Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

RESTATEMENT OF PREVIOUSLY ISSUED CONSOLIDATED FINANCIAL STATEMENTS

As discussed in Note 1A to the consolidated financial statements, the company has restated its previously issued financial statements for the years ended December 31, 2001, 2002 and 2003 and the first quarter of 2004. The restatement is primarily the result of the inappropriate application of accounting principles for revenue recognition and inadequate provisions for bad debts in Brazil during the period. Refer to Note 1A for further information, including the impact of the restatement for each of the restated periods included in this filing. As a result of the restatement, in aggregate, net sales decreased $37 million (0.2% of the originally reported amount) and net income decreased $33 million (1.5% of the originally reported amount) over the three-year period ended December 31, 2003.

Refer to the company’s Form 10-K/A for the year ended December 31, 2003 (which reflects the above-mentioned restatement) for management’s discussion and analysis of financial condition and results of operations of Baxter International Inc. and its subsidiaries (the company or Baxter) for the year ended December 31, 2003. The following is management’s discussion and analysis of the financial condition and results of operations of the company for the quarter ended March 31, 2004. For the first quarter of 2004, net sales were unchanged as a result of the restatement and net income decreased $2 million (1.1% of the originally reported amount). For the first quarter of 2003, net sales decreased $2 million (0.1% of the originally reported amount) and net income decreased $2 million (0.9% of the originally reported amount). The information in this discussion and analysis reflects this restatement, but is not otherwise updated.

Currency exchange rate fluctuations benefited sales growth by 7 points during the three months ended March 31, 2004 principally because the United States Dollar weakened since the prior year quarter relative to the Euro. These fluctuations impacted sales growth for all three segments. Refer to Note 8 to the condensed consolidated financial statements for a summary of net sales by segment.

Medication Delivery

The Medication Delivery segment generated 9% sales growth during the three months ended March 31, 2004 (including 5 percentage points due to the favorable impact of foreign currency fluctuations), with the strongest sales growth in international markets. Increased sales of certain generic and branded pre-mixed drugs and drug delivery products contributed 2 points of sales growth. Sales of intravenous therapies, which principally include intravenous solutions and nutritional products, contributed 4 points to the segment’s growth rate for the quarter. Sales of anesthesia and critical care products contributed 1 point to the growth rate, primarily due to increased sales of certain generic drugs. Sales of electronic infusion pumps and related tubing sets also contributed 1 point to the growth rate. Partially offsetting the growth in these product lines was the impact of management’s 2003 decision to exit certain lower-margin distribution businesses outside the United States. The segment’s sales growth in the United States during the first quarter of 2004 was not significantly impacted by the renegotiated long-term contracts with group purchasing organizations, principally Premier Purchasing Partners L.P. (Premier), the most significant of which became effective in February 2004. While sales growth during the remainder of 2004 is expected to be impacted by the reduced pricing included in these contracts, management believes that over time, the impact of reduced pricing will be substantially offset by increased sales volumes and product mix upgrades.

