filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Description of Merck’s Business
Merck & Co., Inc. (Merck or the Company) is a global health care company that delivers innovative health solutions through its prescription medicines, vaccines, biologic therapies and animal health products. The Company’s operations are principally managed on a products basis and include four operating segments, which are the Pharmaceutical, Animal Health, Healthcare Services and Alliances segments. The Pharmaceutical and Animal Health segments are the only reportable segments.
The Pharmaceutical segment includes human health pharmaceutical and vaccine products. Human health pharmaceutical products consist of therapeutic and preventive agents, generally sold by prescription, for the treatment of human disorders. The Company sells these human health pharmaceutical products primarily to drug wholesalers and retailers, hospitals, government agencies and managed health care providers such as health maintenance organizations, pharmacy benefit managers and other institutions. Human health vaccine products consist of preventive pediatric, adolescent and adult vaccines, primarily administered at physician offices. The Company sells these human health vaccines primarily to physicians, wholesalers, physician distributors and government entities. On December 31, 2016, Merck and Sanofi Pasteur S.A. (Sanofi) terminated their equally-owned joint venture, Sanofi Pasteur MSD (SPMSD), which developed and marketed vaccines in Europe. In 2017, Merck began recording vaccine sales and incurring costs as a result of operating its vaccines business in the European markets that were previously part of the SPMSD joint venture, which was accounted for as an equity method affiliate.
The Animal Health segment discovers, develops, manufactures and markets animal health products, including pharmaceutical and vaccine products, for the prevention, treatment and control of disease in all major livestock and companion animal species, which the Company sells to veterinarians, distributors and animal producers.
The Healthcare Services segment provides services and solutions that focus on engagement, health analytics and clinical services to improve the value of care delivered to patients.
The Alliances segment primarily includes activity from the Company’s relationship with AstraZeneca LP related to sales of Nexium and Prilosec, which concluded in 2018 (see Note 9 to the consolidated financial statements).
Overview
The Company’s performance during 2018 demonstrates execution of its innovation strategy, with revenue growth in oncology, vaccines, hospital acute care and animal health, focused investment in the research and development pipeline, and disciplined allocation of resources. Additionally, Merck completed several business development transactions, expanded its capital expenditures program primarily to increase future manufacturing capacity, and returned capital to shareholders.
Worldwide sales were $42.3 billion in 2018, an increase of 5% compared with 2017. Strong growth in the oncology franchise reflects the performance of Keytruda, as well as alliance revenue related to Lynparza and Lenvima resulting from Merck’s business development activities. Also contributing to revenue growth were higher sales of vaccines, driven primarily by Gardasil/Gardasil 9, and growth in the hospital acute care franchise, largely attributable to Bridion and Noxafil. Higher sales of animal health products, reflecting increases in companion animal and livestock products both from in-line and recently launched products, also contributed to revenue growth. Growth in these areas was partially offset by competitive pressures on Zepatier and Zostavax, as well as the ongoing effects of generic and biosimilar competition that resulted in sales declines for products including Zetia, Vytorin, and Remicade.
Augmenting Merck’s portfolio and pipeline with external innovation remains an important component of the Company’s overall strategy. In 2018, Merck continued executing on this strategy by entering into a strategic collaboration with Eisai Co., Ltd. (Eisai) for the worldwide co-development and co-commercialization of Lenvima. Lenvima is an orally available tyrosine kinase inhibitor discovered by Eisai, which is approved for certain types of thyroid cancer, hepatocellular carcinoma, and in combination for certain patients with renal cell carcinoma. Under the agreement, Merck and Eisai will develop and commercialize Lenvima jointly, both as monotherapy and in combination with Keytruda. In addition, Merck acquired Viralytics Limited (Viralytics), a company focused on oncolytic immunotherapy treatments for a range of cancers. Also, the Company announced an agreement to acquire Antelliq Group (Antelliq), a leader in digital animal identification, traceability and monitoring solutions.
During 2018, the Company advanced its leadership in oncology through focused commercial execution, the achievement of important regulatory milestones and the presentation of clinical data. Keytruda continues its global launch with multiple new indications across several tumor types, including approval from the U.S. Food and Drug Administration (FDA) for the treatment of certain patients with cervical cancer, primary mediastinal large B-cell lymphoma (PMBCL), a type of non-Hodgkin lymphoma, hepatocellular carcinoma, Merkel cell carcinoma, and in combination with chemotherapy for the treatment of certain patients with squamous non-small-cell lung cancer (NSCLC). Also during 2018, the European Commission (EC) approved Keytruda for the treatment of certain patients with head and neck squamous cell carcinoma (HNSCC), for the adjuvant treatment of melanoma, and in combination with chemotherapy for the first-line treatment of certain patients with nonsquamous NSCLC. This was the first approval in Europe for an anti-PD-1 therapy in combination with chemotherapy. Also in 2018, Keytruda was approved in China for the treatment of certain patients with melanoma. Additionally, Merck recently announced the receipt of five new approvals for Keytruda in Japan, including three expanded uses in advanced NSCLC, one in adjuvant melanoma, as well as a new indication in advanced microsatellite instability-high (MSI-H) tumors. Keytruda also continues to launch in many other international markets.
In 2018, Lynparza, which is being developed in a collaboration with AstraZeneca PLC (AstraZeneca), received FDA approval for use in certain patients with metastatic breast cancer who have been previously treated with chemotherapy, and for use as maintenance treatment of adult patients with certain types of advanced ovarian, fallopian tube or primary peritoneal cancer who are in complete or partial response to chemotherapy. Additionally, Lenvima was approved in the United States, European Union (EU), Japan and China for the treatment of certain patients with hepatocellular carcinoma. The FDA and EC also approved two new HIV-1 medicines: Delstrigo, a once-daily fixed-dose combination tablet of doravirine, lamivudine and tenofovir disoproxil fumarate; and Pifeltro (doravirine), a new non-nucleoside reverse transcriptase inhibitor to be administered in combination with other antiretroviral medicines.
Merck continues to invest in its pipeline, with an emphasis on being a leader in immuno-oncology and expanding in other areas such as vaccines and hospital acute care. In addition to the recent regulatory approvals discussed above, the Company has continued to advance its late-stage pipeline with several regulatory submissions. Keytruda is under review in the United States in combination with axitinib, a tyrosine kinase inhibitor, for the first-line treatment of patients with advanced renal cell carcinoma for which it has been granted Priority Review by the FDA; in the EU for the first-line treatment of certain patients with metastatic squamous NSCLC; in the United States and in the EU as monotherapy for the first-line treatment of certain patients with locally advanced or metastatic NSCLC; in the United States as monotherapy for the treatment of certain patients with advanced small-cell lung cancer (SCLC); and in the United States as monotherapy or in combination with chemotherapy for the first-line treatment of certain patients with recurrent or metastatic HNSCC for which it has been granted Priority Review by the FDA. Additionally, MK-7655A, the combination of relebactam and imipenem/cilastatin, has been accepted for Priority Review by the FDA for the treatment of complicated urinary tract infections and complicated intra-abdominal infections caused by certain susceptible Gram-negative bacteria in adults with limited or no alternative therapies available. Merck has also started the submission of a rolling Biologics License Application (BLA) to the FDA for V920, an investigational Ebola Zaire disease vaccine candidate.
The Company’s Phase 3 oncology programs include Keytruda in the therapeutic areas of breast, cervical, colorectal, esophageal, gastric, hepatocellular, mesothelioma, nasopharyngeal, ovarian, renal and small-cell lung cancers; Lynparza for pancreatic and prostate cancer; and Lenvima in combination with Keytruda for endometrial cancer. Additionally, the Company has candidates in Phase 3 clinical development in several other therapeutic areas, including V114, an investigational polyvalent conjugate vaccine for the prevention of pneumococcal disease that received Breakthrough Therapy designation from the FDA for the prevention of invasive pneumococcal disease caused by the vaccine serotypes in pediatric patients 6 weeks to 18 years of age; MK-7264, gefapixant, a selective, non-narcotic, orally-administered P2X3-receptor agonist being developed for the treatment of refractory, chronic cough; and MK-1242, vericiguat, an investigational treatment for heart failure being developed in a collaboration (see “Research and Development” below).
The Company is allocating resources to effectively support its commercial opportunities in the near term while making the necessary investments to support long-term growth. Research and development expenses in 2018 reflect higher clinical development spending and investment in discovery and early drug development.
In October 2018, Merck’s Board of Directors approved a 15% increase to the Company’s quarterly dividend, raising it to $0.55 per share from $0.48 per share on the Company’s outstanding common stock. Also in October 2018, Merck’s Board of Directors approved a $10 billion share repurchase program and the Company entered into $5 billion of accelerated share repurchase (ASR) agreements. During 2018, the Company returned $14.3 billion to shareholders through dividends and share repurchases.
Earnings per common share assuming dilution attributable to common shareholders (EPS) for 2018 were $2.32 compared with $0.87 in 2017. EPS in both years reflect the impact of acquisition and divestiture-related costs, as well as restructuring costs and certain other items. Certain other items in 2018 include a charge related to the formation of the collaboration with Eisai and in 2017 include a provisional net tax charge related to the enactment of U.S. tax legislation and a charge related to the formation of a collaboration with AstraZeneca. Non-GAAP EPS, which exclude these items, were $4.34 in 2018 and $3.98 in 2017 (see “Non-GAAP Income and Non-GAAP EPS” below).
Pricing
Global efforts toward health care cost containment continue to exert pressure on product pricing and market access worldwide. In the United States, pricing pressure continues on many of the Company’s products. Changes to the U.S. health care system as part of health care reform, as well as increased purchasing power of entities that negotiate on behalf of Medicare, Medicaid, and private sector beneficiaries, have contributed to pricing pressure. In several international markets, government-mandated pricing actions have reduced prices of generic and patented drugs. In addition, the Company’s revenue performance in 2018 was negatively affected by other cost-reduction measures taken by governments and other third-parties to lower health care costs. The Company anticipates all of these actions will continue to negatively affect revenue performance in 2019.
Cyber-attack
On June 27, 2017, the Company experienced a network cyber-attack that led to a disruption of its worldwide operations, including manufacturing, research and sales operations. Due to a backlog of orders for certain products as a result of the cyber-attack, the Company was unable to fulfill orders for certain products in certain markets, which had an unfavorable effect on sales in 2018 and 2017 of approximately $150 million and $260 million, respectively. In addition, the Company recorded manufacturing-related expenses, primarily unfavorable manufacturing variances, in Cost of sales, as well as expenses related to remediation efforts in Selling, general and administrative expenses and Research and development expenses, which aggregated approximately $285 million in 2017, net of insurance recoveries of approximately $45 million. Costs in 2018 were immaterial.
As referenced above, the Company has insurance coverage insuring against costs resulting from cyber-attacks and has received insurance proceeds. However, there are disputes with certain of the insurers about the availability of some of the insurance coverage for claims related to this incident.
Operating Results
Sales
Worldwide sales were $42.3 billion in 2018, an increase of 5% compared with 2017. Sales growth was driven primarily by higher sales in the oncology franchise reflecting strong growth of Keytruda, as well as alliance revenue related to Lynparza and Lenvima. Also contributing to revenue growth were higher sales of vaccines, driven primarily by human papillomavirus (HPV) vaccine Gardasil/Gardasil 9, as well as higher sales in the hospital acute care franchise, largely attributable to Bridion and Noxafil. Higher sales of animal health products also drove revenue growth in 2018.
Sales growth in 2018 was partially offset by declines in the virology franchise driven primarily by lower sales of hepatitis C virus (HCV) treatment Zepatier, as well as lower sales of shingles (herpes zoster) vaccine Zostavax. The ongoing effects of generic and biosimilar competition for cardiovascular products Zetia and Vytorin, and immunology product Remicade, as well as lower sales of products within the diversified brands franchise also partially offset revenue growth in 2018. The diversified brands franchise includes certain products that are approaching the expiration of their marketing exclusivity or that are no longer protected by patents in developed markets.
Sales in the United States were $18.2 billion in 2018, growth of 5% compared with 2017. The increase was driven primarily by higher sales of Keytruda, Gardasil/Gardasil 9, NuvaRing, and Bridion, as well as alliance revenue
from Lynparza and Lenvima, and higher sales of animal health products. Growth was partially offset by lower sales of Zepatier, Zetia, Vytorin, Zostavax, Januvia, Janumet, Invanz, and products within the diversified brands franchise.
International sales were $24.1 billion in 2018, an increase of 6% compared with 2017. The increase primarily reflects growth in Keytruda, Gardasil/Gardasil 9, Januvia, Janumet and Atozet, as well as higher sales of animal health products. Sales growth was partially offset by lower sales of Zepatier, Remicade, Zetia, Vytorin, and products within the diversified brands franchise. International sales represented 57% of total sales in both 2018 and 2017.
Worldwide sales were $40.1 billion in 2017, an increase of 1% compared with 2016. Sales growth in 2017 was driven primarily by higher sales of Keytruda, Zepatier and Bridion. Additionally, sales in 2017 benefited from the December 31, 2016 termination of SPMSD, which marketed vaccines in most major European markets. In 2017, Merck began recording vaccine sales in the markets that were previously part of the SPMSD joint venture resulting in incremental vaccine sales of approximately $400 million during 2017. Higher sales of Pneumovax 23, Adempas, and animal health products also contributed to revenue growth in 2017. These increases were largely offset by the effects of generic competition for certain products including Zetia, which lost U.S. market exclusivity in December 2016, Vytorin, which lost U.S. market exclusivity in April 2017, Cubicin due to U.S. patent expiration in June 2016, and Cancidas, which lost EU patent protection in April 2017. Revenue growth was also offset by continued biosimilar competition for Remicade and ongoing generic erosion for products including Singulair and Nasonex. Collectively, the sales decline attributable to the above products affected by generic and biosimilar competition was $3.3 billion in 2017. Lower sales of other products within the diversified brands franchise, as well as lower combined sales of the diabetes franchise of Januvia and Janumet, and declines in sales of Isentress/Isentress HD also partially offset revenue growth. Additionally, sales in 2017 were reduced by $125 million due to a borrowing the Company made from the U.S. Centers for Disease Control and Prevention (CDC) Pediatric Vaccine Stockpile of doses of Gardasil 9 as discussed below. Also, the Company was unable to fulfill orders for certain products in certain markets due to the cyber-attack, which had an unfavorable effect on sales in 2017 of approximately $260 million.
See Note 19 to the consolidated financial statements for details on sales of the Company’s products.
Pharmaceutical Segment
Oncology
Keytruda is approved in the United States and in the EU as monotherapy for the treatment of certain patients with NSCLC, melanoma, classical Hodgkin lymphoma (cHL), HNSCC and urothelial carcinoma, a type of bladder cancer, and in combination with chemotherapy for certain patients with nonsquamous NSCLC. Keytruda is also approved in the United States as monotherapy for the treatment of certain patients with gastric or gastroesophageal junction adenocarcinoma and MSI-H or mismatch repair deficient cancer. In addition, the FDA recently approved Keytruda for the treatment of certain patients with cervical cancer, PMBCL, hepatocellular carcinoma, Merkel cell carcinoma, and in combination with chemotherapy for patients with squamous NSCLC (see below). Keytruda is approved in Japan for the treatment of certain patients with NSCLC, both as monotherapy and in combination with chemotherapy, melanoma, cHL, MSI-H tumors, and urothelial carcinoma. Additionally, Keytruda has been approved in China for the treatment of certain patients with melanoma. Keytruda is also approved in many other international markets. The Keytruda clinical development program includes studies across a broad range of cancer types (see “Research and Development” below).
