Merck & Co., Inc. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. Figures are unaudited; amounts are in U.S. dollars unless noted.
Business context and period performance
Merck is a diversified pharmaceutical and healthcare company. Pharmaceutical products, including vaccines, are its largest business. Worldwide sales increased 5% in Q3 and 1% for the first nine months year over year. Management cited growth in Keytruda, Gardasil/Gardasil 9, and other products, partly offset by mature-product declines, pricing pressure, foreign exchange, and reduced Venezuelan operations.
Key financial metrics
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Sales | $10.536bn | $10.073bn | $29.692bn | $29.283bn |
| Income before taxes | $2.887bn | $2.397bn | $6.015bn | $4.585bn |
| Net income attributable to Merck | $2.184bn | $1.826bn | $4.515bn | $3.465bn |
| Diluted GAAP EPS | $0.78 | $0.64 | $1.62 | $1.22 |
| Diluted non-GAAP EPS | $1.07 | $0.96 | $2.89 | $2.66 |
| Gross margin | 67.6% | 62.7% | 64.4% | 62.1% |
Non-GAAP measures exclude acquisition and divestiture costs, restructuring costs, and other specified items; they are not GAAP measures. The filing attributes much of the gross-margin improvement to lower acquired-intangible amortization and purchase-accounting charges, lower restructuring and impairment charges, and favorable product mix.
- Cash flow: Operating cash flow was $6.744bn for the first nine months, down from $8.292bn. Investing activities used $647m, compared with $4.141bn used in 2015; financing activities used $7.067bn, compared with $2.981bn. Cash and cash equivalents ended the period at $7.907bn.
- Liquidity and debt: Cash and investments totaled $24.724bn; working capital was $13.885bn. Debt carrying value was approximately $25.143bn, including $1.487bn current and $23.656bn long-term debt. Merck had an undrawn $6bn revolving credit facility maturing in 2021. Management said 80%–90% of cash and investments were held by foreign subsidiaries and could incur significant tax if repatriated as dividends.
- Shareholder returns: Dividends paid totaled $3.853bn and treasury-stock purchases were $2.418bn in the first nine months. The declared quarterly dividend was $0.46 per share.
Material changes versus the prior comparable period
- Q3 and nine-month sales grew, but foreign exchange reduced reported sales performance by 1% and 3%, respectively. Management also cited about $150m of Q3 Japan sales due to shipment timing and approximately $170m of Q3 sales lost from reduced Venezuelan operations; the Venezuela impact was approximately $620m for the first nine months.
- GAAP earnings increased year over year. The nine-month comparison includes the prior-year $715m Venezuela currency devaluation charge and other significant differences, including prior-year tax benefits and gains. Q3 2015 included a $250m gain on the sale of migraine programs.
- Research and development expense rose 11% in Q3 and 12% year to date, reflecting clinical-development spending and, year to date, higher pipeline impairments, restructuring, and licensing costs.
- Operating cash flow declined by $1.548bn year over year. The company reported a roughly $680m net cash payment for the Vioxx securities settlement during the period.
Outlook, management commentary, risks, and unusual items
- Outlook: Management expected pricing actions and austerity measures, including Japan’s biennial price reductions, to continue weighing on revenue for the remainder of 2016. It anticipated approximately $900m of restructuring-program costs in 2016 and approximately $800m of additional pretax costs to complete remaining actions, expected substantially by the end of 2017. The filing does not provide a clear full-year revenue or EPS guidance figure.
- Product and pipeline developments: Keytruda sales rose to $356m in Q3 from $159m; the filing describes multiple approvals and clinical developments announced in 2016. Merck discontinued odanacatib development after analysis confirmed increased stroke risk. It also recorded product and pipeline impairment charges, including $252m for Zontivity and $225m for in-process R&D programs in the first nine months.
- Competition and exclusivity: Management anticipated a rapid, substantial decline in U.S. Zetia sales after a generic launch permitted in December 2016. It expected significant U.S. Cubicin declines after patent expiry, continued Remicade declines from biosimilar competition, and further pressure on several mature brands. A court ruling against Merck’s NuvaRing patent could permit earlier generic entry; Merck appealed.
- Acquisitions and collaborations: Merck acquired Afferent for $510m, with up to $750m of additional contingent consideration, and acquired a majority stake in StayWell for $150m plus a $150m intercompany loan. A proposed acquisition of approximately 93% of Brazil’s Vallée for about $400m remained subject to regulatory review and closing conditions. Merck also paid Moderna $200m under a cancer-vaccine collaboration.
- Legal and regulatory exposure: The Vioxx securities-class settlement was funded; Merck reported an approximately $680m net cash cost after available insurance proceeds. Significant ongoing matters include Fosamax, Januvia/Janumet, Propecia/Proscar, patent disputes involving Keytruda, and other litigation. The company said it could not reasonably estimate possible losses for certain litigation. An IRS matter concerning the 2006–2008 examination could materially affect results, liquidity, or financial position if resolved unfavorably.
- Other unusual items: The company recorded a $117m net gain from certain patent-litigation settlements in the first nine months. It also recognized $75m of sales from rights sold to certain products. Merck and Sanofi Pasteur planned to end their European vaccine joint venture by year-end 2016, subject to approvals and other conditions.
Important facts for investors to verify
- How much of reported sales growth reflects sustainable demand versus Japan shipment timing, foreign exchange, and one-time rights-sale revenue.
- The pace and financial effect of anticipated generic and biosimilar competition, especially for Zetia, Cubicin, Remicade, and NuvaRing.
- Keytruda’s commercial and clinical progress, including the effects and status of its patent disputes in the U.S. and Europe.
- Whether cash generation, working capital, and foreign-held cash support dividends, repurchases, acquisitions, and debt obligations without increased borrowing or repatriation costs.
- Potential costs or outcomes of the unresolved IRS issue, product-liability and patent litigation, and future impairment or restructuring charges.