes into account Number one, creation of shareholder value. It's never secondary. Never secondary. It's always primary. And that is creation of improved returning investor capital with accretion of value through discount cash flows. So we're going through this process. It's been very, very intense. And we hope to have the new set of the businesses going forward and what we're going to deal with and how we're going to suffice our mission and vision by, as I said, early January.

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

Robbie, I'll let Jay really comment on the numbers. I'll tell you about a couple aspects. What we're seeing, supply chain is performing well against a very set difficult situation sets of circumstances, as we said, labor inflation and material inflation have been significant to Baxter, and they're doing a great job navigating through that. Our procurement group is doing a heroic job getting the products to us. What is happening is there is a significant amount of backlog and backorder for the company on products depending on semiconductors. And it's not one company or two, it's several. It's a plethora of companies that produce products for us, and we source semiconductors from them. A couple of things that we are doing that I feel more confident that throughout 2023 the situation will be better is that we are developing long-term relationships directly with the manufacturers of the chips. instead of going to distributors or going directly to board assemblers. The second thing is the amount of decommit that companies are coming forward during the quarter makes sometimes very difficult for us to predict what we can assemble and ship at the end of the quarter. It's getting better into 2023 as our supply chain now has a full view of commitments into 2023 of what we need to make our our growth. Businesses that have been very affected by this are Frontline Care, which is our business under our position here at ROM, our PSS, our Passion Patient Support Systems, the ability to make more pumps. We have very good demand for our current pump, our Sigma Spectrum pump. We can make more because we're missing two or three key components that are, in short, a shortage in the marketplace due to high demand from other sources in the automotive and other areas. So what I can tell you is we are doing everything we can and the supply constraint is really what has impacted BEX's performance on the top line. Now, VIPs are Value Improvement Programs. have been a significant drive of cost reduction for us in our operations group. I'll pass on to Jake to give him more clarity on the numbers that you asked. Sure.

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

Great. Thanks a lot.

Thank you.

Rick Wise of Seafold is on the line with a question. Please state your question.

Good morning, Jill. Hi, Jay. I thought I'd focus on Hillrom, which you described as down mid-single digits. First, I wanted to understand, is the decline, if I think of Hillrom maybe as a mid-single digit-ish kind of grower, was the decline, to what degree was it integration bumps with Baxter? To what extent was it components? Was it all supplying components? I'd just like to frame that. And, Joe, when do you think, based on what you know today, Hillrom could return to being Hillrom for you? Is it going to take into 24? Do you think it's second half of next year? And then I have a follow-up question also related to Hillrom.

Rick, I'm going to have Jay answer that. I'm out-closed answering the question, but Jay should start. Yeah, sure. Overall, Rick,

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

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

Gotcha. Maybe I'll change the topic a little bit for my follow-up. You talked about passing along the cost pressures and you're in the process or you're well along signing new price agreements. Can you help us think through, I mean, is this 100% of your business? How do we think about the impact? And just even touchy-feely, Jay, how do we sort of factor that into our thinking as we look ahead to 2023? that you could have another 50 basis points of price on half the portfolio. Any extra depth or color perspective would be great. Thank you so much.

Rick, we have great questions, so we're going to split Jay and me here. But let me start by saying that we do not comment in pricing on general force of business. But as Baxter has taken, so much into input costs that went up significantly in the last two years. We are very focused in recouping a portion of that, if all possible. So, we already had, as I mentioned, price actions throughout the year. But I would say that beyond what I have said, I'm not going to comment on any specifics about pricing discussions or agreements with our customers. But I can say to you, in my opening remarks, as I said, we strongly prefer to build on our long-term relationships with our customers to reach agreements on how best to share and increase cost of delivering products to them, which costs us a significant amount of more money because the cost of oil, the cost of logistics, cost of raw materials, cost of labor, and everything that goes in. We have made significant progress towards that end, but to the extent that we do not reach agreement with any customer, we will, of course, continue to evaluate the options in front of us to recover the increased cost of our delivery and our mission to serve patients. That's very important to us because Baxter, if you ask any of our 65,000 employees, It's all about the mission of the company. It's an incredible company. I came here seven years ago, almost to the date. And I continue to be impressed by the dedication of our employees. But we took a significant amount of cost increase in the last two years in our input cost. And supply chain has done a great job trying to defray that. But as you can see, by our margins, it's not possible. We would like that to be a partnership with our suppliers that continue to understand that for us to deliver what we're delivering to them and the innovation and the products, we need that partnership to continue on. And I will end there and pass on to Jay.

