filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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The following commentary should be read in conjunction with the consolidated financial statements and accompanying notes.
EXECUTIVE OVERVIEW
Description of the Company and Business Segments
Baxter International Inc., through its subsidiaries, provides a broad portfolio of essential healthcare products including acute and chronic dialysis therapies; sterile IV solutions; infusion systems and devices; parenteral nutrition therapies; inhaled anesthetics; generic injectable pharmaceuticals; and surgical hemostat and sealant products. The company’s global footprint and critical nature of its products and services play a key role in expanding access to healthcare in emerging and developed countries. These products are used by hospitals, kidney dialysis centers, nursing homes, rehabilitation centers, doctors’ offices and by patients at home under physician supervision.
The company manages its business based on three geographic segments: Americas (North and South America), EMEA (Europe, Middle East and Africa) and APAC (Asia-Pacific).
For financial information about Baxter’s segments, see Note 18 in Item 8 of this Annual Report on Form 10-K.
Acquisition of Claris Injectables Limited
On July 27, 2017, Baxter acquired 100 percent of Claris Injectables Limited (Claris), a wholly owned subsidiary of Claris Lifesciences Limited, for total cash consideration of approximately $629 million, net of cash acquired. 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. Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of Claris.
Acquisition of Recothrom and Preveleak
In March 2018, Baxter acquired two hemostat and sealant products from Mallinckrodt plc: RECOTHROM Thrombin topical
(Recombinant), the first and only stand-alone recombinant thrombin, and PREVELEAK Surgical Sealant, which is used in vascular
reconstruction. The purchase price included an upfront payment of approximately $163 million and potential contingent payments in
the future. Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of the RECOTHROM and PREVELEAK products.
Baxter had approximately 50,000 employees and conducted business in over 100 countries as of December 31, 2018. In 2018, the company generated approximately 58% of its revenues outside the United States. The company maintained approximately 50 manufacturing facilities and over 100 distribution facilities in the United States, Europe, Asia-Pacific, Latin America and Canada as of December 31, 2018.
Financial Results
Baxter’s global net sales totaled $11.1 billion in 2018, an increase of 5% over 2017 on a reported basis and 4% on a constant currency basis. International sales totaled $6.4 billion in 2018, an increase of 6% compared to 2017 on a reported basis and 4% on a constant currency basis. Sales in the United States totaled $4.7 billion in 2018, an increase of 5% compared to 2017.
Baxter’s income from continuing operations totaled $1.6 billion, or $2.99 per diluted share in 2018, $724 million, or $1.30 per diluted share in 2017 and $4,966 million, or $9.01 per diluted share in 2016. Income from continuing operations in 2018 included special items which resulted in a net decrease to income from continuing operations of $36 million, or $0.06 per diluted share. Income from continuing operations in 2017 included special items which resulted in a net decrease to income from continuing operations of $652 million, or $1.18 per diluted share. Income from continuing operations in 2016 included special items which resulted in a net increase to income from continuing operations of $3.9 billion, or $7.05 per diluted share. The company’s special items are discussed further in the Results of Operations section below.
Baxter’s financial results included R&D expenses totaling $655 million in 2018, which reflects the company’s focus on balancing increased investments to support its new product pipeline with efforts to optimize overall R&D spending.
The company’s financial position remains strong, with operating cash flows from continuing operations totaling $2.1 billion in 2018. The company has continued to execute on its disciplined capital allocation framework, which is designed to optimize stockholder
value creation through reinvestment in the businesses, dividends and share repurchases, as well as acquisitions and other business development initiatives as discussed in the Strategic Objectives section below.
Capital expenditures totaled $681 million in 2018 as the company continues to invest across its businesses to support future growth, including additional investments in support of new and existing product capacity expansions. The company’s investments in capital expenditures in 2018 were focused on projects that improve production efficiency and enhance manufacturing capabilities to support its strategy of geographic expansion with select investments in growing markets.
The company also continued to return value to its stockholders in the form of dividends. During 2018, the company paid cash dividends to its stockholders totaling $376 million. Additionally, in 2018 the company repurchased 35.8 million shares through cash repurchases pursuant to Rule 10b5-1 repurchase plans, an accelerated share repurchase plan and otherwise. For information on the company’s share repurchase plans, see Note 13 in Item 8 of this Annual Report on Form 10-K.
Strategic Objectives
Baxter continues to focus on several key objectives to successfully execute its long-term strategy to achieve sustainable growth and deliver enhanced stockholder value. Baxter’s diversified and broad portfolio of medical products that treat life-threatening acute or chronic conditions and its global presence are core components of the company’s strategy to achieve these objectives. The company is focused on three strategic factors as part of its pursuit of industry leading performance: optimizing its core portfolio globally; operational excellence focused on streamlining its cost structure and enhancing operational efficiency; and maintaining a disciplined and balanced approach to capital allocation.
Optimizing the Core Portfolio Globally
Baxter has categorized its product portfolio into four strategic business groupings. Those groupings include core growth, core return on capital, maintain or manage differently and strategic bets. Within the core growth grouping, Baxter looks to invest for long-term, higher margin growth. Baxter seeks to optimize its return on investment and to maintain or enhance its market position with its core return on capital products. Maintain or manage differently products are those for which Baxter looks to sustain or reposition its underlying investment. Finally, the strategic bet grouping includes products for which Baxter is evaluating its market position and investment strategy. These products cover mature and emerging markets. Baxter continues to evaluate each product category’s placement in light of shifting market dynamics and company priorities and may reassign a product category into a different business grouping from time to time.
As part of this portfolio review, Baxter seeks to optimize its position in product areas where the company has a stable, profitable business model, identify and alter investments in products that have reached the end of their life cycles or with respect to which market positions have evolved unfavorably. In the course of doing so, Baxter expects to continue to reallocate capital to more promising opportunities or business groupings, as described above.
As part of this strategy, Baxter is shifting its investments to drive innovation where it has compelling opportunities to serve patients and healthcare professionals while advancing the business and will accelerate the pace in bringing these advances to market. Baxter is in the midst of launching several new products, geographic expansions and line extensions by 2023 including in such areas as chronic and acute renal care, smart pump technology, hospital pharmaceuticals and nutritionals, surgical sealants, and more. These comprise a mix of entirely new offerings, improvements on existing technologies, and the expansion of current products into new geographies.
Operational Excellence
As part of its pursuit of improved margin performance, Baxter is working to optimize its cost structure and as such is critically assessing optimal support levels in light of the company’s ongoing portfolio optimization efforts.
The company intends to continue to actively manage its cost structure to help ensure that it is committing resources to the highest value uses. Such high value activities include supporting innovation, building out the portfolio, expanding patient access and accelerating growth for the company’s stockholders.
Baxter has undertaken a comprehensive review of all aspects of its operations and is actively implementing changes in line with its business goals.
Maintaining Disciplined and Balanced Capital Allocation
Baxter’s capital allocation strategies include the following:
| • | reinvest in the business, by funding opportunities that are positioned to deliver sustainable growth, support the company’s innovation efforts and improve margin performance; |
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| • | return capital to stockholders through dividends, to meaningfully increase with earnings growth; |
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| • | share repurchases; and |
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| • | identify and pursue accretive M&A opportunities. |
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Responsible Corporate Citizen
The company strives for continued growth and profitability, while furthering its focus on acting as a responsible corporate citizen. At Baxter, sustainability means creating lasting social, environmental and economic value by addressing the needs of the company’s wide-ranging stakeholder base. Baxter’s comprehensive sustainability program is focused on areas where the company is uniquely positioned to make a positive impact. Priorities include providing employees a safe, healthy and inclusive workplace, fostering a culture that drives integrity, strengthening access to healthcare, enhancing math and science education, and driving environmental performance across the product life cycle including development, manufacturing and transport. Baxter and the Baxter International Foundation provide financial support and product donations in support of critical needs, from assisting underserved communities to providing emergency relief for countries experiencing natural disasters.
Throughout 2018 the company continued to implement a range of water conservation strategies and facility-based energy saving initiatives. In the area of product stewardship and life cycle management, Baxter is pursuing efforts such as sustainable design and reduced packaging. Baxter is also responding to the challenges of climate change through innovative greenhouse gas emissions-reduction programs, such as shifting to less carbon-intensive energy sources in manufacturing and transport. Additionally, the company developed new long-term goals to drive continued environmental stewardship while creating healthier, more sustainable communities where Baxter employees work and live.
Risk Factors
The company’s ability to sustain long-term growth and successfully execute the strategies discussed above depends in part on the company’s ability to manage within an increasingly competitive and regulated environment and to address the other risk factors described in Item 1A of this Annual Report on Form 10-K.