In August 2018, the FDA approved an expanded label for Keytruda in combination with pemetrexed and platinum chemotherapy for the first-line treatment of patients with metastatic nonsquamous NSCLC, with no EGFR or ALK genomic tumor aberrations, based on results of the KEYNOTE-189 trial. Keytruda in combination with pemetrexed and carboplatin was first approved in 2017 under the FDA’s accelerated approval process for the first-line treatment of patients with metastatic nonsquamous NSCLC, based on tumor response rates and progression-free survival (PFS) data from a Phase 2 study (KEYNOTE-021, Cohort G1). In accordance with the accelerated approval process, continued approval was contingent upon verification and description of clinical benefit, which was demonstrated in KEYNOTE-189 and resulted in the FDA converting the accelerated approval to full (regular) approval. Also, in September 2018, the EC approved Keytruda in combination with pemetrexed and platinum chemotherapy for the first-line treatment of metastatic nonsquamous NSCLC in adults whose tumors have no EGFR or ALK positive mutations.
In June 2018, the FDA approved Keytruda for the treatment of patients with recurrent or metastatic cervical cancer with disease progression on or after chemotherapy whose tumors express PD-L1 as determined by an FDA-
approved test. Also in June 2018, the FDA approved Keytruda for the treatment of adult and pediatric patients with refractory PMBCL, or who have relapsed after two or more prior lines of therapy.
In September 2018, the EC approved Keytruda as monotherapy for the treatment of recurrent or metastatic HNSCC in adults whose tumors express PD-L1 with a tumor proportion score (TPS) of ≥50%, and who progressed on or after platinum-containing chemotherapy, based on data from the Phase 3 KEYNOTE-040 trial.
In October 2018, the FDA approved Keytruda, in combination with carboplatin and either paclitaxel or nab-paclitaxel, for the first-line treatment of patients with metastatic squamous NSCLC based on results from the KEYNOTE-407 trial. This approval marks the first time an anti-PD-1 regimen has been approved for the first-line treatment of squamous NSCLC regardless of tumor PD-L1 expression status.
In November 2018, the FDA approved Keytruda for the treatment of patients with hepatocellular carcinoma who have been previously treated with sorafenib based on data from the KEYNOTE-224 trial.
In December 2018, the FDA approved Keytruda for the treatment of adult and pediatric patients with recurrent locally advanced or metastatic Merkel cell carcinoma, based on the results of the Cancer Immunotherapy Trials Network’s CITN-09/KEYNOTE-017 trial.
Also in December 2018, the EC approved Keytruda for the adjuvant treatment of adults with stage III melanoma and lymph node involvement who have undergone complete resection. Keytruda was approved for this indication by the FDA in February 2019. These approvals were based on data from the pivotal Phase 3 EORTC1325/KEYNOTE-054 trial, conducted in collaboration with the European Organisation for Research and Treatment of Cancer.
Global sales of Keytruda were $7.2 billion in 2018, $3.8 billion in 2017 and $1.4 billion in 2016. The year-over-year increases were driven by volume growth as the Company continues to launch Keytruda with multiple new indications globally. Sales in the United States continue to build across the multiple approved indications, in particular for the treatment of NSCLC reflecting both the continued adoption of Keytruda in the first-line setting as monotherapy for patients with metastatic NSCLC whose tumors have high PD-L1 expression, as well as the uptake of Keytruda in combination with pemetrexed and carboplatin, a commonly used chemotherapy regimen, for the first-line treatment of metastatic nonsquamous NSCLC with or without PD-L1 expression. Other indications contributing to sales growth include HNSCC, bladder, and melanoma. Recently approved indications, including squamous NSCLC and MSI-H cancer, also contributed to growth in 2018. Sales growth in international markets reflects continued uptake for the treatment of NSCLC as the Company has secured reimbursement in most major markets. Sales growth in international markets in 2018 also includes contributions from the more recently approved indications as described above, including for the treatment of HNSCC, bladder cancer and in combination with chemotherapy for the treatment of NSCLC in the EU, multiple new indications in Japan, and for the treatment of melanoma in China.
In January 2017, Merck entered into a settlement and license agreement to resolve worldwide patent infringement litigation related to Keytruda. Pursuant to the settlement, the Company will pay royalties of 6.5% on net sales of Keytruda in 2017 through 2023; and 2.5% on net sales of Keytruda in 2024 through 2026.
Global sales of Emend, for the prevention of chemotherapy-induced and post-operative nausea and vomiting, were $522 million in 2018, a decline of 6% compared with 2017 including a 1% favorable effect from foreign exchange. The decline primarily reflects lower demand in the United States due to competition. Worldwide sales of Emend were $556 million in 2017, an increase of 1% compared with 2016. The patent that provided U.S. market exclusivity for Emend expired in 2015 and the patent that provides market exclusivity in most major European markets will expire in May 2019. The patent that provides U.S. market exclusivity for Emend for Injection expires in September 2019 and the patent that provides market exclusivity in major European markets expires in February 2020 (although six-month pediatric exclusivity may extend this date). The Company anticipates that sales of Emend in these markets will decline significantly after these patent expiries.
Lynparza, an oral poly (ADP-ribose) polymerase (PARP) inhibitor being developed as part of a collaboration with AstraZeneca entered into in July 2017 (see Note 4 to the consolidated financial statements), is currently approved for certain types of ovarian and breast cancer. Merck recorded alliance revenue of $187 million in 2018 and $20 million in 2017 related to Lynparza. The revenue increase reflects the approval of new indications, as well as a full year of activity in 2018. In January 2018, the FDA approved Lynparza for use in patients with BRCA-mutated, human epidermal growth factor receptor 2 (HER2)-negative metastatic breast cancer who have been previously treated with chemotherapy,
triggering a $70 million capitalized milestone payment from Merck to AstraZeneca. Lynparza was also approved in Japan in July 2018 for use in patients with unresectable or recurrent BRCA-mutated, HER2-negative breast cancer who have received prior chemotherapy. Additionally, Lynparza was approved for use as a maintenance therapy in patients with platinum-sensitive relapsed ovarian cancer, regardless of BRCA mutation status in Japan in January 2018 and in the EU in May 2018. In December 2018, the FDA approved Lynparza for use as maintenance treatment of adult patients with deleterious or suspected deleterious germline or somatic BRCA-mutated advanced epithelial ovarian, fallopian tube or primary peritoneal cancer who are in complete or partial response to first-line platinum-based chemotherapy based on the results of the SOLO-1 clinical trial, triggering a $70 million capitalized milestone payment from Merck to AstraZeneca.
Lenvima, an oral receptor tyrosine kinase inhibitor being developed as part of a collaboration with Eisai entered into in March 2018 (see Note 4 to the consolidated financial statements), is approved for certain types of thyroid cancer, hepatocellular carcinoma, and in combination for certain patients with renal cell carcinoma. Merck recorded alliance revenue of $149 million in 2018 related to Lenvima. In 2018, Lenvima was approved for the treatment of certain patients with hepatocellular carcinoma in the United States, the EU, Japan and China, triggering capitalized milestone payments of $250 million in the aggregate from Merck to Eisai.
Vaccines
On December 31, 2016, Merck and Sanofi terminated their equally-owned joint venture, SPMSD, which developed and marketed vaccines in Europe. Accordingly, vaccine sales in 2018 and 2017 include sales of Merck vaccines in the European markets that were previously part of the SPMSD joint venture, whereas sales in periods prior to 2017 do not. Prior to 2017, vaccine sales in these European markets were sold through the SPMSD joint venture, the results of which were reflected in equity income from affiliates included in Other (income) expense, net. Supply sales to SPMSD, however, are included in vaccine sales in periods prior to 2017. Incremental vaccine sales resulting from the termination of the SPMSD joint venture were approximately $400 million in 2017, of which approximately $215 million relate to Gardasil/Gardasil 9.
Worldwide sales of Gardasil/Gardasil 9, vaccines to help prevent certain cancers and other diseases caused by certain types of HPV, were $3.2 billion in 2018, growth of 37% compared with 2017 including a 1% favorable effect from foreign exchange. Sales growth was driven primarily by higher sales in the Asia Pacific region, particularly in China reflecting continued uptake since launch, as well as higher demand in certain European markets. The sales increase was also attributable to the replenishment in 2018 of doses borrowed from the CDC Pediatric Vaccine Stockpile in 2017 as discussed below. In April 2018, China’s Food and Drug Administration approved Gardasil 9 for use in girls and women ages 16 to 26. In October 2018, the FDA approved an expanded age indication for use in women and men ages 27 to 45 for the prevention of certain cancers and diseases caused by the nine HPV types covered by the vaccine.
During 2017, the Company made a request to borrow doses of Gardasil 9 from the CDC Pediatric Vaccine Stockpile, which the CDC granted. The Company’s decision to borrow the doses from the CDC was driven in part by the temporary shutdown resulting from the cyber-attack that occurred in June 2017, as well as by overall higher demand than expected. As a result of the borrowing, the Company reversed the sales related to the borrowed doses and recognized a corresponding liability. The Company subsequently replenished a portion of the doses borrowed from the stockpile. The net effect of the borrowing and subsequent partial replenishment was a reduction in sales of $125 million in 2017. The Company replenished the remaining borrowed doses in 2018 resulting in the recognition of sales of $125 million in 2018 and a reversal of the related liability.
Global sales of Gardasil/Gardasil 9 were $2.3 billion in 2017, growth of 6% compared with 2016. Sales growth was driven primarily by higher sales in Europe resulting from the termination of the SPMSD joint venture noted above, as well as higher demand in the Asia Pacific region due in part to the launch in China, partially offset by lower sales in the United States. Lower sales in the United States reflect the timing of public sector purchases and the CDC stockpile borrowing as described above.
The Company is a party to certain third-party license agreements with respect to Gardasil/Gardasil 9 pursuant to which the Company pays royalties on worldwide Gardasil/Gardasil 9 sales. The royalties, which vary by country and range from 7% to 13%, are included in Cost of sales.
Global sales of ProQuad, a pediatric combination vaccine to help protect against measles, mumps, rubella and varicella, were $593 million in 2018, an increase of 12% compared with 2017, driven primarily by higher volumes
and pricing in the United States and volume growth in certain European markets. Worldwide sales of ProQuad were $528 million in 2017, an increase of 7% compared with $495 million in 2016. Sales growth in 2017 was driven primarily by higher pricing and volumes in the United States, as well as volume growth in international markets, particularly in Europe. Foreign exchange favorably affected global sales performance by 1% in 2017.
Worldwide sales of M-M-R II, a vaccine to help protect against measles, mumps and rubella, were $430 million in 2018, an increase of 13% compared with 2017, driven primarily by volume growth in Latin America. Global sales of M-M-R II were $382 million in 2017, an increase of 8% compared with $353 million in 2016. Sales growth in 2017 was largely attributable to higher sales in Europe resulting from the termination of the SPMSD joint venture. Foreign exchange favorably affected global sales performance by 1% in 2018 and unfavorably affected global sales performance by 1% in 2017.
Global sales of Varivax, a vaccine to help prevent chickenpox (varicella), were $774 million in 2018, an increase of 1% compared with 2017, reflecting volume growth in Latin America and the Asia Pacific region, along with higher pricing in the United States, largely offset by volume declines in Turkey from the loss of a government tender due to competition. Worldwide sales of Varivax were $767 million in 2017, a decline of 3% compared with $792 million in 2016. The sales decline in 2017 was driven primarily by lower volumes in Brazil due to the loss of a government tender, as well as lower sales in the United States reflecting lower demand that was partially offset by higher pricing. Higher sales in Europe resulting from the termination of the SPMSD joint venture partially offset the sales decline in 2017.
Worldwide sales of Pneumovax 23, a vaccine to help prevent pneumococcal disease, were $907 million in 2018, an increase of 10% compared with 2017. Sales growth was driven primarily by higher pricing in the United States and volume growth in Europe. Global sales of Pneumovax 23 were $821 million in 2017, an increase of 28% compared with 2016, driven primarily by higher demand and pricing in the United States, as well as higher sales in Europe resulting from the termination of the SPMSD joint venture. Foreign exchange unfavorably affected sales performance by 1% in 2017.
Global sales of RotaTeq, a vaccine to help protect against rotavirus gastroenteritis in infants and children, were $728 million in 2018, an increase of 6% compared with 2017, driven primarily by the launch in China. Worldwide sales of RotaTeq were $686 million in 2017, an increase of 5% compared with 2016, driven primarily by higher sales in Europe resulting from the termination of the SPMSD joint venture.
Worldwide sales of Zostavax, a vaccine to help prevent shingles (herpes zoster) in adults 50 years of age and older, were $217 million in 2018, a decline of 68% compared with 2017, driven by lower volumes in most markets, particularly in the United States. Lower demand in the United States reflects the launch of a competing vaccine that received a preferential recommendation from the CDC’s Advisory Committee on Immunization Practices in October 2017 for the prevention of shingles over Zostavax. The declines were partially offset by higher demand in certain European markets. The Company anticipates competition will continue to have an adverse effect on sales of Zostavax in future periods. Global sales of Zostavax were $668 million in 2017, a decline of 2% compared with 2016 including a 1% favorable effect from foreign exchange. The sales decline was driven primarily by lower demand in the United States reflecting the approval of a competing vaccine as noted above, partially offset by growth in Europe resulting from the termination of the SPMSD joint venture and volume growth in the Asia Pacific region.
In 2018, the FDA approved Vaxelis (Diphtheria and Tetanus Toxoids and Acellular Pertussis Adsorbed, Inactivated Poliovirus, Haemophilus b Conjugate [Meningococcal Protein Conjugate] and Hepatitis B [Recombinant] Vaccine) for use in children from 6 weeks through 4 years of age (prior to the 5th birthday). Vaxelis, which is currently being marketed in Europe, was developed as part of a joint-partnership between Merck and Sanofi. Merck and Sanofi are working to maximize production of Vaxelis to allow for a sustainable supply to meet anticipated U.S. demand. Commercial supply will not be available prior to 2020.
Hospital Acute Care
Global sales of Bridion, for the reversal of two types of neuromuscular blocking agents used during surgery, were $917 million in 2018, growth of 30% compared with 2017, driven primarily by volume growth in the United States and certain European markets. Worldwide sales of Bridion were $704 million in 2017, growth of 46% compared with 2016, driven by strong global demand, particularly in the United States.
Worldwide sales of Noxafil, for the prevention of invasive fungal infections, were $742 million in 2018, an increase of 17% compared with 2017 including a 2% favorable effect from foreign exchange. Sales growth primarily reflects higher demand in the United States, certain European markets and China. Global sales of Noxafil were $636 million in 2017, an increase of 7% compared with 2016, primarily reflecting higher demand and pricing in the United States, as well as volume growth in Europe. The patent that provides U.S. market exclusivity for Noxafil expires in July 2019. Additionally, the patent for Noxafil will expire in a number of major European markets in December 2019. The Company anticipates sales of Noxafil in these markets will decline significantly thereafter.
Global sales of Invanz, for the treatment of certain infections, were $496 million in 2018, a decline of 18% compared with 2017 including a 1% unfavorable effect from foreign exchange. The sales decline was driven by lower volumes in the United States. The patent that provided U.S. market exclusivity for Invanz expired in November 2017 and generic competition began in the second half of 2018. The Company is experiencing a significant decline in U.S. Invanz sales as a result of this generic competition and expects the decline to continue. Worldwide sales of Invanz were $602 million in 2017, an increase of 7% compared with 2016, driven primarily by higher sales in the United States, reflecting higher pricing that was partially offset by lower demand, as well as higher demand in Brazil.
Global sales of Cubicin, an I.V. antibiotic for complicated skin and skin structure infections or bacteremia when caused by designated susceptible organisms, were $367 million in 2018, a decline of 4% compared with 2017 including a 1% favorable effect from foreign exchange. Worldwide sales of Cubicin were $382 million in 2017, a decline of 65% compared with 2016, resulting from generic competition in the United States following expiration of the U.S. composition patent for Cubicin in June 2016.