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BioScience

Sales in the BioScience segment increased 9% for the three months ended March 31, 2004 (including 7 percentage points due to the favorable impact of foreign currency fluctuations), with sales growth strongest in the United States. The primary driver of the segment’s growth rate for the quarter was increased sales of recombinants, contributing 6 points of growth. Recombinant growth was principally fueled by higher demand for Recombinate Antihemophilic Factor (rAHF) (Recombinate), as well as the launch of the advanced recombinant therapy, ADVATE (Antihemophilic Factor (Recombinant), Plasma/Albumin-Free Method) rAHF-PFM, which received regulatory approval in the United States in July 2003 and in Europe in March 2004. Of the 6 points of growth relating to recombinants, sales of ADVATE contributed 4 points, with an increased sales contribution expected during the remainder of 2004 as the launch of this new product continues and broadens in the United States and Europe. These factors were partially offset by the impact of the entry or re-entry into the marketplace in 2003 by certain competitors. Sales of plasma-based products, which were relatively flat for the quarter, were impacted by competitive pressures, as well as a continuing shift in the market from plasma-based to recombinant hemophilia products. As discussed further below, as a result of these competitive pressures, the company closed 26 plasma collection centers and a plasma fractionation plant during 2003, and plans to reduce plasma production and close additional centers during 2004, to improve the economics of the plasma business. Higher sales of anti-body therapies, including IGIV (immune globulin intravenous) for immune deficiencies, contributed 2 points to the growth rate for the quarter, and increased sales of biosurgery products contributed 1 point to the growth rate. Sales of transfusion therapies products contributed 1 point of growth, partially due to the continued launch and penetration of the ALYX platform, an automated blood collection system. Partially offsetting the growth in these product lines was the impact of lower sales of vaccines, principally due to lower sales of NeisVac-C for the prevention of meningitis C. Sales of vaccines are impacted by the timing of government tenders, and there were no significant tenders filled during the first quarter of 2004.

Renal

Sales from continuing operations in the Renal segment increased 16% for the three months ended March 31, 2004 (including 8 percentage points due to the favorable impact of foreign currency fluctuations), with sales growth strongest in international markets. Increased sales of products for peritoneal dialysis contributed 11 points to the segment’s growth rate for the quarter. Increased penetration of products for peritoneal dialysis continues to be strongest in emerging markets such as Latin America and Asia, where many people with end-stage renal disease are currently under-treated. The majority of the remaining 5 points of growth during the three months ended March 31, 2004 was related to increased sales of hemodialysis products.

The following tables show key ratios of certain income statement items as a percent of sales.

Foreign currency fluctuations, principally relating to the strengthened Euro, accounted for approximately 2 points of the gross margin decline from 2003 to 2004. Also, as discussed

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above, sales of the BioScience segment’s plasma-based products have been impacted by increased competition and related pricing pressures, which, while stabilizing, unfavorably affected the gross margin for these products during the first quarter of 2004 as compared to the prior year quarter. In addition, costs associated with the company’s employee pension and other postretirement benefit plans have increased since the prior year quarter (as further discussed below). These factors were partially offset by cost savings relating to the company’s restructuring initiatives (as further discussed below).

Marketing and administrative expenses as a percent of sales increased slightly during the quarter primarily due to foreign currency fluctuations, increased employee pension and other postretirement benefit plan costs, and the impact of reduced costs in the prior year quarter due to a change in the employee vacation policy. These factors were partially offset by cost savings relating to the company’s 2003 restructuring initiatives and other actions designed to reduce the company’s expense base.

Expenses associated with the company’s pension and other postretirement benefit plans increased $17 million during the first quarter of 2004, as detailed in Note 6, principally due to a reduction in the discount rate and the amortization of unrecognized losses. Refer to the 2003 Annual Report for further information.

R&D expenses in the first quarter of 2004 were flat as compared to the prior year. Management does not expect R&D spending to increase significantly for full year 2004, with increased spending on certain projects across the three segments offset by the benefits of the 2003 restructuring initiatives, and the termination of certain programs (such as the recombinant hemoglobin protein project, which was terminated in the second quarter of 2003).

RESTRUCTURING INITIATIVES

Second quarter 2003 restructuring charge

During the second quarter of 2003, the company recorded a $337 million restructuring charge ($202 million, or $0.33 per diluted share, on an after-tax basis) principally associated with management’s decision to close certain facilities and reduce headcount on a global basis. Management decided to take these actions in order to position the company more competitively and to enhance the company’s profitability. Refer to Note 4 for additional information.

During the first quarter of 2004, $37 million of the reserve for cash costs was utilized. Approximately 87% of the targeted positions have been eliminated as of March 31, 2004. The majority of the costs are expected to be paid and the majority of the remaining positions are expected to be eliminated by the end of 2004.