RESULTS OF OPERATIONS
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 2018, 2017 and 2016.
| years ended December 31 (in millions) | 2018 | 2017 | 2016 | |||||||||
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| Gross Margin | ||||||||||||
| Intangible asset amortization expense | $ | (169 | ) | $ | (154 | ) | $ | (163 | ) | |||
| Business optimization items1 | (49 | ) | (53 | ) | (156 | ) | ||||||
| Intangible asset impairment2 | — | — | (51 | ) | ||||||||
| Separation-related costs3 | — | (1 | ) | (1 | ) | |||||||
| Product-related items4 | 6 | (17 | ) | 18 | ||||||||
| Acquisition and integration activities5 | (27 | ) | (8 | ) | — | |||||||
| Litigation and contractual disputes6 | (8 | ) | — | — | ||||||||
| Hurricane Maria benefits (costs)7 | 32 | (32 | ) | — | ||||||||
| European medical devices regulation9 | (6 | ) | — | — | ||||||||
| Total Special Items | $ | (221 | ) | $ | (265 | ) | $ | (353 | ) | |||
| Impact on Gross Margin Ratio | (2.0 pts) | (2.5 pts) | (3.5 pts) | |||||||||
| Marketing and Administrative Expenses | ||||||||||||
| Business optimization items1 | $ | 145 | $ | 116 | $ | 173 | ||||||
| Separation-related costs3 | — | 18 | 53 | |||||||||
| Acquisition and integration activities5 | 23 | 20 | — | |||||||||
| Historical reserve adjustments8 | — | (12 | ) | — | ||||||||
| Litigation and contractual disputes6 | 2 | 21 | — | |||||||||
| Total Special Items | $ | 170 | $ | 163 | $ | 226 | ||||||
| Impact on Marketing and Administrative Expense Ratio | 1.5 pts | 1.5 pts | 2.2 pts | |||||||||
| Research and Development Expenses | ||||||||||||
| Business optimization items1 | $ | 26 | $ | — | $ | 80 | ||||||
| Acquisition and integration activities5 | 7 | — | — | |||||||||
| European medical devices regulation9 | 3 | — | — | |||||||||
| Total Special Items | $ | 36 | $ | — | $ | 80 | ||||||
| Other Operating Income | ||||||||||||
| Claris Settlement10 | $ | (80 | ) | $ | — | $ | — | |||||
| Hurricane Maria benefits7 | (10 | ) | — | — | ||||||||
| Total Special Items | $ | (90 | ) | $ | — | $ | — | |||||
| Other (Income) Expense, Net | ||||||||||||
| Acquisition and integration activities5 | $ | (24 | ) | $ | — | $ | — | |||||
| Net realized gains on Retained Shares transactions11 | — | — | (4,391 | ) | ||||||||
| Loss on debt extinguishment12 | — | — | 149 | |||||||||
| Tax matter13 | — | — | 9 | |||||||||
| Venezuela deconsolidation14 | — | 33 | — | |||||||||
| Total Special Items | $ | (24 | ) | $ | 33 | $ | (4,233 | ) | ||||
| Income Tax Expense | ||||||||||||
| Tax effects of special items and impact of U.S. Tax Reform13 | $ | 277 | $ | 191 | $ | (314 | ) | |||||
| Total Special Items | $ | 277 | $ | 191 | $ | (314 | ) | |||||
| Impact on Effective Tax Rate | (13.2 pts) | 22.5 pts | (22.1 pts) |
Intangible asset amortization expense is identified as a special item to facilitate an evaluation of current and past operating performance and is consistent with how management and the company’s Board of Directors internally assess 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 generally accepted accounting principles (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.
| 1 | In 2018, 2017 and 2016, the company’s results were impacted by costs associated with the company’s execution of certain strategies to optimize its organization and cost structure on a global basis. These actions included streamlining the company’s international operations, rationalizing its manufacturing facilities, reducing its general and administrative infrastructure, re-aligning certain R&D activities and cancelling certain R&D programs. The company recorded business optimization charges of $220 million, $169 million and $409 million in 2018, 2017 and 2016, respectively. The company’s results in 2018 included a charge of $117 million related to restructuring activities, $94 million of costs to implement business optimization programs, which primarily included external consulting and project employee costs, and $9 million of accelerated depreciation associated with facilities to be closed. The $117 million of restructuring charges included $100 million of employee termination costs, $7 million of asset impairment charges related to facility closures and $10 million of other exit costs. The company’s results in 2017 included a charge of $70 million related to restructuring activities, $89 million of costs to implement business optimization programs, which primarily included external consulting and project employee costs, and $10 million of accelerated depreciation associated with facilities to be closed. The $70 million of restructuring charges included $59 million of employee termination costs, $6 million of asset impairment charges related to facility closures and $5 million of other exit costs. The company’s results in 2016 included a charge of $285 million related to restructuring activities, $65 million of costs to implement business optimization programs, which primarily included external consulting and project employee costs, $33 million of accelerated depreciation associated with facilities to be closed, and $26 million of Gambro integration costs. The $285 million of restructuring charges included $180 million of employee termination costs, $54 million of costs related to the discontinuance of the VIVIA home hemodialysis development program, $47 million of asset impairment charges related to acquired in-process R&D and facility closures and $4 million of other exit costs. Refer to Note 8 of this Annual Report on Form 10-K in Item 8 for further information regarding these charges and related reserves. |
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| 2 | The company’s results in 2016 included a $51 million asset impairment primarily related to developed technology. |
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| 3 | The company’s results in 2017 and 2016 included costs related to the Baxalta separation of $19 million and $54 million, respectively. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for further information related to the separation of Baxalta. |
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| 4 | The company’s results in 2018 included a net benefit of $6 million related to an adjustment to its accrual for SIGMA SPECTRUM infusion pump inspection and remediation activities. The company’s results in 2017 included a net charge of $17 million related to SIGMA SPECTRUM infusion pump inspection and remediation activities and other historical product reserves. The company’s results in 2016 included a net benefit of $18 million primarily related to adjustments to the COLLEAGUE and SIGMA SPECTRUM infusion pump reserves. Refer to Note 7 in Item 8 of this Annual Report on Form 10-K for further information regarding these charges and related reserves. |
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| 5 | The company’s results in 2018 included acquisition and integration expenses related to the company’s acquisitions of Claris and the RECOTHROM and PREVELEAK products of $50 million, upfront payments related to R&D collaborations and license agreements of $7 million and a gain of $24 million from remeasuring its previously held investment to fair value upon acquisition of a controlling interest in its joint venture in Saudi Arabia. The company’s results in 2017 included acquisition and integration expenses of $28 million related to the company’s acquisition of Claris. Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for further information regarding business development activities. |
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| 6 | The company’s results in 2018 included a charge of $10 million related to certain product litigation. The company’s results in 2017 included charges of $21 million related to litigation and contractual disputes for businesses or arrangements in which the company is no longer engaged or a party thereto. |
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| 7 | The company’s results in 2018 included a benefit of $42 million related to insurance recoveries as a result of losses incurred due to Hurricane Maria. The company’s results in 2017 included a charge of $32 million related to the impact of Hurricane Maria on the company’s operations in Puerto Rico. The costs primarily included inventory and fixed asset impairments as well as idle facility costs. Refer to Note 1 in Item 8 of this Annual Report on Form 10-K for further information regarding the impact of Hurricane Maria. |
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| 8 | The company's results in 2017 included a benefit of $12 million related to an adjustment to the company's historical rebates and discounts reserve. |
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| 9 | The company’s results in 2018 included costs of $9 million related to updating its quality systems and product labeling to comply with the new medical device reporting regulation and other requirements of the European Union’s regulations for medical devices that will become effective in 2020. |
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| 10 | The company’s results in 2018 included a benefit of $80 million for settlement of certain claims related to the acquired operations of Claris. Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for further information regarding the acquisition of Claris. |
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| 11 | The company’s results in 2016 included net realized gains of $4.4 billion related to the debt-for-equity exchanges of the company’s retained shares in Baxalta for certain indebtedness, the exchange of retained shares in Baxalta for Baxter shares and the contribution of retained shares in Baxalta to Baxter’s U.S. pension fund. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for further information regarding the separation of Baxalta. |
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| 12 | The company’s results in 2016 included a net debt extinguishment loss totaling $149 million related to the March 2016 debt-for-equity exchange for certain company indebtedness and certain debt redemptions. Refer to Note 9 in Item 8 of this Annual Report on Form 10-K for additional information. |
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| 13 | Reflected in this item is the income tax impact of the special items identified in this table. Additionally, the company’s results in 2018 included a net tax benefit of $196 million, primarily related to updates to the estimated impact of U.S. federal tax reform previously made by the company. The company’s results in 2017 included a net tax charge of $322 million related to the estimated impact of U.S. tax reform on the company’s tax related assets and liabilities. The company’s results in 2016 included a net after-tax benefit of $10 million related to the settlement of an income tax matter in the company’s non-wholly owned subsidiary in Turkey. This amount was comprised of $19 million included in income tax expense offset by $9 million in non-controlling interest recorded in other (income) expense, net. The tax effect of each adjustment is based on the jurisdiction in which the adjustment is incurred and the tax laws in effect for each such jurisdiction. |
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| 14 | The company’s results in 2017 included a charge of $33 million related to the deconsolidation of its Venezuelan operations. Refer to Note 1 in Item 8 of this Annual Report on Form 10-K for further information regarding the deconsolidation of the company’s Venezuelan operations. |
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Net Sales
| Percent change | |||||||||||||||||||||||||||||
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| At actual currency rates | At constant currency rates | ||||||||||||||||||||||||||||
| years ended December 31 (in millions) | 2018 | 2017 | 2016 | 2018 | 2017 | 2018 | 2017 | ||||||||||||||||||||||
| United States | $ | 4,723 | $ | 4,510 | $ | 4,259 | 5 | % | 6 | % | 5 | % | 6 | % | |||||||||||||||
| International | 6,404 | 6,051 | 5,904 | 6 | % | 2 | % | 4 | % | 2 | % | ||||||||||||||||||
| Total net sales | $ | 11,127 | $ | 10,561 | $ | 10,163 | 5 | % | 4 | % | 4 | % | 4 | % |
Net sales for the year ended December 31, 2018 increased 5% at actual rates and 4% at constant currency rates. Net sales for the year ended December 31, 2017 increased 4% at actual and constant currency rates.
