Pharmaceuticals & Medical Equipment

INITIATING COVERAGE REPORT

William C. Dunkelberg Owl Fund th March, 17 2014 Michael Lam: Lead Analyst mlam@theowlfund.com Ethan Friedland: Associate Analyst efriedland@theowlfund.com Niclas Dombrowski: Associate Analyst ndombrowski@theowlfund.com

Baxter International, Inc.

Exchange: NYSE Ticker: BAX Target Price: $79.57
COMPANY OVERVIEW Baxter International Inc is a diversified health care company that derives its sales from the US (42.28% of revenue), Europe (30.13%), Asia-Pacific (15.58%), and Latin America and Canada (12.01%). Baxter manufactures in 30 countries and sells its products in over 100. Baxter is divided into two segments: BioScience and Medical Products. The BioScience segment accounts for 43% of revenue and 63.5% of pretax income. The segment includes processing plasma based proteins to treat hemophilia and other blood disorders, plasma based therapies, biosurgery products and some vaccines. The reported sub-segments include Hemophilia (22.5% of total revenue), Bio Therapeutics (13.9%), Bio Surgery (4.7%) and Vaccines (1.9%) The Medical Products segment accounts for 57% of revenue and 36.5% of pretax income. The segment includes IV products, premixed drug systems, pre-filled vials and syringes, infusion pumps, and inhalation anesthetics. Services included are pharmacy compounding, drug formulation, and renal therapies and dialysis. The reported sub-segments include Fluid Systems (20.4% of total revenue), Specialty Pharmaceuticals (9.9%), and BioPharma Solutions (6.5%). INVESTMENT THESIS

Sector Outperform Recommendation: BUY

Key Statistics:
Price Return Shares O/S (mm) Market Cap (mm) $66.49 22.57% 1,010 $36,257 52 Week Low 52 Week High Yield Enterprise Value $62.80 $74.60 2.94% $8,094

Earnings History:
Quarters 1Q13 2Q13 3Q13 4Q13 EPS $1.055 $1.218 $1.190 $1.258 Rev. YoY 1.77% 2.72% 8.43% 16.39% Price -1.89% 0.05% -0.47% -1.06%

Health Care:

BAXs multiple and price was heavily discounted due to deep concerns on the expected increasing competition in its largest business sub-segment, Hemophilia. The competition is expected to provide a longer acting drug that will steal market share from BAX. These expectations caused a number of analyst downgrades at the end of September 2013, where the company dropped 12% within the week. BAX is currently trading at a 18% discount to its implied NTM Price to Earnings ratio against its weighted peer group. However, BAX is still one of the most diversified healthcare companies in the world with a wide economic moat built through its diversification, scope and scale, and intangible assets. Moving forward; further development of BAXs pipeline, the growth and efficiency provided by Gambro, managements business optimization initiatives, and industry tailwinds should sustain growth and boost earnings. This will result in BAX returning to normal trading levels to yield a total gain of 22.57%.

Earnings Projections:
Year 2011 2012 2013 2014e 2015e Q1 $0.973 $1.009 $1.055 $1.083 $1.213 Q2 $1.059 $1.170 $1.218 $1.277 $1.370 Q3 $1.083 $1.147 $1.190 $1.323 $1.427 Q4 $1.160 $1.070 $1.258 $1.435 $1.540 Total $4.28 $4.40 $4.72 $5.12 $5.55

All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via CapIQ, Bloomberg and other vendors. The William C. Dunkelberg Owl fund does and seeks to do business with companies covered in its research reports.

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RISKS Competition: Any acceleration in the production of a competitors pipeline or new entrance will result in a loss of market share in key high margin areas, and lower brand recognition leading to a slowdown in earnings and sales growth. Pipeline Failure: Any bad news in relations to the pipeline would delay the release of profit earning products. Inability to stay ahead will need to loss of industry leader status and erode brand recognition. Regulations: Increased regulation or increased reimbursement pressure would adversely affect top line growth and shrink bottom line potential growth. International: BAX is an international company with 57% of sales derived outside of the US. Currency fluctuations, downgrade in emerging market growth, or international crises would take away from top line growth.

