Baxter's Mixed Message

Baxter (NYSE:BAX) released some good news and a little bad news this week, but investors appear more interested in the latter.

Net income for the quarter climbed 39% year over year, although that kind of earnings growth clearly isn't sustainable. Sales rose just 7% for the quarter -- 3% when excluding changes in currency rates.

Baxter's BioScience division saw the largest revenue increase. Its 20% jump in sales was mainly thanks to ADVATE, its hemophilia A treatment, and increased demand for its vaccines in Europe. Baxter recently received FDA approval for an additional dosage strength of ADVATE, which should help it increase sales of the product further in the coming quarters.

In addition to the sales growth, margin improvements made the largest contributions to Baxter's bottom-line increases. Gross margin rose substantially from 43.6% to 49.2% year over year. Net margins jumped to an impressive 15.2% in the same period, up from 11.7%.

Given the stellar performance for the first half of the year, the company increased its earnings outlook for the entire year to $2.65 to $2.70 per share, compared to its previous guidance of $2.60 to $2.65, excluding special items. It expects sales growth of 4%-5%, excluding the impact of currency rates for the year.

Baxter should really find a place to invest the $2.5 billion it has in the bank. It plans to use some of that to continue its stock buyback program, which it announced in 2006, but I'd like to see it use some of the funds to further increase sales. It could try to develop more products in-house by increasing its research and development budget even further, although this might also be a good time for Baxter to buy one of its smaller partners, like Halozyme Therapeutics (NASDAQ:HALO) or the DynPort Vaccine Company portion of Computer Sciences Corporation (NYSE:CSC).

The one downer for Baxter was the recall it announced Wednesday afternoon on 4,500 of its COLLEAGUE triple-channel infusion pumps. During the earnings conference call, CEO Bob Parkinson said that the company had already solved the software problem and was currently testing the fix. The device is a minimal part of Baxter's total sales, so the recall won't affect its bottom line too much.

The stock ended yesterday down 5%, suggesting that investors are focusing on the recall more than the strong earnings growth. Baxter certainly won't be able to keep earnings growth near 40% -- it can only improve margins so far. But if it can keep sales growth around 7% while holding costs in check, Baxter's stock price should continue the climb it's enjoyed for the past year and a half.

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Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Fool's disclosure policy is rock-solid.