Foreign currency favorably impacted net sales by one percentage point during 2018 compared to 2017 principally due to the weakening of the U.S dollar relative to the Euro, British Pound and Chinese Yuan, partially offset by the strengthening of the U.S. dollar relative to the Brazilian Real and Australian Dollar. Changes in foreign currency exchange rates had no net impact on net sales during 2017 compared to the prior year.
The comparisons presented at constant currency rates reflect comparative local currency sales at the prior year’s foreign exchange rates. This measure provides information on the change in net sales assuming that foreign currency exchange rates had 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.
On March 19, 2018, Baxter acquired two hemostat and sealant products from Mallinckrodt plc: RECOTHROM Thrombin topical (Recombinant), the first and only stand-alone recombinant thrombin, and PREVELEAK Surgical Sealant, which is used in vascular reconstruction. The purchase price included cash payments of $163 million and potential contingent payments in the future. In 2018, consolidated Baxter results include $52 million of net sales of RECOTHROM and PREVELEAK.
On July 27, 2017, the company completed the acquisition of Claris, a wholly owned subsidiary of Claris Lifesciences Limited, for total cash consideration of approximately $629 million, net of cash acquired. The Claris acquisition contributed $140 million and $57 million of net sales in 2018 and 2017, respectively.
Global Business Unit Net Sales Reporting
The company’s global business units (GBUs) include the following:
| • | Renal Care includes sales of the company’s peritoneal dialysis (PD), hemodialysis (HD) and additional dialysis therapies and services. |
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| • | Medication Delivery includes sales of the company’s IV therapies, infusion pumps, administration sets and drug reconstitution devices. |
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| • | Pharmaceuticals includes sales of the company’s premixed and oncology drug platforms, inhaled anesthesia and critical care products and pharmacy compounding services. |
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| • | Clinical Nutrition includes sales of the company’s parenteral nutrition (PN) therapies and related products. |
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| • | Advanced Surgery includes sales of the company’s biological products and medical devices used in surgical procedures for hemostasis, tissue sealing and adhesion prevention. |
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| • | Acute Therapies includes sales of the company’s continual renal replacement therapies (CRRT) and other organ support therapies focused in the intensive care unit (ICU). |
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| • | Other includes sales primarily from the company’s pharmaceutical partnering business. |
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The following is a summary of net sales by GBU.
| Percent change | |||||||||||||||||||||||||||||
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| At actual currency rates | At constant currency rates | ||||||||||||||||||||||||||||
| years ended December 31 (in millions) | 2018 | 2017 | 2016 | 2018 | 2017 | 2018 | 2017 | ||||||||||||||||||||||
| Renal Care | $ | 3,662 | $ | 3,480 | $ | 3,421 | 5 | % | 2 | % | 4 | % | 2 | % | |||||||||||||||
| Medication Delivery | 2,669 | 2,698 | 2,596 | (1 | )% | 4 | % | (2 | )% | 4 | % | ||||||||||||||||||
| Pharmaceuticals | 2,092 | 1,883 | 1,722 | 11 | % | 9 | % | 10 | % | 9 | % | ||||||||||||||||||
| Clinical Nutrition | 877 | 882 | 858 | (1 | )% | 3 | % | (3 | )% | 2 | % | ||||||||||||||||||
| Advanced Surgery | 800 | 707 | 690 | 13 | % | 2 | % | 12 | % | 2 | % | ||||||||||||||||||
| Acute Therapies | 517 | 456 | 429 | 13 | % | 6 | % | 11 | % | 6 | % | ||||||||||||||||||
| Other | 510 | 455 | 447 | 12 | % | 2 | % | 10 | % | 1 | % | ||||||||||||||||||
| Total Baxter | $ | 11,127 | $ | 10,561 | $ | 10,163 | 5 | % | 4 | % | 4 | % | 4 | % |
Renal Care net sales increased 5% and 2% in 2018 and 2017, respectively. Excluding the impact of foreign currency, net sales increased 4% and 2% in 2018 and 2017, respectively. The increase in 2018 was primarily driven by global growth in the PD business as well as increased international sales in the HD business. The company expects net sales in its U.S. in-center HD business to decline in 2019, which will partially offset expected global growth in the Renal Care business. The increase in 2017 was 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, partially offset by lower sales of HD products internationally. Additionally, net sales were negatively impacted in 2017 by approximately $50 million as compared to 2016 due to certain international strategic market exits.
Medication Delivery net sales decreased 1% in 2018 and increased 4% in 2017. Excluding the impact of foreign currency, net sales decreased 2% in 2018 and increased 4% in 2017. The decrease in 2018 was partially attributable to supply constraints associated with the company’s small volume parenterals (SVPs) due to Hurricane Maria as well as lower international sales resulting from a reallocation of volume to the U.S. As a result of those supply constraints, some customers have changed their protocols for use of these products and some others shifted to competitive products. The increase in 2017 was driven by select pricing and improved volumes for U.S. IV solutions. This increase was also positively impacted by increased sales of the company’s IV access administrative sets, reflecting the on-going pull through from the company’s growing SPECTRUM infusion pump base. Net sales were negatively impacted in 2017 by approximately $35 million as compared to 2016 due to certain international strategic market exits. Additionally, 2017 net sales were also negatively impacted due to the impact of Hurricane Maria.
Pharmaceuticals net sales increased 11% and 9% in 2018 and 2017, respectively. Excluding the impact of foreign currency, net sales increased 10% and 9% in 2018 and 2017, respectively. The increase in 2018 was a result of the benefit from the acquisition of Claris, increased sales of the company’s premixed injectables and inhaled anesthetics, as well as increased demand for pharmacy compounding services. The acquisition of Claris in 2017 contributed $140 million of net sales in 2018 compared to $57 million of net sales in 2017. Partially offsetting the increase in 2018 was reduced sales of U.S. cyclophosphamide, which decreased from $185 million in 2017 to $166 million in 2018. The company expects sales of U.S. cyclophosphamide and BREVIBLOC to decline in 2019 by approximately $70 million and $75 million, respectively. The increase in 2017 was a result of increased sales of pre-mixed
injectable drugs, a one-time benefit from a pharmacy compounding early contract settlement, improved pricing for BREVIBLOC, and increased sales of TransDerm Scop resulting from temporary supply disruptions. The acquisition of Claris in 2017 also contributed $57 million of net sales. The increase was partially offset by a reduction in sales of U.S. cyclophosphamide from $210 million in 2016 to $185 million in 2017 due to the entry of competitors into the market and the negative impact of Hurricane Maria. Additionally, net sales were negatively impacted in 2017 by approximately $10 million as compared to 2016 due to certain international strategic market exits.
Clinical Nutrition net sales decreased 1% in 2018 and increased 3% in 2017. Excluding the impact of foreign currency, net sales decreased 3% in 2018 and increased 2% in 2017. The decrease in 2018 was driven by the impact of Hurricane Maria related supply constraints which resulted in some customers in the U.S. changing protocols for parenteral nutritional therapies or shifting to outsourced nutrition compounding centers and competitive products, partially offset by improved volumes internationally for the company’s nutritional therapies. The increase in 2017 was driven by improved volumes, new product launches and ongoing geographic expansion for the company’s PN therapies. Partially offsetting the increase in 2017 was reduced sales due to the impact of Hurricane Maria.
Advanced Surgery net sales increased 13% and 2% in 2018 and 2017, respectively. Excluding the impact of foreign currency, net sales increased 12% and 2% in 2018 and 2017, respectively. The increase in 2018 was primarily driven by the acquisition of RECOTHROM and PREVELEAK from Mallinckrodt, which contributed $52 million of net sales in 2018, and improved sales for the company’s core hemostats and sealants. The increase in 2017 was primarily driven by improved volumes internationally. Offsetting performance in 2017 was reduced sales of non-core surgical products Actifuse and Peristrips.
Acute Therapies net sales increased 13% and 6% in 2018 and 2017, respectively. Excluding the impact of foreign currency, net sales increased 11% and 6%, respectively. The increases in 2018 and 2017 were due to higher demand for the company’s CRRT systems to treat acute kidney injuries and higher demand for other products from an intense flu season in 2018.
Other net sales increased 12% and 2% in 2018 and 2017, respectively. Excluding the impact of foreign currency, net sales increased 10% and 1% in 2018 and 2017, respectively. The increases in 2018 and 2017 were due primarily to favorable volumes for products manufactured by Baxter on behalf of its pharmaceutical partners, including the impact of increasing safety stock levels of select products.
Gross Margin and Expense Ratios
| Change | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| years ended December 31 (as a percent of net sales) | 2018 | 2017 | 2016 | 2018 | 2017 | |||||||||||
| Gross margin | 43.0 | % | 42.3 | % | 40.5 | % | 0.7 pts | 1.8 pts | ||||||||
| Marketing and administrative expenses | 23.5 | % | 24.3 | % | 26.8 | % | (0.8 pts) | (2.5 pts) |
Gross Margin
The special items identified above had an unfavorable impact of 2.0, 2.5 and 3.5 percentage points on the gross margin ratio in 2018, 2017 and 2016, respectively. Refer to the Special Items section above for additional detail.
Excluding the impact of the special items, the gross margin ratio increased 0.2 percentage points in 2018. The gross margin ratio increased primarily due to a favorable product mix and manufacturing efficiencies, partially offset by the negative impact of foreign exchange rates, incremental supply chain costs and the impact of lost sales due to Hurricane Maria.