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

Thank you very much. Thanks.

Peter Jickering of Deutsche Bank is on the line with a question. Please state your question.

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

we have seen sporadic cancellations of orders in institutions that are small and have labor issues in implementing CapEx projects that sometimes are large. But for the most part, we haven't seen that wave of retraction of capital programs. As a matter of fact, if we could make Three times, four times more infusion pumps, we would have sold, I believe, those pumps. If we had made twice as many of our monitors, we would have sold the monitors. So it becomes a little different when it comes to beds. Beds are a larger implementation. And software, software like nurse call, button software like Volt becomes more elaborate. Those are the ones that sometimes we see postponements. not because of the price, but more because of the labor, not because of the cost, I should say, but more because of the labor. So at the moment in time, I don't believe we're seeing a retraction in the capital market. We're seeing a high cost of labor for hospitals and a shortage of labor that makes it difficult for them to undertake large programs sometimes.

Okay, fair enough. And then a follow-up on the supply chain. Can you break out the $100 million impact to revenues in 3Q on semiconductors versus the other raw materials? Out of curiosity, what are the other raw material shortages? And then on the semiconductor side, the macro data shows that the pressure peak sort of end of 2Q has been improving sort of during 3Q. So curious to see any semiconductor shortage improvement from July versus October. Okay.

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

More so, what we're doing is, because we're seeing this issue with this pandemic, The semiconductor manufacturers, not all chips are created the same. So you hear Intel sales are down quite a bit. In PCs, this is good news. For our chips, it's not. We don't use the same chips at all. We actually use very little, very few chips from Intel, for instance. We use our chips, our IoT, Internet of Things. They're thicker. They're much thicker. And they are chips that are using better software. So that demand, by the way, some of these chips are about 12% of the semiconductor output, industry output. So because of that, we work very close now directly with companies. We're being very successful with a few companies that are working very well with us. But what we also do, we start a redesign program for our boards. We have identified critical components. We have started a process in our Reno business to redesign 30 of our boards with one of our suppliers. And we have frontline care A program started right now to replace six key semiconductors that may be constrained in the next 18 months with redesign of boards. So redesign of boards is not as simple as everybody thinks. It's not a plug and play because the form and fit and function of the semiconductors change. You have to redesign the board. You have sometimes to revalidate and clinically revalidate the board. So saying just that we're redesigning boards, the panacea is not. It's all hands on deck. is finding new ways to deal with our current suppliers, is buying directly from them, buying through brokers throughout the world, inventory that is available, as well as redesigning the boards so we can have alternates that can be put in in the future. So we became a much more sharp company when it comes to semiconductors and boards. And this process, despite the fact, is very painful. We had to acquire significant expertise in this area. It is going to pay dividends in the future.

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

No, I'm saying that in 2021, This time of the year, last year in 2021, we did not own Huron, but their orders were extremely high, primarily the rentals were extremely high because of COVID. What I'm saying to you is we have not seen our book of business be affected by capital constraints. Now and going forward, what we see is delays in some accounts due to labor shortages and primary large installations. But we have continued dialogue with everyone about orders. As a matter of fact, I'm planning to see in the first quarter next year a large installation that we're going to probably be doing in hospitals in the U.S. So I don't see, we don't see today a significant change in the order pattern in capital. That's what I meant. I'm not comparing it to 2021, which had significant high rental revenue into Huron because the COVID effect primarily, as you know, coming out of the summer is going to Omicron in October, November of last year. Great. Thanks so much, guys. Yeah, thank you.

Joanne Winch of Citi. Is on the line with a question? Please state your question.

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

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

Thanks.

Thank you, Joanna.

We have time for one more question.

We have Joshua Jennings of Cowan on the line with a question. Please state your question.

Hi, good morning. Thanks a lot. Joe, maybe I wanted to ask just about connected care initiatives and just how, if anything, you can share this on progress post the Hill Room acquisition on developing these connected care technologies or programs, and how should we be thinking about updates and tracking the progress? And then maybe just a second question for Jay, just thinking about the the target of getting down to 2.75 times net leverage in 2024. Just help us think through some of the puts and takes and your confidence level in terms of that you are on pace to hit that target. Thanks for taking the questions.

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

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

Thanks a lot.

Thank you very much.

Ladies and gentlemen, that is all the time we have today for questions. This concludes today's conference call with Baxter International. Thank you for participating.