Baxter International Q2 2022 Earnings Call Transcript

AlphaStreet
Provided by AlphaStreet
July 28, 2022
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Operator

Good morning, ladies and gentlemen, and welcome to Baxter International's Second Quarter 2022 Earnings Conference Call. Your line will remain in a listen-only mode until the question-and-answer segment of today's call. [Operator Instructions] As a reminder, this call is being recorded by Baxter and is copyrighted material. It cannot be recorded or rebroadcast without Baxter's permission. If you have any objections, please disconnect at this time.

I would now like to turn the call over to Ms. Clare Trachtman, Vice President, Investor Relations at Baxter International. Ms. Trachtman, you may begin your conference.

Clare Trachtman
Vice President of Investor Relations at Baxter International

Good morning, and welcome to our second quarter 2022 earnings conference call. Joining me today are Joe Almeida, Baxter's Chairman and Chief Executive Officer, and Jay Saccaro, Baxter's Chief Financial Officer. On the call this morning, we will be discussing Baxter's second quarter 2022 financial results and our full-year financial outlook for 2022.

With that, let me start our prepared remarks by reminding everyone that this presentation, including comments regarding our financial outlook for the third quarter and full-year 2022 and our 2022 to 2025 long range plans, the recent acquisition of Hillrom, new product development, the potential impact of proposed pricing actions, business development and regulatory matters contains forward-looking statements that involve risks and uncertainties, and of course, our actual results could differ materially from our current expectations. Please refer to today's press release and our SEC filings for more detail concerning factors that could cause actual results to differ materially. In addition, on today's call, non-GAAP financial measures will be used to help investors understand Baxter's ongoing business performance. A reconciliation of the non-GAAP financial measures being discussed today to the comparable GAAP financial measures is included in our earnings release issued this morning and available on our website.

On the call this morning, we will be discussing operational sales growth, which adjusts for the impact of foreign exchange and the acquisition of Hillrom.

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

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

Thank you, Clare. And good morning, everyone. We appreciate your joining today's call. I will begin with an overview of the macroeconomic factors that have and will continue to impact our performance in 2022. I will then provide some commentary on the second quarter. Jay will take a closer look at our financials and outlook, after which we will open up the lines for your questions.

I want to start by thanking many of you for joining us at our 2022 investor conference, whether in person or virtually. Our goal was to share our strategies that drive leading edge healthcare innovation, create compelling value for patients, clinicians, employees and investors. It was also a great opportunity to showcase how the acquisition of Hillrom is helping power the next phase of our transformation journey by fueling connected care innovation, expanding the global reach of our combined portfolio and growing our presence across the continuum of care. And our innovation hall offered a firsthand look at how this momentum is already coming to life in tangible ways in hospitals, homes, and physician's offices worldwide.

With respect to our current environment, overall demand remains strong across our combined portfolio. At the same time, we experienced significant back orders and backlogs for certain products due to ongoing supply chain challenges, like those impacting industries globally. This is affecting access to a variety of raw materials and components, including electromechanical components using many of our products. Securing these necessary components has resulted in incremental spot purchases with costs that are meaningfully above and beyond what we had anticipated earlier this year. In addition, the delays in receiving many of these materials and/or components have forced unplanned temporary shutdowns in our manufacturing facilities, which negatively impact our absorption rates.

Taken together, the negative impact of these increased spot purchases and temporary shutdowns will primarily be realized in Baxter's results during the second half of the year. In addition, ongoing inflationary pressures coupled with increased freight expenses, primarily driven by the rapid rise in diesel and jet fuel prices has created incremental pressures on the cost of doing business for the company.

As the quarter progressed, we saw both diesel and jet fuel prices diverging from crude oil, increasing at a much faster pace. Historically, changes to both diesel and jet fuel prices have trended in line with the degree of change seen in crude oil prices. And with our mission to save and sustain lives, we will never compromise on doing what is right to address the urgent needs of the patients and clinicians that depend on us. This means utilizing more expedited shipping channels than anticipated as we work relentlessly to ensure products get to where they are most needed. It also means carrying higher levels of inventory than normal as many of our raw materials and finished goods are held up in transit, given ongoing global supply chain challenges.

At our investor conference, you will have heard some of the significant actions we have been implementing in response to unprecedented challenges. Our actions reflect the unrelenting commitment to operational excellence that has been a signature of our multi-year transformation. This tenacity is helping us navigate and mitigate near-term pressures to the degree possible as we stay focused on driving long-term value and growth for our shareholders and other key stakeholders.

As always, we remain committed to ensuring we have the optimal cost structure. And to that end, we are actively identifying opportunities to further optimize our expense base to enhance performance, including pulling forward certain Hillrom cost synergies. Given the significant increase in costs that we have absorbed and continue to incur in the production and delivery of our portfolio of life saving products, we are preparing to pass through a portion of this incremental cost to our customers in the second half of 2022 and beyond.

Shifting now to our second quarter financial performance, which is the second full quarter since the close of our Hillrom acquisition. Sales for the quarter grew 21% on a reported basis and 26% at constant currency rates. Legacy Hillrom sales contributed $750 million to our total $3.7 billion in sales for the second quarter. Excluding the impact of Hillrom and foreign exchange, second quarter sales increased 3% on an operational basis.

