Merck & Co., Inc. quarterly report, Q2 FY2011

Merck & Co., Inc. — Q2 2011 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2011. Unaudited consolidated results; comparisons are with the corresponding 2010 periods. Amounts are in U.S. dollars unless stated otherwise.

Business context and financial performance

Merck reports a diversified pharmaceutical business, alongside Animal Health, Consumer Care and alliance activities. The 2009 Merck–Schering-Plough merger continues to drive integration and restructuring costs.

Metric	Q2 2011	Q2 2010	Six months 2011	Six months 2010
Sales	$12.151bn	$11.346bn	$23.732bn	$22.768bn
Income before taxes	$1.672bn	$1.241bn	$3.401bn	$1.856bn
Net income attributable to Merck	$2.024bn	$752m	$3.067bn	$1.051bn
Diluted EPS	$0.65	$0.24	$0.98	$0.33
Gross margin	64.7%	59.9%	64.8%	57.1%
Cash from operating activities	Not provided by quarter	$4.573bn	$4.691bn

Quarterly sales increased 7%; first-half sales increased 4%. Foreign exchange contributed 4 percentage points to quarterly sales growth and 2 points to first-half growth. Higher Januvia/Janumet, Remicade, Singulair, Isentress, Zostavax and animal-health sales helped offset declines in products including Cozaar/Hyzaar. Segment profit for Pharmaceuticals rose 8% in both the quarter and first half.

Q2 operating expenses included $4.284bn of materials and production, $3.525bn of marketing and administrative costs, $1.936bn of R&D and $668m of restructuring costs. The reported net income increase substantially reflects unusual tax benefits, rather than sales growth alone.

Cash, debt and liquidity

• At June 30, cash and cash equivalents were $12.342bn; cash and investments totaled $16.156bn. Working capital was $16.605bn.
• Total debt, including current debt, was approximately $18.306bn ($2.523bn current and $15.783bn long-term), versus $17.882bn at December 31, 2010. The company reported total debt at 17.2% of total liabilities and equity.
• First-half cash flow: $4.573bn from operations, $943m used in investing and $2.429bn used in financing; cash increased $1.442bn to $12.342bn.
• Capital expenditures were $689m in the first half; full-year 2011 capital expenditures were estimated at $1.9bn. First-half dividends paid were $2.351bn. A $0.38-per-share quarterly dividend was declared for Q3 and Q4.
• Much of the cash and investments held by foreign subsidiaries would incur significant tax payments if repatriated. Merck said U.S. operating cash flow remains its primary source for domestic needs.

Material changes and unusual items

• The effective tax rate was negative 22.8% in Q2 and 8.1% for the first half, reflecting a $700m net benefit from settlement of the IRS 2002–2005 audit and a $230m benefit from foreign and state tax-rate changes. Merck paid approximately $465m to the IRS in connection with the settlement and is appealing one issue.
• First-half earnings also included a $500m charge for the Johnson & Johnson arbitration settlement, partly offset by a $127m gain on sale of manufacturing assets. In 2010, comparison periods included a $443m gain related to AstraZeneca’s asset option exercise.
• Merck acquired Inspire Pharmaceuticals for approximately $420m in May 2011. The company sold its BioManufacturing Network in March, recognizing a $127m gain.
• Effective July 1, 2011, Merck relinquished Remicade and Simponi marketing rights in several territories, retaining Europe, Russia and Turkey; profits in the retained territories are now split equally with Johnson & Johnson. J&J received a one-time $500m payment in April. The retained territories represented about 70% of Merck’s 2010 revenue of $2.8bn from the products.
• Merck recorded $439m of intangible-asset impairment charges in the first half, including $321m for in-process R&D and $118m related to a marketed product. Further impairments could be material.

Outlook, management commentary and risks

• The Merger Restructuring Program is expected to cost $5.8bn–$6.6bn pretax cumulatively, with substantial completion expected by end-2013 except certain manufacturing actions extending to 2015. Management expects annual savings of $3.5bn–$4.0bn by end-2013 and $4.0bn–$4.6bn upon completion. Merck estimated combined 2011 restructuring costs of $1.3bn–$1.5bn. A newly announced phase targets an additional 12%–13% workforce reduction measured from merger-time employment.
• Merck did not provide clear overall full-year sales or EPS guidance in the supplied filing text. Management expects continuing declines in Cozaar/Hyzaar and Primaxin; it also warned of substantial Singulair sales losses following expected 2012 patent expiry and continuing Fosamax declines after loss of exclusivity.
• Supply constraints affect certain vaccines, including ProQuad, Varivax and Zostavax; ProQuad was not expected to be available for the remainder of 2011. The company also reported manufacturing difficulties with some women’s-health products.
• Pipeline and regulatory developments included FDA approval of Victrelis in May and EU approval in July; the FDA issued a Complete Response letter for Janumet XR in July. Merck discontinued telcagepant development. A Phase II/III V710 vaccine study was terminated after a data monitoring committee cited lack of likely efficacy and a safety concern involving more deaths and multi-organ dysfunction among vaccine recipients.
• Legal exposure remains significant. Vioxx litigation includes unresolved claims for which Merck said it could not reasonably estimate possible loss; the DOJ investigation was ongoing against a previously established $950m reserve. The Vioxx legal-defense reserve was $58m at June 30. Other material matters include Fosamax, NuvaRing, Vytorin/Zetia, antitrust/AWP, patent and environmental proceedings.
• Merck reported $1.8bn of receivables in Greece, Italy, Spain and Portugal, about 75% from hospitals and public-sector customers. Receivables outstanding more than one year totaled about $370m, approximately 90% from those four countries. Management noted slower collections but did not expect material write-offs.
• Canadian tax assessments for 1999–2004 would add approximately $340m of tax plus $375m interest through June 30; Merck contests the assessments and said it expects no material effect on financial position or liquidity.
• Management concluded disclosure controls and procedures were effective as of June 30, 2011, while noting ongoing integration and enterprise resource-planning system implementation.

Most important facts for investors to verify

• How much of the earnings and EPS increase is recurring: assess the $700m audit-related tax benefit, $230m tax-rate benefit, restructuring, impairments and purchase-accounting effects.
• Whether restructuring spending, timing and projected savings remain on track, including the added workforce-reduction phase and manufacturing actions.
• The revenue and profit impact of the revised Remicade/Simponi rights and the $500m settlement payment after July 1, 2011.
• Product concentration and patent exposure, particularly Singulair’s expected 2012 expiry, alongside growth durability in Januvia/Janumet and other key products.
• Developments in Vioxx and other litigation, the adequacy of reserves and insurance recoveries, and collection trends for European public-sector receivables.
• Cash availability after considering foreign repatriation taxes, debt, planned capital spending, dividends and the authorized share-repurchase program.