Merck & Co., Inc. quarterly report, Q2 FY2018

Merck & Co., Inc. — 2018 Q2 Form 10-Q

Business context and period: Pharmaceutical and Animal Health company; unaudited results for the quarter and six months ended June 30, 2018, compared with 2017. Amounts are U.S. dollars; financial statement figures are in millions except per-share data.

Financial performance and liquidity

Metric	Q2 2018	Q2 2017	Six months 2018	Six months 2017
Sales	$10,465	$9,930	$20,502	$19,365
Income before taxes	$2,086	$2,439	$3,432	$4,442
Net income attributable to Merck	$1,707	$1,946	$2,443	$3,496
Diluted EPS	$0.63	$0.71	$0.90	$1.27
Operating cash flow	Not provided for quarter	Not provided for quarter	$4,537	$3,603

• Sales grew 5% in Q2 and 6% in the first half; foreign exchange contributed 1 and 2 percentage points, respectively. Merck attributed growth primarily to Keytruda, oncology collaboration revenue, vaccines, hospital acute care products, and Animal Health.
• Net income attributable to Merck declined about 12% in Q2 and 30% year to date; diluted EPS fell about 11% and 29%, respectively. First-half R&D expense rose to $5,470 from $3,612, substantially reflecting the Eisai collaboration charge and Viralytics acquisition charge.
• Reported gross margin was 67.3% in Q2 versus 68.6%; first-half margin was 67.8% versus 68.2%. The filing cites collaboration milestone amortization, cyber-attack-related manufacturing variances, and foreign exchange as pressures.
• At June 30, cash and cash equivalents were $5,310, short-term investments $2,284, and investments $10,033, totaling $17,627 in cash and investments, versus $20,623 at year-end. Working capital was $5,936 versus $6,152.
• Total debt, including current maturities, was $23,338 ($3,379 current and $19,959 long term), compared with $24,410 at December 31, 2017. Total debt was 27.4% of total liabilities and equity, versus 27.8%.
• First-half investing cash flow was $476, versus $2,066; financing cash outflow was $5,689, versus $4,757. The company paid $2,610 in dividends and purchased $2,162 of treasury stock in the first half.
• Quarterly dividends declared were $0.48 per share; the filing reports $0.96 declared per share for the first half.

Material changes and notable items

• Keytruda sales reached $1,667 in Q2 versus $881 and $3,131 in the first half versus $1,465. Gardasil/Gardasil 9 sales rose 30% in Q2 and 27% year to date. Animal Health sales grew 14% in both periods.
• Offsets included sharp declines in Zepatier and Zostavax, and continuing generic or biosimilar pressure on Zetia, Vytorin, Remicade, and other products. Merck expected competition to continue materially affecting Zostavax and Zepatier.
• First-half reported earnings include a $1.4 billion pretax R&D charge for the Eisai oncology collaboration and a $344 million R&D charge for Viralytics. The Viralytics acquisition cost AUD 502 million ($378 million); the acquisition charge reflects the transaction accounting described in the filing.
• Merck recorded a $115 million gain in first-half other income from settlement of patent litigation. The Propecia/Proscar litigation settlement was agreed at $4.3 million, subject to participation conditions.
• The company recorded additional potential sales-milestone liabilities and intangible assets: $200 million for Lynparza and $375 million for Adempas in Q2. These obligations generate amortization expense.
• Merck adopted several accounting standards in 2018, including revenue recognition, with a net $48 million increase to equity from the listed adoption adjustments. Reported 2018 revenue was not restated to prior-year accounting; the adoption effect on first-half sales was a $29 million reduction.

Outlook, risks, and contingencies

• Merck estimated the 2017 cyber-attack would reduce 2018 sales by approximately $200 million; the impact was about $70 million in Q2 and $145 million in the first half. Manufacturing sites were operational, but some product order backlogs remained. Merck anticipated replenishing the remaining borrowed Gardasil 9 doses in the second half of 2018.
• Management expected approximately $500 million of pretax restructuring costs for full-year 2018. The filing does not provide a clear full-year sales or earnings guidance range.
• Management cited ongoing global pricing and market-access pressure and anticipated continued adverse effects from international austerity measures. In July 2018, Merck committed to limit average U.S. net-price increases across its human health portfolio to no more than inflation annually.
• The company disclosed a provisional $5.3 billion U.S. tax transition-tax liability and anticipated a net payment of $5.1 billion after expected foreign tax credits. Certain tax calculations remained provisional; Merck had not finalized its accounting policy for GILTI.
• Legal matters include roughly 3,975 Fosamax cases, approximately 1,260 Januvia/Janumet product-user claims, and around 600 Propecia/Proscar lawsuits before settlement. The company said it could not reasonably estimate possible losses for certain litigation until further developments; it stated that other matters were not expected to be material. Legal defense reserves were approximately $155 million.
• Merck noted risks from product competition, patent challenges and potential loss of exclusivity, clinical and regulatory outcomes, litigation, foreign exchange, and possible future intangible-asset impairment. The company had $8.9 billion remaining under its share-repurchase authorization at June 30 and an undrawn $6.0 billion credit facility.

Most important facts for investors to verify

• Whether Keytruda and other growth products can sustain growth sufficient to offset mature-product erosion and pricing pressure.
• How much of the reported earnings decline reflects collaboration and acquisition charges versus underlying operating trends; compare GAAP results with Merck’s non-GAAP figures, noting the company excludes significant costs from non-GAAP measures.
• Progress in resolving cyber-related supply backlogs, the projected $200 million full-year sales impact, and the remaining vaccine-stockpile replenishment.
• Cash generation, investment balances, debt maturities, and the funding impact of collaboration commitments, dividends, and share repurchases.
• Developments in major litigation, the provisional tax transition-tax calculation, and the regulatory and clinical milestones cited in the filing.