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Management expects that the actions initiated in 2003 will generate incremental annual savings of approximately $0.15 to $0.20 per diluted share when fully implemented. The cost savings principally relate to employee compensation and primarily benefit the marketing and administrative expenses line in the consolidated income statement. Management estimates that the cost savings in the first quarter of 2004 were approximately $0.04 per diluted share, and expects that the full year 2004 savings will total approximately $0.15 per diluted share.

2004 restructuring initiatives

In January 2004, management announced plans (which were finalized during the second quarter of 2004) to implement additional actions to improve the company’s financial position. These actions will include the elimination of approximately 3,500 to 4,000 additional positions, or approximately 7 to 8 percent of the global workforce. Nearly three quarters of the positions to be eliminated will impact general and administrative expenses. The company also intends to further enhance profitability and cash flows by adjusting its plasma production. Accordingly, Baxter plans to reduce plasma production and close additional plasma collection centers. Management anticipates that an after-tax restructuring charge of approximately $350 to $400 million, or $0.55 to $0.65 per diluted share, will be recorded in the second quarter of 2004, principally for severance and costs associated with the closing of facilities. Management anticipates that these additional initiatives will yield savings of $0.05 per diluted share in the second half of 2004, $0.20 to $0.25 per diluted share in 2005, and $0.30 to $0.35 per diluted share when fully implemented in 2006.

NET INTEREST EXPENSE

Net interest expense increased $2 million for the three months ended March 31, 2004 principally due to lower capitalized interest and higher effective interest rates.

OTHER EXPENSE, NET

Other expense decreased during the three months ended March 31, 2004. Included in other income and expense in both 2004 and 2003 were amounts relating to fluctuations in currency exchange rates, minority interests and income related to equity method investments. Other expense in 2003 included a $13 million pre-tax impairment charge relating to an investment in a publicly traded company, with the decline in value deemed to be other than temporary.

PRE-TAX INCOME

Refer to Note 8 to the condensed consolidated financial statements for a summary of financial results by segment. Certain items are maintained at the company’s corporate headquarters and are not allocated to the segments. They primarily include certain foreign currency fluctuations, the majority of the foreign currency and interest rate hedging activities, net interest expense, income and expense related to certain non-strategic investments, corporate headquarters costs, certain nonrecurring gains and losses, and certain special charges (such as in-process research and development, restructuring and asset impairments). In addition, the above-mentioned increased costs associated with the pension and other postretirement benefit plans have not been completely allocated to the segments. The following is a summary of significant factors impacting the segments’ financial results.

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Medication Delivery

Pre-tax income increased 13% for the three months ended March 31, 2004. The growth in pre-tax income was primarily the result of strong sales growth, the close management of costs, the benefits of the recent restructuring initiatives, and changes in currency exchange rates (as noted above, foreign currency hedging activities for all segments are recorded at corporate, and are not included in segment results). As noted above, while results for the first quarter of 2004 were not significantly impacted by the recently renegotiated long-term contracts with group purchasing organizations, principally Premier, sales and earnings growth during the remainder of 2004 is expected to be impacted by the reduced pricing included in these contracts.

BioScience

Pre-tax income decreased 1% (as restated) for the three months ended March 31, 2004. The decline in pre-tax income was primarily due to changes in currency exchange rates, lower sales of higher-margin vaccines, reduced gross margins for plasma-based products, and a modest increase in inventory reserves, partially offset by lower R&D spending as a result of the recent prioritization initiatives (including the termination of the recombinant hemoglobin protein project in 2003), the close management of costs, and the benefits of the recent restructuring initiatives.

Renal

Pre-tax income increased 21% (as restated) for the three months ended March 31, 2004. The increase in pre-tax income was primarily due to strong sales growth, changes in currency exchange rates, an improved sales mix, the close management of costs, and the benefits of the recent restructuring initiatives, partially offset by increased R&D spending.