Global sales of Cancidas, an anti-fungal product sold primarily outside of the United States, were $326 million in 2018, a decline of 23% compared with 2017, and were $422 million in 2017, a decline of 24% compared with 2016. Foreign exchange favorably affected global sales performance by 2% in 2018. The sales declines were driven primarily by generic competition in certain European markets. The EU compound patent for Cancidas expired in April 2017. Accordingly, the Company is experiencing a significant decline in Cancidas sales in these European markets and expects the decline to continue.
Immunology
Sales of Simponi, a once-monthly subcutaneous treatment for certain inflammatory diseases (marketed by the Company in Europe, Russia and Turkey), were $893 million in 2018, growth of 9% compared with 2017 including a 4% favorable effect from foreign exchange. Sales of Simponi were $819 million in 2017, growth of 7% compared with 2016 including a 1% favorable effect from foreign exchange. Sales growth in both years was driven by higher demand in Europe. The Company anticipates sales of Simponi will be unfavorably affected in future periods by the recent launch of biosimilars for a competing product.
Sales of Remicade, a treatment for inflammatory diseases (marketed by the Company in Europe, Russia and Turkey), were $582 million in 2018, a decline of 31% compared with 2017, and were $837 million in 2017, a decline of 34% compared with 2016. Foreign exchange favorably affected sales performance by 2% in 2018. The Company lost market exclusivity for Remicade in major European markets in 2015 and no longer has market exclusivity in any of its marketing territories. The Company is experiencing pricing and volume declines in these markets as a result of biosimilar competition and expects the declines to continue.
Virology
Worldwide sales of Isentress/Isentress HD, an HIV integrase inhibitor for use in combination with other antiretroviral agents for the treatment of HIV-1 infection, were $1.1 billion in 2018, a decline of 5% compared with 2017, and were $1.2 billion in 2017, a decline of 13% compared with 2016. Foreign exchange favorably affected global sales performance by 1% in 2017. The sales declines primarily reflect competitive pressure in the United States and Europe.
In August 2018, the FDA approved two new HIV-1 medicines: Delstrigo, a once-daily fixed-dose combination tablet of doravirine, lamivudine and tenofovir disoproxil fumarate; and Pifeltro (doravirine), a new non-nucleoside reverse transcriptase inhibitor to be administered in combination with other antiretroviral medicines. Both Delstrigo and Pifeltro are indicated for the treatment of HIV-1 infection in adult patients with no prior antiretroviral treatment experience. Delstrigo and Pifeltro were also approved by the EC in November 2018. In January 2019, the FDA accepted for review supplemental New Drug Applications (NDA) for Pifeltro and Delstrigo seeking approval for
use in patients living with HIV-1 who are switching from a stable antiretroviral regimen and whose virus is suppressed. The Prescription Drug User Fee Act (PDUFA) date for the supplemental NDAs is September 20, 2019.
Global sales of Zepatier, a treatment for adult patients with certain types of chronic hepatitis C virus (HCV) infection, were $455 million in 2018, a decline of 73% compared with 2017. The sales decline was driven primarily by the unfavorable effects of increasing competition and declining patient volumes, particularly in the United States, Europe and Japan. The Company anticipates that sales of Zepatier in the future will continue to be adversely affected by competition and lower patient volumes. Worldwide sales of Zepatier were $1.7 billion in 2017 compared with $555 million in 2016. Sales growth in 2017 was driven primarily by higher sales in Europe, the United States and Japan following product launch in 2016.
Cardiovascular
Combined global sales of Zetia (marketed in most countries outside the United States as Ezetrol), Vytorin (marketed outside the United States as Inegy), as well as Atozet and Rosuzet (both marketed in certain countries outside of the United States), medicines for lowering LDL cholesterol, were $1.8 billion in 2018, a decline of 26% compared with 2017 including a 3% favorable effect from foreign exchange. The sales decline was driven primarily by lower demand in the United States and Europe. Zetia and Vytorin lost market exclusivity in the United States in December 2016 and April 2017, respectively. Accordingly, the Company experienced a rapid and substantial decline in U.S. Zetia and Vytorin sales as a result of generic competition and has lost nearly all U.S. sales of these products. In addition, the Company lost market exclusivity in major European markets for Ezetrol in April 2018 and has also lost market exclusivity in certain European markets for Inegy (see Note 11 to the consolidated financial statements). Accordingly, the Company is experiencing significant sales declines in these markets as a result of generic competition and expects the declines to continue. These declines were partially offset by higher sales in Japan due in part to the launch of Atozet. Combined worldwide sales of the ezetimibe family were $2.4 billion in 2017, a decline of 39% compared with 2016. The sales decline was driven by lower volumes and pricing of Zetia and Vytorin in the United States as a result of generic competition due to the loss of U.S. market exclusivity as described above.
Pursuant to a collaboration with Bayer AG (Bayer) (see Note 4 to the consolidated financial statements), Merck has lead commercial rights for Adempas, a cardiovascular drug for the treatment of pulmonary arterial hypertension, in countries outside the Americas while Bayer has lead rights in the Americas, including the United States. The companies share profits equally under the collaboration. In 2016, Merck began promoting and distributing Adempas in Europe. Transition from Bayer in other Merck territories, including Japan, continued in 2017. Revenue from Adempas includes sales in Merck’s marketing territories, as well as Merck’s share of profits from the sale of Adempas in Bayer’s marketing territories. Merck recorded revenue related to Adempas of $329 million in 2018, an increase of 10% compared with 2017, reflecting higher sales in Merck’s marketing territories, partially offset by lower profit sharing from Bayer due in part to lower pricing in the United States. Revenue related to Adempas was $300 million in 2017, an increase of 78% compared with 2016, reflecting both higher sales in Merck’s marketing territories, as well as the recognition of higher profit sharing from Bayer. Foreign exchange favorably affected global sales performance by 3% in 2018 and by 1% in 2017.
Diabetes
Worldwide combined sales of Januvia and Janumet, medicines that help lower blood sugar levels in adults with type 2 diabetes, were $5.9 billion in 2018, essentially flat compared with 2017. Global combined sales of Januvia and Janumet were $5.9 billion in 2017, a decline of 3% compared with 2016. Foreign exchange favorably affected sales performance by 1% in both 2018 and 2017. Sales performance in both periods was driven primarily by ongoing pricing pressure, particularly in the United States, partially offset by higher demand in most international markets. The Company expects pricing pressure to continue.
Women’s Health
Worldwide sales of NuvaRing, a vaginal contraceptive product, were $902 million in 2018, an increase of 19% compared with 2017 including a 1% favorable effect from foreign exchange. Sales growth was driven primarily by higher pricing in the United States. The patent that provided U.S. market exclusivity for NuvaRing expired in April 2018 and the Company anticipates a significant decline in U.S. NuvaRing sales in future periods as a result of generic competition. Global sales of NuvaRing were $761 million in 2017, a decline of 2% compared with 2016 including a 1% favorable effect from foreign exchange. The sales decline was driven primarily by lower sales in the United States reflecting lower volumes that were partially offset by higher pricing, and lower demand in Europe.
Animal Health Segment
Global sales of Animal Health products were $4.2 billion in 2018, an increase of 9% compared with 2017, reflecting growth from both in-line and recently launched companion animal and livestock products. Higher sales of companion animal products reflect growth in the Bravecto line of products that kill fleas and ticks in dogs and cats for up to 12 weeks, as well as higher sales of companion animal vaccines. Growth in livestock products reflects higher sales of ruminant, poultry and swine products. Worldwide sales of Animal Health products were $3.9 billion in 2017, an increase of 11% compared with 2016, primarily reflecting higher sales of companion animal products, largely driven by growth in Bravecto, reflecting both growth in the oral formulation and continued uptake in the topical formulation, which was launched in 2016. Animal Health sales growth in 2017 was also driven by higher sales of ruminant, poultry and swine products.
In December 2018, the Company signed an agreement to acquire Antelliq, a leader in digital animal identification, traceability and monitoring solutions (see Note 3 to the consolidated financial statements).
Costs, Expenses and Other
| ($ in millions) | 2018 | Change | 2017 | Change | 2016 | ||||||||||||
| Cost of sales | $ | 13,509 | 5 | % | $ | 12,912 | -8 | % | $ | 14,030 | |||||||
| Selling, general and administrative | 10,102 | — | % | 10,074 | 1 | % | 10,017 | ||||||||||
| Research and development | 9,752 | -6 | % | 10,339 | 1 | % | 10,261 | ||||||||||
| Restructuring costs | 632 | -19 | % | 776 | 19 | % | 651 | ||||||||||
| Other (income) expense, net | (402 | ) | -20 | % | (500 | ) | * | 189 | |||||||||
| $ | 33,593 | — | % | $ | 33,601 | -4 | % | $ | 35,148 |
- Greater than 100%.
Cost of Sales
Cost of sales was $13.5 billion in 2018, $12.9 billion in 2017 and $14.0 billion in 2016. Costs in 2018 include a $423 million charge related to the termination of a collaboration agreement with Samsung Bioepis Co., Ltd. (Samsung) for insulin glargine (see Note 3 to the consolidated financial statements). Also in 2018, the Company recorded $188 million of cumulative amortization expense for amounts capitalized in connection with the recognition of liabilities for potential future milestone payments related to collaborations (see Note 4 to the consolidated financial statements). Cost of sales includes expenses for the amortization of intangible assets recorded in connection with business acquisitions which totaled $2.7 billion in 2018, $3.1 billion in 2017 and $3.7 billion in 2016. Costs in 2017 and 2016 also include intangible asset impairment charges of $58 million and $347 million, respectively, related to marketed products and other intangibles recorded in connection with business acquisitions (see Note 8 to the consolidated financial statements). Costs in 2017 also include a $76 million intangible asset impairment charge related to a licensing agreement. The Company may recognize additional non-cash impairment charges in the future related to intangible assets that were measured at fair value and capitalized in connection with business acquisitions and such charges could be material. Also included in cost of sales are expenses associated with restructuring activities which amounted to $21 million, $138 million and $181 million in 2018, 2017 and 2016, respectively, primarily reflecting accelerated depreciation and asset write-offs related to the planned sale or closure of manufacturing facilities. Separation costs associated with manufacturing-related headcount reductions have been incurred and are reflected in Restructuring costs as discussed below.
Gross margin was 68.1% in 2018 compared with 67.8% in 2017 and 64.5% in 2016. The year-over-year improvements in gross margin reflect a lower net impact from the amortization of intangible assets and intangible asset impairment charges related to business acquisitions, as well as restructuring costs as noted above, which reduced gross margin by 6.3 percentage points in 2018, 8.3 percentage points in 2017 and 10.6 percentage points in 2016. The gross margin improvement in 2018 compared with 2017 also reflects the favorable effects of product mix and amortization of unfavorable manufacturing variances recorded in 2017, resulting in part from the June 2017 cyber-attack. The gross margin improvement in 2018 was partially offset by a charge associated with the termination of a collaboration agreement
with Samsung, as well as the unfavorable effects of pricing pressure and cumulative amortization expense for potential future milestone payments related to collaborations as noted above. The gross margin improvement in 2017 compared with 2016 also reflects the favorable effects of product mix. Manufacturing-related costs associated with the cyber-attack partially offset the gross margin improvement in 2017.
Selling, General and Administrative
Selling, general and administrative (SG&A) expenses were $10.1 billion in 2018, essentially flat compared with 2017, reflecting higher administrative costs and the unfavorable effect of foreign exchange, offset by lower selling and promotional expenses. SG&A expenses were $10.1 billion in 2017, an increase of 1% compared with 2016. Higher administrative costs, including costs associated with the Company operating its vaccines business in the European markets that were previously part of the SPMSD joint venture, remediation costs related to the cyber-attack, and higher promotional expenses related to product launches, were partially offset by lower restructuring and acquisition and divestiture-related costs, lower selling expenses and the favorable effect of foreign exchange. SG&A expenses in 2016 include restructuring costs of $95 million related primarily to accelerated depreciation for facilities to be closed or divested. Separation costs associated with sales force reductions have been incurred and are reflected in Restructuring costs as discussed below. SG&A expenses also include acquisition and divestiture-related costs of $32 million, $44 million and $78 million in 2018, 2017 and 2016, respectively, consisting of integration, transaction, and certain other costs related to business acquisitions and divestitures.
Research and Development
Research and development (R&D) expenses were $9.8 billion in 2018, a decline of 6% compared with 2017. The decrease primarily reflects lower expenses in 2018 for upfront and license option payments related to the formation of oncology collaborations, lower in-process research and development (IPR&D) impairment charges, and a reduction in expenses associated with a decrease in the estimated fair value measurement of liabilities for contingent consideration, partially offset by higher clinical development spending and investment in discovery and early drug development, as well as higher expenses related to other business development activities, including a charge in 2018 for the acquisition of Viralytics. R&D expenses were $10.3 billion in 2017, an increase of 1% compared with 2016. The increase was driven primarily by a charge in 2017 related to the formation of a collaboration with AstraZeneca, an unfavorable effect from changes in the estimated fair value measurement of liabilities for contingent consideration, and higher clinical development spending, largely offset by lower IPR&D impairment charges and lower restructuring costs.
R&D expenses are comprised of the costs directly incurred by Merck Research Laboratories (MRL), the Company’s research and development division that focuses on human health-related activities, which were $5.1 billion in 2018, $4.6 billion in 2017 and $4.4 billion in 2016. Also included in R&D expenses are costs incurred by other divisions in support of R&D activities, including depreciation, production and general and administrative, as well as licensing activity, and certain costs from operating segments, including the Pharmaceutical and Animal Health segments, which in the aggregate were $2.8 billion, $2.9 billion and $2.6 billion for 2018, 2017 and 2016, respectively. Additionally, R&D expenses in 2018 include a $1.4 billion charge related to the formation of a collaboration with Eisai (see Note 4 to the consolidated financial statements), as well as a $344 million charge for the acquisition of Viralytics (see Note 3 to the consolidated financial statements). R&D expenses in 2017 include a $2.35 billion charge related to the formation of a collaboration with AstraZeneca (see Note 4 to the consolidated financial statements). R&D expenses also include IPR&D impairment charges of $152 million, $483 million and $3.6 billion in 2018, 2017 and 2016, respectively (see Note 8 to the consolidated financial statements). The Company may recognize additional non-cash impairment charges in the future related to the cancellation or delay of other pipeline programs that were measured at fair value and capitalized in connection with business acquisitions and such charges could be material. In addition, R&D expenses include expense or income related to changes in the estimated fair value measurement of liabilities for contingent consideration recorded in connection with acquisitions. During 2018 and 2016, the Company recorded a net reduction in expenses of $54 million and $402 million, respectively, to decrease the estimated fair value of liabilities for contingent consideration related to the discontinuation or delay of certain programs (see Note 6 to the consolidated financial statements). During 2017, the Company recorded charges of $27 million to increase the estimated fair value of liabilities for contingent consideration. R&D expenses in 2016 also reflect $142 million of accelerated depreciation and asset abandonment costs associated with restructuring activities.
Restructuring Costs
In 2010 and 2013, the Company commenced actions under global restructuring programs designed to streamline its cost structure. The actions under these programs include the elimination of positions in sales, administrative and headquarters organizations, as well as the sale or closure of certain manufacturing and research and development sites and the consolidation of office facilities. The Company also continues to reduce its global real estate footprint and improve the efficiency of its manufacturing and supply network.
Restructuring costs, primarily representing separation and other related costs associated with these restructuring activities, were $632 million, $776 million and $651 million in 2018, 2017 and 2016, respectively. In 2018, 2017 and 2016, separation costs of $473 million, $552 million and $216 million, respectively, were incurred associated with actual headcount reductions, as well as estimated expenses under existing severance programs for headcount reductions that were probable and could be reasonably estimated. Merck eliminated approximately 2,160 positions in 2018, 2,450 positions in 2017 and 2,625 positions in 2016 related to these restructuring activities. Also included in restructuring costs are asset abandonment, shut-down and other related costs, as well as employee-related costs such as curtailment, settlement and termination charges associated with pension and other postretirement benefit plans and share-based compensation plan costs. For segment reporting, restructuring costs are unallocated expenses.
