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Edited Transcript of FME.DE earnings conference call or presentation 29-Oct-19 2:30pm GMT

Q3 2019 Fresenius Medical Care AG & Co KGaA Earnings Call

Bad Homburg Nov 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Fresenius Medical Care AG & Co KGaA earnings conference call or presentation Tuesday, October 29, 2019 at 2:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Dominik Heger

Fresenius Medical Care AG & Co. KGaA - Executive VP and Head of IR, Strategic Development & Communications

* Michael Brosnan

Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG

* Robert Maurice Powell

Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG

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Conference Call Participants

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* Edward Nicholas Ridley-Day

Redburn (Europe) Limited, Research Division - Research Analyst

* Hans Bjorn Eskil Bostrom

Crédit Suisse AG, Research Division - Research Analyst

* Hassan Al-Wakeel

Barclays Bank PLC, Research Division - Research Analyst

* James Alexander Stewart Vane-Tempest

Jefferies LLC, Research Division - Senior Equity Analyst

* Michael Klaus Jungling

Morgan Stanley, Research Division - MD, Head of MedTech & Services and Analyst

* Patrick Andrew Robert Wood

BofA Merrill Lynch, Research Division - Director in Equity Research and Head of the EMEA MedTech & Services Team

* Sebastian Walker

UBS Investment Bank, Research Division - Associate Analyst

* Thomas M. Jones

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

* Veronika Dubajova

Goldman Sachs Group Inc., Research Division - Equity Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by. I am Hailey, your Chorus Call operator. Welcome and thank you for joining the Fresenius Medical Care Earnings Release for the First Quarter 2019 Results. (Operator Instructions)

I would now like to turn the conference over to Dominik, Head of Investor Relations. Please go ahead.

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Dominik Heger, Fresenius Medical Care AG & Co. KGaA - Executive VP and Head of IR, Strategic Development & Communications [2]

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Thank you, Hailey. We would like to welcome all of you to the Fresenius Medical Care Earnings Call for the Third Quarter 2019. We appreciate you joining today.

Now it is my pleasure, as always, to start out the call by mentioning our cautionary language that is in our safe harbor statement as well as in our presentation and in all the materials that we have distributed earlier today. For further details concerning risks and uncertainties, please refer to these documents as well as to all of our SEC filings.

As we do have a hard stop after 60 minutes, I would like to limit the number of questions again to 2 in order to give everyone the chance to ask questions. It would be great if we could make this really work.

With us today is, of course, Rice Powell, our CEO and Chairman of the management board. Rice will give you a short update on Q3 and the outlook. And of course, also with us is Mike Brosnan, our Chief Financial Officer, who will give you an update on the financials.

I will now hand over to Rice. The floor is yours.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [3]

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Thank you, Dominik. Hello, everyone. It's great to have you with us today. I'll begin my prepared remarks on Slide 4 with a high-level overview of our growth in the quarter.

As you can see, our growth trend continued in the third quarter. We provided more than 13 million treatments to an ever-increasing number of patients around the globe, and we're just slightly above 340,000 patients as we ended Q3. We are continuing to expand our infrastructure and education efforts to increase the number of treatments that are being performed in a home setting. I'm going to talk more about this in another slide or so.

Our clinic base has now [crossed] the 4,000-unit mark, and this allows us to capture the growth potential around the world that we see in the various markets. In the medium to long term, with a ramp-up of our home business, particularly in the United States, we will see a slowdown in the clinic infrastructure expansion. We've talked about that before, but I wanted to re-highlight that today.

You should have also noticed in our press release from this morning that we have appointed Dr. Frank Maddux as our Global Chief Medical Officer coming on to our management board. Obviously, the quality of our treatment is critical, and one of the many important reasons that we appointed this role to the management board is to assure that we continue to strive for better clinical outcomes, to be on the leading edge on the science and the marriage of medicine with our operations in order to provide the very best for our patients.

Turning to Slide 5 and the details of our clinical outcomes. I think the key takeaway is that the quality of our care is the most important driver of our provider business, and we're committed to continuing the great outcomes that we have for our patients around the globe.

In our segments, North America, Europe, Middle East and Africa, as well as Asia Pacific, the number of days our patients were hospitalized went down in the quarter on a year-over-year basis. And you can see those figures, I won't read them to you now, at the very bottom, days in hospital per patient year.

Now turning to Slide 6. Our growth story continues. We have delivered strong organic growth across all regions. In North America, we had very robust growth in our U.S. Dialysis business with a record growth in home dialysis. The significant step-up in our product revenue was supported by both core products and in addition, the NxStage acquisition and the rollout of those products, if you will.

In the second quarter call, we indicated to you that there was an incremental risk to program year 2 of the ESCOs. And this was based on indication that we were [beginning] to receive from CMS. The final savings for program year 2 were published in September, and unfortunately, these were lower than the previous indications. As a consequence, we had an incremental adjustment for program year 2. Based on the current indications, we've also adjusted for other program years, but we will discuss with the government on these program years and the methodology applied in future meetings.

Let me be as clear as I can be. We are very unhappy. We do not feel that we're getting the level of transparency that we need or the cooperation in understanding the methodology. We were in Washington as late as Friday, talking with them and letting them know how unhappy we are about this, and we will continue to do that in the next weeks and months to come.