INCOME TAXES

The effective income tax rate from continuing operations for the first quarter of 2004 and 2003 was 25% and 24%, respectively. The effective income tax rate was substantially unchanged, with minor differences principally due to changes in the mix of earnings between the various tax jurisdictions.

INCOME AND EARNINGS PER DILUTED SHARE FROM CONTINUING OPERATIONS

Income from continuing operations of $187 million (as restated), or $0.30 per diluted share (as restated), for the three months ended March 31, 2004 decreased 13% from the $215 million (as restated), or $0.36 per diluted share, reported in the prior year quarter. The significant factors causing the decline are discussed above.

LOSS FROM DISCONTINUED OPERATIONS

The loss from discontinued operations was $11 million and $1 million in the current and prior year quarter, respectively. Refer to Note 3 for further discussion of the discontinued operations. Management expects the divestiture plan will be completed during 2004.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with generally accepted accounting principles (GAAP) requires management to make estimates and judgments that affect the

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reported amounts of assets, liabilities, revenues and expenses. A summary of the company’s significant accounting policies is included in Note 1 to the company’s consolidated financial statements for the year ended December 31, 2003, which are included in the 2003 Annual Report. Certain of the company’s accounting policies are considered critical, as these policies are the most important to the depiction of the company’s financial statements and require significant, difficult or complex judgments by management, often employing the use of estimates about the effects of matters that are inherently uncertain. Such policies are summarized in the Management’s Discussion and Analysis section of the 2003 Annual Report. There have been no significant changes in the application of the critical accounting policies since December 31, 2003.

LIQUIDITY AND CAPITAL RESOURCES

CASH FLOWS

Cash flows from continuing operations

The company reported cash outflows from continuing operations of $53 million (as restated) for the three months ended March 31, 2004. These cash outflows increased $31 million as compared to the prior year quarter. The increase in cash outflows was due to lower cash flows relating to accounts receivables and liabilities, payments related to the restructuring programs, and contributions to the pension trust, partially offset by higher earnings (before non-cash items) and improved cash flows relating to inventories.

Accounts Receivable

The decrease in cash flows relating to accounts receivable was partially due to reduced cash flows from the company’s securitization arrangements, as detailed in Note 5. Management continues to increase its focus on working capital efficiency. With this increased focus, the company improved its accounts receivable collections (days sales outstanding improved from 62.8 days (as restated) at March 31, 2003 to 61.4 days (as restated) at March 31, 2004).

Inventory balances increased $64 million (as restated) from December 31, 2003 to March 31, 2004. A portion of the increase related to fluctuations in currency exchange rates (particularly the strengthened Euro), which did not impact cash flows. Inventory turns are impacted by seasonality in certain of the company’s businesses, and are generally highest in the fourth quarter of the year, and lower earlier in the year, for these businesses.

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Liabilities, Including Restructuring Payments and Contributions to the Pension Trust

Cash flows relating to accounts payable and accrued liabilities were lower in the first quarter of 2004 as compared to the prior year quarter, partially due to the timing of payments relating to income taxes. Cash payments associated with restructuring programs increased $30 million in the first quarter of 2004. The company also contributed $54 million to its pension trust during the first three months of 2004, versus no contributions in the prior year quarter.

Cash flows from discontinued operations

Cash outflows relating to discontinued operations decreased $5 million during the first quarter, from a $6 million outflow in 2003 to a $1 million outflow in 2004. As discussed in Note 3 and above, the company has divested the majority of the discontinued operations and plans to complete the divestiture plan in 2004.

Cash flows from investing activities

Capital Expenditures

Capital expenditures decreased for the three months ended March 31, 2004 by $85 million, from $175 million (as restated) in 2003 to $90 million (as restated) in 2004. As discussed in the 2003 Annual Report, management is reducing its level of investments in capital expenditures in 2004 as certain significant long-term projects are completed. Management currently anticipates that the company’s capital expenditures will not exceed $650 million in 2004. Construction in progress also decreased 8% from December 31, 2003 to March 31, 2004, as the company placed assets into service.