On the bottom line, adjusted earnings per share of $0.87 were up 9% year-over-year. Growth on both the top and bottom line continues to be constrained by the macroeconomic factors shared previously.

That said, performance across our businesses in the second quarter reflects our overall positive trajectory amid the broader state of the market demand. This includes solid growth at constant currency rates in renal care, medication delivery, pharmaceuticals, clinical nutrition, and advanced surgery.

With the specific regard to pharmaceuticals, I want to flag that we are continuing to experience price erosion in the US due to generic competition, as well as some pressure from supply constraints and a shift in demand for inhaled anesthesia. As we noted at our investor conference, we are continuing to emphasize differentiated generic formulations and packaging, as well as international opportunities to drive growth for this business moving forward.

I'm also pleased to share that Alok Sonig joined us a few weeks ago as our new president of pharmaceuticals. Alok brings to Baxter more than 25 years of experience in the life sciences industry, most recently serving as the US CEO and Global Head of Research and Development in Biosimilars at Lupin. We are excited to welcome Alok to the team and look forward to realizing the benefits of the experience he brings to this business. Both Acute Therapies and BioPharma Solutions declined mid-single digits year-over-year at constant currency rates, reflecting a challenging comparison to last year due to pandemic-related sales for both of these products categories.

As compared to Q2 2021 when our newly acquired Hillrom business was a standalone company, its sales rose low-single digits at constant currency rates. This demand reflects mid-single digit growth in frontline care, offset by softness in patient support systems and global surgical solutions. Sales in all three of the legacy Hillrom businesses have been impacted by significantly higher-than-normal backlogs reflecting challenges in accessing components as well as delays in certain product installs because of hospital staffing concerns and challenges.

On a positive note, our integration process continues to proceed rapidly with key milestones on track or ahead of expectations. And as you saw at our investor conference, we are moving swiftly on our opportunities to expand access across our combined portfolio and embrace heightened potential in connected care.

Now looking ahead, given the factors I outlined earlier in my remarks, external conditions, expectations and the market's ability to project trends continue to evolve rapidly, both upstream and downstream, even in the months between our investor conference and today, and this is impacting our business. As such, we're adjusting our guidance for the balance of 2022 as indicated in our press release. Jay will share additional commentary in his remarks.

At the same time, we continue to foresee long-term stabilization of conditions. Given this anticipated stabilization and our updated 2022 guidance, I want to reiterate my confidence in our long-term outlook and prospects as provided in May.

Baxter has proven its resilience time and again over the course of its 90 plus years. Our durable portfolio focused on essential care and vast global footprint remain the strategic core of our underlying strength and stability. The acquisition of Hillrom has expanded the scope of our essential portfolio and has also created additional opportunities in connected care that are vital to accelerating our future impact as a healthcare leader and innovator.

Finally, I hope that you have had a chance to review Baxter's annual corporate responsibility report issued in June. It highlights our progress toward our 2030 corporate responsibility goals, which reflect our commitment to empower patients, protect our planet, and champion our people and communities. If you have not yet had the opportunity, you can find the report posted on our website, baxter.com.

Now, I'll pass it to Jay to share more on our performance and outlook.

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

Thanks, Joe. And good morning, everyone. As Joe mentioned, we're continuing to navigate a dynamic and ever-changing macro environment. This near-term volatility has created certain challenges for our business, and led us to lowering our full-year outlook. But we're committed to working through these headwinds and delivering on our long-term commitments off this new base. Most importantly, demand for our Baxter products remain strong and our integrated supply chain and commercial teams are working tirelessly to get products in the hands of our customers and patients to fulfill our mission.

Turning to our financial performance. Second quarter 2022 global sales of $3.7 billion advanced 21% on a reported basis, 26% constant currency, and 3% operationally. As the US dollar strengthened over the quarter, foreign exchange negatively impacted reported sales by approximately 500 basis points. And as Joe mentioned, sales within the quarter were constrained due to lack of both raw materials and component availability, particularly as it relates to electromechanical components.

Second quarter sales were also impacted by a lack of hospital access, which is needed to install select products, particularly in our patient support systems product category. We estimate these constraints negatively impacted sales by over 300 basis points in the quarter. Compared to the prior-year period, operational sales grew 3%, reflecting a gradual recovery in hospital admission rates and elective surgeries, strength in our medication delivery and nutrition businesses and solid growth in PD. On the bottom line, adjusted earnings increased 9% to $0.87 per share, falling within our guidance range of $0.86 to $0.89 cents per share.

Now, I'll walk through performance by our regional segments and key product categories. Note that constant currency growth is equal to operational sales growth for all global businesses and Baxter's three legacy geographic regions.

Starting with sales by operational segment, sales in the Americas increased 2% on a constant currency basis. Sales in Europe, Middle East and Africa grew 6% on a constant currency basis, and sales in our APAC region increased 1% on a constant currency basis. Sales in our APAC region were negatively impacted in the quarter by the resurgence of COVID cases in the region, particularly in China, which we estimate was an impact of approximately $15 million.

Moving on to performance by key product category, global sales for renal care were $931 million, increasing 2% on a constant currency basis. Performance in the quarter was driven by solid growth in our PD business where we observe both a sequential and year-over-year improvement in global patient volumes. This growth was partially offset by lower in-center HD sales, partially due to HD monitor supply challenges due to component availability.