In September, we achieved another milestone in China with the launch of the 4008A dialysis machine. This is an important step in a market with the largest dialysis patient population in the world.

We are on track with our cost improvement measures. Our cost optimization program, which targets to optimize our geographical footprint, specifically within the Fresenius Kidney Care organization in the U.S., is underway and working as well as our GEP activities that we've spoken of previously.

If you would, please join me in turning to Slide 7. I'd like to highlight that we've delivered organic revenue growth of 5.2% in the quarter. We achieved 5% adjusted revenue growth on a constant currency basis, which is in the midpoint of our revenue guidance for the year 2019. And despite the negative impact from the ESCO matter, we were able to deliver 2% net income growth on an adjusted basis, which compares with a minus 6% for the first half of this year.

Taking a look at organic development and turning to Slide 8. Our global organic revenue growth of 5% was driven by solid growth in North America and supported by even higher growth in our international businesses. Adjusted for the effects from Sound in 2018, IFRS 16 and NxStage, we delivered in North America revenue growth of approximately 7%. The organic growth in North America was negatively affected by the impact of the ESCO write-down. As expected, we saw stronger momentum in our Europe, Middle East and Africa business in the third quarter, and Asia Pacific was a significant contributor to our revenue growth in the quarter as well.

Moving to the services side of our business on Slide 9. We saw both strong same market and organic growth in the third quarter. In 2019, the same market growth in North America continues to perform nicely with an increase of approximately 4%. And looking at a sequential quarter, looking at Q2 where we were at roughly 3.5%, so we continue to move upward.

Our development in North America was negatively impacted by the adjustments for accounts receivables that have transitioned to the category of a legal dispute, and that is in the number of EUR 84 million. The EMEA services organization saw strong organic growth of 7% in the quarter.

Asia Pacific continued the strong growth trends supported by their Care Coordination business out of Australia. And the exchange rates and hyperinflation, as we've discussed many times, continued to produce a drag on the results in our Latin American business.

Now turning to Slide 10 in the products business. As you can imagine, we are very pleased with the very strong 13% growth at constant currency in the quarter on our products book of business. In North America, we saw strong performance of 24% with support from both the base rental products business as well as from the NxStage acquisition and the rollout of their portfolio. On an organic basis, growth was at 10%. And also, please keep in mind that the reported numbers are somewhat affected by the IFRS 16 implementation, which really focuses around the hemodialysis equipment.

Europe, Middle East and Africa, our largest products business, delivered 10% constant currency growth, and this was due to higher sales of dialyzers and bloodlines. And on an organic basis, EMEA produced 11% growth in the quarter.

Asia Pacific saw 9% constant currency as well as organic growth driven by higher sales of their dialyzer and bloodline business. And even in Latin America, our [indiscernible] product sales delivered a 4% organic growth in the quarter.

Before we discuss the financial details of the quarter with Mike, I'd like to move to the outlook on Page 11 of my presentation. I realize this is out of the order we sent you this morning, but I'd still like to, if you will, let me go ahead and make some comments on the outlook.

Although not everything went our way in the first 9 months of the year, given where we are today, we are confirming our outlook for 2019. We are very comfortably in the range for our revenue guidance, but with the impact from the ESCOs, it puts us in the lower end of our range from the earnings side, and we've mentioned this to you previously.

Now considering 2020, we have just begun our budgeting process for the next year. Any potential carryovers such as the ESCO situation, something of that nature, is going to be worked on as we go through the budgeting process, and we'll be updating you as appropriate as we conclude those works and those meetings.

And with this now, I'd like to hand it over to Mike to take you through the financials for the quarter.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [4]

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Thank you, Rice, and hello, everybody. So I'm on Chart 13, and I'll just walk through the bridge between the Q3 2018 reported numbers over to the reported as well for the current year.

So as you can see, on the top of the chart with regard to revenues, we've reflected the $7 million (sic) [EUR 7 million] adjustment that is associated with Sound in the third quarter of 2018. This is purely a revaluation of the first half of Sound revenues adjusted to the year-to-date Q3 average exchange rates. You see that from time-to-time with our one-off effects. This gets you to a base for comparison to the current year of EUR 4.51 billion. And then you can see the 5% growth that we had in the quarter, roughly EUR 190 million on a constant currency basis. That 5% growth reflects an organic revenue growth of 5% as well. And that 5% organic revenue growth has already been adjusted for the receivables writeoff that took place in the quarter for -- in the North American business. The revenue development is clearly within the targeted range of 3% to 7%.

Currency translation was favorable with EUR 134 million. We're reflecting the transition from the old leasing standard to the new IFRS standard, which is a reduction in revenues in the quarter of EUR 35 million. And you have the impact of the NxStage -- [newly] acquired NxStage operations to get to our reported revenues of EUR 4.419 billion on the top line.

The -- turning to the bottom of the chart and looking at the development of our net income, the same protocol. On the left-hand side, you see adjustments to the gain from divestitures associated with Care Coordination activities in the quarter of EUR 17 million last year. You also may remember that we increased our reserve for the FCPA matter in Q3 of last year to bring it up to the amount we ultimately settled with the government on. So that's the EUR 75 million. Gets you to a base of $343 million (sic) [EUR 343 million].