Acquisitions and Investments In and Advances to Affiliates

Net cash outflows relating to acquisitions and investments in and advances to affiliates decreased by $57 million during the first three months of 2004, from $71 million in 2003 to $14 million in 2004. The current quarter included outflows relating to the 2003 acquisition of certain assets of Alpha Therapeutic Corporation, which are included in the BioScience segment. The 2003 outflows included the funding of a $50 million loan to Cerus Corporation, a minority investment holding which is included in the BioScience segment. Also included in net cash outflows in 2003 was an $11 million common stock investment in Acambis, Inc., which was divested later in 2003.

Divestitures and Other

Net cash flows relating to divestitures and other totaled $26 million in 2004, and principally related to the sale of a building and the return of collateral.

Cash flows from financing activities

Debt Issuances, Net of Redemptions and Other Payments of Debt

Debt issuances, net of redemptions and other payments of debt, decreased $827 million in the first quarter, from $1.018 billion in 2003 to $191 million in 2004. As discussed in the 2003 Annual Report, in March 2003 the company issued $600 million of term debt in anticipation of the redemption of approximately $800 million of convertible debentures in May 2003, when the holders exercised their rights to put the debentures to the company.

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Other Financing Activities

Common stock cash dividends increased in 2004 by $15 million due to a higher level of common shares outstanding. Cash received for stock issued under employee benefit plans increased by $15 million principally due to a higher level of stock option exercises and purchases under the company’s employee stock purchase plans. Stock repurchases decreased from 2003 to 2004. In the first quarter of 2004 the company paid $11 million to repurchase stock from Shared Investment Plan (SIP) participants. Refer to Note 9 and Part II, Item 2(e), Changes In Securities, Use of Proceeds and Issuer Purchases of Equity Securities, of this report for further information regarding the SIP and these repurchases. In the first quarter of 2003 the company purchased 3.1 million shares of common stock for $153 million from counterparty financial institutions in conjunction with the settlement of equity forward agreements. Refer to the 2003 Annual Report for further information.

CREDIT FACILITIES, ACCESS TO CAPITAL, AND COMMITMENTS AND CONTINGENCIES

Refer to the 2003 Annual Report for further discussion of the company’s credit facilities, access to capital, and commitments and contingencies.

The company had $646 million (as restated) of cash and equivalents at March 31, 2004. The company also maintains two revolving credit facilities, which totaled $1.4 billion at March 31, 2004, and which have funding expiration dates through November 2007. The facilities enable the company to borrow funds on an unsecured basis at variable interest rates. The company has never drawn on these facilities and does not intend to do so in the foreseeable future. Management believes these credit facilities are adequate to support ongoing operational requirements. The credit facilities contain certain covenants, including a maximum net-debt-to-capital ratio and a minimum interest coverage ratio. At March 31, 2004, as in prior periods, the company was in compliance with all covenants. The company’s net-debt-to-capital ratio, as defined below, of 43.0% (as restated) at March 31, 2004 was well below the credit facilities’ net-debt-to-capital covenant. Similarly, the company’s actual interest coverage ratio of 10.4 to 1 (as restated) in the first quarter of 2004 was well in excess of the minimum interest coverage ratio covenant. The net-debt-to-capital ratio, which is calculated in accordance with the company’s primary credit agreements, and is not a measure defined by GAAP, is calculated as net debt (short-term and long-term debt and lease obligations, less cash and equivalents) divided by capital (the total of net debt and stockholders’ equity). The net-debt-to-capital ratio at March 31, 2004 and the corresponding covenant in the company’s credit agreements give 70% equity credit to the company’s equity units. Refer to the 2003 Annual Report for a description of the equity units, which were issued in December 2002. The minimum interest coverage ratio is a four-quarter rolling calculation of the total of income from continuing operations before income taxes plus interest expense (before interest income), divided by interest expense (before interest income). Baxter also maintains certain other short-term credit arrangements. The above-mentioned financial statement restatement had no impact on the company’s compliance with the financial covenants in its debt agreements.

