Merck & Co., Inc. — Q1 2018 Form 10-Q
Business context and period: Unaudited results for the three months ended March 31, 2018, compared with Q1 2017. Merck is a pharmaceutical and animal-health company; Animal Health became a separately reportable segment this quarter.
Financial performance
| Metric | Q1 2018 | Q1 2017 |
|---|---|---|
| Sales | $10.037 billion | $9.434 billion |
| Income before taxes | $1.345 billion | $2.003 billion |
| Net income attributable to Merck | $736 million | $1.551 billion |
| Diluted GAAP EPS | $0.27 | $0.56 |
| Diluted non-GAAP EPS | $1.05 | $0.88 |
| Operating cash flow | $1.155 billion | $286 million |
| Capital expenditures | $450 million | $339 million |
- Sales increased 6%, including a 3% favorable foreign-exchange effect. Pharmaceutical segment sales rose to $8.919 billion; Animal Health sales were $1.065 billion.
- Keytruda sales more than doubled to $1.464 billion from $584 million. Growth was partly offset by declines in Zepatier, Zostavax, and products facing generic or biosimilar competition.
- Gross margin was 68.3%, versus 67.7%. The improvement reflected lower relative impacts from intangible amortization, impairments, and restructuring, partly offset by manufacturing variances and foreign exchange.
- R&D expense rose to $3.196 billion from $1.830 billion, primarily reflecting a $1.4 billion charge for the Eisai oncology collaboration, plus higher development spending and foreign exchange. The collaboration charge received no tax benefit.
- The effective tax rate was 44.9%, versus 22.3%; Merck cited the Eisai charge and acquisition, divestiture, and restructuring costs, partly offset by the benefit of foreign earnings.
- Operating cash flow improved year over year. Cash flow after capital expenditures was approximately $705 million, compared with approximately negative $53 million in Q1 2017 (derived from reported figures). Cash flow figures include timing and collaboration-related items.
Liquidity, debt, and capital allocation
- At March 31, cash and cash equivalents were $4.483 billion; short-term investments were $2.863 billion and investments were $11.033 billion. Merck reported total cash and investments of $18.379 billion, down from $20.623 billion at year-end.
- Working capital was $7.125 billion, compared with $6.152 billion at December 31, 2017. Total debt was approximately $23.556 billion, down from approximately $24.410 billion; reported debt-to-total-liabilities-and-equity was 27.4%, versus 27.8%.
- Financing activities used $2.722 billion, including $1.003 billion of debt payments, $1.299 billion of dividends, and $566 million of share repurchases. The quarterly dividend declared was $0.48 per share, compared with $0.47 a year earlier.
- Merck had a $6 billion revolving credit facility maturing in 2022 and reported no borrowings under it.
Material changes, outlook, and risks
- GAAP earnings declined substantially despite sales growth, mainly because of the Eisai collaboration charge and the higher effective tax rate. Non-GAAP EPS increased; Merck’s non-GAAP measure excludes acquisition and divestiture costs, restructuring, the Eisai charge, and other specified items.
- Merck expects the 2017 cyber-attack to reduce 2018 sales by approximately $200 million. The attack reduced Q1 2018 sales by about $75 million; Merck also expects to replenish remaining borrowed Gardasil 9 doses in the second half of 2018. Insurance coverage disputes remain possible.
- Management expects pricing actions and healthcare austerity measures to continue pressuring revenue. Generic and biosimilar competition remains a headwind; Merck specifically anticipated material adverse effects on Zostavax and Zepatier sales, among others.
- Approximately $500 million of additional restructuring costs were expected in 2018. The filing provides no overall revenue or earnings guidance.
- The Eisai agreement included $750 million in upfront payments and up to $650 million in option payments through 2021, plus potential clinical, regulatory, and sales milestones. Merck recorded a $1.4 billion aggregate Q1 R&D charge related to upfront and future option payments.
- Significant litigation includes Fosamax, Januvia/Janumet, and Propecia/Proscar claims. Merck stated it could not reasonably estimate possible losses for certain matters. On April 9, 2018, it agreed to a conditional $4.3 million Propecia/Proscar settlement. The filing also describes patent disputes, including adverse decisions in parts of the Gilead litigation.
- Other unusual items included a $115 million gain on settlement of patent litigation within other income. Merck reported a provisional $5.1 billion net transition-tax payment under the U.S. Tax Cuts and Jobs Act in its 2017 financial statements; the estimate remained subject to finalization.
Most important facts to verify
- Whether Keytruda growth and the broader oncology pipeline can offset competition, pricing pressure, and declines in older products.
- Actual timing and cash impact of Eisai option payments, collaboration milestones, and development costs.
- Progress in restoring cyber-attack-affected operations, the anticipated $200 million sales impact, and insurance recoveries or disputes.
- Updates to tax estimates, especially the transition tax and the effective tax rate.
- Developments in major product-liability and patent cases, including any changes to loss estimates or legal reserves.