Additional costs associated with the Company’s restructuring activities are included in Cost of sales, Selling, general and administrative and Research and development as discussed above. The Company recorded aggregate pretax costs of $658 million in 2018, $927 million in 2017 and $1.1 billion in 2016 related to restructuring program activities (see Note 5 to the consolidated financial statements). The Company has substantially completed the actions under these programs.
Other (Income) Expense, Net
Other (income) expense, net, was $402 million of income in 2018, $500 million of income in 2017 and $189 million of expense in 2016. For details on the components of Other (income) expense, net, see Note 15 to the consolidated financial statements.
| Segment Profits | |||||||||||
| ($ in millions) | 2018 | 2017 | 2016 | ||||||||
| Pharmaceutical segment profits | $ | 24,292 | $ | 22,495 | $ | 22,141 | |||||
| Animal Health segment profits | 1,659 | 1,552 | 1,357 | ||||||||
| Other non-reportable segment profits | 103 | 275 | 146 | ||||||||
| Other | (17,353 | ) | (17,801 | ) | (18,985 | ) | |||||
| Income before taxes | $ | 8,701 | $ | 6,521 | $ | 4,659 |
Pharmaceutical segment profits are comprised of segment sales less standard costs, as well as SG&A and R&D expenses directly incurred by the segment. Animal Health segment profits are comprised of segment sales, less all cost of sales, as well as SG&A and R&D expenses directly incurred by the segment. For internal management reporting presented to the chief operating decision maker, Merck does not allocate the remaining cost of sales not included in segment profits as described above, research and development expenses incurred in MRL, or general and administrative expenses, nor the cost of financing these activities. Separate divisions maintain responsibility for monitoring and managing these costs, including depreciation related to fixed assets utilized by these divisions and, therefore, they are not included in segment profits. Also excluded from the determination of segment profits are acquisition and divestiture-related costs (amortization of purchase accounting adjustments, intangible asset impairment charges and expense or income related to changes in the estimated fair value measurement of liabilities for contingent consideration), restructuring costs, and a portion of equity income. Additionally, segment profits do not reflect other expenses from corporate and manufacturing cost centers and other miscellaneous income or expense. These unallocated items, including a charge related to the termination of a collaboration agreement with Samsung for insulin glargine in 2018, a loss on the extinguishment of debt in 2017, and a charge related to the settlement of worldwide Keytruda patent litigation and gains on divestitures in 2016, are reflected in “Other” in the above table. Also included in “Other” are miscellaneous corporate profits (losses), as well as operating profits (losses) related to third-party manufacturing sales. In the first quarter of 2018, the Company adopted a new accounting standard related to the classification of certain defined benefit plan costs, which resulted in a change to the measurement of segment profits (see Note 19 to the consolidated financial statements). Prior period amounts have been recast to conform to the new presentation.
Pharmaceutical segment profits grew 8% in 2018 compared with 2017 primarily reflecting higher sales and lower selling and promotional costs. Pharmaceutical segment profits grew 2% in 2017 compared with 2016 primarily reflecting higher sales and the favorable effects of product mix. Animal Health segment profits grew 7% in 2018 and 14% in 2017 driven primarily by higher sales, partially offset by increased selling and promotional costs.
Taxes on Income
The effective income tax rates of 28.8% in 2018, 62.9% in 2017 and 15.4% in 2016 reflect the impacts of acquisition and divestiture-related costs, restructuring costs and the beneficial impact of foreign earnings. The effective income tax rate in 2018 includes measurement-period adjustments to the provisional amounts recorded in 2017 associated with the enactment of U.S. tax legislation known as the Tax Cuts and Jobs Act (TCJA), including $124 million related to the transition tax (see Note 16 to the consolidated financial statements). In addition, the effective income tax rate for 2018 reflects the unfavorable impacts of a $1.4 billion pretax charge recorded in connection with the formation of a collaboration with Eisai and a $423 million pretax charge related to the termination of a collaboration agreement with Samsung for which no tax benefits were recognized. The effective income tax rate for 2017 includes a provisional net charge of $2.6 billion related to the enactment of the TCJA. The effective income tax rate for 2017 also reflects the unfavorable impact of a $2.35 billion pretax charge recorded in connection with the formation of a collaboration with AstraZeneca for which no tax benefit was recognized, partially offset by the favorable impact of a net tax benefit of $234 million related to the settlement of certain federal income tax issues (see Note 16 to the consolidated financial statements), and a benefit of $88 million related to the settlement of a state income tax issue.
Net (Loss) Income Attributable to Noncontrolling Interests
Net (loss) income attributable to noncontrolling interests was $(27) million in 2018 compared with $24 million in 2017 and $21 million in 2016. The loss in 2018 primarily reflects the portion of goodwill impairment charges related to certain business in the Healthcare Services segment that are attributable to noncontrolling interests.
Net Income and Earnings per Common Share
Net income attributable to Merck & Co., Inc. was $6.2 billion in 2018, $2.4 billion in 2017 and $3.9 billion in 2016. EPS was $2.32 in 2018, $0.87 in 2017 and $1.41 in 2016.
Non-GAAP Income and Non-GAAP EPS
Non-GAAP income and non-GAAP EPS are alternative views of the Company’s performance that Merck is providing because management believes this information enhances investors’ understanding of the Company’s results as it permits investors to understand how management assesses performance. Non-GAAP income and non-GAAP EPS exclude certain items because of the nature of these items and the impact that they have on the analysis of underlying business performance and trends. The excluded items (which should not be considered non-recurring) consist of acquisition and divestiture-related costs, restructuring costs and certain other items. These excluded items are significant components in understanding and assessing financial performance.
Non-GAAP income and non-GAAP EPS are important internal measures for the Company. Senior management receives a monthly analysis of operating results that includes non-GAAP EPS. Management uses these measures internally for planning and forecasting purposes and to measure the performance of the Company along with other metrics. Senior management’s annual compensation is derived in part using non-GAAP income and non-GAAP EPS. Since non-GAAP income and non-GAAP EPS are not measures determined in accordance with GAAP, they have no standardized meaning prescribed by GAAP and, therefore, may not be comparable to the calculation of similar measures of other companies. The information on non-GAAP income and non-GAAP EPS should be considered in addition to, but not as a substitute for or superior to, net income and EPS prepared in accordance with generally accepted accounting principles in the United States (GAAP).
A reconciliation between GAAP financial measures and non-GAAP financial measures is as follows:
| ($ in millions except per share amounts) | 2018 | 2017 | 2016 | ||||||||
| Income before taxes as reported under GAAP | $ | 8,701 | $ | 6,521 | $ | 4,659 | |||||
| Increase (decrease) for excluded items: | |||||||||||
| Acquisition and divestiture-related costs | 3,066 | 3,760 | 7,312 | ||||||||
| Restructuring costs | 658 | 927 | 1,069 | ||||||||
| Other items: | |||||||||||
| Charge related to the formation of an oncology collaboration with Eisai | 1,400 | — | — | ||||||||
| Charge related to the termination of a collaboration with Samsung | 423 | — | — | ||||||||
| Charge for the acquisition of Viralytics | 344 | — | — | ||||||||
| Charge related to the formation of an oncology collaboration with AstraZeneca | — | 2,350 | — | ||||||||
| Charge related to the settlement of worldwide Keytruda patent litigation | — | — | 625 | ||||||||
| Other | (57 | ) | (16 | ) | (67 | ) | |||||
| Non-GAAP income before taxes | 14,535 | 13,542 | 13,598 | ||||||||
| Taxes on income as reported under GAAP | 2,508 | 4,103 | 718 | ||||||||
| Estimated tax benefit on excluded items (1) | 535 | 785 | 2,321 | ||||||||
| Net tax charge related to the enactment of the TCJA (2) | (160 | ) | (2,625 | ) | — | ||||||
| Net tax benefit from the settlement of certain federal income tax issues | — | 234 | — | ||||||||
| Tax benefit related to the settlement of a state income tax issue | — | 88 | — | ||||||||
| Non-GAAP taxes on income | 2,883 | 2,585 | 3,039 | ||||||||
| Non-GAAP net income | 11,652 | 10,957 | 10,559 | ||||||||
| Less: Net (loss) income attributable to noncontrolling interests as reported under GAAP | (27 | ) | 24 | 21 | |||||||
| Acquisition and divestiture-related costs attributable to noncontrolling interests | (58 | ) | — | — | |||||||
| Non-GAAP net income attributable to noncontrolling interests | 31 | 24 | 21 | ||||||||
| Non-GAAP net income attributable to Merck & Co., Inc. | $ | 11,621 | $ | 10,933 | $ | 10,538 | |||||
| EPS assuming dilution as reported under GAAP | $ | 2.32 | $ | 0.87 | $ | 1.41 | |||||
| EPS difference (3) | 2.02 | 3.11 | 2.37 | ||||||||
| Non-GAAP EPS assuming dilution | $ | 4.34 | $ | 3.98 | $ | 3.78 |
| (1) | The estimated tax impact on the excluded items is determined by applying the statutory rate of the originating territory of the non-GAAP adjustments. |
(2) Amount in 2017 was provisional (see Note 16 to the consolidated financial statements).
| (3) | Represents the difference between calculated GAAP EPS and calculated non-GAAP EPS, which may be different than the amount calculated by dividing the impact of the excluded items by the weighted-average shares for the applicable year. |
Acquisition and Divestiture-Related Costs
Non-GAAP income and non-GAAP EPS exclude the impact of certain amounts recorded in connection with business acquisitions and divestitures. These amounts include the amortization of intangible assets and amortization of purchase accounting adjustments to inventories, as well as intangible asset impairment charges and expense or income related to changes in the estimated fair value measurement of liabilities for contingent consideration. Also excluded are integration, transaction, and certain other costs associated with business acquisitions and divestitures.
Restructuring Costs
Non-GAAP income and non-GAAP EPS exclude costs related to restructuring actions (see Note 5 to the consolidated financial statements). These amounts include employee separation costs and accelerated depreciation associated with facilities to be closed or divested. Accelerated depreciation costs represent the difference between the depreciation expense to be recognized over the revised useful life of the asset, based upon the anticipated date the site will be closed or divested or the equipment disposed of, and depreciation expense as determined utilizing the useful
life prior to the restructuring actions. Restructuring costs also include asset abandonment, shut-down and other related costs, as well as employee-related costs such as curtailment, settlement and termination charges associated with pension and other postretirement benefit plans and share-based compensation costs.
Certain Other Items
Non-GAAP income and non-GAAP EPS exclude certain other items. These items are adjusted for after evaluating them on an individual basis, considering their quantitative and qualitative aspects, and typically consist of items that are unusual in nature, significant to the results of a particular period or not indicative of future operating results. Excluded from non-GAAP income and non-GAAP EPS in 2018 is a charge related to the formation of a collaboration with Eisai (see Note 4 to the consolidated financial statements), a charge related to the termination of a collaboration agreement with Samsung for insulin glargine (see Note 3 to the consolidated financial statements), a charge for the acquisition of Viralytics (see Note 3 to the consolidated financial statements), and measurement-period adjustments related to the provisional amounts recorded for the TCJA (see Note 16 to the consolidated financial statements). Excluded from non-GAAP income and non-GAAP EPS in 2017 is a charge related to the formation of a collaboration with AstraZeneca (see Note 4 to the consolidated financial statements), as well as a provisional net tax charge related to the enactment of the TCJA, a net tax benefit related to the settlement of certain federal income tax issues and a tax benefit related to the settlement of a state income tax issue (see Note 16 to the consolidated financial statements). Excluded from non-GAAP income and non-GAAP EPS in 2016 is a charge to settle worldwide patent litigation related to Keytruda.
Research and Development
A chart reflecting the Company’s current research pipeline as of February 22, 2019 is set forth in Item 1. “Business — Research and Development” above.
Research and Development Update
The Company currently has several candidates under regulatory review in the United States and internationally.
Keytruda is an approved anti-PD-1 therapy in clinical development for expanded indications in different cancer types.
In February 2019, the FDA accepted and granted Priority Review for a supplemental BLA for Keytruda in combination with Inlyta (axitinib), a tyrosine kinase inhibitor, for the first-line treatment of patients with advanced renal cell carcinoma. This supplemental BLA is based on findings from the Phase 3 KEYNOTE-426 trial, which demonstrated that Keytruda in combination with axitinib, as compared to sunitinib, significantly improved overall survival (OS) and PFS in the first-line treatment of advanced renal cell carcinoma. These data were presented at the American Society for Clinical Oncology (ASCO) Genitourinary Cancers Symposium in February 2019. The supplemental BLA also included supporting data from the Phase 1b KEYNOTE-035 trial. The FDA set a PDUFA date of June 20, 2019. Merck has filed data from KEYNOTE-426 with regulatory authorities worldwide.
In February 2019, the Committee for Medicinal Products for Human Use of the European Medicines Agency (EMA) adopted a positive opinion recommending Keytruda, in combination with carboplatin and either paclitaxel or nab-paclitaxel, for the first-line treatment of metastatic squamous NSCLC in adults. This recommendation is based on results from the pivotal Phase 3 KEYNOTE-407 trial, which enrolled patients regardless of PD-L1 tumor expression status. The trial showed a significant improvement in OS and PFS for patients taking Keytruda in combination with chemotherapy (carboplatin and either paclitaxel or nab-paclitaxel) compared with chemotherapy alone. If approved, this would mark the first approval in Europe for an anti-PD-1 therapy in combination with chemotherapy for adults with metastatic squamous NSCLC. In October 2018, the FDA approved Keytruda in combination with carboplatin-paclitaxel or nab-paclitaxel as a first-line treatment for metastatic squamous NSCLC, regardless of PD-L1 expression.
In December 2018, the FDA extended the action date for the supplemental BLA seeking approval for Keytruda as monotherapy for the first-line treatment of locally advanced or metastatic NSCLC in patients whose tumors express PD-L1 (TPS ≥1%) without EGFR or ALK genomic tumor aberrations. The supplemental BLA is based on results of the Phase 3 KEYNOTE-042 trial where Keytruda monotherapy demonstrated a significant improvement in OS compared with chemotherapy in this patient population. The Company submitted additional data and analyses to
the FDA, which constituted a major amendment and extended the PDUFA date by three months to April 11, 2019. Merck continues to work closely with the FDA during the review of this supplemental BLA.
In February 2019, the FDA accepted and granted Priority Review for a supplemental BLA for Keytruda as monotherapy for the treatment of patients with advanced SCLC whose disease has progressed after two or more lines of prior therapy. This supplemental BLA, which is seeking accelerated approval for this new indication, is based on data from the SCLC cohorts of the Phase 2 KEYNOTE-158 and Phase 1b KEYNOTE-028 trials. The FDA set a PDUFA date of June 17, 2019. Keytruda is also being studied in combination with chemotherapy in the ongoing Phase 3 KEYNOTE-604 study in patients with newly diagnosed extensive stage SCLC.
In February 2019, the FDA accepted a supplemental BLA for Keytruda as monotherapy or in combination with platinum and 5-fluorouracil chemotherapy for the first-line treatment of patients with recurrent or metastatic HNSCC. This supplemental BLA is based in part on data from the pivotal Phase 3 KEYNOTE-048 trial where Keytruda demonstrated a significant improvement in OS compared with the standard of care, as monotherapy in patients whose tumors expressed PD-L1 with Combined Positive Score (CPS)≥20 and CPS≥1 and in combination with chemotherapy in the total patient population. These data were presented at the European Society for Medical Oncology (ESMO) 2018 Congress. The FDA granted Priority Review to the supplemental BLA and set a PDUFA date of June 10, 2019. KEYNOTE-048 also serves as the confirmatory trial for KEYNOTE-012, a Phase 1b study which supported the previous accelerated approval for Keytruda as monotherapy for the treatment of patients with recurrent or metastatic HNSCC with disease progression on or after platinum-containing chemotherapy.
