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Baxter International Inc.'s (the company or Baxter) 1998 Annual Report to Stockholders ("Annual Report") contains management's discussion and analysis of financial condition and results of operations for the year ended December 31, 1998. In the Annual Report, management outlined its key financial objectives for 1999. The objectives, which are summarized below, were established based on total company results prior to the July 1999 announcement of the plan to spin off the cardiovascular business as a distribution to stockholders. Refer to Note 2 to the Condensed Consolidated Financial Statements for further information regarding the planned spin-off. Accordingly, the results presented below reflect the combined results of both continuing and discontinued operations.
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RESULTS THROUGH
FULL YEAR 1999 OBJECTIVES SEPTEMBER 30, 1999
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. Increase net sales approximately . Net sales during the nine months ended
10 percent. September 30, 1999 increased 11 percent.
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. Grow net earnings in the low double . Excluding the cumulative effect of a change in
digits. accounting principle in 1999 and charges for
in-process research and development, litigation and
exit and other reorganization costs in 1998, net
income for the nine months ended September 30, 1999
increased approximately 14 percent.
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. Generate $500 million in operational cash . The company generated operational cash flow of
flow, after investing approximately $265 million during the nine months ended
$1 billion in capital improvements and September 30, 1999. The total of capital expenditures
research and development. and research and development expenses for the nine
months ended September 30, 1999 was $705 million.
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RESULTS OF OPERATIONS
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The following management discussion and analysis pertains to continuing operations, unless otherwise noted.
NET SALES TRENDS
Three months ended Nine months ended
September 30, Percent September 30, Percent
(in millions) 1999 1998 Increase 1999 1998 Increase
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International $ 846 $ 787 8% $2,509 $2,261 11%
United States 743 640 16% 2,102 1,841 14%
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Total net sales $1,589 $1,427 11% $4,611 $4,102 12%
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Refer to Note 10 to the Condensed Consolidated Financial Statements for a
summary of net sales by segment.
Blood Therapies
Sales in the Blood Therapies segment increased 14 percent and 17 percent for the three- and nine-month periods ended September 30, 1999, respectively. Strong demand for Recombinate(TM) Antihemophilic Factor (recombinant) generated significant worldwide growth, contributing almost half of the total Blood Therapies business sales growth for both the quarter and year-to-date period. Due to the company's 1998 increase in manufacturing capacity for Recombinate and the strong demand for this product, sales growth was unusually strong in late 1998 and early 1999. While sales for the fourth quarter of 1999 are expected to continue to remain strong, management expects that the fourth quarter sales growth rate will be lower than in the first nine months of the year. Sales of the segment's plasma-based products also contributed strongly to the sales growth for both the quarter and year-to-date period, especially in the United States, as the supply constraints that impacted the entire factor concentrates industry in 1998 have eased somewhat in 1999. Sales in the automated and manual blood-collection businesses had a minor impact on overall segment sales growth.
Renal
The Renal segment generated sales growth of 5 percent and 11 percent during the three and nine months ended September 30, 1999, respectively. International sales were particularly strong in the year-to-date period, with growth generated from the segment's Renal Therapy Services (RTS) business, which operates dialysis clinics in partnership with local physicians and hospitals in international markets. Sales growth for RTS was lower in the third quarter as compared to earlier in the year due to a reduction in acquisitions. This trend is expected to continue for the rest of the year. Domestically, the Renal Management Services business, which is a renal-disease management organization, contributed to sales growth for both the three- and nine-month periods ended September 30, 1999. The base business, which consists of products for hemodialysis and peritoneal dialysis, generated low-to-mid single digit percentage sales growth during the first nine months of the year, with sales growth stronger outside the United States.