Excluding the impact of the special items, the gross margin ratio increased 0.8 percentage points in 2017. The gross margin ratio was impacted by select price increases, favorable manufacturing performance and a benefit from the company’s business transformation initiatives aimed at simplifying the portfolio to drive efficiency and reduce costs, partially offset by the impact of foreign currency.
Marketing and Administrative Expenses
The special items identified above had an unfavorable impact of 1.5, 1.5 and 2.2 percentage points on the marketing and administrative expenses ratio in 2018, 2017 and 2016, respectively. Refer to the Special Items section above for additional detail.
Excluding the impact of the special items, the marketing and administrative expenses ratio decreased 0.8 percentage points in 2018 due to the actions taken by the company to restructure its cost position 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 terminated as of July 1, 2018, and increased freight expenses as the company worked to ensure adequate product availability to meet customer needs. In addition, a change in the estimated useful life of the company’s ERP systems contributed to the reduction in the marketing and administrative expense ratio.
Excluding the impact of the special items, the marketing and administrative expense ratio decreased 1.8 percentage points in 2017 due to the actions taken by the company to restructure its cost position 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 continued to wind down.
Pension and Other Postemployment Benefit Plan Expense
Expense related to the company’s pension and other postemployment benefits (OPEB) plans decreased $85 million in 2018 primarily as a result of the split and freeze of its U.S. pension plans announced in January 2018 coupled with a higher expected return on assets. Expense related to the company’s pension and OPEB plans increased $9 million in 2017 primarily due to a reduction in the expected return on assets. The company expects expenses from pension and OPEB plans to decrease in 2019 as a result of higher discount rates. Refer to Note 14 in Item 8 of this Annual Report on Form 10-K for further information regarding pension and other postemployment benefit plan expenses.
Business Optimization Items
Beginning in the second half of 2015, the company has initiated actions to transform the company’s 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 December 31, 2018, the company incurred cumulative pre-tax costs of $796 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 $75 million and capital expenditures of $50 million related to these initiatives by the end of 2020. These costs will primarily include employee termination costs and implementation costs. The reductions in our cost base from these actions in the aggregate are expected to provide cumulative annual pretax savings of approximately $1.2 billion once the remaining actions are complete. The savings from these actions will impact cost of sales, marketing and administrative expenses, and R&D expenses. The company estimates that actions taken through December 31, 2018 have resulted in approximately $975 million of savings in 2018. Approximately 90 percent of the expected annual pretax savings are expected to be realized by the end of 2019, with the remainder by the end of 2020.
In addition to the programs above, the company recorded additional business optimization charges of $125 million in 2016. These charges primarily included employee termination costs, contract termination costs, asset impairments, and Gambro integration costs. Approximately 40% of these other 2016 charges were non-cash. The company does not anticipate incurring any additional costs related to these programs in the future. The actions in the aggregate provide annual pre-tax savings of approximately $19 million. The savings from these actions impact cost of sales, marketing and administrative expenses, and R&D expenses.
Refer to Note 8 in Item 8 of this Annual Report on Form 10-K for additional information regarding the company’s business optimization initiatives.
Research and Development
| Percent change | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| years ended December 31 (in millions) | 2018 | 2017 | 2016 | 2018 | 2017 | |||||||||||||
| Research and development expenses | $ | 655 | $ | 613 | $ | 646 | 7 | % | (5)% | |||||||||
| as a percent of net sales | 5.9 | % | 5.8 | % | 6.4 | % | 0.1 pts | (0.6) pts |
The special items identified above had an unfavorable impact of $36 million in 2018 and $80 million in 2016.
Excluding the impact of the special items, the research and development expenses ratio decreased in 2018 as a result of actions taken by the company to restructure its cost position and focus on expense management, partially offset by an increase in project-related expenditures.
Excluding the impact of special items, the research and development expenses ratio increased in 2017 as a result of the company’s increased investment in new product development and geographic expansion.
Net Interest Expense
Net interest expense was $45 million, $55 million and $66 million in 2018, 2017 and 2016, respectively. The decrease in 2018 was primarily driven by higher interest income earned as a result of favorable interest rates. The decrease in 2017 was principally driven by lower outstanding debt as a result of the first quarter 2016 debt-for-equity exchanges and reduced coupon rates resulting from the third quarter 2016 and second quarter 2017 debt issuances, partially offset by lower capitalized interest compared to 2016. Refer to Note 3 in Item 8 of this Annual Report on Form 10-K for a summary of the components of net interest expense for 2018, 2017 and 2016.
Other (Income) Expense, Net
Other (income) expense, net was income of $139 million, expense of $19 million and income of $4,275 million in 2018, 2017 and 2016, respectively. The current year results included $73 million of income related to foreign currency fluctuations principally relating to intercompany receivables, payables and monetary assets denominated in a foreign currency, pension and OPEB income of $48 million and a $24 million gain from remeasuring the company’s previously held investment to fair value upon acquisition of a controlling interest in its joint venture in Saudi Arabia. The 2017 results included $50 million of income related to foreign currency fluctuations principally relating to intercompany receivables, payables and monetary assets denominated in a foreign currency, partially offset by the $33 million loss on the deconsolidation of the company’s Venezuela operations, $8 million of losses related to investment impairments and $33 million of expense related to pension and OPEB plans. The 2016 results included net realized gains of $4.4 billion on the Retained Shares transactions, dividend income of $16 million from the Retained Shares, and $28 million of income related to foreign currency fluctuations principally relating to intercompany receivables, payables and monetary assets denominated in a foreign currency. These income items were partially offset by net debt extinguishment losses of $153 million and expense of $21 million related to pension and OPEB plans.
Income Taxes
Effective Income Tax Rate
The effective income tax rate for continuing operations was 3.7% in 2018, 40.5% in 2017, and (0.2%) in 2016. The special items identified above had a favorable impact of 13.2 percentage points on the effective income tax rate in 2018, an unfavorable impact of 22.5 percentage points in 2017 and a favorable impact of 22.1 percentage points in 2016. Refer to the Special Items section above for additional detail.
The company’s provision for income taxes and its effective rate decreased in 2018 compared to 2017 primarily due to special items, the most significant of which was the company’s finalization of its provisional adjustments resulting from the U.S. Tax Cuts and Jobs Act of 2017 (the 2017 Tax Act). SEC Staff Accounting Bulletin 118 (SAB 118) allowed a one-year measurement period from the December 22, 2017 Tax Act enactment date to refine the provisional amounts recognized in the 2017 financial statements.
The company recorded several SAB 118 measurement period provisional adjustments in 2018. First, after further studying the 2017 Tax Act and associated U.S. Treasury Department Proposed Regulations, the company refined its provisional estimate of a full valuation allowance against its U.S. foreign tax credit deferred tax assets (DTAs) and released a $194 million valuation allowance due to the company’s ability to utilize a portion of its U.S. foreign tax credits DTAs. Second, the 2017 Tax Act requires the company to pay U.S. income taxes on accumulated foreign subsidiary earnings not previously subject to U.S. income tax at a rate of 15.5% to the extent of foreign cash and certain other net current assets and 8% on the remaining earnings. In 2017, the company recognized a provisional charge for its one-time transitional tax expense of $529 million, the majority of which was non-cash. During 2018, the company refined its estimated one-time transition tax expense, recognizing a benefit of $5 million. Third, the 2017 Tax Act lowered the U.S. Federal rate from 35% to 21% and generally exempts foreign income from U.S. taxation. The company finalized its provisional revaluation of U.S. deferred tax assets, recording an additional $8 million benefit.
The benefit from the lower U.S. federal rate was almost wholly offset by changes to deductions related to the 2017 Tax Act. These changes included lost tax benefits from the allocations of certain U.S. expenses to exempt foreign income. The company’s tax provision for 2018 does not include any tax charge related to either the Global Intangible Low Taxed Income (GILTI) or Base Erosion Anti-Abuse Tax (BEAT) provisions as the company does not believe that it is subject to either. Refer to Note 16 in Item 8 of this Annual Report on Form 10-K for further information related to the 2017 Tax Act and the finalization of associated SAB 118 provisional adjustments.
In addition to the 2017 Tax Act SAB 118 measurement period adjustments, the company’s provision for income taxes and its effective rate decreased in 2018 compared to 2017 due to a settlement of a 2008 through 2010 transfer pricing Competent Authority proceeding between the U.S. and Germany, the reversal of a foreign valuation allowance as a result of continued profit improvements, and the receipt of tax free income from the settlement of Claris contingent matters. Partially offsetting the decrease in the effective tax rate
was a decrease in benefits related to deductions in excess of share-based compensation costs (windfall tax benefits), the revaluation of Swedish net deferred tax assets and miscellaneous transfer pricing-related income tax accruals.
The company’s provision for income taxes and its effective rate increased in 2017 compared to 2016 primarily due to special items including provisional charges resulting from the 2017 Tax Act, the tax-free net realized gains recognized in 2016 on the Baxalta Retained Shares and resolution of uncertain tax positions related to a foreign subsidiary in 2016. In addition, the company’s provision for income taxes and its effective tax rate in 2017 increased due to tax benefits recognized in 2016 from partially settling an IRS (2008-2013) income tax audit, settling a German (2008-2011) income tax audit and other miscellaneous transfer pricing matters. Partially offsetting the increase in the effective tax rate was a benefit of $56 million in 2017 related to deductions in excess of share-based compensation costs (windfall tax benefits) and the mix of earnings in lower tax jurisdictions relative to higher tax jurisdictions.
