Merck & Co., Inc. — Q3 2010 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2010. Amounts are in U.S. dollars; financial statements are unaudited.
Business context and reporting period
Merck completed its merger with Schering-Plough on November 3, 2009. Under acquisition accounting, Merck is the accounting acquirer, and Schering-Plough’s results are included only after the merger date. Accordingly, 2010 revenue and expenses include the combined business, while 2009 comparisons generally do not; reported growth is therefore not a like-for-like measure of underlying performance.
Financial performance and position
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Sales | $11.125 billion | $6.050 billion | $33.893 billion | $17.335 billion |
| Net income attributable to Merck | $341.6 million | $3.424 billion | $1.393 billion | $6.406 billion |
| Diluted EPS | $0.11 | $1.61 | $0.44 | $3.03 |
| Gross margin | 62.3% | 76.4% | 58.8% | 76.2% |
| Operating cash flow | Not presented by quarter | $7.283 billion | $1.150 billion |
Sales rose substantially as the combined company’s products were consolidated, including Zetia and Vytorin, and legacy Schering-Plough products. Merck cited growth in Januvia, Janumet, Isentress and Singulair, partly offset by declines in Cozaar/Hyzaar, Fosamax and other products affected by patent expiry or competition. Foreign exchange reduced Q3 sales by 1% and increased nine-month sales by 1%.
Profit comparisons reflect significant merger-related accounting and unusual items. Merck attributed lower 2010 net income and EPS primarily to intangible-asset amortization and inventory step-up from the merger, the $950 million Vioxx-related legal reserve, lower affiliate income, in-process R&D impairments, restructuring costs and the prior-year $2.763 billion Merial sale gain. Q3 2010 also included a $380 million tax benefit from a foreign tax-rate change. Management reported non-GAAP diluted EPS of $0.85 for Q3 and $2.54 for the nine months, versus $0.90 and $2.47, respectively, in 2009; these non-GAAP measures exclude specified items and are not directly comparable to GAAP results.
Cash flow and liquidity: Nine-month investing cash outflow was $2.490 billion and financing cash outflow was $4.146 billion. Capital expenditures were $1.018 billion; management estimated full-year 2010 capital expenditures of $1.8 billion. Cash and cash equivalents were $9.874 billion at September 30. Cash and investments totaled $12.762 billion, working capital was $10.433 billion, and total debt was approximately $18.148 billion at carrying value ($4.116 billion current and $14.032 billion long-term). Debt was 16.8% of total liabilities and equity. The company had two undrawn credit facilities totaling $4 billion to support commercial paper and general corporate needs.
Material changes versus prior comparable periods
- Reported revenue more than doubled, but the increase primarily reflects the merger and consolidation of formerly partnered products, not solely organic growth.
- Gross margin fell 14.1 percentage points in Q3 and 17.4 points for the nine months. Merck said merger-related intangible amortization, inventory purchase-accounting charges and restructuring reduced gross margin.
- Nine-month operating cash flow increased from $1.150 billion to $7.283 billion. The 2009 period included $4.1 billion of Vioxx settlement payments and a $660 million Canadian tax settlement payment.
- Current and long-term debt totaled about $18.1 billion, compared with $17.5 billion at December 31, 2009; cash and investments increased to $12.8 billion from $10.0 billion.
- Equity income from affiliates declined to $416.8 million from $1.861 billion for the nine months, reflecting the merger-related consolidation of the MSP Partnership, the prior-year Merial disposition and lower AstraZeneca partnership returns.
Outlook, management commentary, risks and unusual items
- Restructuring: The merger restructuring program is expected to reduce the worldwide workforce by about 15%, eliminate 2,500 vacant positions and be substantially completed by the end of 2012. Estimated cumulative pretax costs are $3.5–$4.3 billion, with expected annual savings of $2.7–$3.1 billion in 2012. Merck anticipated combined 2010 restructuring costs of $1.7–$2.0 billion. A separate 2008 program was expected to cost $1.6–$2.0 billion and be substantially completed by the end of 2011.
- Market and product risks: Management expected European austerity and pricing actions to pressure revenue through the remainder of 2010 and into 2011. Patent expirations and generic competition are affecting Cozaar/Hyzaar, Fosamax and other brands; Singulair’s U.S. patent exclusivity was expected to expire in August 2012. Vaccine supply constraints affected Zostavax and other products. The PegIntron RediPen recall reduced Q3 revenue by an estimated $25 million and added about $30 million of inventory-related expense.
- Legal and regulatory exposure: On October 29, 2010, Merck announced a $950 million reserve related to anticipated resolution of the U.S. Department of Justice Vioxx investigation; discussions remained ongoing. The filing says losses for other Vioxx matters could not be reasonably estimated and unfavorable outcomes could materially affect financial position, liquidity and results. Other material proceedings include Fosamax and NuvaRing product-liability litigation, AWP pricing cases, patent disputes and arbitration over Remicade/Simponi distribution rights. An adverse Remicade/Simponi arbitration outcome could materially affect results and liquidity.
- Other contingencies: Canadian tax authorities proposed additional assessments of approximately $310 million plus $325 million interest for certain intercompany-pricing matters; Merck disputed the claims and was preparing to litigate. The filing also describes pending tax examinations and related collateral.
- Transactions and accounting items: Merck expected the animal-health joint venture with sanofi-aventis to close in Q1 2011, subject to approvals and other conditions; the stated minimum value to Merck was $9.25 billion, subject to transaction adjustments. Merger purchase-price allocation remained preliminary. The company recorded $216.2 million of nine-month IPR&D impairment charges and cautioned that further impairments could occur.
- Policy and controls: U.S. health-care reform reduced revenue by approximately $43 million in Q3 and $120 million in the first nine months; a separate $147 million tax charge was recorded in Q1. The filing describes additional Part D discounts and an industry fee beginning in 2011. Management stated disclosure controls were effective as of September 30, 2010, while integration of the legacy companies’ financial-reporting systems continued.
Important facts for investors to verify
- Separate merger-driven revenue consolidation from underlying product growth when assessing sales trends.
- Track the timing and cash/non-cash composition of restructuring costs against the stated savings targets and 2010 cost estimate.
- Monitor the final Vioxx DOJ resolution, remaining litigation exposure and whether the $950 million reserve proves sufficient.
- Verify the outcome of the Remicade/Simponi arbitration and the status and economics of the proposed animal-health joint venture.
- Assess exposure to patent expirations, European pricing measures, vaccine supply constraints and the PegIntron recall.
- Review debt maturities, commercial-paper dependence, cash generation and the potential cash impact of tax disputes and other contingencies.