CATALYSTS Drug Development: BAXs pipeline has 53 drugs within different stages of clinical trials. Key drugs set to launch this year include: HyQvia, Rixubis, OBI-1, and FEIBA prophylaxis. Key drugs in Phase III trials include: BAX 855, BAX 111, and BAX817. The execution of the development and launches of these drugs are crucial for the company to accelerate growth, diversify BAXs product mix, and combat new competition. BAX has shown its commitment through an increase in R&D and SG&A margins to ensure the successful development and launch of these drugs. Gambro: Gambro is a medical technology company based in Sweden that manufactures products for Dialysis treatment. BAX acquired Gambro in September 2013 for $4 billion. With the acquisition of Gambro completed, BAX expects to enhance its market leading position in Renal, optimize manufacturing, create efficiencies through its current Real business, and boost penetration rates in key products and demographics. Gambro will create deal synergies of about $300 million by 2017 and accretion of $135 million in 2014. Expectations are that by 2015, 80% of the expected synergies will be realized. Business Optimization Initiative: Management has committed to the optimization of its business through initiatives to grow margins and earnings. In 2013, there were eliminations of a number of positions to streamline operations, rationalize manufacturing footprint, and optimize general and administrative functions in 2013. The savings from these initiatives should add $0.13 to 2014 earnings, and $0.17 to 2015 earnings. Management plans to reinvest a portion of these savings into activities to support the global launch of new products. Industry Consolidation: The increased regulation and charges such as the device tax creates a difficult environment for smaller competitors. This added market requirement will also raise the barriers of entry for the small competitors, allowing for the large companies to develop larger market share. BAX will be able to more easily navigate these changes through its size and diversification. Although the company has just completed a major acquisition, BAX is still committed to capitalize on possible acquisitions to grow market share growth.

ECONOMIC MOATS: Summary: BAX has a wide and stable economic moat. The moat has been developed through constant innovation, a commitment to R&D, and market leading products. The moat stems from 3 major advantages: Diversification, Economies of Scale and Scope, and Intangible Assets. Diversification: BAX operates as a biotech, a medical device, and a specialty pharmaceutical firm with operations in over 30 countries. The diversification offers efficiencies between departments, convince for customers, and low reliance on specific business units. Scale/Scope: With only a few competitors in the BioScience industry, specifically in Hemophilia and Plasma production, efficient scale is created through oligopolistic competition. Scope is achieved in the medical product segment where cross selling and diversification allows for a cost advantage. Intangible Assets: Includes strong brand recognition, patent protection, and pipeline development. With over 70% of sales from market leading products, and a brand recognized of safety and efficiency along with patent protection; allows for pricing power on premium products.

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TARGET PRICE
The target price is computed using a weighted comparison group. The target multiple is the weighted average of the implied multiples that BAX trades at against its peer groups, yielding a target NTM P/E of 15.88x. The target multiple is multiplied by consensus NTM EPS of $5.01 per share to yield $79.57 price target. After factoring the companys 2.90% dividend yield results in a projected return of 22.57%.

PEER GROUP IDENTIFICATION

Bioscience Peer Group - (43% of revenue)
o o o o o Biogen Idec Inc. (NasdaqGS:BIIB) Bayer AG (DB:BAYN) Novo Nordisk A/S (CPSE:NOVO B) CSL Ltd. (ASX:CSL) Grifols, S.A. (CATS:GRF)

Medical Product Peer Group - (57% of revenue)

o o o Becton, Dickson and Co. (NYSE: BDX) Covidien PLC (NYSE COV) CareFusion Corporation (NYSE:CFN)