Sales and medication delivery of $710 million increased 4% on a constant currency basis. Growth in this business reflects strong global demand for our products and our IV therapy portfolio. This was partially offset by lower sales in APAC, driven by COVID-related lockdowns in China and the resulting impact on utilization. This product category was also impacted by lower sales of large volume pumps in the quarter due to constrained demand from the lack of component availability. Pharmaceutical sales of $528 million grew 3% on a constant currency basis. Performance in the quarter was driven by increased sales internationally for inhaled anesthetics, offsetting increased competition within our US generic injectables portfolio, as well as supply constraints for select molecules.

Moving to clinical nutrition. Total sales were $230 million, increasing 4% on a constant currency basis. Performance in the quarter was driven by demand for our broad multi-chamber product offering, vitamins and automated compounding. Sales in advanced surgery were $263 million, advancing 8% on a constant currency basis. Growth in the quarter reflects continued gradual recovery of elective procedures in the US and Europe, as well as strong demand for RECOTHROM given competitive constraints. Recovery in our APAC region remains subdued, with several countries experiencing somewhat depressed levels of surgical volumes.

Sales in our acute therapies business were $173 million, declining 4% on a constant currency basis, reflecting the difficult comparison to the prior-year period where we experienced elevated demand for CRRT, given the rising COVID cases.

Biopharma solutions in the quarter were $163 million, declining 5% on a constant currency basis and reflecting an expected step down in sales of COVID vaccines compared to the same period last year. COVID vaccine sales for the quarter totaled approximately $35 million. Hillrom contributed $715 million in sales in the quarter, which included $364 million of sales in patient support systems, $282 million of sales in frontline care and $69 million of sales in global surgical solutions. Hillrom grew 2% on a constant currency basis as compared to Q2 2021 when the company was a standalone entity.

Despite solid growth in the quarter, sales came in below our expectations largely due to the supply constraints for electromechanical parts, primarily implant packing frontline care, as well as select delays in product installations and patient support systems in global surgical solutions due to lack of hospital access. As a result, we're experiencing unprecedented levels of product backlog throughout these businesses. Demand remains strong, though, and we'll continue to monitor the situation and work this backlog as rapidly as possible.

And while to date, we haven't yet seen an impact on the flow of capital orders, we are taking a more conservative approach for the second half given delays related to hospital staffing challenges, as well as more cautious commentary from customers regarding hospital capex.

Moving through the rest of the P&L. Our adjusted gross margin of 42.5% decreased by 10 basis points over the prior year, reflecting the impact of increased expenses, primarily driven by inflation and freight.

Adjusted SG&A of $839 million represented 22.4% as a percent of sales, an increase of 150 basis points versus prior year, driven by the addition of Hillrom, as well as higher freight expenses, partially offset by lower bonus accruals under our annual employee incentive compensation plans. Adjusted R&D spending in the quarter of $148 million represents 4% as a percent of sales, a decrease of 50 basis points versus prior year.

Adjusted operating margin in the quarter was 16.2%, a decrease of 100 basis points versus the prior year, primarily driven by incremental freight expenses in the quarter, resulting from higher fuel prices and inflation, partly offset by actions we are taking to improve productivity and reduce spend. Adjusted net interest expense totaled $89 million in the quarter, an increase of $55 million versus the prior year, driven by higher outstanding debt balances related to the acquisition of Hillrom. Given the current interest rate environment, we now expect net interest expense to be slightly higher than we had previously forecasted.

Adjusted other non-operating income totaled $33 million in the quarter, an increase of $31 million compared to the prior-year period, driven by foreign exchange and equity investment gains, as well as amortization of pension benefits. The adjusted tax rate in the quarter was 18.8% as compared to 17.8% in the prior period. The year-over-year increase was driven by the addition of Hillrom as well as lower stock-based compensation award deductions as compared to the prior-year period. And as previously mentioned, adjusted earnings of $0.87 per diluted share advanced 9% versus the prior-year period.

Let me conclude my comments by discussing our outlook for the third quarter and full-year 2022, including some key assumptions underpinning our revised guidance. As discussed, throughout the second quarter, Baxter experienced increased inflationary pressure related to fuel commodity and labor prices. Our prior outlook did not assume the divergence we're experiencing between diesel and crude oil, but did assume an easing commodity pricing, in line with external indices forecasts.

Our current outlook now assumes pricing for these key raw materials remains at current levels for the remainder of the year. We anticipate component availability remains challenging through the second half of 2022, which will continue to impact our overall production volumes and absorption rates.

We anticipate our order backlog will stay at elevated levels, resulting in a phasing impact of top line sales, primarily for infusion pumps in the frontline care business. Our teams are working tirelessly to secure key electronic components to lower our backlog to more normalized levels. In addition, we project a potential slowdown in hospital capital spending in the second half of the year, which will impact our PSS and GSS businesses.

For the third quarter of 2022, we expect global sales growth of high teens on a reported basis, mid-20s on a constant currency basis and low-single digits operationally, and we expect adjusted earnings excluding special items of $0.79 to $0.83 per diluted share.