I.V. Systems/Medical Products
The I.V. Systems/Medical Products segment generated 14 percent and 10 percent sales growth during the three and nine months ended September 30, 1999, respectively, with strong growth
in both the domestic and international markets. This growth was driven principally by increased sales from a multiyear agreement with Premier, Inc., a major U.S. customer, and strong sales of the Colleague(R) single-channel and triple-channel volumetric pumps in the United States and certain international markets. In addition, the anesthesia business generated significant sales growth for both the quarter and year-to-date period. In April 1998, the company acquired the Pharmaceutical Products Division of The BOC Group's Ohmeda health-care business (Ohmeda), a domestic manufacturer of inhalants and drugs used for general and local anesthesia. In the second quarter of 1999, the company obtained exclusive rights to market and sell the first generic formulation for Propofol approved by the United States Food and Drug Administration. Propofol is an intravenous drug used for the induction or maintenance of anesthesia in surgery, and as a sedative in monitored anesthesia care. This new agreement contributed to third quarter 1999 sales growth and is expected to generate over $50 million in sales in 2000.
The following table shows key ratios of certain income statement items as a percent of sales:
GROSS MARGIN AND EXPENSE RATIOS
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Three months ended Nine months ended
September 30, Increase September 30,
1999 1998 (decrease) 1999 1998 Decrease
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Gross profit margin 44.9% 44.4% 0.5 pts 44.0% 45.1% (1.1 pts)
Marketing and
administrative expenses 20.6% 21.4% (0.8 pts) 20.6% 21.2% (0.6 pts)
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The gross profit margin increased in the third quarter principally due to the
recognition of favorable manufacturing variations in the Blood Therapies
business and a more favorable products and services mix. The gross profit
margin decreased for the year-to-date period primarily due to a less favorable
products and services mix and currency exchange rate fluctuations. In addition,
the gross profit margin decline in the year-to-date period was affected by the
recognition of unfavorable manufacturing variances in the first quarter of 1999
related to increased investments and reduced production in 1998 in the Blood
Therapies segment in response to heightened FDA regulatory activity with respect
to safety and quality systems.
Marketing and administrative expenses decreased as a percent of sales for both the three- month and nine-month periods ended September 30, 1999 as the company effectively leveraged expenses across all segments as a result of strong sales and a focus on cost control. Management expects to continue to decrease the expense ratio during the fourth quarter as it focuses on cost control across all business units, integrates recent acquisitions and implements the reorganization programs discussed below.
RESEARCH AND DEVELOPMENT
Three months ended Nine months ended
September 30, Percent September 30, Percent
(in millions) 1999 1998 Decrease 1999 1998 Decrease
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Research and
development expenses $ 83 $ 89 (7%) $ 242 $ 247 (2%)
As a percent of sales 5% 6% 5% 6%
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Research and development (R&D) expenses above exclude the in-process R&D charge recorded in the second quarter of 1998 relating to the acquisition of Somatogen, Inc. (Somatogen). Refer to Note 5 to the Condensed Consolidated Financial Statements for further information regarding this charge. R&D expenses decreased as a percentage of sales in 1999 as compared to 1998, primarily due to the September 1998 decision to end the clinical development of the company's first-generation oxygen-carrying therapeutic called HemAssist(R)(DCLHb). Excluding R&D expenses relating to the terminated HemAssist program and the Somatogen next-generation program, R&D expenses increased 8 percent and 12 percent in the three and nine months ended September 30, 1999, respectively. Management expects the growth rate in R&D expenses will increase in the future as the company focuses on the next-generation oxygen-carrying therapeutics program within its Blood Therapies segment, as well as on other R&D initiatives across the three segments.
NET LITIGATION CHARGE
As further discussed in Note 8 to the Condensed Consolidated Financial Statements, during the third quarter of 1998, the company recorded a $178 million net litigation charge relating to mammary implants, plasma-based therapies and other litigation.
EXIT AND OTHER REORGANIZATION PROGRAMS
Refer to Note 7 to the Condensed Consolidated Financial Statements for a discussion of the company's charges, utilization of the reserves and headcount reductions to date. During the third quarter of 1998, the company recorded a $122 million charge as a result of the decision to end its first-generation oxygen-carrying therapeutics program, exit certain non-strategic investments, primarily in Asia, and reorganize certain other activities.