In November 2018, Merck announced that the Phase 3 KEYNOTE-181 trial investigating Keytruda as monotherapy in the second-line treatment of advanced or metastatic esophageal or esophagogastric junction carcinoma met a primary endpoint of OS in patients whose tumors expressed PD-L1 (CPS ≥10). In this pivotal study, treatment with Keytruda resulted in a statistically significant improvement in OS compared to chemotherapy (paclitaxel, docetaxel or irinotecan) in patients with CPS ≥10, regardless of histology. The primary endpoint of OS was also evaluated in patients with squamous cell histology and in the entire intention-to-treat study population. While directionally favorable, statistical significance for OS was not met in these two patient groups. Per the statistical analysis plan, the key secondary endpoints of PFS and objective response rate (ORR) were not formally tested, as OS was not reached in the full intention-to-treat study population. These results were presented in January 2019 at the ASCO Gastrointestinal Cancers Symposium and have been submitted for regulatory review.
Additionally, Keytruda has received Breakthrough Therapy designation from the FDA for the treatment of high-risk early-stage triple-negative breast cancer in combination with neoadjuvant chemotherapy. The FDA’s Breakthrough Therapy designation is intended to expedite the development and review of a candidate that is planned for use, alone or in combination, to treat a serious or life-threatening disease or condition when preliminary clinical evidence indicates that the drug may demonstrate substantial improvement over existing therapies on one or more clinically significant endpoints.
In October 2018, Merck announced the first presentation of results from an interim analysis of KEYNOTE-057, a Phase 2 trial evaluating Keytruda for previously treated patients with high-risk non-muscle invasive bladder cancer. An interim analysis of the study’s primary endpoint showed a complete response rate of nearly 40% at three months with Keytruda in patients whose disease was unresponsive to Bacillus Calmette-Guérin therapy, the current standard of care for this disease, and who were ineligible for or who refused to undergo radical cystectomy. These results, as well as other study findings, were presented at the ESMO 2018 Congress.
In February 2019, Merck announced that the pivotal Phase 3 KEYNOTE-240 trial evaluating Keytruda, plus best supportive care, for the treatment of patients with advanced hepatocellular carcinoma who were previously treated with systemic therapy, did not meet its co-primary endpoints of OS and PFS compared with placebo plus best supportive care. In the final analysis of the study, there was an improvement in OS for patients treated with Keytruda compared to placebo, however these OS results did not meet statistical significance per the pre-specified statistical plan. Results for PFS were also directionally favorable in the Keytruda arm compared with placebo but did not reach statistical significance. The key secondary endpoint of ORR was not formally tested, since superiority was not reached for OS or PFS. Results will be presented at an upcoming medical meeting and have been shared with the FDA for discussion.
The Keytruda clinical development program consists of more than 900 clinical trials, including more than 600 trials that combine Keytruda with other cancer treatments. These studies encompass more than 30 cancer types including: bladder, cervical, colorectal, esophageal, gastric, head and neck, hepatocellular, Hodgkin lymphoma, non-Hodgkin lymphoma, melanoma, mesothelioma, nasopharyngeal, NSCLC, ovarian, PMBCL, prostate, renal, small-cell lung and triple-negative breast, many of which are currently in Phase 3 clinical development. Further trials are being planned for other cancers.
Lynparza, is an oral PARP inhibitor currently approved for certain types of ovarian and breast cancer. In July 2017, Merck and AstraZeneca entered into a global strategic oncology collaboration to co-develop and co-commercialize AstraZeneca’s Lynparza for multiple cancer types (see Note 4 to the consolidated financial statements).
In April 2018, Merck and AstraZeneca announced that the EMA validated for review the Marketing Authorization Application for Lynparza for use in patients with deleterious or suspected deleterious BRCA-mutated, HER2-negative metastatic breast cancer who have been previously treated with chemotherapy in the neoadjuvant, adjuvant or metastatic setting. This was the first regulatory submission for a PARP inhibitor in breast cancer in Europe.
Lynparza tablets are also under review in the EU as a maintenance treatment in patients with newly-diagnosed, BRCA-mutated advanced ovarian cancer who were in complete or partial response following first-line standard platinum-based chemotherapy. This submission was based on positive results from the pivotal Phase 3 SOLO-1 trial. The trial showed a statistically-significant and clinically-meaningful improvement in PFS for Lynparza compared to placebo, reducing the risk of disease progression or death by 70% in patients with newly-diagnosed, BRCA-mutated advanced ovarian cancer who were in complete or partial response to platinum-based chemotherapy.
In December 2018, Merck and AstraZeneca announced positive results from the randomized, open-label, controlled, Phase 3 SOLO-3 trial of Lynparza tablets in patients with relapsed ovarian cancer after two or more lines of treatment. The trial was conducted as a post-approval commitment in agreement with the FDA. Results from the trial showed BRCA-mutated advanced ovarian cancer patients treated with Lynparza following two or more prior lines of chemotherapy demonstrated a statistically significant and clinically meaningful improvement in the primary endpoint of ORR and the key secondary endpoint of PFS compared to chemotherapy. Merck and AstraZeneca plan to discuss these results with the FDA.
MK-7655A is a combination of relebactam, an investigational beta-lactamase inhibitor, and imipenem/cilastatin (an approved carbapenem antibiotic). In February 2019, Merck announced that the FDA accepted for Priority Review an NDA for MK-7655A for the treatment of complicated urinary tract infections and complicated intra-abdominal infections caused by certain susceptible Gram-negative bacteria in adults with limited or no alternative therapies available. The PDUFA date is July 16, 2019. In April 2018, Merck announced that a pivotal Phase 3 study of MK-7655A demonstrated a favorable overall response in the treatment of certain imipenem-non-susceptible bacterial infections, the primary endpoint, with lower treatment-emergent nephrotoxicity (kidney toxicity), a secondary endpoint, compared to a colistin (colistimethate sodium) plus imipenem/cilastatin regimen. The FDA had previously designated this combination a Qualified Infectious Disease Product with designated Fast Track status for the treatment of hospital-acquired bacterial pneumonia, ventilator-associated bacterial pneumonia, complicated intra-abdominal infections and complicated urinary tract infections.
V920 (rVSV∆G-ZEBOV-GP, live attenuated), is an investigational Ebola Zaire disease vaccine candidate being studied in large scale Phase 2/3 clinical trials. In December 2015, Merck announced that the application for Emergency Use Assessment and Listing (EUAL) for V920 was accepted for review by the World Health Organization (WHO). According to the WHO, the EUAL process is designed to expedite the availability of vaccines needed for public health emergencies such as another outbreak of Ebola. The WHO decision to grant V920 EUAL status will be based on data regarding quality, safety, and efficacy/effectiveness; as well as a risk/benefit analysis for emergency use. While EUAL designation allows for emergency use, the vaccine remains investigational and has not yet been licensed for commercial distribution. In July 2016, Merck announced that the FDA granted V920 Breakthrough Therapy designation, and that the EMA granted the vaccine candidate PRIME (PRIority MEdicines) status. In November 2018, Merck announced that it has started the submission of a rolling BLA to the FDA for V920. This rolling submission was made pursuant to the FDA’s Breakthrough Therapy designation. Merck expects the rolling submission of the BLA to be completed in 2019. The Company also intends to file V920 with the EMA in 2019.
In February 2019, Merck announced that the FDA accepted for Priority Review a supplemental NDA for Zerbaxa to treat adult patients with nosocomial pneumonia, including ventilator-associated pneumonia, caused by certain susceptible Gram-negative microorganisms. The PDUFA date is June 3, 2019. Zerbaxa is also under review for this indication by the EMA. Zerbaxa is currently approved in the United States for the treatment of adult patients with complicated urinary tract infections caused by certain susceptible Gram-negative microorganisms, and is also indicated, in combination with metronidazole, for the treatment of adult patients with complicated intra-abdominal infections caused by certain susceptible Gram-negative and Gram-positive microorganisms.
In addition to the candidates under regulatory review, the Company has several drug candidates in Phase 3 clinical development in addition to the Keytruda programs discussed above.
MK-7264, gefapixant, is a selective, non-narcotic, orally-administered P2X3-receptor agonist being investigated in Phase 3 trials for the treatment of refractory, chronic cough and in a Phase 2 trial for the treatment of women with endometriosis-related pain.
Lenvima, is an orally available tyrosine kinase inhibitor currently approved for certain types of thyroid cancer, hepatocellular carcinoma, and in combination for certain patients with renal cell carcinoma. In March 2018, Merck and Eisai entered into a strategic collaboration for the worldwide co-development and co-commercialization of Lenvima (see Note 4 to the consolidated financial statements). Under the agreement, Merck and Eisai will develop and commercialize Lenvima jointly, both as monotherapy and in combination with Keytruda. Per the agreement, the companies will jointly initiate clinical studies evaluating the Keytruda/Lenvima combination to support 11 potential indications in six types of cancer (endometrial cancer, NSCLC, hepatocellular carcinoma, head and neck cancer, bladder cancer and melanoma), as well as a basket trial targeting multiple cancer types. The FDA granted Breakthrough Therapy designation for Keytruda in combination with Lenvima for the potential treatment of patients with advanced and/or metastatic renal cell carcinoma and for the potential treatment of certain patients with advanced and/or metastatic non-microsatellite instability high/proficient mismatch repair endometrial carcinoma.
MK-1242, vericiguat, is an investigational treatment for heart failure being studied in patients suffering from chronic heart failure with reduced ejection fracture (Phase 3 clinical trial) and from chronic heart failure with preserved ejection fracture (Phase 2 clinical trial). The development of vericiguat is part of a worldwide strategic collaboration between Merck and Bayer (see Note 4 to the consolidated financial statements).
V114 is an investigational polyvalent conjugate vaccine for the prevention of pneumococcal disease. In June 2018, Merck initiated the first Phase 3 study in the adult population for the prevention of invasive pneumococcal disease. Currently five Phase 3 adult studies are ongoing, including studies in healthy adults 50 years of age or older, adults with risk factors for pneumococcal disease, those infected with HIV, and those who are recipients of allogeneic hematopoietic stem cell transplant. In October 2018, Merck began the first Phase 3 study in the pediatric population. Currently, three studies are ongoing, including studies in healthy infants and in children afflicted with sickle cell disease. In January 2019, Merck announced that V114 received Breakthrough Therapy designation from the FDA for the prevention of invasive pneumococcal disease caused by the vaccine serotypes in pediatric patients 6 weeks to 18 years of age.
As a result of changes in the herpes zoster vaccine environment, Merck is ending development of V212, its investigational vaccine for the prevention of shingles in immunocompromised patients.
The Company maintains a number of long-term exploratory and fundamental research programs in biology and chemistry as well as research programs directed toward product development. The Company’s research and development model is designed to increase productivity and improve the probability of success by prioritizing the Company’s research and development resources on candidates the Company believes are capable of providing unambiguous, promotable advantages to patients and payers and delivering the maximum value of its approved medicines and vaccines through new indications and new formulations. Merck is pursuing emerging product opportunities independent of therapeutic area or modality (small molecule, biologics and vaccines) and is building its biologics capabilities. The Company is committed to ensuring that externally sourced programs remain an important component of its pipeline strategy, with a focus on supplementing its internal research with a licensing and external alliance strategy focused on the entire spectrum of collaborations from early research to late-stage compounds, as well as access to new technologies.
The Company also reviews its pipeline to examine candidates that may provide more value through out-licensing. The Company continues to evaluate certain late-stage clinical development and platform technology assets to determine their out-licensing or sale potential.
The Company’s clinical pipeline includes candidates in multiple disease areas, including cancer, cardiovascular diseases, diabetes, infectious diseases, neurosciences, obesity, pain, respiratory diseases, and vaccines.
Acquired In-Process Research and Development
In connection with business acquisitions, the Company has recorded the fair value of in-process research projects which, at the time of acquisition, had not yet reached technological feasibility. At December 31, 2018, the balance of IPR&D was $1.1 billion.
The IPR&D projects that remain in development are subject to the inherent risks and uncertainties in drug development and it is possible that the Company will not be able to successfully develop and complete the IPR&D programs and profitably commercialize the underlying product candidates. The time periods to receive approvals from the FDA and other regulatory agencies are subject to uncertainty. Significant delays in the approval process, or the Company’s failure to obtain approval at all, would delay or prevent the Company from realizing revenues from these products. Additionally, if certain of the IPR&D programs fail or are abandoned during development, then the Company will not realize the future cash flows it has estimated and recorded as IPR&D as of the acquisition date, and the Company may also not recover the research and development expenditures made since the acquisition to further develop such programs. If such circumstances were to occur, the Company’s future operating results could be adversely affected and the Company may recognize impairment charges and such charges could be material.
In 2018, 2017, and 2016 the Company recorded IPR&D impairment charges within Research and development expenses of $152 million, $483 million and $3.6 billion, respectively (see Note 8 to the consolidated financial statements).
Additional research and development will be required before any of the remaining programs reach technological feasibility. The costs to complete the research projects will depend on whether the projects are brought to their final stages of development and are ultimately submitted to the FDA or other regulatory agencies for approval.
Acquisitions, Research Collaborations and License Agreements
Merck continues to remain focused on pursuing opportunities that have the potential to drive both near- and long-term growth. Certain of the more recent transactions are described below. Merck is actively monitoring the landscape for growth opportunities that meet the Company’s strategic criteria.
In March 2018, Merck and Eisai announced a strategic collaboration for the worldwide co-development and co-commercialization of Lenvima, an orally available tyrosine kinase inhibitor discovered by Eisai. Under the agreement, Merck and Eisai will develop and commercialize Lenvima jointly, both as monotherapy and in combination with Merck’s anti-PD-1 therapy, Keytruda. Under the agreement, Merck made an upfront payment to Eisai of $750 million and will make payments of up to $650 million for certain option rights through 2021 (of which $325 million will be paid in March 2019, $200 million is expected to be paid in 2020 and $125 million is expected to be paid in 2021). The Company recorded a charge of $1.4 billion in Research and development expenses in 2018 related to the upfront payment and future option payments. In addition, the agreement provides for Eisai to receive up to $385 million associated with the achievement of certain clinical and regulatory milestones and up to $3.97 billion for the achievement of milestones associated with sales of Lenvima (see Note 4 to the consolidated financial statements).
In June 2018, Merck acquired Viralytics Limited (Viralytics), an Australian publicly traded company focused on oncolytic immunotherapy treatments for a range of cancers, for AUD 502 million ($378 million). The transaction provided Merck with full rights to Cavatak (V937, formerly CVA21), Viralytics’s investigational oncolytic immunotherapy. Cavatak is based on Viralytics’s proprietary formulation of an oncolytic virus (Coxsackievirus Type A21) that has been shown to preferentially infect and kill cancer cells. Cavatak is currently being evaluated in multiple Phase 1 and Phase 2 clinical trials, both as an intratumoral and intravenous agent, including in combination with Keytruda. Under a previous agreement between Merck and Viralytics, a study is investigating the use of the Keytruda and Cavatak combination in melanoma, prostate, lung and bladder cancers. The transaction was accounted for as an acquisition of an asset. Merck recorded net assets of $34 million (primarily cash) at the acquisition date and Research
and development expenses of $344 million in 2018 related to the transaction. There are no future contingent payments associated with the acquisition.