And again, you can see the growth of EUR 6 million, reflecting earnings growth of approximately 2% on a constant currency basis. And again, this reflects the revenue recognition adjustment for the accounts receivables and legal dispute. On a constant currency basis, that's worth EUR 79 million as well as the adjustments that we took associated with the ESCO program. And this was partially offset by remeasurement of the fair value of our Humacyte investment, which was EUR 72 million on a constant currency basis.

Following on, as we move to the right, there were favorable currency translation effects of EUR 14 million, unfavorable front-loading of the IFRS 16 adjustment of EUR 16 million, unfavorable effects on -- associated with the NxStage operation of EUR 15 million, some transaction costs associated with the NxStage acquisition as well as EUR 18 million of costs associated with the cost optimization program for the third quarter and a EUR 20 million gain associated with divestitures of some of our Care Coordination activities to arrive at net reported income of EUR 333 million.

If we turn to the next chart, Chart 14, I'm just briefly going to comment on the as-reported and the adjusted margin development for the quarter. Operating income increased from EUR 527 million to EUR 595 million on a reported basis. This reflects a margin increase of about 50 basis points from 13% to 13.5%. The main drivers for the margin increase were, not surprisingly, the accrual we made in the prior year associated with the FCPA that I commented on a moment ago, the remeasurement effect of the fair value of our Humacyte investment for EUR 76 million and the favorable impact from the higher utilization of oral-based ancillaries with favorable margins in the quarter.

This was partially offset by higher personnel costs; the adjustment associated with accounts receivable,for the reason I have mentioned; the ESCO effect, essentially the reduction in our expectations for performance on the ESCOs, which I'm sure we'll talk some more about in the Q&A. And that would get you to the reported results.

On an adjusted basis, the light blue, all of the explanations are consistent, but obviously the base period has been adjusted for the FCPA-related charges. As a consequence, you see margins declining from 14.7% to 13.7%, largely associated with the values you see on the right.

Turning to the next chart, and this is my final chart, on cash flows and leverage. The cash flows in the third quarter increased compared to the comparable period due to principally the implementation of IFRS 16. This leads to the reclassification of the repayment portion of the [rent payments through financing] and consequently has an improvement in operating cash flows. It was also supported by strong cash collections globally. This resulted in cash from operations of just under 20% of revenues in Q3 compared to just under 19% in Q3 of 2018.

Looking at the bottom of the page -- well, actually, pardon me, so looking at CapEx, that increased slightly by EUR 27 million, just reflecting a higher spend on our clinical network. Free cash flow at EUR 584 million is substantially better than last year. And although we don't show our acquisitions, we invested about EUR 68 million in acquisitions net of divestitures in the quarter.

As a result of our free cash flow development and our acquisition spending, our net debt, which is our debt net of cash, excluding IFRS 16, has increased from EUR 5.4 billion at the end of December 2018 to EUR 8 billion at the end of September. This include -- including the additional lease liabilities, as a result of the implementation of IFRS 16, the debt increased to EUR 12.7 billion. You can see our leverage ratios, without IFRS 16, we're at 2.5x debt to EBITDA. And including the IFRS 16 adjustment, we're at 3.2.

So that's the conclusion of my prepared remarks. I would hand the call back to Dominik.

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Dominik Heger, Fresenius Medical Care AG & Co. KGaA - Executive VP and Head of IR, Strategic Development & Communications [5]

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Thank you, Mike. Thank you, Rice, for the presentation. I'm happy to turn over after a short presentation to the Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) First question comes from the line of Sebastian Walker of UBS.

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Sebastian Walker, UBS Investment Bank, Research Division - Associate Analyst [2]

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So two, if I could. Just first on home, so good progress there in terms of patient growth. I was wondering if you can talk through maybe some of the challenges that you've went through over the past 9 months and shifting towards home as well as if you could confirm whether you're still comfortable with investments easing after the first half of 2020. That's the first one. And then just secondly, in terms of the Humacyte fair value revaluation, how large was that? And what drove the revaluation?

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [3]

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Sebastian, it's Rice. I'll take the first one, and then Mike will take Humacyte. So I would say we're pleased with the progress we've made with NxStage and the integration to date. Challenges, I think, are exactly as we stated they would be. We are trying to, as I'd like to say, walk and chew gum at the same time, meaning that we are trying to expand the infrastructure, we're hiring, getting ready to continue to train more patients. And so that's always somewhat strenuous when you're trying to do both those things at the same time.

As you say and I think the bulk of the investment in education training and the centers that we need will be pretty much done probably by midyear next year although it will take some time to get, into next year, before we finish that. I think what we're learning from this work is it's imperative that we make sure that we are in constant contact with our physician base and listening to them as to things that we could tweak in the training, things that we could do better with educational materials, et cetera. So it's the constant communication from what I would say the service side of the business.

From the product side of the business, I'm pleased that with the growth, NxStage is doing a good job of the ramp-up and being able to stay ahead of the game, if you will, from a supply standpoint. So really, really busy, lots of work, learning as we go. But at this point through Q3, really pleased with the progress that we're making. Mike?