For full-year 2022, we now expect global sales growth of high teens on a reported basis, mid-20s constant currency, and 2% to 3% operationally. As mentioned earlier, operational growth for Baxter excludes the impact of foreign exchange and Hillrom. The reduction in our sales guidance reflects increased foreign exchange headwinds, a lower sales outlook for our pharmaceuticals business and the legacy Hillrom business.

Moving down the P&L, we expect full-year adjusted operating margin to be between 17% to 17.5%, reflecting the impact of all the various macroeconomic dynamics discussed today.

For the year, we now expect interest expense to total approximately $400 million, given rate increases and adjusted tax rate of approximately 19%, and a diluted average share count of approximately 510 million shares. In addition, we expect the incremental FX top line headwinds will negatively impact earnings per share by approximately $0.05 in the second half of the year. Based on these factors, we now expect 2022 adjusted earnings excluding special items of $3.60 to $3.70 per diluted share.

With that, we can now open the call up to Q&A.

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Operator

[Operator Instructions]. Our first question comes from Robbie Marcus.

Robbie Marcus
Analyst at J.P. Morgan

Jay and Joe, there's a lot of moving pieces. And we just had the Analyst Day in May. So I was hoping maybe you can bucket for us the biggest changes from when you first gave guidance in January, EPS is now about a 15% lower. How should we think about the biggest impacts? How many are transitory? And how much of that is, would you say, more semi-permanent or permanent?

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

I'll start by answering this question in relation to the guidance that we shared in April. And then I'll add some additional commentary as it relates to what changed since May. Because I think that's perhaps the easiest way to do it.

Q2 from an earnings standpoint largely came in line with our expectations. And the complexion of that was a bit different. But, really, the big driver of this relates to the second half of the year, where we're reducing the outlook by over $0.45.

And I think there are a few different component pieces to this. First of all, from a commercial sales standpoint, we have had serious constraints related to electromechanical components, along with other raw materials. The result of that is our Hillrom business is off over $100 million in sales, in large part because of these constraints. We're also seeing some pharma pricing that's been challenging on the Baxter side. So, in combination, the commercial sales has impacted us roughly $0.15, maybe a little bit more than that, with the lion's share of that impact related to product shortage and component shortages.

Now, on the offset side to that, we are offsetting that with lower spending, lower bonus accruals, and so the work that we're doing in terms of P&L preservation is offsetting that miss and it's also offsetting a $0.05 FX headwind in the second half of the year.

The major impact comes down to headwinds that we're experiencing in our integrated supply chain. We have a roughly $0.45 impact in the second half of the year, and it's across a number of factors. Higher fuel rates and freight, roughly $0.15 of impact. Some of this has to do with the decoupling that was described between diesel prices and the price of oil that we started to see and that has continued through the second quarter. Some of it has to do with the fact that, because our supply chain is so strained, we are forced to expedite freight and we were experiencing significantly higher outbound freight and inbound freight than we normally would experience.

From an inflation standpoint, on materials, it's roughly $0.05, and other inflation related to labor, utilities, and overhead is $0.04. We had been hoping for some improvement in these categories. But, frankly, we've seen elevated levels in Q2 remain elevated. And so, as a result, we see a roughly $0.09 impact in these inflationary categories.

And then, the final piece, and it's substantial, relates to the productivity of our facilities. We're off roughly $0.20 of impact. And what this comes down to is, our supply chain relies on critical components from our suppliers in order for us to produce the products that we produce. There have been many instances where we are not able to secure electromechanical components, other components necessary to our manufacturing products, or critical raw materials. And so, the result of that is, this is the first time in my career I've seen numerous unplanned stoppages in our facilities as a result, and it's having a dramatic impact on a couple of things.

First, on absorption levels in those facilities. That's obvious. But in addition to that, in terms of our ability to pursue planned VIPs, it's seriously hampered and impacted by our ability to continually run those facilities.

And just to share a couple of examples. We have a manufacturing facility in Hechingen in Germany. And that's a manufacturing facility that produces dialyzers on a continuous basis. It's a continuous flow plant. So, disrupting that is a real serious deal, as you think about the operational efficiency of that. We've been forced to shut that plan for three days as a result of lack of power coming from the company that we deal with in Germany.

Our North Cove manufacturing facility, our flagship facility, recently had to close a first shift, as a result of lack of critical components. Our facility Skaneateles has been running suboptimally. We had anticipated that that would improve. It has not. Our facility that manufactures pump Sigma Spectrum, we've been running at very low levels, if at all, because of lack of electromechanical devices.

So, Robbie, it's an interesting and very challenging confluence of events. And it's an incredibly volatile dynamic that we're experiencing as we look at our supplier base. But in combination, these headwinds have impacted us $0.45.

Now, the good news is, operationally, we see a path forward, I commented that from a long range plan standpoint, assuming things stay at these levels, we have a pathway to the improvement that we outlined. I am certainly hopeful that we see easing of electromechanical components, along with some of the prices that I discussed, along with the normalization of freight lanes and freight times and the impact. So, I'm optimistic that all of those things will occur. But in the short term, we're not anticipating that. And we've made necessary adjustments to our cost structure to offset as much as possible. So really, that's the story now.