The 1998 program is substantially complete. Management believes remaining restructuring reserves are adequate to complete the actions contemplated by the program. Future cash expenditures will be funded by cash generated from operations. The 1995 program has been completed and management's objectives were met for the originally estimated cost. The plant closures and consolidations in Puerto Rico lower manufacturing costs and help mitigate any future exposure to gross margin erosion arising from pricing pressures, primarily in the United States.
OTHER INCOME AND EXPENSE
Net interest expense decreased for the three- and nine-month periods ended September 30, 1999 as compared to the prior-year periods due principally to the impact of a greater mix of foreign currency denominated debt, which bears a lower average interest rate, and lower average debt levels.
PRETAX INCOME
Refer to Note 10 to the Condensed Consolidated Financial Statements for a summary of financial results by segment.
Blood Therapies
The pretax income growth of 42 percent and 19 percent for the three and nine months ended September 30, 1999, respectively, was driven by strong sales, a reduction in R&D expenses
due to the termination of the HemAssist (DCLHb) program, leveraging of marketing and administrative expenses, and fluctuations in currency exchange rates. As discussed above, the gross profit margin for the Blood Therapies segment was impacted in the quarter by the recognition of favorable manufacturing variances and in the year-to-date period by the recognition of unfavorable manufacturing variances. Additionally, the blood-collection businesses generated lower profits in 1999 principally as a result of a less favorable mix of sales, pricing pressures due to competition and continued regulatory activity in the industry, which has affected certain of the segment's customers.
Renal
Pretax income increased approximately 27 percent and 23 percent for the quarter and year-to-date period, respectively. Solid sales growth for both periods and the favorable effect of currency exchange rate fluctuations were partially offset by a less favorable product and services mix, particularly in the year- to-date period, and increased investments in the business.
I.V. Systems/Medical Products
Pretax income increased 35 percent and 12 percent for the three months and nine months ended September 30, 1999, respectively. This growth in profitability for both the quarter and year-to-date period was primarily a result of strong sales and an improved gross profit margin, particularly in the United States, which was partially due to favorable manufacturing variances.
INCOME TAXES FROM CONTINUING OPERATIONS
The effective income tax rate for continuing operations was 26 percent for both the three- and nine-month periods ended September 30, 1999. Excluding the charges for net litigation and exit and other reorganization costs in the third quarter of 1998 and the in-process research and development charge in the second quarter of 1998, the effective income tax rate for continuing operations was 22 percent and 24 percent for the three- and nine-month periods ended September 30, 1998, respectively. The increase in the effective income tax rate for both periods was principally due to a larger portion of the company's earnings being generated in higher tax jurisdictions.
DISCONTINUED OPERATION
Income from the discontinued operation increased by $10 million and $17 million for the three months and nine months ended September 30, 1999, respectively. These results primarily reflect growth in the higher-margin tissue heart valves and valve-repair product lines and favorable currency exchange rate fluctuations, partially offset by reduced profits in certain other product and service lines due to pricing and competitive pressures, loss of a distribution agreement and a reduction in the number of open-heart surgical procedures.
CHANGE IN ACCOUNTING PRINCIPLE
In the first quarter of 1999, the company recorded a $27 million after-tax charge for the cumulative effect of a change in accounting principle. The charge related to the adoption of AICPA Statement of Position (SOP) 98-5, "Reporting on the Costs of Start-up Activities." Excluding the initial effect of adopting this standard, management does not anticipate that the new SOP will have a material impact on future results of operations.
LIQUIDITY AND CAPITAL RESOURCES
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Management assesses the company's liquidity in terms of its overall ability to mobilize cash to support ongoing business levels and to fund its growth. Management uses an internal performance measure called operational cash flow that evaluates each operating business and geographic region on all aspects of cash flow under its direct control.