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [4]

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Thanks, Rice. Sebastian, relative to Humacyte, this is an investment that we made roughly a year ago. And the -- so from an accounting point of view, we felt the timing was about right to take a look at the carrying value [with] that investment. We are obliged even for a company that's not publicly traded to, from time-to-time, take a look. And we had an independent valuation done over the course of the third quarter. I think that supported the fact that a revaluation of the investment was in order. I think this is largely the result of things to be -- things seem to be progressing very nicely with the FDA in terms of the company's early products registration process. So we reflected an adjustment of EUR 76 million in current currency for that investment.

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Operator [5]

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The next question is from Veronika Dubajova of Goldman Sachs.

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Veronika Dubajova, Goldman Sachs Group Inc., Research Division - Equity Analyst [6]

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I will keep it to 2 as well. My first one is on the ESCO accrual reversal. Just maybe, Rice, Mike, can you talk about the degree of confidence that you have that this is it? And then maybe just help us think about, as we think about 2020, obviously, given that the benchmark that CMS is looking at seems to have changed, how should we be thinking about the profitability profile of Care Coordination as a whole? What's the right number for us to bear in mind there? That's my first question. And my second question is the product growth in the quarter, clearly very impressive. So would love to get your thoughts on how sustainable you think that is.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [7]

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Okay, Veronika. I'll take the first. I think that was one question in 2 parts, and the second question -- I think that counts for 3. But I'll take the first, and then Rice can take the rest.

So I appreciate from some of the early reports I was looking at, folks need some clarification about the statement that I made in the second quarter. We took a $41 million (sic) [EUR 41 million] charge in the second quarter, and at that time, I was asked where we stand going forward. And I said that I thought the worst was behind us. That was based on what we knew at that time. And when you look at the charge we took in Q3, EUR 46 million, there's about EUR 18 million of that, that actually relates to risk we took because we were really expecting the government to see certain parts of the prior year financials, particularly year 2, our way. And in the third quarter, the government came out, closed out the second year at a level that was disappointing to us, as we said. So we had to clean that up and address that. So that actually was a relatively small part of the adjustment we took in Q3. And that's why I said in Q2 that I thought the worst was behind us, at least in terms of the historical period.

What we also -- what was also published in the third quarter is we received the report from the government for the first quarter of year 4, that's the first quarter of this calendar year. And we have been seeing savings in our risk-based reporting for years 1, years 2 and years 3. And for the first quarter of this year, the government's reports indicated that it had slipped into a cost position. So the spending for the patients in our program was slightly higher than the benchmark.

We continue to struggle and have questions and have discussions with CMMI about the changes that take place from 1 quarter to the next in terms of the reporting we get and also the patient attribution. So we've continued to have those discussions. We did make a change this quarter as a result of the struggles we've had over the last several quarters. And we've decided that we will [book to the report] every quarter. And so in effect, what that meant is if we're showing a cost for Q1, we have adjusted our year 4 year-to-date results for the ESCO program to conform to the most recent reporting we have, which is a very slight cost for the program in the first quarter.

So the balance of that adjustment you're seeing, it's about EUR 28 million, basically reflects a year-to-date adjustment for the current period ESCO experience based on the first quarter report we got from the government.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [8]

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Yes. I mean, Veronika, given what Mike has taken you through, we can't just think this is all sunshine and light. We've got to take a pretty cold, hard look at it, which is what we've done. But it's also why we're doubling down relative to being back in D.C. and continue to push on this. I won't repeat my earlier comments, but we are just not comfortable that we're getting the full story. I'll leave it at that.

On the product performance -- let's turn to a happier note. On the product performance, how sustainable is it? I would say that we've seen good -- really good performance in EMEA. We've seen some tenders turned on. We've seen fulfillment of tenders go our way. So I'm encouraged. Is it going to be as high in the fourth quarter this year? I can't prognosticate that, but we're going to continue to push forward. As you know, we got a new machine out in the market in September. It will take off like a gunshot in the fourth quarter, but I think it will help us because it's targeted for emerging market, in particular, we took it to China first. So we'll have to see how that plays out over time.

So let me say that I expect we should have good performance as we look at the fourth quarter and we go into next year. But I wouldn't say it could be as good as it was this past quarter. I just don't have a way to prognosticate that at this point. But we will obviously keep pushing and continue to be excited about what we're seeing on [the products folks to be able to do] truly around the world. Everybody had a good quarter. So if we can keep every region producing in that way, even if the numbers aren't as high as they were this quarter, it's going to still be a great story.

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Veronika Dubajova, Goldman Sachs Group Inc., Research Division - Equity Analyst [9]

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That's great. And if I can just very briefly before I go, I want to thank Mike for all of his detailed answers throughout the years and wish you all the best, Mike. It's been a true pleasure. Thanks.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [10]

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Thank you, Veronika. I appreciate that.

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Operator [11]

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The next question is from the line of Patrick Wood of Bank of America.

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Patrick Andrew Robert Wood, BofA Merrill Lynch, Research Division - Director in Equity Research and Head of the EMEA MedTech & Services Team [12]

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I have 2, please, if I can. The first one on the commercial mix. Obviously, it sounds a little bit better. I'm just curious for you guys a little bit some of the -- put some flesh on the bones of what's driving that, how you see the mix profile going forward and what you hear in general from your private payers. Just a little bit of color around that would be great.