Peer Analysis Target Price= $79.57

Relative Target Multiple = 15.88.x NTM Forecasted EPS = $5.01

INDUSTRY ANALYSIS BioScience The hemophilia market is expected to growth by a CAGR of 5.9% till 2016 to a market volume of $11.4 billion due to increased recombinant and prophylaxis use, and growing treatment and volumes per patient in emerging markets. The market in whole faces greater competition due to more companies having developed sufficient therapies. Barriers of entry for the hemophilia A market, 70% of the total hemophilia, are high because of the difficult production process and lack of an recent extension to the half-life of proteins. However for hemophilia B, there have been developments that have increased the half life of drugs which has slightly lowered the barriers of entry. Approximately 400,000 patients are believed to have hemophilia A globally, where only about one-third of patients is diagnosed and receives treatment. About 80,000 people are estimated to have hemophilia B globally, but only roughly 30% of them are diagnosed and treated. Another trend has been the growth of the plasma fractionation market, where capacity and production has grown at 10% in the past decade. In response to these trends, BAX has gained more emerging market exposure such as with is partnership in Brazil, developed long acting products (BAX 885), and expanded its plasma capacity by investing in a new facility. Medical Products Economic weakness and high unemployment rates from the latest financial crisis have caused lower hospital utilization, higher uncompensated care costs and decreased hospital capital expenditure resulting in slowdown in demand for medical products. Revenues are expected to rise in the upper single digit rate from macroeconomic improvements, new products, expansion into emerging markets, and industry consolidation. Headwinds include lower capital expenditures and longer replacement cycles at US hospitals, pricing pressures, European austerity policy, and currency risk. The medical device tax of 2.3% on sales as part of ACA, pressures companies to align costs to prevent lower profit margins and increases industry consolidation. In the long run, aging populations, especially in the USA, Europe and Japan, increasing global demand and spending for health care products stimulate steady growth. According to GlobalData, the renal denervation market is expected to benefit from the general market rebound, decreases in international barriers, and increased global demand. The expected growth in these markets will be tailwinds for BAXs medical products unit, especially with its increased exposure in the renal denervation space with its acquisition of Gambro.

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PRODUCT ANALYSIS Overview BAX has developed a diversified product line offered worldwide and specifically gained brand recognition as the leader in the treatment of Hemophilia, Immune Disorders, and Alpha-1 Antitrypsin deficiency; with initiatives to expand deeper in the fields of Renal Denervation and Oncology. BAX currently has 53 drugs in the pipeline where a product has either been Launched (25), Registered (2), Pre-registration (1), Phase III (6), Phase II (5), Phase I (3), Clinical (1), and Discovery (10). As of now, BAXs key drug offerings with significant developments are within the categories of Anesthesia, Immunoglobulin, Hemophilia, Biotherapy, and Renal. o Anesthesia: The key drugs include Suprane and Forane which are the liquids that vaporized to create general inhalant for anesthetic purposes. There are concerns of increased competition and sales erosion for Suprane. o Immunoglobulin: Includes its key offering Gammagard, and is used to treat immune deficiencies, and bacterial infections. The expected US launch of HyQvia is expected to boost sales and growth of this segment. o Hemophilia: This segment includes BAXs gold standard products such as the high margin Advate and Recombinate drugs used to combat Hemophilia. Concerns for this segment are an increase in competition from longer acting products that could reshape the industry leaders. New drug launches and a diversified business should help BAX navigate through these changes until the release of its own long acting product BAX 855. o Biotherapy: The major product with significant implication is the generic Cyclophosphamide, which is an injection used to treat specific cancers. BAX is anticipating an increase in competition and a loss of market share. o Renal: Includes Peritoneal Dialysis and Hemodialiys which is the process of removing waste and excess fluids from the body created from Renal denervation. The segment is expected to grow at a faster face due to the acquisition of Gambro. Pipeline Highlights o BAX855: BAXs longer acting equivalent to Advate, BAXs top hemophilia a drug, is currently in Phase III of clinical trials. The product is expected to file for approval at the end of 2014, and launch in the middle of 2015. o BAX817: The recombinant factor for the treatment of both hemophilia A and B with inhibitors, expected to launch in 2016 o BAX 111: The recombinant form to treat Von Willebrand diseases, a bleeding disorder where the blood is not able to clot properly. Currently in Phase III trials with a target launch in 2014 o HyQvia: The long acting version on BAXs immunoglobulin product Gammagard, a liquid antibody to treat immune disorder. The product received regulatory approval in Europe and is expected to be launched in America in the second half of 2014. o RIXUBIS: The recombinant factor drug used to treat, prevent or reduce the frequency of bleeding for hemophilia B patients. The product is expected to launch in the US in the first half of 2014 o FEIBA: The anti-inhibitor blood clot preventive drug for hemophilia patients with inhibitors. FDA approved at the end of 2013, and officially launched in the US in the first half of 2014. o OBI-1 Used for acquired hemophilia and delivered via an IV treatment. Launch date is expected for the second half of 2014

