Merck & Co., Inc. — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2017. Figures are unaudited and in U.S. dollars; financial statement amounts are in millions unless noted.
Business context and performance
Merck is a pharmaceutical and vaccine company, with additional Animal Health, Healthcare Services and Alliances businesses. Its Pharmaceutical segment is the largest. Comparisons are affected by the December 2016 termination of the Sanofi Pasteur MSD (SPMSD) vaccine joint venture: 2017 includes European vaccine sales Merck previously reflected through equity income, while 2016 sales did not.
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Sales | $9,930 | $9,844 | $19,365 | $19,156 |
| Income before taxes | $2,439 | $1,504 | $4,442 | $3,128 |
| Net income attributable to Merck | $1,946 | $1,205 | $3,496 | $2,330 |
| Diluted GAAP EPS | $0.71 | $0.43 | $1.27 | $0.83 |
| Gross margin | 69.0% | 63.7% | 68.5% | 62.7% |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $3,603 | $3,773 |
Sales increased 1% in both periods; foreign exchange reduced growth by 1%. Growth was led by Keytruda, Zepatier and vaccines, with a contribution from taking European vaccine operations in-house. Keytruda sales rose to $881 million in Q2 from $314 million, and to $1,465 million for the half year from $563 million. Zetia and Vytorin, Cubicin and Remicade declined amid generic or biosimilar competition; Januvia/Janumet and Isentress also weakened.
Gross margin improved primarily because of lower acquired-intangible amortization, impairments and restructuring charges, as well as favorable product mix and fewer inventory write-offs. The effective tax rate was 20.0% for Q2 and 21.0% for the half year; the 2017 rates include an $88 million benefit from settlement of a state tax issue. Non-GAAP diluted EPS was $1.01 for Q2 and $1.89 for the half year, versus $0.93 and $1.82, respectively; Merck’s non-GAAP measure excludes specified acquisition-related, restructuring and other items.
Cash flow, debt and liquidity
- Six-month operating cash flow was $3.6 billion, down from $3.8 billion. The 2017 period included a $625 million payment related to the Keytruda patent settlement; 2016 included approximately $680 million paid for the Vioxx shareholder settlement.
- Investing activities provided $2.1 billion, compared with $243 million; financing activities used $4.8 billion, compared with $6.2 billion. Cash and cash equivalents increased by $1.3 billion to $7.8 billion.
- Cash and investments totaled $24.1 billion at June 30, 2017, including $12.0 billion in cash, cash equivalents and short-term investments. Merck said generally 80%–90% of cash and investments were held by foreign subsidiaries and could incur significant tax if repatriated as dividends.
- Debt totaled approximately $24.9 billion: $3.2 billion of loans payable and current maturities, plus $21.7 billion of long-term debt. Total debt to total liabilities and equity was 26.8%, versus 26.0% at year-end 2016. The company’s $6.0 billion credit facility, maturing in 2022, was undrawn.
- Working capital was $9.4 billion, down from $13.4 billion at year-end, primarily because $3.0 billion of notes due in the first half of 2018 were reclassified as current debt. Merck paid $2.6 billion in dividends and repurchased $2.2 billion of shares during the half year; $2.9 billion remained under its repurchase authorization.
Material changes, outlook and risks
- Cyberattack: A June 27 network attack disrupted worldwide manufacturing, research and sales operations. Merck was restoring affected facilities; active pharmaceutical ingredient operations were not yet producing bulk product at the time of the filing. It continued shipping and expected no significant effect on sales of key products, but anticipated temporary order delays for some products and markets, remediation costs and uncertainty over insurance coverage.
- Outlook: Merck said pricing pressure and government austerity measures were expected to continue weighing on revenue for the remainder of 2017. The filing does not provide clear numerical full-year sales or earnings guidance in the supplied text.
- Oncology collaboration: A July 2017 AstraZeneca agreement provides for a $1.6 billion upfront payment and $750 million in option payments. Merck expects to record $2.35 billion of R&D expense in Q3 2017; up to a further $6.15 billion may be payable upon future regulatory and sales milestones.
- Restructuring and impairments: Merck expects to substantially complete its restructuring programs by year-end 2017 and incur approximately $300 million of additional pretax costs. It recorded a $47 million impairment on Intron A in Q2 and cautioned that future product or pipeline impairments could be material.
- Pipeline and regulatory events: Three Keytruda combination studies in multiple myeloma were placed on full or partial clinical hold after more deaths were observed in Keytruda arms; the FDA concluded risks outweighed potential benefits in those studies. Separately, a Phase 3 Keytruda head-and-neck cancer trial did not meet its prespecified overall-survival endpoint. Merck reported that the existing indication remained unchanged. The anacetrapib REVEAL study met its primary endpoint, but Merck had not decided whether to seek regulatory approval.
- Competition and legal exposure: Merck anticipated further declines for products facing generic or biosimilar entry, including Zetia/Vytorin, Cubicin, Invanz, Cancidas, Remicade and potentially NuvaRing. Significant legal matters include Fosamax, Januvia/Janumet and Propecia/Proscar product litigation; patent disputes; an approximately $80 million contribution to a K-Dur settlement; and a UK competition authority allegation concerning Remicade discounts. Merck generally stated it could not estimate possible losses for certain litigation. An IRS matter concerning 2006–2008 tax years could materially affect results if resolved unfavorably.
- Other unusual item: The six-month effective tax rate benefited from the $88 million state tax settlement. Merck also reported an FDA Complete Response Letter concerning supplemental Januvia/Janumet applications seeking to add TECOS data to product labeling.
Management stated that disclosure controls and procedures were effective as of June 30, 2017, and that no material change in internal control over financial reporting had occurred during the period.
Investor verification priorities
- Assess whether reported sales growth is sustainable after separating the SPMSD transition, currency effects, launch growth and underlying product trends.
- Track the cyberattack’s full operational, sales, cost and insurance effects, particularly the restoration of API production and any ongoing supply delays.
- Reconcile GAAP and non-GAAP earnings, including acquisition and restructuring adjustments, the state-tax benefit, and the planned $2.35 billion Q3 collaboration charge.
- Monitor cash generation, near-term debt maturities, the concentration of cash offshore, share repurchases and dividend commitments.
- Follow Keytruda trial safety and efficacy developments, regulatory decisions and competitive positioning, alongside generic-entry exposure for established products.
- Review developments in material litigation, the UK competition inquiry and the IRS tax examination, for which outcomes or potential losses may remain uncertain.