As we think about what's changed since May, in May, every one of these categories on the supply chain that I've described, and most prominently, some of these disruptions that we're seeing, those are the things that have changed the most since May. And so, it's been widespread and a very difficult environment.

I think we have put forth the best forecasts available, the most conservatively realistic forecasts available, reflecting what current prices are, what our current understanding of plant shutdowns will be, but it's been a very dynamic environment that's led us to this place.

Robbie Marcus
Analyst at J.P. Morgan

And maybe just as a follow up, Jay, at the Analyst Day that you talked about in the new LRP that you think - floor of 75 basis points and margin expansion, I guess would be the floor over the LRP. Do you think that still holds, given the new environment? Or there may be some changes to that comment?

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

We do. Robbie, we went through an analytic exercise based on the evolution of the environment over the last four to six weeks. We went through an analytic exercise and we looked at, first of all, the overall quantum of improvement over the LRP, that 350 to 400, the expected sales compounded growth rate of 4% to 5%, along with the free cash flow conversion. We looked at all of that. In addition, we looked at 2023 and the statements that we made. We validated all of those statements, that those are intact, relative to where things currently sit. So, based on the challenging environment that we've experienced, I was pleased that we're able to confirm that at this point.

Listen, if European gas gets shut off in the winter, if that situation exacerbates and takes a further toll, a further step down on the supply chain, who knows what will happen? But as we sit here today, based on what we know and the current rates and the current expectations around chips and so on, we feel good about the long range plan commitment, albeit starting off the lower base.

Operator

Vijay Kumar of Evercore is on the line with a question.

Vijay Kumar
Analyst at Evercore ISI

Jay, just off of those last comments you just made on affirmation of LRP plan, I think the LRP had 350 to 400 basis points of margin expansion. I guess my question is expansion over what baseline? Are we looking at 2022 as the baseline? I think the updated guide implies 17.5% op margins. If you could just clarify that thing, that'll be helpful.

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

The updated LRP is off the lower base. So, it was a relative improvement from 2022. Vijay, the factors that I listed, the $0.45, I suspect that a number of them will be transitory, okay? But as we've thought about the modeling, we really don't have enormous easing of some of these constraints that we've seen. So, let's see how that evolves over time. But for now, what we're able to do is confirm the growth against this lower level.

Vijay Kumar
Analyst at Evercore ISI

One for Joe. Joe, these electronic components shortages, et cetera, some of your peers are seeing some alleviation. And I guess, from a Street perspective, the fear is, is this what we're seeing in Hillrom? Is this a capex slowdown, right? Based on your comments, it feels like this is not a demand issue and there is a potential for a catch up based on your comments on backlog and order book. Maybe talk about why this is not a demand issue, why you're confident about the outlook for Hillrom and the business?

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

Vijay, when we look at Baxter, let me take this in two portions. We have experienced significant shortages of semiconductors. And the semiconductors - and sometimes, we all read in the news, the semiconductor business may alleviate as consumer goods will decline due to recession, potential recession, inflation and so forth.

We as a company and many, many people in the medical devices use chips that are not the same chips used in consumer goods, and that varies by nanometers. You probably know this as well. We use thicker chips, chips that have embedded software. Our suppliers - we have a half a dozen suppliers. And one of these suppliers has been a real problem. And coincidentally, this supplier is one that supplies most of our frontline care products. This is not an issue in our [indecipherable] more so into our frontline care. And also affects our ability to make Sigma Spectrum pump, as Jay mentioned.

So, we need to separate that. So when it comes to capital, we have not seen a widespread change in demand. What we saw in the second quarter are fewer accounts that moved the implementation and the justification was more on staff shortages and the ability to really deploy them to get the products installed, which requires manpower and they were short in that area.

We look conservatively at this. We look at our business in many dimensions. We have a very healthy backlog at the moment. Very, very healthy. I can sit here today and say that, if I had enough chips, we could produce a significant amount of revenue due to pumps, monitors and other devices that we have.

One of the things that bite us twice in this conversation is not having the chips is the ability to program and plan your factories accordingly because it becomes a real ramp at the end of the quarter when the supplier sends us a bunch of chips, and then we assemble them and we get them out of the door as soon as possible. So, it has been a real tricky situation.

It seems to - that we see the light at the end of the tunnel as we start to make progress with some of our suppliers. But we're sitting here today, I would say the demand is strong. This is the headline. Second is the chip - the semiconductor situation is very fluent. Third is that we have the capability to put those products on the market and have the demand for them as soon as we've got the product, the components shipped to us. So, I want to make sure that those two things are separate.

Capital has slowed down. We haven't seen that. Our backlog, as I said, has been all-time high in both business. However, we had people postpone installations in the second quarter due to staff shortage, as we were told.

Operator

Pito Chickering of Deutsche Bank is on the line with a question.

Pito Chickering
Analyst at Deutsche Bank Aktiengesellschaft

The first one is on the capex side. You talked about seeing some delays from customers who are pushing out orders on capex spending. Is this Hillrom [Phonetic], I guess any color you can give us on what parts of your book business you're seeing those delays of capex.