In February 2019, Merck and Immune Design entered into a definitive agreement under which Merck will acquire Immune Design for $5.85 per share in cash for an approximate value of $300 million. Immune Design is a late-stage immunotherapy company employing next-generation in vivo approaches to enable the body’s immune system to fight disease. Immune Design’s proprietary technologies, GLAAS and ZVex, are engineered to activate the immune system’s natural ability to generate and/or expand antigen-specific cytotoxic immune cells to fight cancer and other chronic diseases. Under the terms of the acquisition agreement, Merck, through a subsidiary, will initiate a tender offer to acquire all outstanding shares of Immune Design. The closing of the tender offer will be subject to certain conditions, including the tender of shares representing at least a majority of the total number of Immune Design’s outstanding shares, the expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act and other customary conditions. The transaction is expected to close early in the second quarter of 2019.
Capital Expenditures
Capital expenditures were $2.6 billion in 2018, $1.9 billion in 2017 and $1.6 billion in 2016. Expenditures in the United States were $1.5 billion in 2018, $1.2 billion in 2017 and $1.0 billion in 2016. In October 2018, the Company announced it plans to invest approximately $16 billion on new capital projects from 2018-2022. The focus of this investment will primarily be on increasing manufacturing capacity across Merck’s key businesses.
Depreciation expense was $1.4 billion in 2018, $1.5 billion in 2017 and $1.6 billion in 2016. In each of these years, $1.0 billion of the depreciation expense applied to locations in the United States. Total depreciation expense in 2017 and 2016 included accelerated depreciation of $60 million and $227 million, respectively, associated with restructuring activities (see Note 5 to the consolidated financial statements).
Analysis of Liquidity and Capital Resources
Merck’s strong financial profile enables it to fund research and development, focus on external alliances, support in-line products and maximize upcoming launches while providing significant cash returns to shareholders.
| Selected Data | |||||||||||
| ($ in millions) | 2018 | 2017 | 2016 | ||||||||
| Working capital | $ | 3,669 | $ | 6,152 | $ | 13,410 | |||||
| Total debt to total liabilities and equity | 30.4 | % | 27.8 | % | 26.0 | % | |||||
| Cash provided by operations to total debt | 0.4:1 | 0.3:1 | 0.4:1 |
The decline in working capital in 2018 compared with 2017 reflects the utilization of cash and short-term borrowings to fund $5.0 billion of ASR agreements, a $1.25 billion payment to redeem debt in connection with the exercise of a make-whole provision as discussed below, as well as a $750 million upfront payment related to the formation of a collaboration with Eisai discussed above. The decline in working capital in 2017 compared with 2016 primarily reflects the reclassification of $3.0 billion of notes due in the first half of 2018 from long-term debt to short-term debt, $1.85 billion of upfront and option payments related to the formation of the AstraZeneca collaboration discussed above, as well as $810 million paid to redeem debt in connection with tender offers discussed below.
Cash provided by operating activities was $10.9 billion in 2018, $6.5 billion in 2017 and $10.4 billion in 2016. The lower cash provided by operating activities in 2017 reflects a $2.8 billion payment related to the settlement of certain federal income tax issues (see Note 16 to the consolidated financial statements), payments of $1.85 billion related to the formation of a collaboration with AstraZeneca (see Note 4 to the consolidated financial statements), and a $625 million payment made by the Company related to the previously disclosed settlement of worldwide Keytruda patent litigation. Cash provided by operating activities continues to be the Company’s primary source of funds to finance operating needs, capital expenditures, treasury stock purchases and dividends paid to shareholders.
Cash provided by investing activities was $4.3 billion in 2018 compared with $2.7 billion in 2017. The increase in cash provided by investing activities was driven primarily by lower purchases of securities and other investments, partially offset by higher capital expenditures, lower proceeds from the sales of securities and other investments, and a $350 million milestone payment in 2018 related to a collaboration with Bayer (see Note 4 to the consolidated financial statements). Cash provided by investing activities was $2.7 billion in 2017 compared with a use
of cash in investing activities of $3.2 billion in 2016. The change was driven primarily by lower purchases of securities and other investments, higher proceeds from the sales of securities and other investments and a lower use of cash for the acquisitions of businesses.
Cash used in financing activities was $13.2 billion in 2018 compared with $10.0 billion in 2017. The increase in cash used in financing activities was driven primarily by higher purchases of treasury stock (largely under ASR agreements as discussed below), higher payments on debt and payment of contingent consideration related to a prior year business acquisition, partially offset by an increase in short-term borrowings. Cash used in financing activities was $10.0 billion in 2017 compared with $9.0 billion in 2016. The increase in cash used in financing activities was driven primarily by proceeds from the issuance of debt in 2016, as well as higher purchases of treasury stock and lower proceeds from the exercise of stock options in 2017, partially offset by lower payments on debt in 2017.
The Company’s contractual obligations as of December 31, 2018 are as follows:
| Payments Due by Period | |||||||||||||||||||
| ($ in millions) | Total | 2019 | 2020—2021 | 2022—2023 | Thereafter | ||||||||||||||
| Purchase obligations (1) | $ | 2,349 | $ | 886 | $ | 1,011 | $ | 407 | $ | 45 | |||||||||
| Loans payable and current portion of long-term debt | 5,309 | 5,309 | — | — | — | ||||||||||||||
| Long-term debt | 19,882 | — | 4,237 | 4,000 | 11,645 | ||||||||||||||
| Interest related to debt obligations | 7,680 | 662 | 1,163 | 932 | 4,923 | ||||||||||||||
| Unrecognized tax benefits (2) | 44 | 44 | — | — | — | ||||||||||||||
| Transition tax related to the enactment of the TCJA (3) | 4,899 | 275 | 873 | 1,217 | 2,534 | ||||||||||||||
| Leases | 997 | 188 | 348 | 218 | 243 | ||||||||||||||
| $ | 41,160 | $ | 7,364 | $ | 7,632 | $ | 6,774 | $ | 19,390 |
| (1) | Includes future inventory purchases the Company has committed to in connection with certain divestitures. |
| (2) | As of December 31, 2018, the Company’s Consolidated Balance Sheet reflects liabilities for unrecognized tax benefits, interest and penalties of $2.3 billion, including $44 million reflected as a current liability. Due to the high degree of uncertainty regarding the timing of future cash outflows of liabilities for unrecognized tax benefits beyond one year, a reasonable estimate of the period of cash settlement for years beyond 2019 cannot be made. |
| (3) | In connection with the enactment of the TCJA, the Company is required to pay a one-time transition tax, which the Company has elected to pay over a period of eight years as permitted under the TCJA (see Note 16 to the consolidated financial statements). |
Purchase obligations are enforceable and legally binding obligations for purchases of goods and services including minimum inventory contracts, research and development and advertising. Amounts reflected for research and development obligations do not include contingent milestone payments related to collaborative arrangements and acquisitions. Contingent milestone payments are not considered contractual obligations as they are contingent upon the successful achievement of developmental, regulatory approval and commercial milestones. At December 31, 2018, the Company has liabilities for milestone payments related to collaborations with AstraZeneca, Eisai and Bayer (see Note 4 to the consolidated financial statements). Also excluded from research and development obligations are potential future funding commitments of up to approximately $40 million for investments in research venture capital funds. Loans payable and current portion of long-term debt reflects $149 million of long-dated notes that are subject to repayment at the option of the holders. Required funding obligations for 2019 relating to the Company’s pension and other postretirement benefit plans are not expected to be material. However, the Company currently anticipates contributing approximately $50 million to its U.S. pension plans, $150 million to its international pension plans and $15 million to its other postretirement benefit plans during 2019.
In December 2018, the Company exercised a make-whole provision on its $1.25 billion, 5.00% notes due 2019 and repaid this debt.
In November 2017, the Company launched tender offers for certain outstanding notes and debentures. The Company paid $810 million in aggregate consideration (applicable purchase price together with accrued interest) to redeem $585 million principal amount of debt that was validly tendered in connection with the tender offers.
In November 2016, the Company issued €1.0 billion principal amount of senior unsecured notes consisting of €500 million principal amount of 0.50% notes due 2024 and €500 million principal amount of 1.375% notes due 2036. The Company used the net proceeds of the offering of $1.1 billion for general corporate purposes.
The Company has a $6.0 billion credit facility that matures in June 2023. The facility provides backup liquidity for the Company’s commercial paper borrowing facility and is to be used for general corporate purposes. The Company has not drawn funding from this facility.
In March 2018, the Company filed a securities registration statement with the U.S. Securities and Exchange Commission (SEC) under the automatic shelf registration process available to “well-known seasoned issuers” which is effective for three years.
Effective as of November 3, 2009, the Company executed a full and unconditional guarantee of the then existing debt of its subsidiary Merck Sharp & Dohme Corp. (MSD) and MSD executed a full and unconditional guarantee of the then existing debt of the Company (excluding commercial paper), including for payments of principal and interest. These guarantees do not extend to debt issued subsequent to that date.
The Company continues to maintain a conservative financial profile. The Company places its cash and investments in instruments that meet high credit quality standards, as specified in its investment policy guidelines. These guidelines also limit the amount of credit exposure to any one issuer. The Company does not participate in any off-balance sheet arrangements involving unconsolidated subsidiaries that provide financing or potentially expose the Company to unrecorded financial obligations.
In October 2018, Merck announced that its Board of Directors approved a 15% increase to the Company’s quarterly dividend, raising it to $0.55 per share from $0.48 per share on the Company’s outstanding common stock. Payment was made in January 2019. In January 2019, the Board of Directors declared a quarterly dividend of $0.55 per share on the Company’s common stock for the second quarter of 2019 payable in April 2019.
In November 2017, Merck’s Board of Directors authorized purchases of up to $10 billion of Merck’s common stock for its treasury. The treasury stock purchase authorization has no time limit and will be made over time in open-market transactions, block transactions, on or off an exchange, or in privately negotiated transactions. In October 2018, Merck’s Board of Directors authorized an additional $10 billion of treasury stock purchases with no time limit for completion and the Company entered into ASR agreements of $5 billion as discussed below. The Company spent $9.1 billion to purchase shares of its common stock for its treasury during 2018. As of December 31, 2018, the Company’s remaining share repurchase authorization was $11.9 billion. The Company purchased $4.0 billion and $3.4 billion of its common stock during 2017 and 2016, respectively, under authorized share repurchase programs.
On October 25, 2018, the Company entered into ASR agreements with two third-party financial institutions (Dealers). Under the ASR agreements, Merck agreed to purchase $5 billion of Merck’s common stock, in total, with an initial delivery of 56.7 million shares of Merck’s common stock, based on the then-current market price, made by the Dealers to Merck, and payments of $5 billion made by Merck to the Dealers on October 29, 2018, which were funded with existing cash and investments, as well as short-term borrowings. The number of shares of Merck’s common stock that Merck may receive, or may be required to remit, upon final settlement under the ASR agreements will be based upon the average daily volume weighted-average price of Merck’s common stock during the term of the ASR program, less a negotiated discount. Final settlement of the transaction under the ASR agreements is expected to occur in the first half of 2019, but may occur earlier at the option of the Dealers, or later under certain circumstances. If Merck is obligated to make adjustment payments to the Dealers under the ASR agreements, Merck may elect to satisfy such obligations in cash or in shares of Merck’s common stock.
Financial Instruments Market Risk Disclosures
The Company manages the impact of foreign exchange rate movements and interest rate movements on its earnings, cash flows and fair values of assets and liabilities through operational means and through the use of various financial instruments, including derivative instruments.
A significant portion of the Company’s revenues and earnings in foreign affiliates is exposed to changes in foreign exchange rates. The objectives and accounting related to the Company’s foreign currency risk management program, as well as its interest rate risk management activities are discussed below.
Foreign Currency Risk Management
The Company has established revenue hedging, balance sheet risk management, and net investment hedging programs to protect against volatility of future foreign currency cash flows and changes in fair value caused by volatility in foreign exchange rates.
The objective of the revenue hedging program is to reduce the variability caused by changes in foreign exchange rates that would affect the U.S. dollar value of future cash flows derived from foreign currency denominated sales, primarily the euro and Japanese yen. To achieve this objective, the Company will hedge a portion of its forecasted foreign currency denominated third-party and intercompany distributor entity sales (forecasted sales) that are expected to occur over its planning cycle, typically no more than two years into the future. The Company will layer in hedges over time, increasing the portion of forecasted sales hedged as it gets closer to the expected date of the forecasted sales. The portion of forecasted sales hedged is based on assessments of cost-benefit profiles that consider natural offsetting exposures, revenue and exchange rate volatilities and correlations, and the cost of hedging instruments. The Company manages its anticipated transaction exposure principally with purchased local currency put options, forward contracts, and purchased collar options.
Because Merck principally sells foreign currency in its revenue hedging program, a uniform weakening of the U.S. dollar would yield the largest overall potential loss in the market value of these hedge instruments. The market value of Merck’s hedges would have declined by an estimated $441 million and $400 million at December 31, 2018 and 2017, respectively, from a uniform 10% weakening of the U.S. dollar. The market value was determined using a foreign exchange option pricing model and holding all factors except exchange rates constant. Although not predictive in nature, the Company believes that a 10% threshold reflects reasonably possible near-term changes in Merck’s major foreign currency exposures relative to the U.S. dollar. The cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows.
The Company manages operating activities and net asset positions at each local subsidiary in order to mitigate the effects of exchange on monetary assets and liabilities. The Company also uses a balance sheet risk management program to mitigate the exposure of net monetary assets that are denominated in a currency other than a subsidiary’s functional currency from the effects of volatility in foreign exchange. In these instances, Merck principally utilizes forward exchange contracts to offset the effects of exchange on exposures denominated in developed country currencies, primarily the euro and Japanese yen. For exposures in developing country currencies, the Company will enter into forward contracts to partially offset the effects of exchange on exposures when it is deemed economical to do so based on a cost-benefit analysis that considers the magnitude of the exposure, the volatility of the exchange rate and the cost of the hedging instrument. The cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows.
A sensitivity analysis to changes in the value of the U.S. dollar on foreign currency denominated derivatives, investments and monetary assets and liabilities indicated that if the U.S. dollar uniformly weakened by 10% against all currency exposures of the Company at December 31, 2018 and 2017, Income before taxes would have declined by approximately $134 million and $92 million in 2018 and 2017, respectively. Because the Company was in a net short (payable) position relative to its major foreign currencies after consideration of forward contracts, a uniform weakening of the U.S. dollar will yield the largest overall potential net loss in earnings due to exchange. This measurement assumes that a change in one foreign currency relative to the U.S. dollar would not affect other foreign currencies relative to the U.S. dollar. Although not predictive in nature, the Company believes that a 10% threshold reflects reasonably possible near-term changes in Merck’s major foreign currency exposures relative to the U.S. dollar. The cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows.
The economy of Argentina was determined to be hyperinflationary in 2018; consequently, in accordance with U.S. GAAP, the Company began remeasuring its monetary assets and liabilities for those operations in earnings. The impact to the Company’s results was immaterial.
The Company also uses forward exchange contracts to hedge its net investment in foreign operations against movements in exchange rates. The forward contracts are designated as hedges of the net investment in a foreign operation. The Company hedges a portion of the net investment in certain of its foreign operations. The unrealized gains or losses on these contracts are recorded in foreign currency translation adjustment within Other Comprehensive Income (Loss) (OCI), and remain in Accumulated Other Comprehensive Income (Loss) (AOCI) until either the sale or complete or substantially complete liquidation of the subsidiary. The Company excludes certain portions of the change in fair value of its derivative instruments from the assessment of hedge effectiveness (excluded component). Changes in fair value of the excluded components are recognized in OCI. In accordance with the new guidance adopted on January 1, 2018 (see Note 2 to the consolidated financial statements), the Company has elected to recognize in earnings the initial value of the excluded component on a straight-line basis over the life of the derivative instrument, rather
than using the mark-to-market approach. The cash flows from these contracts are reported as investing activities in the Consolidated Statement of Cash Flows.