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FINANCIALS Revenue Total revenue has grown at a CAGR of 5.91% since 2010 with consensus estimates expecting a CAGR of 4.86% for the next 3 years. Sales are primarily contract based with the end clientele mainly being hospitals, facilities, and doctor offices. Growth projections for 2014 are in the upper single due to the contribution from Gambro, international expansion specifically in Brazil, and new product launches. BioScience revenue has grown at a 5.19% CAGR since 2010 driven primarily by its key drug Advate, new product launches, and expansion of its international footprint. Expectations are that sales will continue to grow at an annual average of 3- 4% as BAX continues to innovate current drugs, and launch new ones. Growth projections have been dampened due to an expect loss in market share due to completion in the Hemophilia sub-segment from longer acting products. Medical Products revenue has grown at a CAGR of 6.48% since 2010 driven by growth by the acquisition of Gambro, and an increase in worldwide demand. Guidance is for the segment to grow in the lower double digits in 2014 due to the accretion, the increase in penetration, and commercial synergies created by Gambro. Headwinds for growth include expected competition within the generic cyclophosphamide and a slowdown in China demand. Overall, there are concerns about BAXs ability to grow sales with the expected increase in competition in the Hemophilia market. BAX still remains one of the more diversified healthcare companies that will be able to source its growth through different business segments and geographic locations. BAX has committed to the expansion of its other businesses such as with Gambro, increase international exposure as with its recent agreement with Brazil, and invested heavily in pipeline development. These developments should ease the initial loss of market share in the Hemophilia market until BAX releases its long acting drug, BAX855, in late 2015. Margins: Gross margin has fluctuated between 50% and 52% between 2010 and 2013 and is currently at 51.1%. EBITDA margin has ranged between 26% and 27% 2010 and is currently at 26.1% due to the increased restructuring and merger expenses associated with the integration of Gambro, increased SG&A, and increased R&D. Net margin has been as low as 11.1% in 2010 and as high 16.4% in 2012, with the current margin at 13.2%. GM is expected to decrease by 1.5% in 2014 due to the lower margin business of Gambro, and currency related issues. However EBITDA margin and Net Margin is expected to increase due to the lower restructuring costs, the efficiencies of Gambro, and the effects of the business optimization initiatives.

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The Bioscience segment accounts for 63.5% of total pre-tax income, and operates with on a 37.10% pre-tax income margin. In comparison, the Medical Supplies segment accounts for 36.5% of total pre-tax income, and operates on a 16.08% pre-tax income margin. The segment is more profitable than its counterpart because of the high margin nature, premium pricing, and efficient scale of the pharmaceutical industry versus the medical supplies industry. The margins in the BioScience are expected to face some near term pressure due to the expected release of its competitors longer acting hemophilia drug. However, BAX margin should stabilize due to the expected filing and release of new drugs, and emerging market expansion. The margin in the Medical Supplies unit is expected to increase as the BAX begins to realize efficiencies from its Gambro acquisition. R&D R&D expense was accelerated in 2013 to 8.17% of sales versus the average its 3 year average R&D margin of 6.9%. The increase shows BAXs intent on innovating current products, expanding discovery efforts, and accelerating the current pipeline. Part of this increase is due to Baxters establishment of Baxter Ventures in July of 2011, a strategic initiative t o invest up to $200 million in early-stage companies developing products and therapies to accelerate innovation and growth for the company. Through December 31, 2013, over 25% of Baxter Ventures funds hav e been invested, including in therapeutic areas such as immunology, hematology and renal. Also Baxters BioScience business has been actively engaged in investigating new potential biosimilar and oncology treatments, primarily through business collaborations. Included in Baxters R&D activities in 2013 were upfront and milestone payments of $103 million related to collaboration arrangements and $73 million related to business optimization charges. SG&A: SG&A is important for BAX to incur in order to educate current and potential customers about the complex product and to expand its customer base. In 2013 the SG&A ratio was 24.12% and represents a ratio growth of 2.5% since 2009. SG&A expense in 2013 increased by 10.74% YOY due to the Gambro acquisition. However, the increase in revenue of 7.53% offset the major rise in SG&A expenses. Although the increase in SG&A takes away from the bottom line, the increase is necessary to raise aware, educate clients, and develop strong relationships. Earnings BAXs earning breakdown equates to a 63.5% BioScience and 37.5% Medical Supplies split due to the high margin business and the pricing power that BAX commands within the BioScience segment. BAX missed earnings on Q3 2013 but has consistently beat earnings since the end of 2009, representing 14 consecutive earnings beat. Earnings have grown at a CAGR of 3.66% between 2008 and 2012. However, 2013s EPS was a YOY 12% decrease primarily due to an addition $200 million associated with restructuring and merger relation expense specifically related to Gambro. Guidance for 2014 is $5.05 to $5.25, which accounts for an 8.37% to 12.66 % growth from the adjusted 2013 EPS. Growth in earnings stems from the business optimization initiatives, and the growth and efficiency benefits from Gambro.