The following table reconciles cash flow provided by continuing operations, as determined by generally accepted accounting principles, to operational cash flow:
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Nine months ended September 30, (in millions) 1999 1998 --------------------------------------------------------------------------------------------------------------------- Cash flows from continuing operations per the company's Condensed Consolidated Statements of Cash Flows $ 407 $ 345 Capital expenditures (394) (320) Net interest after tax 38 56 Other, including mammary implant litigation 138 (1) --------------------------------------------------------------------------------------------------------------------- Operational cash flow -- continuing operations 189 80 Operational cash flow -- discontinued operation 76 85 --------------------------------------------------------------------------------------------------------------------- Total operational cash flow $ 265 $ 165 =====================================================================================================================Net cash inflows from continuing operations per the company's Condensed Consolidated Statements of Cash Flows increased for the nine months ended September 30, 1999 due principally to higher earnings and a lower increase in the inventory balance, as the company focuses on growing the business while effectively managing inventory levels. These increases were partially offset by higher net cash outflows relating to litigation (litigation payments net of insurance recoveries), higher prepaid expense and other asset balances, and lower liability balances.
Net cash outflows relating to investing activities decreased for the nine months ended September 30, 1999. Capital expenditures were higher for the nine months ended September 30, 1999 as compared to the prior year period as the company increased its investments in various capital projects across the three segments, in particular with respect to the company's Recombinate product in the Blood Therapies segment. Net cash outflows relating to acquisitions decreased during the nine-month period ended September 30, 1999. In 1999, net cash outflows relating to acquisitions included approximately $32 million for a contingent purchase price payment pertaining to the 1997 acquisition of Immuno International AG. Refer to "Part II - Item 1. Legal Proceedings" for further information. Approximately $14 million of the 1999 total related to acquisitions of dialysis centers in international markets and approximately $12 million related to a minority investment. With respect to net cash outflows relating to acquisitions in 1998, approximately $134 million pertained to the acquisition of Bieffe Medital S.p.A., approximately $94 million related to the acquisition of Ohmeda, and approximately $42 million was used for acquisitions of dialysis centers in international markets. Refer to Note 5 to the Condensed Consolidated Financial Statements for further information regarding significant acquisitions.
Net cash inflows provided from financing activities decreased for the nine months ended September 30, 1999. Included in the total for the nine months ended September 30, 1999 was
$198 million in cash inflows relating to the Shared Investment Plan, which is discussed in Note 4 to the Condensed Consolidated Financial Statements. In addition, cash received for stock issued under employee benefit plans increased in the first three quarters of 1999 as compared to the corresponding prior year period. Offsetting these increased inflows was $71 million in cash outflows related to repurchases of Baxter common stock, as further discussed below, increased common stock cash dividends due to a higher number of shareholders, and other factors. The company's net-debt-to-capital ratio was 42.9 percent and 49.8 percent at September 30, 1999 and 1998, respectively.
As authorized by the board of directors, the company repurchases its stock to optimize its capital structure depending upon its operational cash flows, net debt level and current market conditions. In November 1995, the board of directors authorized the repurchase of up to $500 million over a period of several years, of which $267 million was repurchased as of December 31, 1996. No shares were repurchased between the end of 1996 and the end of the second quarter of 1999. As the net-debt-to-capital ratio is now in the low 40 percent range, the company resumed the share repurchase program in the third quarter of 1999 and repurchased approximately 1.1 million shares of its stock at a net cost of approximately $71 million. Management expects to continue to repurchase shares in the fourth quarter of 1999.
The company intends to fund its short-term and long-term obligations as they mature by issuing additional debt or through cash flow from operations. The company believes it has lines of credit adequate to support ongoing operational requirements. Beyond that, the company believes it has sufficient financial flexibility to attract long-term capital on acceptable terms as may be needed to support its growth objectives.
See "Part II - Item 1. Legal Proceedings" for a discussion of the company's legal contingencies and related insurance coverage with respect to cases and claims relating to the company's plasma-based therapies and mammary implants manufactured by the Heyer-Schulte division of American Hospital Supply Corporation, as well as other matters. Upon resolution of any of these matters, the company may incur charges in excess of presently established reserves. While such future charges could have a material adverse impact on the company's net income or cash flows in the period in which they are recorded or paid, management believes that the outcomes of these actions, individually or in the aggregate, will not have a material adverse effect on the company's consolidated financial position.