Foreign exchange risk is also managed through the use of foreign currency debt. The Company’s senior unsecured euro-denominated notes have been designated as, and are effective as, economic hedges of the net investment in a foreign operation. Accordingly, foreign currency transaction gains or losses due to spot rate fluctuations on the euro-denominated debt instruments are included in foreign currency translation adjustment within OCI.
Interest Rate Risk Management
The Company may use interest rate swap contracts on certain investing and borrowing transactions to manage its net exposure to interest rate changes and to reduce its overall cost of borrowing. The Company does not use leveraged swaps and, in general, does not leverage any of its investment activities that would put principal capital at risk.
In May 2018, four interest rate swaps with notional amounts aggregating $1.0 billion matured. These swaps effectively converted the Company’s $1.0 billion, 1.30% fixed-rate notes due 2018 to variable rate debt. In December 2018, in connection with the early repayment of debt, the Company settled three interest rate swaps with notional amounts aggregating $550 million. These swaps effectively converted a portion of the Company’s $1.25 billion, 5.00% notes due 2019 to variable rate debt. At December 31, 2018, the Company was a party to 19 pay-floating, receive-fixed interest rate swap contracts designated as fair value hedges of fixed-rate notes in which the notional amounts match the amount of the hedged fixed-rate notes as detailed in the table below.
| ($ in millions) | 2018 | |||||||||
| Debt Instrument | Par Value of Debt | Number of Interest Rate Swaps Held | Total Swap Notional Amount | |||||||
| 1.85% notes due 2020 | $ | 1,250 | 5 | $ | 1,250 | |||||
| 3.875% notes due 2021 | 1,150 | 5 | 1,150 | |||||||
| 2.40% notes due 2022 | 1,000 | 4 | 1,000 | |||||||
| 2.35% notes due 2022 | 1,250 | 5 | 1,250 |
The interest rate swap contracts are designated hedges of the fair value changes in the notes attributable to changes in the benchmark London Interbank Offered Rate (LIBOR) swap rate. The fair value changes in the notes attributable to changes in the LIBOR swap rate are recorded in interest expense along with the offsetting fair value changes in the swap contracts. The cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows.
The Company’s investment portfolio includes cash equivalents and short-term investments, the market values of which are not significantly affected by changes in interest rates. The market value of the Company’s medium- to long-term fixed-rate investments is modestly affected by changes in U.S. interest rates. Changes in medium- to long-term U.S. interest rates have a more significant impact on the market value of the Company’s fixed-rate borrowings, which generally have longer maturities. A sensitivity analysis to measure potential changes in the market value of Merck’s investments and debt from a change in interest rates indicated that a one percentage point increase in interest rates at December 31, 2018 and 2017 would have positively affected the net aggregate market value of these instruments by $1.2 billion and $1.3 billion, respectively. A one percentage point decrease at December 31, 2018 and 2017 would have negatively affected the net aggregate market value by $1.4 billion and $1.5 billion, respectively. The fair value of Merck’s debt was determined using pricing models reflecting one percentage point shifts in the appropriate yield curves. The fair values of Merck’s investments were determined using a combination of pricing and duration models.
Critical Accounting Policies
The Company’s consolidated financial statements are prepared in conformity with GAAP and, accordingly, include certain amounts that are based on management’s best estimates and judgments. Estimates are used when accounting for amounts recorded in connection with acquisitions, including initial fair value determinations of assets and liabilities, primarily IPR&D, other intangible assets and contingent consideration, as well as subsequent fair value measurements. Additionally, estimates are used in determining such items as provisions for sales discounts and returns, depreciable and amortizable lives, recoverability of inventories, including those produced in preparation for product launches, amounts recorded for contingencies, environmental liabilities, accruals for contingent sales-based milestone payments and other reserves, pension and other postretirement benefit plan assumptions, share-based compensation assumptions, restructuring costs, impairments of long-lived assets (including intangible assets and goodwill) and investments, and taxes on income. Because of the uncertainty inherent in such estimates, actual results may differ from these estimates. Application of the following accounting policies result in accounting estimates having the potential for the most significant impact on the financial statements.
Acquisitions and Dispositions
To determine whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses, the Company makes certain judgments, which include assessment of the inputs, processes, and outputs associated with the acquired set of activities. If the Company determines that substantially all of the fair value of gross assets included in a transaction is concentrated in a single asset (or a group of similar assets), the assets would not represent a business. To be considered a business, the assets in a transaction need to include an input and a substantive process that together significantly contribute to the ability to create outputs.
In a business combination, the acquisition method of accounting requires that the assets acquired and liabilities assumed be recorded as of the date of the acquisition at their respective fair values with limited exceptions. Assets acquired and liabilities assumed in a business combination that arise from contingencies are generally recognized at fair value. If fair value cannot be determined, the asset or liability is recognized if probable and reasonably estimable; if these criteria are not met, no asset or liability is recognized. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Accordingly, the Company may be required to value assets at fair value measures that do not reflect the Company’s intended use of those assets. Any excess of the purchase price (consideration transferred) over the estimated fair values of net assets acquired is recorded as goodwill. Transaction costs and costs to restructure the acquired company are expensed as incurred. The operating results of the acquired business are reflected in the Company’s consolidated financial statements after the date of the acquisition. The fair values of intangible assets, including acquired IPR&D, are determined utilizing information available near the acquisition date based on expectations and assumptions that are deemed reasonable by management. Given the considerable judgment involved in determining fair values, the Company typically obtains assistance from third-party valuation specialists for significant items. Amounts allocated to acquired IPR&D are capitalized and accounted for as indefinite-lived intangible assets, subject to impairment testing until completion or abandonment of the projects. Upon successful completion of each project, Merck will make a separate determination as to the then-useful life of the asset, generally determined by the period in which the substantial majority of the cash flows are expected to be generated, and begin amortization. Certain of the Company’s business acquisitions involve the potential for future payment of consideration that is contingent upon the achievement of performance milestones, including product development milestones and royalty payments on future product sales. The fair value of contingent consideration liabilities is determined at the acquisition date using unobservable inputs. These inputs include the estimated amount and timing of projected cash flows, the probability of success (achievement of the contingent event) and the risk-adjusted discount rate used to present value the probability-weighted cash flows. Subsequent to the acquisition date, at each reporting period, the contingent consideration liability is remeasured at current fair value with changes (either expense or income) recorded in earnings. Changes in any of the inputs may result in a significantly different fair value adjustment.
The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed in a business combination, as well as asset lives, can materially affect the Company’s results of operations.
The fair values of identifiable intangible assets related to currently marketed products and product rights are primarily determined by using an income approach through which fair value is estimated based on each asset’s
discounted projected net cash flows. The Company’s estimates of market participant net cash flows consider historical and projected pricing, margins and expense levels; the performance of competing products where applicable; relevant industry and therapeutic area growth drivers and factors; current and expected trends in technology and product life cycles; the time and investment that will be required to develop products and technologies; the ability to obtain marketing and regulatory approvals; the ability to manufacture and commercialize the products; the extent and timing of potential new product introductions by the Company’s competitors; and the life of each asset’s underlying patent, if any. The net cash flows are then probability-adjusted where appropriate to consider the uncertainties associated with the underlying assumptions, as well as the risk profile of the net cash flows utilized in the valuation. The probability-adjusted future net cash flows of each product are then discounted to present value utilizing an appropriate discount rate.
The fair values of identifiable intangible assets related to IPR&D are also determined using an income approach, through which fair value is estimated based on each asset’s probability-adjusted future net cash flows, which reflect the different stages of development of each product and the associated probability of successful completion. The net cash flows are then discounted to present value using an appropriate discount rate.
If the Company determines the transaction will not be accounted for as an acquisition of a business, the transaction will be accounted for as an asset acquisition rather than a business combination and, therefore, no goodwill will be recorded. In an asset acquisition, acquired IPR&D with no alternative future use is charged to expense and contingent consideration is not recognized at the acquisition date.
Revenue Recognition
On January 1, 2018, the Company adopted a new standard on revenue recognition (see Note 2 to the consolidated financial statements). Changes to the Company’s revenue recognition policy as a result of adopting the new guidance are described below.
Recognition of revenue requires evidence of a contract, probable collection of sales proceeds and completion of substantially all performance obligations. Merck acts as the principal in substantially all of its customer arrangements and therefore records revenue on a gross basis. The majority of the Company’s contracts related to the Pharmaceutical and Animal Health segments have a single performance obligation - the promise to transfer goods. Shipping is considered immaterial in the context of the overall customer arrangement and damages or loss of goods in transit are rare. Therefore, shipping is not deemed a separately recognized performance obligation.
The vast majority of revenues from sales of products are recognized at a point in time when control of the goods is transferred to the customer, which the Company has determined is when title and risks and rewards of ownership transfer to the customer and the Company is entitled to payment. Certain Merck entities, including U.S. entities, have contract terms under which control of the goods passes to the customer upon shipment; however, either pursuant to the terms of the contract or as a business practice, Merck retains responsibility for goods lost or damaged in transit. Prior to the adoption of the new standard, Merck would recognize revenue for these entities upon delivery of the goods. Under the new guidance, the Company is now recognizing revenue at time of shipment for these entities.
For businesses within the Company’s Healthcare Services segment and certain services in the Animal Health segment, revenue is recognized over time, generally ratably over the contract term as services are provided. These service revenues are not material.
The nature of the Company’s business gives rise to several types of variable consideration including discounts and returns, which are estimated at the time of sale generally using the expected value method, although the most likely amount method is used for prompt pay discounts.
In the United States, sales discounts are issued to customers at the point-of-sale, through an intermediary wholesaler (known as chargebacks), or in the form of rebates. Additionally, sales are generally made with a limited right of return under certain conditions. Revenues are recorded net of provisions for sales discounts and returns, which are established at the time of sale. In addition, revenues are recorded net of time value of money discounts if collection of accounts receivable is expected to be in excess of one year.
The U.S. provision for aggregate customer discounts covers chargebacks and rebates. Chargebacks are discounts that occur when a contracted customer purchases through an intermediary wholesaler. The contracted customer generally purchases product from the wholesaler at its contracted price plus a mark-up. The wholesaler, in turn, charges
the Company back for the difference between the price initially paid by the wholesaler and the contract price paid to the wholesaler by the customer. The provision for chargebacks is based on expected sell-through levels by the Company’s wholesale customers to contracted customers, as well as estimated wholesaler inventory levels. Rebates are amounts owed based upon definitive contractual agreements or legal requirements with private sector and public sector (Medicaid and Medicare Part D) benefit providers, after the final dispensing of the product by a pharmacy to a benefit plan participant. The provision for rebates is based on expected patient usage, as well as inventory levels in the distribution channel to determine the contractual obligation to the benefit providers. The Company uses historical customer segment utilization mix, sales forecasts, changes to product mix and price, inventory levels in the distribution channel, government pricing calculations and prior payment history in order to estimate the expected provision. Amounts accrued for aggregate customer discounts are evaluated on a quarterly basis through comparison of information provided by the wholesalers, health maintenance organizations, pharmacy benefit managers, federal and state agencies, and other customers to the amounts accrued.
The Company continually monitors its provision for aggregate customer discounts. There were no material adjustments to estimates associated with the aggregate customer discount provision in 2018, 2017 or 2016.
Summarized information about changes in the aggregate customer discount accrual related to U.S. sales is as follows:
| ($ in millions) | 2018 | 2017 | |||||
| Balance January 1 | $ | 2,551 | $ | 2,945 | |||
| Current provision | 10,837 | 11,001 | |||||
| Adjustments to prior years | (117 | ) | (286 | ) | |||
| Payments | (10,641 | ) | (11,109 | ) | |||
| Balance December 31 | $ | 2,630 | $ | 2,551 |
Accruals for chargebacks are reflected as a direct reduction to accounts receivable and accruals for rebates as current liabilities. The accrued balances relative to these provisions included in Accounts receivable and Accrued and other current liabilities were $245 million and $2.4 billion, respectively, at December 31, 2018 and were $198 million and $2.4 billion, respectively, at December 31, 2017.
Outside of the United States, variable consideration in the form of discounts and rebates are a combination of commercially-driven discounts in highly competitive product classes, discounts required to gain or maintain reimbursement, or legislatively mandated rebates. In certain European countries, legislatively mandated rebates are calculated based on an estimate of the government’s total unbudgeted spending and the Company’s specific payback obligation. Rebates may also be required based on specific product sales thresholds. The Company applies an estimated factor against its actual invoiced sales to represent the expected level of future discount or rebate obligations associated with the sale.
The Company maintains a returns policy that allows its U.S. pharmaceutical customers to return product within a specified period prior to and subsequent to the expiration date (generally, three to six months before and 12 months after product expiration). The estimate of the provision for returns is based upon historical experience with actual returns. Additionally, the Company considers factors such as levels of inventory in the distribution channel, product dating and expiration period, whether products have been discontinued, entrance in the market of generic competition, changes in formularies or launch of over-the-counter products, among others. The product returns provision for U.S. pharmaceutical sales as a percentage of U.S. net pharmaceutical sales was 1.6% in 2018, 2.1% in 2017 and 1.4% in 2016. Outside of the United States, returns are only allowed in certain countries on a limited basis.
Merck’s payment terms for U.S. pharmaceutical customers are typically net 36 days from receipt of invoice and for U.S. animal health customers are typically net 30 days from receipt of invoice; however, certain products, including Keytruda, have longer payment terms up to 90 days. Outside of the United States, payment terms are typically 30 days to 90 days, although certain markets have longer payment terms.
Through its distribution programs with U.S. wholesalers, the Company encourages wholesalers to align purchases with underlying demand and maintain inventories below specified levels. The terms of the programs allow the wholesalers to earn fees upon providing visibility into their inventory levels, as well as by achieving certain performance parameters such as inventory management, customer service levels, reducing shortage claims and reducing
product returns. Information provided through the wholesaler distribution programs includes items such as sales trends, inventory on-hand, on-order quantity and product returns.
Wholesalers generally provide only the above-mentioned data to the Company, as there is no regulatory requirement to report lot level information to manufacturers, which is the level of information needed to determine the remaining shelf life and original sale date of inventory. Given current wholesaler inventory levels, which are generally less than a month, the Company believes that collection of order lot information across all wholesale customers would have limited use in estimating sales discounts and returns.
Inventories Produced in Preparation for Product Launches
The Company capitalizes inventories produced in preparation for product launches sufficient to support estimated initial market demand. Typically, capitalization of such inventory does not begin until the related product candidates are in Phase 3 clinical trials and are considered to have a high probability of regulatory approval. The Company monitors the status of each respective product within the regulatory approval process; however, the Company generally does not disclose specific timing for regulatory approval. If the Company is aware of any specific risks or contingencies other than the normal regulatory approval process or if there are any specific issues identified during the research process relating to safety, efficacy, manufacturing, marketing or labeling, the related inventory would generally not be capitalized. Expiry dates of the inventory are affected by the stage of completion. The Company manages the levels of inventory at each stage to optimize the shelf life of the inventory in relation to anticipated market demand in order to avoid product expiry issues. For inventories that are capitalized, anticipated future sales and shelf lives support the realization of the inventory value as the inventory shelf life is sufficient to meet initial product launch requirements. Inventories produced in preparation for product launches capitalized at December 31, 2018 and 2017 were $7 million and $80 million, respectively.
Contingencies and Environmental Liabilities
The Company is involved in various claims and legal proceedings of a nature considered normal to its business, including product liability, intellectual property and commercial litigation, as well as certain additional matters (see Note 11 to the consolidated financial statements). The Company records accruals for contingencies when it is probable that a liability has been incurred and the amount can be reasonably estimated. These accruals are adjusted periodically as assessments change or additional information becomes available. For product liability claims, a portion of the overall accrual is actuarially determined and considers such factors as past experience, number of claims reported and estimates of claims incurred but not yet reported. Individually significant contingent losses are accrued when probable and reasonably estimable.