The company anticipates that the effective income tax rate from continuing operations, calculated in accordance with GAAP, will be approximately 18% in 2019. This rate may be further impacted by a number of factors including discrete items, such as tax windfalls or deficiencies attributable to stock compensation exercises as well as additional audit developments, or the tax effect of other special items.
Income from Continuing Operations and Earnings per Diluted Share
Income from continuing operations was $1.6 billion in 2018, $724 million in 2017 and $5.0 billion in 2016. Income from continuing operations per diluted share was $2.99 in 2018, $1.30 in 2017 and $9.01 in 2016. The significant factors and events causing the net changes from 2017 to 2018 and 2016 to 2017 are discussed above. Additionally, income from continuing operations per diluted share was positively impacted by the repurchase of 9.2 million shares in 2017 through Rule 10b5-1 purchase plans and the repurchase of 35.8 million shares in 2018 through Rule 10b5-1 purchase plans, an accelerated share repurchase plan and otherwise. Refer to Note 13 in Item 8 of this Annual Report on Form 10-K for further information regarding the company’s stock repurchases.
(Loss) Income from Discontinued Operations
The following table is a summary of the operating results related to Baxalta, which have been reflected as discontinued operations for the years ended December 31, 2018, 2017 and 2016.
| Years ended December 31 (in millions) | 2018 | 2017 | 2016 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Net sales | $ | — | $ | 7 | $ | 148 | ||||||
| (Loss) income from discontinued operations before income taxes | (13 | ) | 1 | (10 | ) | |||||||
| Gain on disposal of discontinued operations | — | 2 | 19 | |||||||||
| Income tax expense (benefit) | (7 | ) | — | 10 | ||||||||
| Total (loss) income from discontinued operations | $ | (6 | ) | $ | 3 | $ | (1 | ) |
Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for additional information regarding the separation of Baxalta.
In addition, the company recognized additional expense of $10 million, net of tax, in 2017 related to environmental clean-up costs at a former location. Refer to Note 17 in Item 8 of this Annual Report on Form 10-K for additional information regarding environmental liabilities.
Segment results
The company uses operating income on a segment basis to make resource allocation decisions and assess the ongoing performance of the company’s segments. Refer to Note 18 in Item 8 of this Annual Report on Form 10-K for additional details regarding the company’s segments. The following is a summary of significant factors impacting the reportable segments’ financial results.
| Net sales | Operating income | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| years ended December 31 (in millions) | 2018 | 2017 | 2016 | 2018 | 2017 | 2016 | ||||||||||||||||||
| Americas | $ | 5,959 | $ | 5,720 | $ | 5,437 | $ | 2,412 | $ | 2,234 | $ | 2,078 | ||||||||||||
| EMEA | 2,961 | 2,731 | 2,697 | 674 | 564 | 476 | ||||||||||||||||||
| APAC | 2,207 | 2,110 | 2,029 | 538 | 512 | 464 | ||||||||||||||||||
| Corporate and other | — | — | — | (2,025 | ) | (2,019 | ) | (2,273 | ) | |||||||||||||||
| Total | $ | 11,127 | $ | 10,561 | $ | 10,163 | $ | 1,599 | $ | 1,291 | $ | 745 |
Americas
Segment operating income was $2,412 million, $2,234 million and $2,078 million in 2018, 2017 and 2016, respectively. The increase in 2018 was primarily driven by increased net sales and gross margin as a result of the Claris and RECOTHROM and PREVELEAK acquisitions and higher net sales related to premix injectables. Also, driving performance was improved performance in Renal Care, driven primarily by PD growth, and Acute Therapies. Negatively impacting performance in 2018 were the challenges in the Medication Delivery and Clinical Nutrition GBUs as previously described. The increase in 2017 was primarily driven by increased sales and gross margin largely due to strength in the Medication Delivery, Renal Care and Pharmaceuticals GBUs. In addition, marketing and administrative expenses were lower as cost savings were realized from the company’s business optimization programs and continued focus on expense management.
EMEA
Segment operating income was $674 million, $564 million and $476 million in 2018, 2017 and 2016, respectively. The increase in 2018 was primarily driven by higher net sales across multiple GBUs, and improved margins primarily as a result of product mix. The increase in 2017 was largely driven by lower marketing and administrative expenses as cost savings were realized from the company’s business optimization programs and continued focus on expense management.
APAC
Segment operating income was $538 million, $512 million and $464 million in 2018, 2017 and 2016, respectively. Results in 2018 were primarily driven by higher sales, primarily from China in the Renal Care and Clinical Nutrition GBUs. The increase in 2017 was largely driven by strong performance in the Renal Care and Acute Therapies GBUs along with lower marketing and administrative expenses as cost savings were realized from the company’s business optimization programs and continued focus on expense management.
Corporate and other
Certain income and expense amounts are not allocated to a segment. These amounts primarily include corporate headquarters costs, certain R&D costs, certain GBU support costs, stock compensation expense, non-strategic investments and related income and expense, certain employee benefit plan costs as well as certain gains, losses, and other charges (such as business optimization and asset impairments).
LIQUIDITY AND CAPITAL RESOURCES
The company’s cash flows reflect both continuing and discontinued operations.
Cash Flows from Operations — Continuing Operations
Operating cash flows from continuing operations totaled $2.1 billion, $1.9 billion and $1.6 billion in 2018, 2017 and 2016, respectively. The increases were driven by the factors described below.
Net Income
Net income, as adjusted for certain non-cash items, such as depreciation and amortization, net periodic pension benefit and OPEB costs, stock compensation, deferred income taxes and other items increased in 2018 compared to 2017 as well as in 2017 as compared to 2016.
Accounts Receivable
Changes in accounts receivable had a negative impact to cash flows in 2018 compared to a positive impact in 2017 and 2016. Days sales outstanding were 54.3 days, 53.0 days and 54.5 days for 2018, 2017 and 2016, respectively. Days sales outstanding increased in 2018 and decreased in 2017 primarily driven by the timing of collections in certain international markets.
Inventories
Changes in inventories resulted in a cash outflow of $197 million in 2018, an inflow of $76 million in 2017 and an inflow of $80 million in 2016. The following is a summary of inventories at December 31, 2018 and 2017, as well as inventory turns for 2018, 2017 and 2016. Inventory turns for the year are calculated as the annualized fourth quarter cost of sales divided by the year-end inventory balance.
| Inventories | Inventory turns | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (in millions, except inventory turn data) | 2018 | 2017 | 2018 | 2017 | 2016 | |||||||||||||||
| Total company | $ | 1,653 | $ | 1,475 | 3.8 | 4.2 | 4.1 |
Other
The changes in accounts payable and accrued liabilities were an inflow of $53 million in 2018 and $84 million in 2017 and an outflow of $197 million in 2016. The changes were primarily driven by the timing of supplier payments. Days payables outstanding increased to 55.5 days in 2018 compared to 48.7 days in 2017 and 39.6 in 2016, respectively.
Payments related to the execution of the company’s business optimization initiatives were $99 million in 2018, $143 million in 2017 and $164 million in 2016, respectively. Refer to Note 8 in Item 8 of this Annual Report on Form 10-K for further information regarding the business optimization initiatives.
Changes in other balance sheet items had net cash outflows of $105 million and $229 million in 2018 and 2017, respectively, and a net inflow of $90 million in 2016. The change in 2018 compared to 2017 is driven by higher pension contributions in 2017. The cash inflow in 2016 was the result of a U.S. federal income tax refund of $250 million. Cash contributions to the company’s pension plans totaled $51 million, $242 million and $66 million in 2018, 2017 and 2016, respectively.
Cash Flows from Investing Activities — Continuing Operations
Capital Expenditures
Capital expenditures relating to continuing operations totaled $681 million, $634 million and $719 million in 2018, 2017 and 2016, respectively. The company’s capital expenditures were driven by targeted investments in projects to support production of PD and IV solutions as well as expansion activities for dialyzers. The decline in capital expenditures over the three years was due to a reduction in spending related to ongoing projects and the completion of certain expansion activities.
Acquisitions and Investments
Net cash outflows related to acquisitions and investments were $268 million, $686 million and $48 million in 2018, 2017 and 2016, respectively. The cash outflows in 2018 were primarily driven by the $163 million acquisition of RECOTHROM and PREVELEAK from Mallinckrodt and the acquisition of two products from Celerity for $72 million. The cash outflows in 2017 were driven by the acquisition of Claris and the rights to certain molecules from Celerity. The cash outflows in 2016 were driven primarily by the acquisition of the rights to vancomycin from Celerity.
Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for further information about the company’s significant acquisitions and other arrangements.
Divestitures and Other Investing Activities
Net cash inflows relating to divestitures and other investing activities were $11 million, $10 million and $37 million in 2018, 2017 and 2016, respectively. The net inflow in 2018 was primarily driven by the sale of certain investment securities. The net inflow in 2017 was driven by proceeds received from asset sales partially offset by the impact of the deconsolidation of the company’s Venezuelan operations. The net inflow in 2016 was driven by certain asset sales.
Cash Flows from Financing Activities
Debt Issuances, Net of Payments of Obligations
Net cash inflows related to debt and other financing obligations in 2018 were insignificant.
Net cash inflows related to debt and other financing obligations totaled $632 million in 2017 primarily related to the issuance of €600 million of senior notes at a fixed coupon rate of 1.30% due in May 2025. Refer to Note 9 in Item 8 of this Annual Report on Form 10-K for additional details regarding the debt transactions in 2017.