The company intends to fund its short-term and long-term obligations as they mature through cash on hand, future cash flows from operations, by issuing additional debt, or by issuing common stock. As of March 31, 2004, the company can issue up to $399 million of securities, including debt, common stock and other securities, under an effective registration statement filed with the Securities and Exchange Commission. The company’s debt ratings at March 31, 2004 were A3 by Moody’s, A- by Standard & Poor’s and A- by Fitch on senior debt, and P2 by Moody’s, A2 by Standard & Poor’s and F2 by Fitch on short-term debt (all with negative outlooks, with Moody’s ratings under review for possible downgrade based on concerns regarding the transition to new senior management, challenges in certain businesses, and other

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factors). The first quarter 2004 downgrade and any future downgrades of Baxter’s credit ratings unfavorably impact the financing costs associated with the company’s credit arrangements and future debt issuances. Certain specified downgrades, if they occur in the future, would also require the company to post additional collateral pursuant to certain of its arrangements. However, any future downgrades would not affect the company’s ability to draw on its credit facilities, and would not result in an acceleration of the scheduled maturities of any of the company’s outstanding debt.

The company’s ability to generate cash flows from operations, issue debt, enter into other financing arrangements and attract long-term capital on acceptable terms could be adversely affected in the event there is a material decline in the demand for the company’s products, deterioration in the company’s key financial ratios or credit ratings, or other significantly unfavorable changes in conditions. Management believes it has sufficient financial flexibility in the future to issue debt, enter into other financing arrangements, and attract long-term capital on acceptable terms as may be needed to support the company’s growth objectives.

See “Part II - Item 1. Legal Proceedings” for a discussion of the company’s legal contingencies. Upon resolution of any of these uncertainties, the company may incur charges in excess of presently established reserves. While such a future charge could have a material adverse impact on the company’s net income or cash flows in the period in which it is recorded or paid, based on the advice of counsel, management believes that any outcome of these actions, individually or in the aggregate, will not have a material adverse effect on the company’s consolidated financial position.

FORWARD-LOOKING INFORMATION

The matters discussed in this report 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. Many factors 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, but are not limited to, interest rates; technological advances in the medical field; economic conditions; demand and market acceptance risks for new and existing products, technologies and health-care services; the impact of competitive products and pricing; the company’s ability to realize in a timely manner the anticipated benefits from any restructuring programs that the company undertakes, or acquisitions, alliances or other transactions; the geographic mix of the company’s sales; the availability of acceptable raw materials and component supply; global regulatory, trade and tax policies; regulatory, legal or other developments relating to the company’s A, AF and AX series dialyzers; the ability to obtain adequate insurance coverage at reasonable cost; continued price competition; product development risks, including technological difficulties; ability to enforce patents; patents of third parties preventing or restricting the company’s manufacture, sale or use of affected products or technology; actions of regulatory bodies and other government authorities; reimbursement policies of government agencies and private payers; commercialization factors; results of product testing; unexpected quality or safety concerns, whether or not justified, leading to product launch delays, recalls, withdrawals, or declining sales; and other factors described elsewhere in this report or in the company’s other filings with the Securities and Exchange Commission. Additionally, as discussed in Part II – Item 1. Legal Proceedings, upon the resolution of certain legal matters, the company may incur charges in excess of presently established reserves. Any such charge could have a material adverse effect on the company’s results of operations or cash flows in the period in which it is recorded.

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Currency fluctuations are also a significant variable for global companies, especially fluctuations in local currencies where hedging opportunities are not economic or not available. If the United States Dollar strengthens significantly against foreign currencies, the company’s ability to realize projected growth rates in its sales and net earnings outside the United States could 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. The company does not undertake any obligation to update any forward-looking statements as a result of new information, future events, changed assumptions or otherwise, and all forward-looking statements speak only as of the time when made.

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