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Shareholder Return: BAXs dividend is currently 2.95%, representing a payout ratio of 49.70% and a 5 -year dividend growth of 15.47%. With the goal of paying down $1 billion of debt over the next 2-3 years, BAX is expected to bring down the payout ratio to 38.25% during that period. However, after this period, the payout ratio is expected to increase at an annual average of 5.93% for the next 3 years. BAX repurchased shares in the amount of $405 million in 2013, and management expects to buy back about $300 million in 2014. BAX has committed to returning 35-40% of FCF to its shareholders. Debt:

BAXs capital structure has become highly leveraged due to the large amount of debt issued to complete the acquisition of Gambro AB. As of 2013, the debt to equity ratio (D/E) is 108.01% and debt to capital (D/C) is 51.93%, which is a significant increase when compared with 2009s D/E of 55.94% and D/C of 35.87%. Since then, D/E increased year over-year by 10%, with a hike of 20% from 2012s D/E of 84.98% to 108.01% in 2013. BAXs capi tal ratios are well above the comps average D/E of 54.20% and D/C of 32.65%. The long-term debt portion represents about 89% of total debt; where 11% ($1.04B) is due within the next year. Additionally, having a revolving credit line of $1.8B for the next two years and a cash flow from operations enables BAX to meet its liabilities. With a current ratio of 1.69 and an interest coverage ratio of 11.86x, BAX is able to efficiently manage its debt. Furthermore, management committed to pay down over $1B within the next 2-3 years. Free Cash Flow From 2009-2013 FCF has decreased at a CAGR of (3.07%) due to an increase in CAPEX, mostly from M&A activity like the acquisition of Gambro. CAPEX is expected increase to $1.8 billion for 2014 due to Gambro expansion plans and a plasma manufacturing in Georgia. However, 2014 will be the peak value in CAPEX, with expectations that CAPEX will decrease to $1.5 billion in 2015, and decrease each subsequent year. Operating cash flow has grown at a CAGR of 6.49% in the same time period, and expected to grow at a 4.5% annual growth rate due to the expected product launches, and incremental cash flow generated by Gambro. The expected decrease in CAPEX and the expected growth in FCF will increase FCF by a CAGR of 8.65% till 2016.

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VALUATION Undervaluation Investors continue to heavily discount BAX due to concerns surrounding the expected competitive pressures that BAX will face in the Hemophilia market, specifically from Biogen, Novo Nordisk, and Bayer. The main concern stems from Biogens Elocate, a longer acting product, which is set for approval in the second half of 2014. This puts considerable pressure on BAXs Hemophilia sub segment, the largest business segment by sales and earnings. JP Morgan was the first to initiate the concerns and downgraded BAX from Outperform to Neutral, dropping the stock 6% on the day and as low as 12% within the week. BAX is also expecting an increase in competition for its generic cyclophosphamide and is currently waiting for companies to file for a new drug application. Within the last year BAX has underperformed the Healthcare industry due to the concerns listed above where BAX now trades at a 28% discount to the S&P 500 Healthcare Index on a P/E base versus a 5 year average of trading in line with the index. Against the S&P 500 Healthcare Pharmaceuticals Index BAX is currently trading at 26% discount versus its 2% discount on a 5 year average on a P/E basis. Against the S&P 500 Healthcare Equipment Index, BAX is currently trading at a 20% discount versus its 16% five year average on a P/E basis. Discounted Cash Flow