YEAR 2000
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The company is implementing, a comprehensive program to address Year 2000 issues pertaining to both information technology (IT) and non-IT systems. The program is monitored by a steering committee comprised of senior management in key functional areas, which periodically reports to the audit committee of the board of directors as to the program's status. The program consists of identification, compliance and post-implementation phases and considers the effect of the Year 2000 on the company's internal systems, customers, products and services, and manufacturing systems, as well as on its suppliers and other critical business partners. The current status of these areas of scope vary within the post-implementation phase, with substantially all implementation efforts complete. The entire program is expected to be fully implemented by the end of 1999.
The company has been upgrading, replacing or modifying non-compliant internal systems. As of September 30, 1999, substantially all major system upgrades, replacements and
modifications are complete. All necessary remaining upgrades, replacements and modifications to non-compliant internal systems are expected to be complete by the end of 1999.
The total cost to upgrade or replace IT systems that would not have been Year 2000 ready is estimated to be approximately $145 million. Substantially all of the total expenditures required to address Y2K issues has been expended as of September 30, 1999, with the remainder to be expended by the end of 1999. None of the company's systems are being upgraded or replaced solely to address Year 2000 issues, although in some cases the timing of the system upgrades and replacements was accelerated.
Compliance checking of products has been completed and fewer than 20 products were identified to have Year 2000 issues. Substantially all product modifications and replacements have been completed as of September 30, 1999. The remaining modifications and replacements are expected to be completed in accordance with timetables requested by the impacted customers. The company's Year 2000 customer website includes a complete list of the company's electronic medical products, frequent and detailed updates regarding the status of Year 2000 affected products, a product supply requirements policy addressing Year 2000 supply chain issues, Year 2000 transition information and other information regarding the company's Year 2000 program.
The company is actively addressing systems in its manufacturing plants and other facilities. Substantially all of the required changes for date-dependent manufacturing items have been implemented as of the end of the third quarter of 1999, consistent with management's expectations. All necessary changes are expected to be completed by the end of 1999. In addition, the company has been communicating with critical suppliers and other business partners to determine the extent to which any Year 2000 issues affecting such third parties will affect the company. Such communications have included solicitation of written responses to questionnaires and follow-up meetings as needed. To date, the company has achieved responses from substantially all of the critical supplier questionnaires. Such communications are ongoing and are expected to continue through the end of 1999, with action plans developed and implemented as necessary.
Based upon the company's current estimates, and information available at this time, incremental out-of-pocket costs of the Year 2000 program, which are required to be expensed as incurred, have been and are expected to be immaterial to the company's financial results. A large part of the Year 2000 effort has been accomplished through the redeployment of existing resources. The cost of such redeployment or of internal management time has not been specifically quantified. However, no critical projects of the company have been deferred due to the Year 2000 program.
Management of the company believes that its program will be effective to resolve the Year 2000 issue in a timely manner. The company has, however, been formulating contingency plans to address any situations that may arise in which the readiness of the company's internal technology or that of third parties is not reasonably expected to be adequate, and where practical alternatives are available. The company has been assessing the viability of the entire supply chain and is in the process of finalizing any necessary and feasible contingency plans accordingly. Current contingency planning centers on human resource issues, inventory management, and the development of a rapid response capability and monitoring process for critical communications during the transition into the Year 2000. To accumulate ongoing input
into the contingency planning process, the company has been meeting regularly with key health-care industry leaders, contacting customs officials and monitoring the Year 2000 status of key customers, distributors and suppliers. Key company management and other critical resources have been identified to be available during the transition into the Year 2000 to address any business needs and communicate as needed with employees, customers, suppliers and other business partners,
Management does not believe there has been or will be a significant disruption to the company's business due to the Year 2000 remediation effort. However, there can be no assurance that the company's Year 2000 program or the programs of critical business partners will be successful. Any failure to adequately address the Year 2000 issue could significantly disrupt the company's operations and possibly lead to litigation against the company. The costs and expenses associated with any such failure or litigation, or with any disruptions in the economy in general as a result of the Year 2000, are not presently estimable, but could have a material adverse effect on the company's business and results of operations.