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

A lot of this comes down to staffing availability. I think that's been the primary driver that we've seen in terms of - we've seen a bit of an expansion in terms of installations on our care solution. So hospital beds, care communication, some of those items, it's taking longer - the installation process has been taken longer as a result of some of the staffing shortages that we've outlined in the prepared remarks. And then, Joe, again - we don't see at this stage a substantive change to the appetite for capital at hospitals. But we're watching this very carefully. And we're watching to ensure that the delays that we're seeing are related to staffing versus budget constraints or something like that. We've tried to take a cautious forecast through the balance of the year, which protects us in the event that there's some further shortage impacts. But that's what we said.

Now as far as pumps, we're not selling an enormous number of pumps, in large part because of the constraints on electromechanical components. So, that's a huge challenge that we're faced with until we resolve that at some point here in the future.

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

As a matter of fact, we have significant demand for pumps. We just cannot take the orders and we cannot make the products because we don't have the semiconductors going in.

But I want to also to underscore what Jay said. When it comes to capital, capital is not the same for every hospital system. The hospital systems, they are large, they have the capacity to move forward. So we are observing very rapidly what is happening. So, is this postponement of capital issue or supply or staffing issues. Right now, the information that we have is a staffing issue, and those are the smaller accounts that we saw in the second quarter. We have large installations coming in third and fourth quarter, will be a telling point how those go through in the third and fourth quarter.

Pito Chickering
Analyst at Deutsche Bank Aktiengesellschaft

My second question is on the margins. Looking at the implied margin growth from 3Q to 4Q, can you walk us through how you get that margin improvement sequentially? Is this from getting the chips back online and getting leverage from that? Or is it from [indecipherable] margins 3Q from diesel fuel costs. Any color there would be great.

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

Looking at that, I think there's a few things in play. First of all, the fourth quarter of the year is typically our highest margin quarter as a result of incremental sales. And so, if we look at the cadence between the third and fourth quarter of the year, we add well over $100 million in sales. And given that, there is a fairly substantial fixed cost base at a company like ours. Those sales tend to flow through at a much higher margin than the corporate average. So, if you look at the last few years, the fourth quarter is normally higher. Now, that's not always the case. But generally speaking, it's normally higher than the third quarter as a result of these incremental sales.

The second thing is, listen, we take the preservation of the P&L very seriously. And so, while we weren't able to offset the extreme challenges that we've seen, we have offset a portion of those through some cost actions that we're taking. And many of those cost actions, the benefit of those accrues more to the fourth quarter than the third quarter. So, I think, perhaps, those are the two primary drivers that lead to the fourth quarter accelerated versus the third.

And then, the final thing I would say is, we are ramping on the Hillrom synergy side throughout the year. That's been an area that's been going quite well. But each quarter that rolls on, we're adding synergies. So, that's another factor that comes to bear on the fourth quarter in excess of the third on our way to achieving the long term goal that we outlined at the Investor Day.

Operator

Travis Steed of BofA Securities is on the line with a question.

Travis Steed
Analyst at Bank of America Securities

Jay, obviously, a lot of macro pressures right now, but maybe talk a little bit about some of the offsets, things that are in your control. You mentioned pricing a little more visibly, as other companies have as well, just maybe talk a little bit about how much of this inflationary pressures can you actually offset with price? And how long does it take to roll through the P&L, given contracts?

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

Historically, we have realized price increases in the US as part of our standard contracting process. This is normal practice increases. We have taken pricing actions to date, and they are reflected in our 2022. They can offset 100% of our incremental cost. So, therefore, we additionally, right now, are preparing the implementation of a second wave of actions in response to the significant price increases that we have received from our suppliers and our cost increase, Jay outlined in the beginning of the call, in terms of the labor cost and other internal costs, fuel costs, and energy costs and everything. So, we're putting an additional cost increase. At the moment, we're planning to start rolling out the second wave to customers on a global basis, by the way, not only US, in most of our businesses in the coming weeks.

The actions that we're intending right now are to help offset a portion of the significant cost increase that we have, a portion, and doesn't cover everything. But we are determined to go through a second wave of price increases, price actions, I would say - better defined as price actions - throughout the company because of the incremental unprecedented cost increase that we are receiving right now.

Travis Steed
Analyst at Bank of America Securities

Jay, in an earlier question, I think to Robbie, you're still committed to the 75 basis point floor per year. Just curious, when you think about on earnings, does that still translate into low-double digits or is 2023 probably more likely to be more of a transition year with less than double-digit earnings growth for that one year? Any comments on there? And also, where divestitures might fit in the LRP? If you've got to wait on somebody as more macro pressures ease before you'd move into divestitures or you could do that more near term?

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

As it relates to the cadence of earnings, we're committed to the floor of 75 basis points of margin improvement in any given year. And also, as you point out, we're looking at double-digit earnings growth compounded over the period of the plan. 2023, there's two factors in play. Right now, the operating margin expansion, barring meaningful improvements in some of these exogenous factors, will be towards the lower end versus the average rate that we expect to see over the term of the plan, but above the 75 basis points.

The second thing that impacts 2023 in the short term is, given some of the rate hikes that we're seeing from the Fed, you do have that interest expense impacting the 2023 numbers, as we rapidly look to deleverage over the next few years. So that's another factor that comes to bear. So I would say that the 2023 earnings will be a bit below the compounded growth for the overall plan period.

Travis Steed
Analyst at Bank of America Securities

And then divestitures?