And then second one, I don't want to harp on the topic, but on the ESCO side, I mean it feels like CMMI is almost trying to make you leave the program. How much is the aggregate value? And apologies if you've already given this and I missed it. But how much of the aggregate value do you have left that you're carrying for the ESCOs in totality should you decide to exit the program in its entirety?

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [13]

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Patrick, it's Rice. I'll take the first question, and Mike and I'll figure out who's going to take the second one. So I would tell you that commercial mix is improved in a very, very nice way year-over-year. I don't know that there's any additional color I can give you from a payer standpoint. I think I don't have anything new to really comment there. I think it's fair to say it was a year ago on this call that we talked about the fact we thought our process was broken and needs some repair. What I can tell you is that we did go in and do the work and figured out where we needed to get better, where we needed to refocus and what the key parameters are that we want measured and I want to [see them] every month. And that is happening, and that's why I'm comfortable when I tell you we are considerably better than we were a year ago. I'm not one to want to say we fixed the problem, it's all done, we will never have another issue, but what I would say is we've done everything that we committed we were going to do and we're seeing the work. And so I'm pleased with that. And I think I would leave it at that. And Mike, on the ESCO?

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [14]

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Yes. Patrick, I think, fundamentally, what you're asking is what do we anticipate at this point in terms of a receivable from the government associated with the open ESCO years. Let us take a minute to -- let's just take a minute, and see if I can give you a definitive answer. I just want to make sure that we're looking at net receivables, not gross.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [15]

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So to answer a piece of your question while we give Mike a moment here. So we are dropping a location or 2 in the next year's plan. The window has already closed, so at the time, and it's one of my complaints, is when we were looking at what we were going to do in the next year's plan, you're doing it in the midst of not having all the information you need, so that window closed sooner than I wish it had. But even among that, we had a location or 2 that we have made a conscious decision with the physician group that we were not going to continue mainly because of, at that particular point in time, that practice was beginning to break off and go other places, so it didn't make sense to keep it. Mike?

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [16]

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Yes. So Patrick, I'd say, just to guide you, as we look at our balance sheet position years 2, years 3 and years 4, because year 2 has not been paid out yet, it's been closed, we have savings but it has not been paid out yet, we're looking on -- we're looking at about USD 50 million or USD 60 million in terms of net receivables from the plan.

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Operator [17]

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The next question is from Michael Jungling of Morgan Stanley.

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Michael Klaus Jungling, Morgan Stanley, Research Division - MD, Head of MedTech & Services and Analyst [18]

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I've got 2 questions, please. Firstly -- they're both in relation to home dialysis. Firstly, have your visits to Washington re home dialysis indicated how CMS will incentivize the uptick of home dialysis? Will the nephrologists, do you think, be the key focus? And then for the dialysis providers, do you think that they will use sort of a carrot or a stick approach in terms of driving this service program under the presidential order?

And question number two is also on home. With a push towards home, do we see -- or do you have a preference whether you push PD or HHD? Is there something that is for you more interesting, perhaps more commercial and simpler from a logistics perspective?

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [19]

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Sure, Michael. So as you know, with the executive order came out the request for a mandatory study to be done, and then there were several voluntary studies that needed to be done as well. Buried in those proposals are incentive programs for transplantation as well as for home. What I would say to you is -- in your second question is are the docs key and absolutely the physicians are key. What has been going on is unanimously among the provider community and with the physician community. We have gone back all in very long, well-detailed reports, sent back to CMMI, CMS that as they've laid out the voluntary home models, as they've laid out the mandatory, they do not work. They simply have not laid them out in a way the provider community and the physicians' practice [matters].

For instance, in one case in the ETC model proposed, which is the mandatory, they basically were going to either reward or punish the provider for the number of transplants that are done in a certain clinic. And as you well know, we are neither transplant surgeons nor organ procurement folks, so we have no dog in that fracas, if you will. So those are the types of things that we went back and explained that we need to sit down with you because as you have laid it out, it doesn't work.

I would say that CMS has been responsive to that. We've given them our comments. We are waiting for them to come back and talk to us about what we put in the document. Obviously, the driving date here is January 1 is when the mandatory model would begin to start and it would mean taking half of FMC's patients, which are roughly 105,000 or 110,000. And I think we've done a pretty good job of getting them to realize nobody is ready for that given the unworkability of the program. So I would tell you stay tuned, but it is something that we are constantly working and checking on with the folks at CMS.

Relative to growing the business and do I have a preference for home, HD or PD? I would tell you we are seeing huge growth in both. Our PD book in the quarter grew about 7% or 8%, whereas the home book, was 25% -- home HD was 25% or 30%. So we're seeing a big push towards home. I think there's 2 things you have to keep in mind. We are pretty agnostic, or I am, and it's really a physician decision. But remember, PD is a transition therapy. You're using the lining on the stomach as the filter, and that filter will stop its ability to filter over time. The filtration process breaks down. And then that patient is either hopefully open for a transplant or they can go in center or they have to change the type of access they have from the abdomen to a renal access for blood, and they can stay at home on HHD. So I would say to you, I think while we're seeing such great growth with HHD, it's from the fact that many physicians are beginning to understand, do I want to even have to go through that transition period. But that is really a patient-family-physician decision. As I say, we're prepared to grow in either way, but just to give you the fact of what we saw in the third quarter with the [numbers].