Legal defense costs expected to be incurred in connection with a loss contingency are accrued when probable and reasonably estimable. Some of the significant factors considered in the review of these legal defense reserves are as follows: the actual costs incurred by the Company; the development of the Company’s legal defense strategy and structure in light of the scope of its litigation; the number of cases being brought against the Company; the costs and outcomes of completed trials and the most current information regarding anticipated timing, progression, and related costs of pre-trial activities and trials in the associated litigation. The amount of legal defense reserves as of December 31, 2018 and 2017 of approximately $245 million and $160 million, respectively, represents the Company’s best estimate of the minimum amount of defense costs to be incurred in connection with its outstanding litigation; however, events such as additional trials and other events that could arise in the course of its litigation could affect the ultimate amount of legal defense costs to be incurred by the Company. The Company will continue to monitor its legal defense costs and review the adequacy of the associated reserves and may determine to increase the reserves at any time in the future if, based upon the factors set forth, it believes it would be appropriate to do so.
The Company and its subsidiaries are parties to a number of proceedings brought under the Comprehensive Environmental Response, Compensation and Liability Act, commonly known as Superfund, and other federal and state equivalents. When a legitimate claim for contribution is asserted, a liability is initially accrued based upon the estimated transaction costs to manage the site. Accruals are adjusted as site investigations, feasibility studies and related cost assessments of remedial techniques are completed, and as the extent to which other potentially responsible parties who may be jointly and severally liable can be expected to contribute is determined.
The Company is also remediating environmental contamination resulting from past industrial activity at certain of its sites and takes an active role in identifying and accruing for these costs. In the past, Merck performed a worldwide survey to assess all sites for potential contamination resulting from past industrial activities. Where
assessment indicated that physical investigation was warranted, such investigation was performed, providing a better evaluation of the need for remedial action. Where such need was identified, remedial action was then initiated. As definitive information became available during the course of investigations and/or remedial efforts at each site, estimates were refined and accruals were established or adjusted accordingly. These estimates and related accruals continue to be refined annually.
The Company believes that there are no compliance issues associated with applicable environmental laws and regulations that would have a material adverse effect on the Company. Expenditures for remediation and environmental liabilities were $16 million in 2018, and are estimated at $57 million in the aggregate for the years 2019 through 2023. In management’s opinion, the liabilities for all environmental matters that are probable and reasonably estimable have been accrued and totaled $71 million and $82 million at December 31, 2018 and 2017, respectively. These liabilities are undiscounted, do not consider potential recoveries from other parties and will be paid out over the periods of remediation for the applicable sites, which are expected to occur primarily over the next 15 years. Although it is not possible to predict with certainty the outcome of these matters, or the ultimate costs of remediation, management does not believe that any reasonably possible expenditures that may be incurred in excess of the liabilities accrued should exceed $60 million in the aggregate. Management also does not believe that these expenditures should result in a material adverse effect on the Company’s financial position, results of operations, liquidity or capital resources for any year.
Share-Based Compensation
The Company expenses all share-based payment awards to employees, including grants of stock options, over the requisite service period based on the grant date fair value of the awards. The Company determines the fair value of certain share-based awards using the Black-Scholes option-pricing model which uses both historical and current market data to estimate the fair value. This method incorporates various assumptions such as the risk-free interest rate, expected volatility, expected dividend yield and expected life of the options. Total pretax share-based compensation expense was $348 million in 2018, $312 million in 2017 and $300 million in 2016. At December 31, 2018, there was $560 million of total pretax unrecognized compensation expense related to nonvested stock option, restricted stock unit and performance share unit awards which will be recognized over a weighted average period of 1.9 years. For segment reporting, share-based compensation costs are unallocated expenses.
Pensions and Other Postretirement Benefit Plans
Net periodic benefit cost for pension plans totaled $195 million in 2018, $201 million in 2017 and $144 million in 2016. Net periodic benefit (credit) for other postretirement benefit plans was $(45) million in 2018, $(60) million in 2017 and $(88) million in 2016. Pension and other postretirement benefit plan information for financial reporting purposes is calculated using actuarial assumptions including a discount rate for plan benefit obligations and an expected rate of return on plan assets. The changes in net periodic benefit cost year over year for pension plans are largely attributable to changes in the discount rate affecting net loss amortization.
The Company reassesses its benefit plan assumptions on a regular basis. For both the pension and other postretirement benefit plans, the discount rate is evaluated on measurement dates and modified to reflect the prevailing market rate of a portfolio of high-quality fixed-income debt instruments that would provide the future cash flows needed to pay the benefits included in the benefit obligation as they come due. The discount rates for the Company’s U.S. pension and other postretirement benefit plans ranged from 4.00% to 4.40% at December 31, 2018, compared with a range of 3.20% to 3.80% at December 31, 2017.
The expected rate of return for both the pension and other postretirement benefit plans represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. In developing the expected rate of return, the Company considers long-term compound annualized returns of historical market data, current market conditions and actual returns on the Company’s plan assets. Using this reference information, the Company develops forward-looking return expectations for each asset category and a weighted-average expected long-term rate of return for a target portfolio allocated across these investment categories. The expected portfolio performance reflects the contribution of active management as appropriate. For 2019, the expected rate of return for the Company’s U.S. pension and other postretirement benefit plans will range from 7.70% to 8.10%, compared to a range of 7.70% to 8.30% in 2018. The decrease is primarily due to a modest shift in asset allocation.
The Company has established investment guidelines for its U.S. pension and other postretirement plans to create an asset allocation that is expected to deliver a rate of return sufficient to meet the long-term obligation of each
plan, given an acceptable level of risk. The target investment portfolio of the Company’s U.S. pension and other postretirement benefit plans is allocated 30% to 50% in U.S. equities, 15% to 30% in international equities, 30% to 45% in fixed-income investments, and up to 5% in cash and other investments. The portfolio’s equity weighting is consistent with the long-term nature of the plans’ benefit obligations. The expected annual standard deviation of returns of the target portfolio, which approximates 11%, reflects both the equity allocation and the diversification benefits among the asset classes in which the portfolio invests. For non-U.S. pension plans, the targeted investment portfolio varies based on the duration of pension liabilities and local government rules and regulations. Although a significant percentage of plan assets are invested in U.S. equities, concentration risk is mitigated through the use of strategies that are diversified within management guidelines.
Actuarial assumptions are based upon management’s best estimates and judgment. A reasonably possible change of plus (minus) 25 basis points in the discount rate assumption, with other assumptions held constant, would have had an estimated $80 million favorable (unfavorable) impact on the Company’s net periodic benefit cost in 2018. A reasonably possible change of plus (minus) 25 basis points in the expected rate of return assumption, with other assumptions held constant, would have had an estimated $50 million favorable (unfavorable) impact on Merck’s net periodic benefit cost in 2018. Required funding obligations for 2019 relating to the Company’s pension and other postretirement benefit plans are not expected to be material. The preceding hypothetical changes in the discount rate and expected rate of return assumptions would not impact the Company’s funding requirements.
Net loss amounts, which reflect experience differentials primarily relating to differences between expected and actual returns on plan assets as well as the effects of changes in actuarial assumptions, are recorded as a component of AOCI. Expected returns for pension plans are based on a calculated market-related value of assets. Under this methodology, asset gains/losses resulting from actual returns that differ from the Company’s expected returns are recognized in the market-related value of assets ratably over a five-year period. Also, net loss amounts in AOCI in excess of certain thresholds are amortized into net periodic benefit cost over the average remaining service life of employees.
Restructuring Costs
Restructuring costs have been recorded in connection with restructuring programs designed to streamline the Company’s cost structure. As a result, the Company has made estimates and judgments regarding its future plans, including future termination benefits and other exit costs to be incurred when the restructuring actions take place. When accruing termination costs, the Company will recognize the amount within a range of costs that is the best estimate within the range. When no amount within the range is a better estimate than any other amount, the Company recognizes the minimum amount within the range. In connection with these actions, management also assesses the recoverability of long-lived assets employed in the business. In certain instances, asset lives have been shortened based on changes in the expected useful lives of the affected assets. Severance and other related costs are reflected within Restructuring costs. Asset-related charges are reflected within Cost of sales, Selling, general and administrative expenses and Research and development expenses depending upon the nature of the asset.
Impairments of Long-Lived Assets
The Company assesses changes in economic, regulatory and legal conditions and makes assumptions regarding estimated future cash flows in evaluating the value of the Company’s property, plant and equipment, goodwill and other intangible assets.
The Company periodically evaluates whether current facts or circumstances indicate that the carrying values of its long-lived assets to be held and used may not be recoverable. If such circumstances are determined to exist, an estimate of the undiscounted future cash flows of these assets, or appropriate asset groupings, is compared to the carrying value to determine whether an impairment exists. If the asset is determined to be impaired, the loss is measured based on the difference between the asset’s fair value and its carrying value. If quoted market prices are not available, the Company will estimate fair value using a discounted value of estimated future cash flows approach.
Goodwill represents the excess of the consideration transferred over the fair value of net assets of businesses acquired. Goodwill is assigned to reporting units and evaluated for impairment on at least an annual basis, or more frequently if impairment indicators exist, by first assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Some of the factors considered in the assessment include general macroeconomic conditions, conditions specific to the industry and market, cost factors which could have a significant effect on earnings or cash flows, the overall financial performance of the reporting unit,
and whether there have been sustained declines in the Company’s share price. If the Company concludes it is more likely than not that the fair value of a reporting unit is less than its carrying amount, a quantitative fair value test is performed. If the carrying value of a reporting unit is greater than its fair value, a goodwill impairment charge will be recorded for the difference (up to the carrying value of goodwill).
Other acquired intangible assets (excluding IPR&D) are initially recorded at fair value, assigned an estimated useful life, and amortized primarily on a straight-line basis over their estimated useful lives. When events or circumstances warrant a review, the Company will assess recoverability from future operations using pretax undiscounted cash flows derived from the lowest appropriate asset groupings. Impairments are recognized in operating results to the extent that the carrying value of the intangible asset exceeds its fair value, which is determined based on the net present value of estimated future cash flows.
IPR&D that the Company acquires through business combinations represents the fair value assigned to incomplete research projects which, at the time of acquisition, have not reached technological feasibility. The amounts are capitalized and accounted for as indefinite-lived intangible assets, subject to impairment testing until completion or abandonment of the project. The Company tests IPR&D for impairment at least annually, or more frequently if impairment indicators exist, by first assessing qualitative factors to determine whether it is more likely than not that the fair value of the IPR&D intangible asset is less than its carrying amount. If the Company concludes it is more likely than not that the fair value is less than the carrying amount, a quantitative test that compares the fair value of the IPR&D intangible asset with its carrying value is performed. For impairment testing purposes, the Company may combine separately recorded IPR&D intangible assets into one unit of account based on the relevant facts and circumstances. Generally, the Company will combine IPR&D intangible assets for testing purposes if they operate as a single asset and are essentially inseparable. If the fair value is less than the carrying amount, an impairment loss is recognized within the Company’s operating results.
The judgments made in evaluating impairment of long-lived intangibles can materially affect the Company’s results of operations.
Impairments of Investments
The Company reviews its investments in marketable debt securities for impairments based on the determination of whether the decline in market value of the investment below the carrying value is other-than-temporary. The Company considers available evidence in evaluating potential impairments of its investments in marketable debt securities, including the duration and extent to which fair value is less than cost. Changes in fair value that are considered temporary are reported net of tax in OCI. An other-than-temporary impairment has occurred if the Company does not expect to recover the entire amortized cost basis of the marketable debt security. If the Company does not intend to sell the impaired debt security, and it is not more likely than not it will be required to sell the debt security before the recovery of its amortized cost basis, the amount of the other-than-temporary impairment recognized in earnings, recorded in Other (income) expense, net, is limited to the portion attributed to credit loss. The remaining portion of the other-than-temporary impairment related to other factors is recognized in OCI.
Investments in publicly traded equity securities are reported at fair value determined using quoted market prices in active markets for identical assets or quoted prices for similar assets or other inputs that are observable or can be corroborated by observable market data. Changes in fair value are included in Other (income) expense, net. Investments in equity securities without readily determinable fair values are recorded at cost, plus or minus subsequent observable price changes in orderly transactions for identical or similar investments, minus impairments. Such adjustments are recognized in Other (income) expense, net. Realized gains and losses for equity securities are included in Other (income) expense, net.
Taxes on Income
The Company’s effective tax rate is based on pretax income, statutory tax rates and tax planning opportunities available in the various jurisdictions in which the Company operates. An estimated effective tax rate for a year is applied to the Company’s quarterly operating results. In the event that there is a significant unusual or one-time item recognized, or expected to be recognized, in the Company’s quarterly operating results, the tax attributable to that item would be separately calculated and recorded at the same time as the unusual or one-time item. The Company considers the resolution of prior year tax matters to be such items. Significant judgment is required in determining the Company’s tax provision and in evaluating its tax positions. The recognition and measurement of a tax position is based on
management’s best judgment given the facts, circumstances and information available at the reporting date. The Company evaluates tax positions to determine whether the benefits of tax positions are more likely than not of being sustained upon audit based on the technical merits of the tax position. For tax positions that are more likely than not of being sustained upon audit, the Company recognizes the largest amount of the benefit that is greater than 50% likely of being realized upon ultimate settlement in the financial statements. For tax positions that are not more likely than not of being sustained upon audit, the Company does not recognize any portion of the benefit in the financial statements. If the more likely than not threshold is not met in the period for which a tax position is taken, the Company may subsequently recognize the benefit of that tax position if the tax matter is effectively settled, the statute of limitations expires, or if the more likely than not threshold is met in a subsequent period (see Note 16 to the consolidated financial statements).
Tax regulations require items to be included in the tax return at different times than the items are reflected in the financial statements. Timing differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in the tax return in future years for which the Company has already recorded the tax benefit in the financial statements. The Company establishes valuation allowances for its deferred tax assets when the amount of expected future taxable income is not likely to support the use of the deduction or credit. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred or expense for which the Company has already taken a deduction on the tax return, but has not yet recognized as expense in the financial statements.
Recently Issued Accounting Standards
For a discussion of recently issued accounting standards, see Note 2 to the consolidated financial statements.
Cautionary Factors That May Affect Future Results
This report and other written reports and oral statements made from time to time by the Company may contain so-called “forward-looking statements,” all of which are based on management’s current expectations and are subject to risks and uncertainties which may cause results to differ materially from those set forth in the statements. One can identify these forward-looking statements by their use of words such as “anticipates,” “expects,” “plans,” “will,” “estimates,” “forecasts,” “projects” and other words of similar meaning, or negative variations of any of the foregoing. One can also identify them by the fact that they do not relate strictly to historical or current facts. These statements are likely to address the Company’s growth strategy, financial results, product development, product approvals, product potential and development programs. One must carefully consider any such statement and should understand that many factors could cause actual results to differ materially from the Company’s forward-looking statements. These factors include inaccurate assumptions and a broad variety of other risks and uncertainties, including some that are known and some that are not. No forward-looking statement can be guaranteed and actual future results may vary materially.
The Company does not assume the obligation to update any forward-looking statement. One should carefully evaluate such statements in light of factors, including risk factors, described in the Company’s filings with the Securities and Exchange Commission, especially on this Form 10-K and Forms 10-Q and 8-K. In Item 1A. “Risk Factors” of this annual report on Form 10-K the Company discusses in more detail various important risk factors that could cause actual results to differ from expected or historic results. The Company notes these factors for investors as permitted by the Private Securities Litigation Reform Act of 1995. One should understand that it is not possible to predict or identify all such factors. Consequently, the reader should not consider any such list to be a complete statement of all potential risks or uncertainties.
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