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

Listen, when we think about our portfolio management, it's something very actively in our minds. Some are easily executed than others. We have a couple of areas we're working very diligently. One of them is a much faster process, the other one is a little longer. And we're looking at feasibility of the second one, which is a little longer at the moment.

It's all about making sure that Baxter is set up for the future. This portfolio actions that we're going to take and are currently examining are long-lasting initiatives to make sure that Baxter is aligned in allocating capital to the businesses that will be connected to our strategy and our vision in terms of the digital work that we're doing in healthcare, with our ability to deploy our technology across the globe. And right now, Baxter has some businesses that fall - not fall outside our main area of vision. So we're looking at those. I don't have any news about the nature of these businesses. We're probably going to have one action later this year. The second one, we're still analyzing, because of the complexity.

Operator

Joanne Wuensch of Citi is on the line with a question.

Joanne Wuensch
Analyst at Smith Barney Citigroup

Two parts. One, can you quantify the backlog that you're building associated with all these factors? And then second piece of it is, headwinds that are going to roll into 2023 on the revenue side. And thank you for color on the EPS and operating margin side of it.

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

Let me talk about the backlog and Jay will supplement my answer and go to the second part of the question, Joanne. Our backlog has been growing primarily in frontline care. So let me define what we think - how we define backlog because we have two things going on. One is backlog and one is back order.

Our back border is all time high. And what is back order? It is when we take an order and we cannot fulfill 100% of that order. The order is still pending in the system. As soon as we get inventory in the warehouse, it gets shipped to that customer. So, that is all time high at the moment at most probably sevenfold what normally we would see.

Backlog is something new actually because if we don't have to assemble pumps, those pumps don't get into a backlog system. Baxter never used that system, but backlog comes with Hillrom and it's very appropriate for them to look at their business such as this, which is future orders put in the system for delivery in the future. We've been accumulating significant backlog in our frontline care. Right now, we have significant demand, primarily now with the graduation of med school students and students going back. It's one point that we do with that part of the business [Phonetic]. There are other parts of our business, monitors as well, that we feel if we had those chips would have significant revenue increase in the future.

So, we're planning, as we receive those chips, the situation eventually normalizes, the backlog will come back to normal levels. I would say that our backlog today are multiple times what was used to be called normal for Hillrom. And we have also a healthy backlog in our bed system, the traditional Hillrom.

So I want to make sure that you all know that backlog is something new for us. We're going to be talking every call about that and we're telling you right now that backlog is multiple times what is considered normal for Hillrom and Baxter.

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

Looking to 2023, as we think about 2023 sales, there's a couple of factors, headwinds and tailwinds, that are in play here. One headwind for next year is COVID vaccines. We expect that to be a reduction to next year. So that's one factor, and that really hasn't changed since our Investor Day. In addition to that, we don't expect that the chip shortage will be fully alleviated. So we think that will continue to depress the demand to some extent, as we move through next year. Now, I'm hopeful that this will provide an upside for us. But at this point, I don't necessarily see that alleviating.

And then finally, we do hope to have a large volume pump available for the marketplace in 2023. We're extremely excited about all of the work that's going into that, and what that means for the future of our company. So we're hopeful that we will have that to bring to bear in 2023, which would be an upside.

As it relates to margin going into 2023, I guess the big thing I would say is, we are assuming many of the factors that we're experiencing today remain at essentially current levels. And so, we are not anticipating a major alleviation in these product categories. So, that's going to be a continued factor. I'm hopeful that this resolves over time as well, but we've trying to be very, not pessimistic per se, but ultra-realistic as we're looking at the situation. And then, in addition to that, we'll have the continued benefit of Hillrom synergies rolling through to next year's results as a tailwind.

So, that's a little bit of color as we're seeing things shakeout to 2023, but we continue to watch this very carefully.

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

I would just add that we're also excited about the syringe pump that may come faster in terms of approval. They are the large volume parenteral pump, which is the LVP. So, the update is that we are under active review with the FDA on Novum IQ syringe infusion pump. And the large volume infusion pump, it is pending, our response to the FDA additional information request, which we are expecting to respond within this calendar year. And hopefully, both pumps will satisfy the FDA's questions, and hopefully, we can get them approved. But we're excited about the launch of both.

Clare Trachtman
Vice President of Investor Relations at Baxter International

And one comment I would add is that we don't anticipate having the same chip issue with Novum that we are currently experiencing with Spectrum. So we do have some Novum pumps in inventory.

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

Yeah, we have about probably close to 20,000 Novum pumps, large volume pumps in inventory. Yet more will be made preparing for the hopeful launch this year and full next year sales. So, we're working very close to our suppliers, but this is very different. This is a next generation chip, a new generation chip versus what is in Sigma Spectrum.

Operator

Larry Biegelsen of Wells Fargo is on the line with a question.

Larry Biegelsen
Analyst at Wells Fargo & Company

Jay, two to free you. First, simple, on interest expense, based on the $400 million this year, this run rate right now about $440 million, is that how we should think about it for 2023. Or maybe just some color on what you're assuming for rate increases and debt paydown. And then I just have one follow up.