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Operator [20]

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The next question is from the line of Ed Ridley-Day of Redburn.

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Edward Nicholas Ridley-Day, Redburn (Europe) Limited, Research Division - Research Analyst [21]

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Can I start by asking regarding the revenue recognition adjustment? Could you just give us a bit more color about the payers involved in this legal dispute? And also, could you give us some color on -- you mentioned in the release the weakness in your internal controls on financial reporting and why you were sure that you do not expect to have to restate any of your historic financial accounts?

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [22]

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Okay. Ed, I'll take that. It's Mike. Well, first of all, it -- the overall adjustment considers our other government and commercial pay, just to give you the broad category. So this is not Medicare, Medicaid. This is really what we consider to be other governmental payers and commercial pay. And these are relationships where we made the decision that the principal arm of the company that needs to pursue collection is the legal department, not billing and collections department. So that's the broad category. And what we're talking about is, let's say, very broadly speaking, almost all the value comes from a baker's dozen, 12 or 13 relationships. And then there's a variety of others that are for very, very small amounts.

The nature of the weakness, the nature of the internal control weakness is as we looked at this, we concluded that the judgments that we were applying were a bit too heavily weighted towards the legal view and didn't really have a stronger finance view where we might have considered to constrain the revenues. At the time, we moved the receivable into the legal review category and then constrained it again when it moves from that status into an actual legal dispute in court. So that's the conceptual framework, and we concluded that we needed to rebalance the emphasis on who had the stronger view in terms of collectibility at the point in time that we moved the receivable from billing and collections into legal.

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Edward Nicholas Ridley-Day, Redburn (Europe) Limited, Research Division - Research Analyst [23]

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And then -- and just -- that's helpful. But in terms of your counterparties, why are those receivables in dispute?

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [24]

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Well, let me answer the second part of your first question before I do that because you asked me what our level of confidence was in terms of not requiring any prior period adjustments. So once we identified this as a [material] weakness, we performed a lot of additional procedures to satisfy ourselves, what value should be constrained for that book of business, and that's how we arrived at roughly the EUR 84 million. That also included looking at all the prior periods and making a determination that there was any material adjustment related to prior fiscal years, and we've concluded there was not. So what I would say today on the call is there will not be a prior period adjustment related to this issue. So if you don't mind, can you go back and just restate your follow-up question? The slide there...

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Edward Nicholas Ridley-Day, Redburn (Europe) Limited, Research Division - Research Analyst [25]

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Yes. In terms of your counterparties, is there any color that you can give us on why these receivables in dispute? Ultimately, this is money that you believe you are owed.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [26]

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I can't go -- each one of these circumstances is somewhat unique. But I would say that fundamentally, services in the health care provider side in the U.S. were typically billed as a percent of billed charges, and you have various arrangements with your payers. Some of them, quite complex. And very often with your payers, you have more than one plan with those payers. So there can sometimes be some confusion between which plan relates to what percent of the charges. And I think that, in its essence, is -- creates some of the complexity where you can end up with a legitimate disagreement between the provider and the payer in terms of what's owed.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [27]

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In our history, Ed, we've had a couple of these disputes. And you can probably go back in time and see where they really truly ended up in court. And we got those things settled, if you will. Many times these things get fixed before there's a real issue. But as Mike said, this is not a real simple piece of our business. There's a lot of plans. A lot of work goes into it. So I think that's probably as much as we need to say.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [28]

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Yes. And while we're on the topic, I -- just so that none of you are surprised, because we have defined this as a material weakness, you will see kind of an administrative process we go through over the course of the next several days, we will need to amend our 2018 20-F as it relates to our internal controls, SOX declarations. So we'll essentially go back and amend that to indicate that we did have a material weakness, and you'll see us also amend some of the narrative in Q1 and Q2 of this year. At the same time or shortly thereafter, we'll file the Q3 6-K. So you'll see -- if you have your systems pinging, you'll see some activity in terms of amended reports. But there's no change to the financial reports for any of those periods. It's just the narrative around our internal control system.

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Operator [29]

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The next question is from Tom Jones of Berenberg.

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Thomas M. Jones, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [30]

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Thanks for taking my 2 questions. The first was on risk business. I think I can get a sense from your tone what your appetite for further risk business on the government side is. But how has the experience with the ESCOs impacted your willingness, enthusiasm to do risk-based business, sharing capital expense, whatever you want to call it, on the commercial side.

And then the second question I had was related to home dialysis but specifically around skilled nursing facilities. I think most investors tend to think of dialysis as either at the patient's home or in a center. But there is sort of a half-way house of patients sitting in skilled nursing facilities. I know you mentioned this at the time of the NxStage acquisition awhile back. But I just wanted to know, you've owned the business for a while, how you are thinking about that opportunity in the SNFs.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [31]

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Sure, Tom. I'll take a shot at those. So taking risk is not going to go away, and it's something that we think that we can do a good job of. You couldn't tell it by this program with ESCOs at the moment, but again, that's a shared savings and I'll let that lay on my earlier comments. But I would tell you, we are confident that we can do this. We have some commercial arrangements that are small, that we are doing this. And part of the frustration for us is when we look at how that commercial book is performing, it is working. And we take that and we inform ourselves why it isn't working on the ESCO side and when we can have that conversation with CMMI we just don't get any recognition from them that, guys, we're doing this same [day] we do your work with a different set of folks, and it's going just fine. So you tell me what the difference is. So we're not going to back out of being willing to take risk. It just depends on who you're taking the risk with, why don't I say it that way.

