Merck & Co., Inc. quarterly report, Q1 FY2011

Business context and reporting period

Merck & Co., Inc. (the combined company following its 2009 merger with Schering-Plough) reported unaudited results for the three months ended March 31, 2011, compared with the three months ended March 31, 2010. The merger is accounted for as an acquisition with legacy Merck as the accounting acquirer; purchase-accounting effects materially affect period comparisons. Unless noted otherwise, financial amounts are in millions of dollars.

Key financial results

Metric	Q1 2011	Q1 2010
Sales	$11,580	$11,422
Income before taxes	$1,729	$616
Net income attributable to Merck	$1,043	$299
Diluted EPS	$0.34	$0.09
Operating cash flow	$1,721	$1,366
Capital expenditures	$324	$343

• Sales increased 1.4%. Net income attributable to Merck rose substantially, principally reflecting lower merger-related inventory step-up amortization and restructuring costs, partly offset by a $500 million arbitration-settlement charge and higher research and development impairment charges.
• Gross margin was 64.9%, compared with 54.3%. Merger-related intangible amortization, inventory purchase-accounting adjustments, restructuring charges and certain merger costs reduced gross margin by 11.9 percentage points in 2011 versus 21.1 points in 2010; excluding those effects, Merck cited product mix and manufacturing efficiencies.
• GAAP diluted EPS was $0.34; non-GAAP diluted EPS was $0.92, versus $0.09 and $0.83, respectively, in Q1 2010. Non-GAAP results exclude purchase-accounting items, restructuring, merger costs and specified unusual items; Merck cautions that the measure is not standardized.
• Effective tax rate was 38.1%, versus 46.4%. The 2011 rate reflected unfavorable effects from purchase accounting, restructuring and the arbitration charge, partly offset by foreign earnings; the 2010 rate included a $147 million health-reform-related tax charge.
• Cash and cash equivalents were $11,695 at March 31, up from $10,900 at year-end; total cash and investments were $15,113. Working capital was $15,362, compared with $13,423 at year-end. Merck said working capital was more than adequate for operating needs.
• Total debt was approximately $17,846, comprising $2,202 of current debt and $15,644 of long-term debt, versus $17,882 at December 31. Total debt to total liabilities and equity was 16.9% at both dates.
• Cash from investing activities was $105, compared with a $3,148 use in Q1 2010, mainly due to lower net securities purchases and business-disposition proceeds. Financing activities used $1,172, versus providing $942 in Q1 2010; dividends paid were $1,175.

Material changes and business drivers

• Growth in Januvia and Janumet, Singulair, Remicade, Isentress, Nasonex, Zetia and Simponi, along with animal-health and consumer-care products, largely offset declines in Cozaar/Hyzaar and other products.
• Januvia sales rose 45% to $739 and Janumet rose 52% to $305. Cozaar/Hyzaar sales fell 46% to $426 following patent expirations; Merck expected declines to continue. Singulair increased 14% to $1,328, but U.S. and major European patents were expected to expire in August 2012, with substantial sales losses anticipated thereafter.
• Vaccine comparisons were affected by supply limitations and prior-year inventory or government purchases. ProQuad was not expected to be available for the rest of 2011; Zostavax remained on backorder, with intermittent supply issues expected to continue. Varivax sales fell to $144 from $237.
• Pharmaceutical segment sales were $9,820, up from $9,665; segment profits were $6,216, up from $5,740. Other segment sales were $1,609, versus $1,570, while profits were $716, versus $720.
• AZLP equity income was $133, up from $125, but AZLP sales declined to $1,155 from $1,293. Merck said AstraZeneca was likely to exercise in 2012 its option relating to Nexium and Prilosec; exercise would end Merck’s AZLP equity income and substantially reduce supply sales.

Outlook, management commentary, risks and unusual items

• Merck forecast 2011 capital expenditures of approximately $1.9 billion and total 2011 costs of $700 million to $900 million for its merger and 2008 restructuring programs. Merger restructuring actions were expected to be substantially completed by the end of 2012, with cumulative pretax costs of $3.8 billion to $4.6 billion and estimated 2012 annual savings of $2.7 billion to $3.1 billion. The 2008 program was expected to conclude by the end of 2011.
• In April 2011, Merck agreed to acquire Inspire Pharmaceuticals for approximately $430 million in cash, subject to offer conditions, and anticipated closing in Q2 2011. It also announced authorization for up to $5 billion of additional share repurchases, with no time limit.
• Under an amended Remicade/Simponi distribution agreement effective July 1, 2011, Merck will relinquish rights in certain territories and retain Europe, Russia and Turkey; profits in retained territories will be split equally. Merck recorded a $500 million charge in Q1 and paid Johnson & Johnson in April. The retained territories represented about 70% of Merck’s 2010 revenue from the products.
• Other unusual Q1 items included a $134 million gain on sale of manufacturing assets, $302 million of in-process R&D impairment charges, and a restructuring-cost credit of $14 million that included a reserve reduction after Merck decided to retain about 380 employees at its Oss facility. Further pipeline impairment charges could be material.
• After quarter-end, the IRS concluded its examination of legacy Merck’s 2002–2005 returns; Merck made net payments of about $465 million and anticipated a potentially significant noncash favorable financial-statement effect in Q2. A Canadian tax dispute involved proposed tax and interest of approximately $325 million and $360 million, respectively; Merck contested the assessment.
• Key risks include Vioxx litigation and an ongoing DOJ investigation. The company had a $950 million reserve related to anticipated resolution of the DOJ investigation, but said no definitive resolution was certain; it could not reasonably estimate losses for Vioxx lawsuits outside the settlement program. Other notable proceedings include Fosamax, NuvaRing, average-wholesale-price and environmental litigation. Merck said unfavorable Vioxx outcomes could materially affect financial position, liquidity and results.
• Merck identified slower collections and sovereign-debt-related credit risk in parts of Europe: receivables in Greece, Italy, Spain and Portugal totaled about $1.5 billion, including approximately $285 million over one year past due. Other operating risks include patent expirations, generic competition, product-supply constraints and possible impairment of the Saphris/Sycrest asset.
• Pipeline developments included an FDA advisory committee’s unanimous recommendation supporting Victrelis; the FDA was not bound by that recommendation. The V710 vaccine trial enrollment was suspended pending further benefit-risk analysis. Merck also cited product candidates under regulatory review and development, which remain subject to approval and clinical risks.

Important facts for investors to verify

• How much of the earnings and gross-margin improvement reflects underlying operations versus lower purchase-accounting amortization and restructuring charges, and how Merck’s non-GAAP exclusions affect comparisons.
• The timing and financial impact of the Remicade/Simponi rights changes, including the $500 million charge and the future profit split.
• Progress toward restructuring cost and savings estimates, and whether projected savings are realized without impairing growth or execution.
• The status and potential financial exposure of Vioxx, Fosamax, NuvaRing, AWP and environmental matters, including insurance recoveries and reserves.
• Product-level effects of patent expirations and supply constraints, particularly Singulair, Cozaar/Hyzaar and vaccines; also verify pipeline decisions and any further impairment charges.
• Collections of overdue European public-sector receivables, the outcome of tax examinations and disputes, and the expected Q2 IRS-related accounting benefit.
• Whether the Inspire acquisition closes on anticipated terms and how the repurchase authorization affects cash, debt and share count.