WACC 9.213x

EM Method EM:10.0x $78.75

GP Method GP: 3.5% $77.62

Assumptions: The 7 years CAGR sales growth of 4.3 % is derived through the expected growth stated by management in each segment, driven by a combination of geographic expansion and product launches. Gross margins decreases initially due to increase participation in lower margin business, but expand back to historical average after efficiencies are realized and new product launches throughout 2015. EBITDA margin grows with expectation of cost efficiencies through Gambro synergies and managements business optimization initiatives . Depreciation historically has been around 4.5% of sales; the initial increase is account for the recent increase in Capital Expenditures., but begins to decrease back to historical averages. Capital Expenditures is forecasted to be $1.8 billion 2014, but 2014 represents the peak with expectation that the expenditures will decrease in each subsequent year. WACC The WACC is calculated to be 9.239% using the 5 year average weights of 84% for Equity and 16% for Debt. Cost of capital of 9.239% is calculated using CAPM, with a risk free rate of 2.65 %, a market risk premium is 10.14%, and using a 3 year daily beta of .88. The cost of debt of .28% is calculated using the pre-tax weighted cost of ST debt of 21% and interest rate of .34%, the pre-tax weighted cost of LT debt of 89% and interest rate of 2.43%, and the effective tax rate of 33.86%. An additional 1.5% was added to accommodate for the increased risk from new competition, and emerging market uncertainty. Price Targets For the EV/EBITDA method, the implied EV/EBITDA of 10.0x is derived from the relative valuation. This method yields an enterprise value of $40,873.56, an equity value of $42,759.56, and a price target of $78.75 per share. Management expects to FCF to continue growing at low single digit % rate, a 4% rate is used for the growing perpetuity This method yields an enterprise value of $40,263.2, an equity value of $42,149.2, and a price target of $77.62 per share.

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Peer Group Valuation

The relative valuation is completed using two peer groups there were weighted to match BAXs revenue breakdown. Companies used in the Bioscience relative valuation include Biogen, Bayer AG, Novo Nordisk A/S, Grifols, and CSL Ltd. On a 5 year P/E basis, BAX trades at a 29% discount against this group and is currently at a 35% discount. Companies used in the Medical Supplies relative valuation included: Becton Dickson and Co, Covidien PLC, and Care Fusion Corp. On a 5 year P/E basis, BAX trades in at a 5% premium against this group but is currently at a 17% discount. The peer groups include companies that are direct competitors with similar products and geographic location. The price target was achieved by obtaining a weighted average of the implied NTM P/E using the revenue breakdown as the weights to receive a 15.88x multiple. Because Biogen has not yet released the Elocate product, it was excluded in the final calculations. Through the catalyst stated in the previous sections, BAXs multiples should expand back to normal trading levels; resulting in an 18% multiple expansion from its current NTM P/E of 13.36x. Using the implied forward P/E multiplied by consensus EPS estimates of $5.01 per share yields a price target of $79.57. After accounting for a dividend yield of 2.90%, the total return equates to 22.57%.

Implied P/E

Consensus EPS

Target Price $79.57

15.88x

$5.01

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Appendix 5 Year P/E vs. SP 500 Healthcare

5 Year PE vs Bioscience comps

5 Year PE vs Medical Products comps

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DISCLAIMER This report is prepared strictly for educational purposes and should not be used as an actual investment guide. The forward looking statements contained within are simply the authors opinions. The writer does not own any Baxter International, Inc. stock. TUIA STATEMENT Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his tireless dedication to educating students in real-world principles of economics and business, the William C. Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging, practical learning experience. Managed by Fox School of Business graduate and undergraduate students with oversight from its Board of Directors, the WCD Owl Funds goals are threefold: Provide students with hands-on investment management experience Enable students to work in a team-based setting in consultation with investment professionals. Connect student participants with nationally recognized money managers and financial institutions

Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs and partial scholarships for student participants.

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