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Thomas M. Jones, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [32]

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Fair enough. Maybe just a quick follow-up before we move on to the SNFs. On the risk side, it seems a little odd. But on one side, you've got the President and the bosses of the Department of Health kind of pushing you or trying to push you towards risk-sharing models. And then on the other side of the equation, you've got the more -- perhaps the more junior institution in CMS, CMMI simply doing their very best to [foul] everything up. To what extent do you think there's a potential for pressure to be brought on CMS from higher authorities to make this whole program work a bit better?

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [33]

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So 2 comments there, [a: political] . ESCOs were an Obama administration program. The executive order is a Republican. And I think that does make some difference as to how willing they are to deal with future state and where it's going. I don't think it's incongruent that we have an executive order and they want us -- to really incent us to do home and transplant and do more CKD work. We're all for all of that. But out of the gate is they design these voluntary models and the mandatory model, they didn't come ask us enough upfront. I call that a little bit of a junior mistake. But we've all weighed in. [We've all told them we] support, but you got to pay attention to how we run the business. You can't ask us to do something that contorts the way we do the business because there are patients at the end of this process. And so we're waiting to see how that's going to pan out and how well we're going to be listened to, Tom. And if we're not, then we won't play. [There's a voluntary side of this].

Now back to your piece on SNFs. Yes, we believe that is an opportunity for us. There has been some back and forth among regulation development on SNFs and how it's going to be done. I would say that the whole of the dialysis industry isn't necessarily on the same page because we have some skill sets that others don't from the provider community because of our integration. So I think you probably know where I'm going with this. But we believe that those regulations are going to be fair, they'll be right, they support what we're doing. And it is -- to your point, it is a service that we provide by doing it in a skilled nursing facility that's in the best interest of that patient and not loading them up into an ambulance and taking them somewhere. So we're going to continue to push on that. We think we can do it and we can do it well. And we're just continuing to talk about that and make sure that the regulators understand that this is a viable piece of the business that should be regulated in the appropriate way to do the right thing for the patient.

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Operator [34]

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The next question is from James Vane-Tempest of Jefferies International.

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James Alexander Stewart Vane-Tempest, Jefferies LLC, Research Division - Senior Equity Analyst [35]

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I have 2, if I can, please. With the cycling of AB 290 a few weeks ago in California, just curious how about -- what the impact is from here and what you're hearing about potentially other states looking at this development. And then secondly, on the ESCOs again, I mean I understand the challenges you're seeing in the U.S. But how does that factor into your thinking in further developing your ex-U. S. Care Coordination business in the midterm, which is currently doing quite well?

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [36]

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It's Rice. I'll take those. So AB 290, yes, it's signed. Newsom signed it. As you know, we've been out for a while with the impact of that on us in the high single-digit millions. So we will see where it goes from there. As you recall, that bill had a whole bunch of amendments on it, mostly around, I think, trying to induce, if you will, the American Kidney Fund to go out and get another OIG opinion and figure out where premium assistance sits. AKF has said they're not going to do that. It's not necessary to do it because the OIG opinion we have is still alive and well. And so AKF has said they're not going to do it.

So where that bill could have been delayed in implementation, it's now going to implement Jan 1, 2020, as a result of there being no work on the AKF's part relative to revisiting something that's been revisited a couple of times. And the OIG has said, as long as you perform this way, the AKF and the providers are doing exactly what they should be doing with premium assistance. So I think for us, we are in the same place we were last quarter, a quarter before that when we gave you our estimate of high single-million-dollar impact.

As far as the ESCOs ex U.S., we are not doing anything remotely close in any other part of the world to what we've been doing with the ESCOs. So we are still bullish and looking at opportunity. We know a lot more now than we did when we started. So if somebody in, say, Germany or Australia came to us and said, hey, let's do a shared service sort of thing, I'm not sure we would probably stand in for that. But it shouldn't color your thinking on the opportunity rest of world because we've they said, Care Coordination is likely to be different than the way it is in the U.S., and I think that still bears itself out. But we're nowhere anywhere close to doing something like the ESCOs in the international markets at this point.

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Operator [37]

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The next question is from Hans Bostrom of Crédit Suisse.