Clare Trachtman
Vice President of Investor Relations at Baxter International

I'll take that one. We do expect interest rates to come down a little bit next year because as we continue to pay off some of our debt balances. So interest rate will come down. It'll be elevated next year, but it won't be at the same level in 2023 as it was this year, given some of our debt paydowns.

Larry Biegelsen
Analyst at Wells Fargo & Company

So, the math I did there, Clare, is probably not the right way to think about it?

Clare Trachtman
Vice President of Investor Relations at Baxter International

You should not take into account any of the term loans that we will pay down.

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

There should be some paid down. Larry, wildcard, what does the Fed do with rate increases, but as we currently see it.

Larry Biegelsen
Analyst at Wells Fargo & Company

Jay, everyone's asked on this call about the macro headwinds. What happens if diesel prices come down? What happens if some of these headwinds ease? Do we get some of this back? What's the right way to think about it, if, actually, some of these prices come down.

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

Larry, the answer is yes. We get benefits. So, we have been severely impacted by a lot of factors. So, the worldwide stress on the supply chain, the inability of our suppliers to supply and that shows up all over the operations of our company. If we do get alleviation of diesel rates, if we get alleviation of the global supply chain crunch, which would allow us to use less expedited freight, if we're able to see some improvement in material inflation, and finally, and perhaps most importantly, if we can run our plants consistently with the products and the inputs that they need, then, yes, the situation will be significantly better than it is today.

Now, the way we've modelled this, as we look to the second half of the year, we are assuming some level of shutdown. We're assuming elevated rates, continued use of expedited freight. So we've got all that embedded. And that's embedded in much of our thinking for 2023. We should get this back at some point. And so, I'm optimistic that this will turn. I just don't know when, and we're not prepared to call that at this stage.

Jose Almeida
Chairman, President & Chief Executive Officer at Baxter International

I'd just underscore the fact that we will have benefits. So, if diesel cuts - goes down 20%, 25%, this directly impacts our ability to ship products, so ship for less money, affects our renal business profitability, as well as surcharges that we're currently getting from our suppliers on every invoice that we pay for shipment of products. So, that is a potential tailwind if the situation turns. We're watching that very closely. But Jay said, we want to make sure that you have a picture of the future as we see today, as we also understand the trends on the market.

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

And to add to that, Larry, if we have normalized back order/backlog levels, that's another tailwind. And we're not there yet. We're not anticipating that we get there in the near term. But to the extent that we secure the critical components that we have, then we'll be able to see some sales uplift as well.

Operator

Joshua Jennings of Cowen is on the line with a question.

Joshua Jennings
Analyst at Cowen and Company

Just wanted to ask, it's only been a couple of months since the Investor Day, but just on the Hillrom sales synergy side of the forecast in the LRP, I know there's a lot of muddling with the supply constraints and then the current environment, but just any data points you can share just in the 2Q in terms of how your outlook of Hillrom synergies are advancing or is evolving?

And then second, Jay, and I think you called here the guidance updates conservatively realistic. And that makes sense. Assuming that the environment stays consistent, have you baked into the guidance update? Where do you see areas of conservatism in this update? I think investors probably concerned about the potential for another revision. Clearly, if the environment gets worse, it will impact the entire group of large cap medtech players. But it seems like the capital spending slowdown that you're assuming by hospitals in the back half, particularly on the PSS and GSS businesses, there's some conservatism there. But are there any other areas of conservatism you've called out in this guidance revision?

James Saccaro
Executive Vice President & Chief Financial Officer at Baxter International

I think, by the way, we will conclude with this question. So, appreciate everybody joining us today. Here's the interesting thing. While the short term has been extremely volatile, as we look at the acquisition of Hillrom, we are very excited about the long-term prospects. So much of the issue that we're seeing relates to shortfalls and components at this point. But as we laid out the strategy for this business over the long term, from a revenue standpoint, from an integration standpoint, all of those elements are in place and continue to excel. Our synergies are doing better than expected. We reflected that in the financials that we've shared with you for this year. Longer term, tremendous opportunity in terms of product combinations. We are really excited about the innovation potential. So, what I would say is a lot has changed since May. And nobody appreciates that more than me. But what has not changed is our real excitement about the acquisition and where we can take it over the long term.

So, we didn't really have revenue synergies meaningfully in the second quarter, but didn't expect that. But as we move forward, the plan in terms of the revenue synergies that we outlined is very much intact.

Now, as we think about conservatism and things of that nature, I guess what I would say is we've taken a perspective on the worldwide situation that we're currently facing, and reflected that in the forecast that we share. And so, where I think there might be some opportunity is, to Larry's question, if diesel improves, if all of the work that we're doing to secure electronic components is successful, those kinds of things are the things that would drive us above this forecast. I think it's an accurate portrayal of kind of where we sit. I'm just hopeful that this situation that we're in, well, I know that, over time, it will resolve. I just can't answer at this point how quickly that will occur.

So with that, I think we appreciate everybody joining us today and we will conclude the call and are obviously available as always for follow-ups. Thank you all very much for joining.

Operator

[Operator Closing Remarks]

Corporate Executives
  • Clare Trachtman
    Vice President of Investor Relations
  • Jose Almeida
    Chairman, President & Chief Executive Officer
  • James Saccaro
    Executive Vice President & Chief Financial Officer
Analysts

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