Business context and reporting period
Merck & Co., Inc. (the post-merger company) reported unaudited results for the three months ended March 31, 2010. The November 3, 2009 merger with Schering-Plough was accounted for as an acquisition with legacy Merck as the accounting acquirer. Consequently, Q1 2010 includes Schering-Plough, while Q1 2009 does not; reported year-over-year comparisons are therefore not like-for-like.
Financial performance and position
| Metric | Q1 2010 | Q1 2009 / prior balance |
|---|---|---|
| Sales | $11.422 billion | $5.385 billion |
| Income before taxes | $615.8 million | $1.783 billion |
| Net income attributable to Merck | $298.8 million | $1.425 billion |
| Diluted EPS | $0.09 | $0.67 |
| Gross margin | 54.3% | 75.2% |
| Operating cash flow | $1.366 billion | $712.6 million |
| Investing cash flow | $(3.148) billion | $1.390 billion provided |
| Financing cash flow | $942.2 million provided | $391.9 million used |
| Cash and cash equivalents | $8.236 billion | $9.311 billion at Dec. 31, 2009 |
| Cash and investments | $11.772 billion | $10.037 billion at Dec. 31, 2009 |
| Working capital | $11.790 billion | $12.735 billion at Dec. 31, 2009 |
| Total debt, carrying value | $19.103 billion | $17.474 billion at Dec. 31, 2009 |
| Total debt / liabilities and equity | 17.1% | 15.5% at Dec. 31, 2009 |
Q1 2010 sales growth primarily reflects the added Schering-Plough businesses and consolidation of the Merck/Schering-Plough partnership, as well as favorable foreign exchange of 4%. The filing provides unaudited pro forma Q1 2009 sales of $10.683 billion and Merck-attributable net income of $6.884 billion, but cautions that this information is not indicative of actual or future results and excludes potential integration savings.
Profitability was affected by merger-related purchase accounting, restructuring, integration expenses, and health-care-reform tax costs. Materials and production costs included about $1.2 billion of inventory step-up amortization and about $1.2 billion of intangible-asset amortization. The filing attributes 21.1 percentage points of the gross-margin decline to merger-related amortization and 0.4 points to restructuring charges. The effective tax rate was 46.4%, including a $146.5 million charge from a change in tax law.
Management’s non-GAAP measures were net income of $2.639 billion and diluted EPS of $0.83, versus $1.593 billion and $0.74 in Q1 2009. These measures exclude specified purchase-accounting, restructuring, merger-related and other items; the filing notes that such items are significant and that non-GAAP measures are not standardized GAAP measures.
Material changes versus the prior comparable period
- Revenue rose substantially because the current quarter includes Schering-Plough and consolidated Zetia and Vytorin sales; legacy Merck’s equity income from the partnership was included in the prior-year comparison instead.
- GAAP net income and diluted EPS fell sharply despite higher reported sales, primarily reflecting merger-related inventory and intangible amortization, higher restructuring costs, the health-care-reform tax charge, and additional shares issued in the merger.
- Operating cash flow increased from Q1 2009, which included a $660 million payment related to a Canadian tax settlement. Investing cash flow shifted to a large outflow, primarily because of purchases of securities and investments and lower proceeds from sales.
- Interest expense rose and interest income fell, largely due to merger financing. Other expense also included $80 million of foreign-exchange losses related to Venezuela’s currency devaluation; a $102 million royalty-settlement gain partly offset expense.
- Product results were mixed: Januvia, Janumet, Isentress and Singulair grew, while Cozaar/Hyzaar, Fosamax, Gardasil and RotaTeq declined. Cozaar and Hyzaar lost patent protection in major European markets during the quarter, with U.S. patent protection expiring in April 2010.
Outlook, management commentary, risks and unusual items
- Restructuring: The first phase of the merger restructuring targets about a 15% workforce reduction by the end of 2012, plus elimination of 2,500 vacant positions. Management estimated total pretax costs of $2.6–$3.3 billion and annual savings of $2.6–$3.0 billion in 2012. The existing 2008 program is expected to cost $1.6–$2.0 billion and generate cumulative pretax savings of $3.8–$4.2 billion from 2008 through 2013. Combined 2010 restructuring costs were estimated at $700–$900 million. The company reported $287.7 million of restructuring costs in the income statement for Q1; program-related charges of $348.1 million also include amounts classified in other expense lines.
- Other outlook and spending: Management estimated 2010 capital expenditures of $1.9 billion. The filing does not provide consolidated revenue or EPS guidance. It expects substantial U.S. Singulair sales declines within two years after its August 2012 patent expiration. Zostavax supply constraints could continue through 2010 and possibly into 2011.
- Revenue timing: A U.S. distributor purchase program deferred approximately $580 million of pharmaceutical sales; Merck expected to recognize the amount after the special terms expire, net of returns. Health-care reform reduced Q1 revenue by approximately $33 million; further provisions include a 50% Medicare Part D coverage-gap discount beginning in 2011 and an annual industry fee.
- Contingencies: A Centocor arbitration could affect Merck’s rights to distribute Remicade and Simponi; an unfavorable result could be materially adverse. The company also faces extensive Vioxx, Fosamax, NuvaRing, patent, antitrust and other litigation. Vioxx and Fosamax defense-cost reserves were approximately $98 million and $52 million, respectively; the filing states these reserves are for defense costs, not potential liability. Merck said it could not reasonably estimate losses for certain Vioxx claims and investigations, and adverse outcomes could materially affect results, liquidity or financial position.
- Tax matters: The IRS proposed adjustments concerning former Schering-Plough intercompany pricing that could result in approximately $370 million of tax, mostly reducing tax attributes; Merck disputes the proposal. Canadian tax assessments also remain contested. Management said it intends to pursue available appeals.
- Transactions and unusual items: Merck completed the approximately $190 million Avecia acquisition. Sanofi-aventis exercised an option to combine animal-health businesses; Merck expected the transaction to close in Q1 2011, subject to approvals and other conditions. After quarter-end, AstraZeneca paid $647 million under an option arrangement; Merck expected to recognize $443 million of deferred income in Q2 2010.
- Controls: Management concluded disclosure controls were effective at quarter-end and reported no material change in internal control over financial reporting. It was monitoring the April 2010 SAP implementation and integration of the legacy companies.
Most important facts for investors to verify
- Use merger-adjusted comparisons where possible: Q1 2010 and reported Q1 2009 cover different businesses; assess the assumptions and limitations of the pro forma figures.
- Track sales and margins after the one-time $580 million distributor deferral, purchase-accounting amortization, and integration effects.
- Verify execution, cash costs and realized savings from restructuring against management’s estimates and timelines.
- Monitor patent expirations, generic challenges, vaccine supply, and the Centocor arbitration for effects on key-product revenue.
- Follow material litigation and tax developments, including potential exposures not covered by the disclosed defense-cost reserves.
- Reconcile cash, investment purchases, borrowing, dividends and planned capital expenditures, and assess liquidity as integration spending continues.