FORWARD-LOOKING INFORMATION
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The matters discussed in this section that are not historical facts include forward-looking statements. These statements are based on the company's current expectations and involve numerous risks and uncertainties. Some of these risks and uncertainties are factors that affect all international businesses, while some are specific to the company and the health-care arenas in which it operates. The factors below in some cases have affected and could affect the company's actual results, causing results to differ, and possibly differ materially, from those expressed in any such forward-looking statements. These factors include technological advances in the medical field, unforeseen information technology issues related to the company or third parties, economic conditions, demand and market acceptance risks for new and existing products, technologies and health-care services, the impact of competitive products and pricing, manufacturing capacity, new plant start-ups, global regulatory, trade and tax policies, continued price competition, product development risks, including technological difficulties, ability to enforce patents and unforeseen commercialization and regulatory factors. In particular, the company, as well as other companies in its industry, is experiencing increased regulatory activity by the U.S. Food and Drug Administration with respect to its plasma- based biologicals and its complaint-handling systems.
Currency fluctuations are also a significant variable for global companies, especially fluctuations in local currencies where hedging opportunities are unreasonably expensive, or altogether unavailable. If the United States dollar strengthens against most foreign currencies, the company's growth rates in its sales and net earnings will be negatively impacted.
Management believes that its expectations with respect to forward-looking statements are based upon reasonable assumptions within the bounds of its knowledge of the company's business and operations, but there can be no assurance that the actual results or performance of the company will conform to any future results or performance expressed or implied by such forward-looking statements.
NEW ACCOUNTING STANDARD
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In June 1998, the FASB issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" (Statement No. 133) which was to be effective for all fiscal quarters of fiscal
years beginning after June 15, 1999. In June 1999, the FASB issued Statement No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133" (Statement No. 137). Statement No. 137 deferred the effective date of Statement No. 133 to all fiscal quarters of fiscal years beginning after June 15, 2000. Statement No. 133 requires that all derivatives be recorded in the balance sheet as either assets or liabilities and be measured at fair value. If certain conditions are met, a derivative may be specifically designated as (i) a hedge of a recognized asset or liability or an unrecognized firm commitment, (ii) a hedge of the exposure to variable cash flows of a forecasted transaction, or (iii) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. Management is in the process of evaluating this standard and has not yet determined the future impact on the company's consolidated financial statements.
Review by Independent Public Accountants
Reviews of the interim condensed consolidated financial information included in this Quarterly Report on Form 10-Q for the three months and nine months ended September 30, 1999 and 1998 have been performed by PricewaterhouseCoopers LLP, the company's independent public accountants. Their report on the interim condensed consolidated financial information follows. There have been no material adjustments or disclosures proposed by PricewaterhouseCoopers LLP, which have not been reflected in the interim condensed consolidated financial information. This report is not considered a report within the meaning of Sections 7 and 11 of the Securities Act of 1933 and therefore, the independent accountants' liability under Section 11 does not extend to it.
Report of Independent Accountants
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To the Board of Directors and Stockholders of Baxter International Inc.
We have reviewed the accompanying condensed consolidated balance sheet as of September 30, 1999 and the related condensed consolidated statements of income for the three-month and nine-month periods ended September 30, 1999 and 1998, and condensed consolidated statements of cash flows for the nine-month periods ended September 30, 1999 and 1998 of Baxter International Inc. and its subsidiaries. This interim financial information is the responsibility of the company's management.
We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying interim financial information for it to be in conformity with generally accepted accounting principles.
We previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet as of December 31, 1998, and the related consolidated statements of income, cash flows and stockholders' equity for the year then ended (not presented herein), and in our report dated February 5, 1999 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet information as of December 31, 1998, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.
PricewaterhouseCoopers LLP Chicago, Illinois November 12, 1999