Net cash inflows related to debt and other financing obligations totaled $56 million in 2016 primarily related to a $190 million repayment of the company’s 0.95% senior unsecured notes that matured in June 2016, a $130 million repayment of the company’s 5.9% senior unsecured notes that matured in September 2016 and the redemption of approximately $1 billion in aggregate principal amount of senior notes in September 2016, as well as the repayment of other short-term obligations. The company also had $300 million of net repayments related to its commercial paper program. These cash outflows were partially offset by issuances of senior
notes totaling $1.6 billion in August 2016. Refer to Note 9 in Item 8 of this Annual Report on Form 10-K for additional details regarding the debt transactions in 2016.
The company’s debt instruments discussed above are unsecured and contain certain covenants, including restrictions relating to the company’s issuance of secured debt.
Other Financing Activities
Cash dividend payments totaled $376 million in 2018, $315 million in 2017 and $268 million in 2016. The increase in cash dividend payments in 2018 was primarily due to an increase in the quarterly dividend rate from $0.13 to $0.16 per share for quarterly dividends declared between May 2017 and May 2018. In addition, the company increased the quarterly dividend rate from $0.16 to $0.19 per share for quarterly dividends declared beginning May 2018. The increase in cash dividend payments in 2017 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 and the previously mentioned increase in May 2017.
Proceeds from stock issued under employee benefit plans totaled $258 million, $347 million and $286 million in 2018, 2017 and 2016, respectively.
Total realized excess tax benefits of $40 million in 2018 and $56 million in 2017 are presented as an inflow from operating activities as required under new accounting guidance implemented in 2017. Total realized excess tax benefits of $39 million in 2016 are presented in the consolidated statements of cash flows as an inflow in the financing section. Refer to Note 1 in Item 8 of this Annual Report on Form 10-K for additional information regarding the change in accounting.
In 2016, the company executed an equity-for-equity exchange of Retained Shares for 11.5 million outstanding Baxter shares. As authorized by the Board of Directors, the company repurchases its stock depending on 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 $292 million in cash to repurchase approximately 6.3 million shares pursuant to this authority in 2016. In 2017, the company paid $564 million to repurchase approximately 9.2 million shares under this authority pursuant to Rule 10b5-1 plans and otherwise and had $1.1 billion remaining available under this authorization as of December 31, 2017. The Board of Directors increased this authority by an additional $1.5 billion in February 2018 and an additional $2.0 billion in November 2018. In 2018, the company paid $2.5 billion to repurchase approximately 35.8 million shares under this authority pursuant to Rule 10b5-1 plans, the accelerated share repurchase agreement noted below and otherwise and had $2.1 billion remaining available under this authorization as of December 31, 2018. Refer to Note 13 in Item 8 of this Annual Report on Form 10-K for additional details regarding the company’s share repurchase programs.
In December 2018, the company entered into a $300 million accelerated share repurchase agreement (ASR Agreement) with an investment bank. The company funded the ASR Agreement with available cash. Under the ASR Agreement, 3.6 million shares were received by the company upon execution. At final settlement of the ASR Agreement, which is expected to occur no later than the second quarter of 2019, the investment bank may be required to deliver additional shares of common stock to the company or the company may be required to deliver shares of its common stock to the investment bank, with the number of shares to be delivered based on the volume-weighted average price of the company’s common stock during the term of the ASR Agreement.
Credit Facilities, Access to Capital and Credit Ratings
Credit Facilities
As of December 31, 2018, the company’s U.S. dollar-denominated senior revolving credit facility and Euro-denominated senior revolving credit facility had a maximum capacity of $1.5 billion and approximately €200 million, respectively, both maturing in 2020. As of December 31, 2018, 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. The company may, at its option, seek to increase the aggregate commitment under the U.S. facility by up to an additional $750 million. The facilities enable the company to borrow funds on an unsecured basis at variable interest rates, and contain various covenants, including a maximum net leverage ratio and maximum interest coverage ratio.
The company also maintains other credit arrangements, as described in Note 9 in Item 8 of this Annual Report on Form 10-K.
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. In early 2019, the company has issued commercial paper as an additional source of financing. The company had $1.8 billion of cash and cash equivalents as of December 31, 2018, 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 deterioration in credit and economic conditions. As of December 31, 2018, the company’s net accounts receivable from the public sector in Greece, Spain, Portugal and Italy totaled $130 million.
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 December 31, 2018 were as follows:
| Standard & Poor’s | Fitch | Moody’s | ||||
|---|---|---|---|---|---|---|
| Ratings | ||||||
| Senior debt | A- | A- | Baa1 | |||
| Short-term debt | A2 | F2 | P2 | |||
| Outlook | Stable | Stable | Stable |
In the first quarter of 2018, Moody’s upgraded Baxter’s senior unsecured debt ratings from Baa2 to Baa1, and Fitch upgraded Baxter’s senior unsecured debt ratings from BBB+ to A-.
Contractual Obligations
As of December 31, 2018, the company had contractual obligations, excluding accounts payable and accrued liabilities, payable or maturing in the following periods.
| (in millions) | Total | Less than one year | One to three years | Three to five years | More than five years | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Long-term debt and capital lease obligations, including current maturities | $ | 3,495 | $ | 2 | $ | 706 | $ | 211 | $ | 2,576 | ||||||||||
| Interest on short- and long-term debt and capital lease obligations 1 | 1,421 | 101 | 196 | 180 | 944 | |||||||||||||||
| Operating leases | 646 | 122 | 179 | 135 | 210 | |||||||||||||||
| Other long-term liabilities2 | 544 | — | 102 | 43 | 399 | |||||||||||||||
| Purchase obligations3 | 576 | 350 | 165 | 54 | 7 | |||||||||||||||
| Contractual obligations4 | $ | 6,682 | $ | 575 | $ | 1,348 | $ | 623 | $ | 4,136 |
| 1 | Interest payments on debt and capital lease obligations are calculated for future periods using interest rates in effect at the end of 2018. Projected interest payments include the related effects of interest rate swap agreements. Certain of these projected interest payments may differ in the future based on changes in floating interest rates, foreign currency fluctuations or other factors or events. The projected interest payments only pertain to obligations and agreements outstanding at December 31, 2018. Refer to Note 9 in Item 8 of this Annual Report on Form 10-K for further discussion regarding the company’s debt instruments outstanding at December 31, 2018. |
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| 2 | The primary components of other long-term liabilities in the company’s consolidated balance sheet are liabilities relating to pension and OPEB, litigation, and foreign currency hedges. The company projected the timing of the future cash payments based on contractual maturity dates (where applicable) and estimates of the timing of payments (for liabilities with no contractual maturity dates). The actual timing of payments could differ from the estimates. |
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The company contributed $69 million, $260 million and $772 million to its defined benefit pension and OPEB plans in 2018, 2017 and 2016, respectively. The timing of funding in the future is uncertain and is dependent on future movements in interest rates and investment returns, changes in laws and regulations, and other variables. Therefore, the table above excludes pension plan cash outflows. The pension plan balance included in other long-term liabilities (and excluded from the table above) totaled $888 million at December 31, 2018.
| 3 | Includes the company’s significant contractual unconditional purchase obligations. For cancelable agreements, any penalty due upon cancellation is included. These commitments do not exceed the company’s projected requirements and are in the normal course of business. Examples include firm commitments for raw material purchases, utility agreements and service contracts. |
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| 4 | Excludes contingent liabilities and uncertain tax positions. These amounts have been excluded from the contractual obligations above due to uncertainty regarding the timing and amount of future payments. Refer to Notes 11 and 16 in Item 8 of this Annual Report on Form 10-K for additional information regarding these commitments. |
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Off-Balance Sheet Arrangements
Baxter periodically enters into off-balance sheet arrangements. Certain contingencies arise in the normal course of business, and are not recorded in the consolidated balance sheet in accordance with GAAP (such as contingent joint development and commercialization arrangement payments). Also, upon resolution of uncertainties, the company may incur charges in excess of presently established liabilities for certain matters (such as contractual indemnifications). For a discussion of the company’s significant off-balance sheet arrangements, refer to Note 11 in Item 8 of this Annual Report on Form 10-K for information regarding receivable transactions, Note 12 in Item 8 of this Annual Report on Form 10-K regarding joint development and commercialization arrangements and indemnifications, and Note 17 in Item 8 of this Annual Report on Form 10-K regarding legal contingencies.
FINANCIAL INSTRUMENT MARKET RISK
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. Refer to Note 10 and Note 11 in Item 8 of this Annual Report on Form 10-K for further information regarding the company’s financial instruments and hedging strategies.
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 Swedish Krona. 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 at December 31, 2018 is 15 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 December 31, 2018, 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 $16 million with respect to those contracts would decrease by $26 million, resulting in a net liability position. A similar analysis performed with respect to option and forward contracts outstanding at December 31, 2017 indicated that, on a net-of-tax basis, the net asset balance of $7 million would decrease by $25 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 December 31, 2018 by replacing the actual exchange rates at December 31, 2018 with exchange rates that are 10% weaker compared to the actual exchange rates for each applicable currency. All other factors are held constant. These sensitivity analyses disregard 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 analyses also disregard the offsetting change in value of the underlying hedged transactions and balances.
The company’s operations in Argentina are reported using highly inflationary accounting effective July 1, 2018. Changes in the value of the Argentine peso applied to our peso-denominated net monetary asset positions are recorded in income at the time of the change. As of December 31, 2018, the company’s net monetary assets denominated in Argentine pesos are not significant.