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Hans Bjorn Eskil Bostrom, Crédit Suisse AG, Research Division - Research Analyst [38]

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A couple of questions, please. You mentioned the increased use of ancillaries as a reason for your improving margins. I'm just wondering why that might have changed year-on-year and whether you see any changes in regulation inclusions into the bundle in the coming year that might change that profit contribution. And secondly, it seems you had a pretty favorable deviation, certainly relative to my expectations from your both tax and borrowing costs. So I wondered whether these lower levels are sustainable on a quarterly basis going forward.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [39]

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Yes. Hans, it's Rice. On the first and from a big picture, and we'll have to look and see if there's any detail on ancillaries, but I'm not aware of anything substantive changing there. But to your question if this is [around] calcimimetics in the bundle and where is that going to go, as you know, that's been pushed out to like 2024 at this point. So we always wonder when they're going to look at, does something else go into the bundle. Haven't had any discussion on that of late, and as you know, the proposed Medicare reimbursement rates for next year, which should become final here in the next week or so, or early days of November, there was nothing dealing with that at the time. So I don't think there's a change relative to what's moving in the bundle at this point that we can see, but I don't doubt that down the road, that could come to be. And then, Mike, I'll let you do tax and borrowing costs.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [40]

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Okay. Hans, we are seeing generally lower interest expense. Obviously, rates continue to be at historical lows, I think, in particular, in Europe. So we've been able to take advantage of that over the course of the last couple of years through the sale of Sound, which generated substantial cash, allowed us to do a substantial amount of our financing for NxStage using those funds. And where we have had to rebalance our debt portfolio, we've been able to do it at favorable rates over the course of the last 12 to 18 months.

So it's hard to predict what will happen as we go forward, but I think most of the commentary that you read now anticipates lower rates continuing in Europe for some time. And as we look at refinancing activities over the course of the next, let's say, 6 months or so, it would seem to me to be in a favorable rate environment for what can get accomplished in that time. So we may continue to see some benefit in terms of year-over-year interest costs.

And on the tax side, I've mentioned in my review of net income that we had about a EUR 20 million benefit associated with our Care Coordination divestitures. That actually was a tax benefit related to finalizing some of the tax positions on our Sound divestiture from last year. So that's why you see a lower effective tax rate in the third quarter.

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Operator [41]

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The final question comes from the line of Hassan Al-Wakeel of Barclays.

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Hassan Al-Wakeel, Barclays Bank PLC, Research Division - Research Analyst [42]

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I have 2, please. Firstly, you've talked extensively about back-end loaded benefit from efficiency and cost optimization savings. I wonder if there's been any significant benefit in Q3. Or should we still continue to expect the bulk to come through in Q4? And secondly, on ESCOs, apologies if I missed it, but could you comment on what you expect the 2020 Care Coordination margin to look like?

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [43]

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Yes. So Hassan, it's Rice. On the cost optimization, it is heavily weighted into Q4. We did see some improvement in Q3, but there's lots of work that goes on in Q4 to bring that in where we want it to be. And if you just think about, again, what are we doing, we are getting out of office space that we don't need. And we're also looking at rationalizing our clinic footprints. And so that, from the day you decide you might want to do something different with a clinic, it takes a while to actually get the okay to move the patients and get that done before you are then able to make that happen. So that's why it's so back-end organized. And then on the ESCO, Mike, 2020 margin Care Coordination, yes.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [44]

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We'll probably address that in February.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [45]

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Yes. Why don't you let us come back to that, Hassan, because right now, it would be hard to prognosticate something that far out in time. I think we need to finish up what we've got going on here and come back, and we'll do that as part of our normal process going into the new year.

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Hassan Al-Wakeel, Barclays Bank PLC, Research Division - Research Analyst [46]

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Maybe if I can just add on that. Are you able to disclose what roughly the ESCO contribution to the Care Coordination profit in the year was?

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [47]

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Well, I think ESCOs with the adjustments we've taken in the second quarter and the third quarter is roughly almost EUR 90 million [gross added to that] . So it substantially diluted the margin for the Care Coordination business this year.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [48]

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Yes.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [49]

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So EUR 46 million and EUR 41 million in Q2.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [50]

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Yes. But you're right there at EUR 90 million.

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Operator [51]

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And there are no further questions at this time. I hand back to Dominik for closing comments.

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Dominik Heger, Fresenius Medical Care AG & Co. KGaA - Executive VP and Head of IR, Strategic Development & Communications [52]

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Okay. Perfect. So we -- there's no follow-up questions. But before we close the call, I would like to hand back to Rice to check if he has maybe some comments.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [53]

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Yes. One final comment, if I may. I'd like to ask all of you that are listening to join me in thanking Mike for a tremendous amount of contribution, many of which were critical to the success of FMC in Mike's 20 years here. And we want to wish you the best as you make your transition into the next phase. Thank you.

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Michael Brosnan, Fresenius Medical Care AG & Co. KGaA - CFO & Member of the Management Board at Fresenius Medical Care Mgmt AG [54]

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Thank you, Rice. Thank you, everybody. It's been a pleasure. I've enjoyed all 40 of my chats with all of you on the phone. Thank you very much. It's been a lot of fun and a great learning experience for me. Take care.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [55]

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Thanks, folks. We'll conclude the call at this point.

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Dominik Heger, Fresenius Medical Care AG & Co. KGaA - Executive VP and Head of IR, Strategic Development & Communications [56]

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Thank you. Bye-bye.

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Robert Maurice Powell, Fresenius Medical Care AG & Co. KGaA - Chairman of the Management Board & CEO of Fresenius Medical Care Mgmt AG [57]

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Bye-bye.

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Operator [58]

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Ladies and gentlemen, the conference has now concluded, and you may disconnect your telephone. Thank you for joining, and have a pleasant day. Goodbye.