Interest Rate and Other Risks
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 also periodically uses forward-starting interest rate swaps and treasury rate locks to hedge the risk to earnings associated with fluctuations in interest rates relating to anticipated issuances of term debt.
As part of its risk management program, the company performs sensitivity analyses to assess potential gains and losses in earnings relating to hypothetical movements in interest rates. A 13 basis-point increase in interest rates (approximately 10% of the company’s weighted-average interest rate during 2018) affecting the company’s financial instruments, including debt obligations and related derivatives, would have an immaterial effect on the company’s 2018, 2017 and 2016 earnings and on the fair value of the company’s fixed-rate debt as of the end of each fiscal year.
CHANGES IN ACCOUNTING STANDARDS
Refer to Note 1 in Item 8 of this Annual Report on Form 10-K for information on changes in accounting standards.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with GAAP requires the company 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 in Item 8 of this Annual Report on Form 10-K. Certain of the company’s accounting policies are considered critical because these policies are the most important to the depiction of the company’s financial statements and require significant, difficult or complex judgments by the company, often requiring the use of estimates about the effects of matters that are inherently uncertain. Actual results that differ from the company’s estimates could have an unfavorable effect on the company’s results of operations and financial position. The following is a summary of accounting policies that the company considers critical to the consolidated financial statements.
Revenue Recognition and Related Provisions and Allowances
The company’s revenues from product sales are recorded at the net sales price (transaction price), which includes estimates of variable consideration for reserves related to rebates, product returns, sales discounts and wholesaler chargebacks. These reserves are based on estimates of the amounts earned or to be claimed on the related sales. Management's estimates take into consideration historical experience, current contractual and statutory requirements, specific known market events and trends, industry data, and forecasted customer buying and payment patterns. Overall, these reserves reflect the company’s best estimates of the amount of consideration to which it is entitled based on the terms of the contract. The amount of variable consideration included in the net sales price is limited to the amount that is probable not to result in a significant reversal in the amount of the cumulative revenue recognized in a future period.
The company’s contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately may require significant judgment.
The new standard related to revenue recognition has not had a material impact on the company’s consolidated financial statements as compared to historical revenue recognition guidelines. Refer to Note 1 within Item 8 of this Annual Report on Form 10-K for further information.
The company periodically and systematically evaluates the collectability of accounts receivable and determines the appropriate reserve for doubtful accounts. In determining the amount of the reserve, the company considers historical credit losses, the past-due status of receivables, payment history and other customer-specific information, and any other relevant factors or considerations.
The company also provides for the estimated costs that may be incurred under its warranty programs when the cost is both probable and reasonably estimable, which is at the time the related revenue is recognized. The cost is determined based on actual company experience for the same or similar products as well as other relevant information. Estimates of future costs under the company’s warranty programs could change based on developments in the future.
Pension and OPEB Plans
The company provides pension and other postemployment benefits to certain of its employees. The service component of employee benefit expenses is reported in the same line items in the consolidated income statement as the applicable employee’s compensation expense. All other components of these employee benefit expenses are reported in other (income) expense, net in the consolidated income statement. The valuation of the funded status and net periodic benefit cost for the plans is calculated using actuarial assumptions. These assumptions are reviewed annually, and revised if appropriate. The significant assumptions include the following:
| • | interest rates used to discount pension and OPEB plan liabilities; |
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| • | the long-term rate of return on pension plan assets; |
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| • | rates of increases in employee compensation (used in estimating liabilities); |
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| • | anticipated future healthcare trend rates (used in estimating the OPEB plan liability); and |
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| • | other assumptions involving demographic factors such as retirement, mortality and turnover (used in estimating liabilities). |
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Selecting assumptions involves an analysis of both short-term and long-term historical trends and known economic and market conditions at the time of the valuation (also called the measurement date). The use of different assumptions would result in different measures of the funded status and net cost. Actual results in the future could differ from expected results.
The company’s key assumptions are listed in Note 14 in Item 8 of this Annual Report on Form 10-K. The most critical assumptions relate to the plans covering U.S. and Puerto Rico employees, because these plans are the most significant to the company’s consolidated financial statements.
Discount Rate Assumption
Effective for the December 31, 2018 measurement date, the company utilized discount rates of 4.31% and 4.20% to measure its benefit obligations for the U.S. and Puerto Rico pension plans and OPEB plan, respectively. The company used a broad population of approximately 200 Aa-rated corporate bonds as of December 31, 2018 to determine the discount rate assumption. All bonds were denominated in U.S. dollars, with a minimum amount outstanding of $50 million. This population of bonds was narrowed from a broader universe of approximately 700 Moody’s Aa rated, non-callable (or callable with make-whole provisions) bonds by eliminating the top 10th percentile and bottom 40th percentile to adjust for any pricing anomalies and to represent the bonds Baxter would most likely select if it were to actually annuitize its pension and OPEB plan liabilities. This portfolio of bonds was used to generate a yield curve and associated spot rate curve to discount the projected benefit payments for the U.S. and Puerto Rico plans. The discount rate is the single level rate that produces the same result as the spot rate curve.
For plans in Canada, Japan, the United Kingdom and other European countries, the company uses a method essentially the same as that described for the U.S. and Puerto Rico plans. For the company’s other international plans, the discount rate is generally determined by reviewing country- and region-specific government and corporate bond interest rates.
To understand the impact of changes in discount rates on pension and OPEB plan cost, the company performs a sensitivity analysis. Holding all other assumptions constant, for each 50 basis point (i.e., one-half of one percent) increase in the discount rate, global pre-tax pension and OPEB plan cost would decrease by approximately $27 million, and for each 50 basis point decrease in the discount rate, global pre-tax pension and OPEB plan cost would increase by approximately $30 million.
Return on Plan Assets Assumption
In measuring the net periodic cost for 2018, the company used a long-term expected rate of return of 6.25% for the pension plans covering U.S. and Puerto Rico employees. This assumption will not change in 2019. This assumption is not applicable to the company’s OPEB plan because it is not funded.
The company establishes the long-term asset return assumption based on a review of historical compound average asset returns, both company-specific and relating to the broad market (based on the company’s asset allocation), as well as an analysis of current market
and economic information and future expectations. The current asset return assumption is supported by historical market experience for both the company’s actual and targeted asset allocation. In calculating net pension cost, the expected return on assets is applied to a calculated value of plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over five years. The difference between this expected return and the actual return on plan assets is a component of the total net unrecognized gain or loss and is subject to amortization in the future.
To understand the impact of changes in the expected asset return assumption on net cost, the company performs a sensitivity analysis. Holding all other assumptions constant, for each 50 basis point increase (decrease) in the asset return assumption, global pre-tax pension plan cost would decrease (increase) by approximately $25 million.
Other Assumptions
For the U.S. and Puerto Rico plans, beginning with the December 31, 2018 measurement date, the company used the RP 2014 combined mortality table adjusted to reflect Baxter specific past experience with improvements projected using the MP-2018 projection scale adjusted to a long term improvement of 0.8% in 2034. For all other pension plans, the company utilized country- and region-specific mortality tables to calculate the plans’ benefit obligations. The company periodically analyzes and updates its assumptions concerning demographic factors such as retirement, mortality and turnover, considering historical experience as well as anticipated future trends.
The assumptions relating to employee compensation increases and future healthcare costs are based on historical experience, market trends, and anticipated future company actions. Refer to Note 14 in Item 8 of this Annual Report on Form 10-K for information regarding the sensitivity of the OPEB plan obligation and the total of the service and interest cost components of OPEB plan cost to potential changes in future healthcare trend rates.
Legal Contingencies
The company is involved in product liability, patent, commercial, regulatory and other legal proceedings that arise in the normal course of business. Refer to Note 17 in Item 8 of this Annual Report on Form 10-K for further information. 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 accrued. If a loss is not probable or a probable loss cannot be reasonably estimated, no liability is recorded. The company has established reserves for certain of its legal matters. At December 31, 2018, total legal liabilities were $34 million.
The company’s loss estimates are generally developed in consultation with outside counsel and are based on analyses of potential outcomes. With respect to the recording of any insurance recoveries, after completing the assessment and accounting for the company’s legal contingencies, the company separately and independently analyzes its insurance coverage and records any insurance recoveries that are probable of occurring at the gross amount that is expected to be collected. In performing the assessment, the company reviews available information, including historical company-specific and market collection experience for similar claims, current facts and circumstances pertaining to the particular insurance claim, the financial viability of the applicable insurance company or companies, and other relevant information.
While the liability of the company in connection with certain claims cannot be estimated 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 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.
Deferred Tax Asset Valuation Allowances, Reserves for Uncertain Tax Positions and Tax Reform
The company maintains valuation allowances unless it is more likely than not that all or a portion of the deferred tax asset will be realized. Changes in valuation allowances are included in the company’s tax provision in the period of change. In determining whether a valuation allowance is warranted, the company evaluates factors such as prior earnings history, expected future earnings, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if the company takes operational or tax planning actions that could impact the future taxable earnings of a subsidiary.
In the normal course of business, the company is audited by federal, state and foreign tax authorities, and is periodically challenged regarding the amount of taxes due. These challenges relate to the timing and amount of deductions and the allocation of income
among various tax jurisdictions. The company believes its tax positions comply with applicable tax law and the company intends to defend its positions. In evaluating the exposure associated with various tax filing positions, the company records reserves for uncertain tax positions in accordance with GAAP, based on the technical support for the positions, the company’s past audit experience with similar situations, and potential interest and penalties related to the matters. The company’s results of operations and effective tax rate in a given period could be impacted if, upon final resolution with taxing authorities, the company prevailed in positions for which reserves have been established, or was required to pay amounts in excess of established reserves.
On December 22, 2017, the 2017 Tax Act was enacted into law and the new legislation contains several key tax provisions that affected the company, including a one-time mandatory transition tax on accumulated foreign earnings and a reduction of the U.S. corporate income tax rate to 21% effective January 1, 2018, among others. The company was required to recognize the effect of the tax law changes in the period of enactment, such as determining the transition tax, remeasuring its U.S. deferred tax assets and liabilities as well as reassessing the net realizability of its deferred tax assets and liabilities. In December 2017, the SEC staff issued SAB 118 which allowed the company to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. The company has completed its analysis in accordance with SAB 118 and has finalized the accounting for the initial impact of the 2017 Tax Act. Refer to Note 16 within Item 8 of this Annual Report on Form 10-K for further information.
Valuation of Intangible Assets, Including IPR&D
The company acquires intangible assets and records them at fair value. Valuations are generally completed for business acquisitions using a discounted cash flow analysis, incorporating the stage of completion and consideration of market participant assumptions. The most significant estimates and assumptions inherent in a discounted cash flow analysis include the amount and timing of projected future cash flows, the discount rate used to measure the risks inherent in the future cash flows, the assessment of the asset’s life cycle, and the competitive and other trends impacting the asset, including consideration of technical, legal, regulatory, economic and other factors. Each of these factors and assumptions can significantly affect the value of the intangible asset.
Acquired in-process R&D (IPR&D) is the value assigned to acquired technology or products under development which have not received regulatory approval and have no alternative future use. Acquired IPR&D included in a business combination is capitalized as an indefinite-lived intangible asset. Development costs incurred after the acquisition are expensed as incurred. Upon receipt of regulatory approval of the related technology or product, the indefinite-lived intangible asset is then accounted for as a finite-lived intangible asset and amortized on a straight-line basis over its estimated useful life. If the R&D project is abandoned, the indefinite-lived intangible asset is charged to expense.
IPR&D acquired in transactions that are not business combinations is expensed immediately. For such transactions, payments made to third parties on or after regulatory approval are capitalized and amortized over the remaining useful life of the related asset, and are classified as intangible assets.
Due to the inherent uncertainty associated with R&D projects, there is no assurance that actual results will not differ materially from the underlying assumptions used to prepare discounted cash flow analyses, nor that the R&D project will result in a successful commercial product.
Impairment of Goodwill and Other Long-Lived Assets
Goodwill and other indefinite-lived intangible assets are subject to impairment reviews annually, and whenever indicators of impairment exist. The company assesses goodwill for impairment based on its reporting units, which are the same as its operating segments. Goodwill is tested for impairment by performing either a qualitative or quantitative evaluation. The qualitative evaluation is an assessment of factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. As of December 31, 2018, the date of the company’s annual impairment review, the company determined that the fair values of the company’s reporting units were more likely than not in excess of their carrying values. The company performs a qualitative assessment of other indefinite-lived intangible assets, including IPR&D, at least annually. If the intangible asset is determined to be more likely than not impaired as a result of the assessment, the company completes a quantitative impairment test. Intangible assets with definite lives and other long-lived assets (such as fixed assets) are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Refer to Note 1 in Item 8 of this Annual Report on Form 10-K for further information. Fair value measurements used in impairment reviews are based on an estimated future cash flow approach that requires significant judgment with respect to future volume, revenue and expense growth rates, changes in working capital use, foreign currency exchange rates, the selection of an appropriate discount rate, asset groupings, and other assumptions and estimates. The estimates and assumptions used are consistent with the company’s business plans and reflect its judgements about the estimates and assumptions that market participants would use in valuing the related assets. The use of alternative estimates and assumptions could increase or decrease the estimated fair values of the assets, and potentially result in different impacts to the company’s results of operations. Actual results may differ from the company’s estimates.
CERTAIN REGULATORY MATTERS
The U.S. Food and Drug Administration (FDA) commenced an inspection of Claris’ facilities in Ahmedabad, India in July 2017, immediately prior to the closing of the Claris acquisition. FDA completed the inspection, at which time FDA issued a related Form-483 (Claris 483). In July 2018, FDA issued a Warning Letter based on observations identified in the 2017 inspection (Claris Warning Letter).1 The Claris Warning Letter includes a number of observations across a variety of areas. The company submitted its response to the Claris Warning Letter in August 2018 and is continuing to implement corrective and preventive actions, which have included product recalls that are financially immaterial to the company, to address FDA’s observations as set forth in the Claris 483 or the Claris Warning Letter and other items identified in connection with integrating Claris into the company’s quality systems. The company had a Regulatory Meeting with FDA on November 6, 2018 and continues to cooperate with FDA in connection with the resolution of these matters.
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 FDA regarding one or both of these facilities in October 2014, November 2015, July 2017, April 2018 and October 2018. The Warning Letter addresses observations related to Current Good Manufacturing Practice violations at the two facilities.
Refer to Item 1A of this Annual Report on Form 10-K for additional discussion of regulatory matters and how they may impact the company.
1 Available online at https://www.fda.gov/ICECI/EnforcementActions/WarningLetters/ucm613538.htm
FORWARD-LOOKING INFORMATION
This annual 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 (including estimates regarding the company’s ability to obtain approval for distribution in the U.S. of new products manufactured at its Baxter Ahmedabad facility), strategic objectives, sales from new product offerings, 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 with the separation of the company’s biopharmaceuticals and medical products businesses (including the 2016 disposition of the company’s formerly retained shares in Baxalta (Retained Shares)), the impact of competition, future sales growth, business development activities (including the recent acquisitions of Claris Injectables and two surgical products from Mallinckrodt plc), Hurricane Maria related production disruptions, 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:
| • | failure to achieve our long-term financial improvement goals; |
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| • | demand for and market acceptance risks for and competitive pressures related to new and existing products (including challenges with the company’s ability to accurately predict these pressures and the resulting impact on customer inventory levels), and the impact of those products on quality and patient safety concerns; |
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| • | product development risks, including satisfactory clinical performance, the ability to manufacture at appropriate scale, and the general unpredictability associated with the product development cycle; |
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| • | the company’s ability to finance and develop new products or enhancements on commercially acceptable terms or at all; |
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| • | the company’s ability to identify business development and growth opportunities and to successfully execute on business development strategies; |
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| • | product quality or patient safety issues, leading to product recalls, withdrawals, launch delays, warning letters (including the Claris Warning Letter), import bans, sanctions, seizures, litigation, or declining sales; |
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| • | the continuity, availability and pricing of acceptable raw materials and component supply, and the related continuity of our manufacturing and distribution; |
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| • | inability to create additional production capacity in a timely manner or the occurrence of other manufacturing or supply difficulties (including as a result of natural disaster or otherwise); |
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| • | breaches or failures of the company’s information technology systems or products, including by cyber-attack, unauthorized access or theft; |
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| • | future actions of (or failures to act or delays in acting by) FDA, the European Medicines Agency or any other regulatory body or government authority (including the DOJ or the Attorney General of any State) that could delay, limit or suspend product development, manufacturing or sale or result in seizures, recalls, injunctions, monetary sanctions or criminal or civil liabilities; |
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| • | failures with respect to the company’s quality, compliance or ethics programs; |
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| • | future actions of third parties, including third-party payers, the impact of healthcare reform and its implementation, suspension, repeal, replacement, amendment, modification and other similar actions undertaken by the United States or foreign governments, including with respect to pricing, reimbursement, taxation and rebate policies; legislation, regulation and other governmental pressures in the United States or globally, including the cost of compliance and potential penalties for purported noncompliance thereof, all of which may affect pricing, reimbursement, taxation and rebate policies of government agencies and private payers or other elements of the company’s business, including new or amended laws, rules and regulations (such as the California Consumer Privacy Act of 2018 and the European Union’s General Data Protection Regulation which became effective in May 2018, for example); |
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| • | the impact of competitive products and pricing, including generic competition, drug reimportation and disruptive technologies; |
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| • | global regulatory, trade and tax policies; |
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| • | the ability to protect or enforce the company’s owned or in-licensed patent or other proprietary rights (including trademarks, copyrights, trade secrets and know-how) or patents of third parties preventing or restricting the company’s manufacture, sale or use of affected products or technology; |
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| • | the impact of any goodwill impairments on our operating results; |
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| • | any failure by Baxalta or Shire to satisfy its obligations under the separation agreements, including the tax matters agreement, or that certain letter agreement entered into with Shire and Baxalta; |
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| • | the impact of global economic conditions (including potential trade wars) on the company and its customers and suppliers, including foreign governments in countries in which the company operates; |
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| • | fluctuations in foreign exchange and interest rates; |
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| • | any changes in law concerning the taxation of income (whether with respect to current or future tax reform), including income earned outside the United States; |
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| • | actions by tax authorities in connection with ongoing tax audits; |
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| • | loss of key employees or inability to identify and recruit new employees; |
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| • | the outcome of pending or future litigation; |
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| • | the adequacy of the company’s cash flows from operations to meet its ongoing cash obligations and fund its investment program; and |
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| • | other factors identified elsewhere in this Annual Report on Form 10-K including those factors described in Item 1A and other filings with the Securities and Exchange Commission, all of which are available on the company’s website. |
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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.
Previous: Item 6. Selected Financial Data. · Next: Item 7A. Quantitative and Qualitative Disclosures About Market Risk.