OMNIUM Merck Betting on immunotherapy · This ongoing development contrasts with the 2008-2014 period, primarily marked by unproductive R&D and financial “deals”. The roadmap

Merck Betting on immunotherapy

A new era in cancer treatment has recently started with the understanding of the link between cancer biology and immunity. The first wave of immuno-oncology drugs is now established and Merck is leading the way with its Keytruda, which has shown impressive clinical benefits in several cancers compared with standard treatments. The company is using Keytruda as the foundation of a groundbreaking oncology franchise that has the potential to compete with Roche’s. This ongoing development contrasts with the 2008-2014 period, primarily marked by unproductive R&D and financial “deals”. The roadmap is now clear, the portfolio is becoming more simple and less patent sensitive. This new story is backed by a sound financial profile: ✦  Merck is highly profitable, has a strong balance-sheet and returns a 3.3% dividend + 2.5% in buy backs. ✦  Over the next 3 years, a 5% annual sales growth and margin improvements should boost EPS by 35%.

Following a mega-fusion in 2009, Merck’s P&L has been full of restructuring costs and is still loaded with “intangible asset amortization” (8% of sales in 2017), creating a cloudy reporting, which is probably weighting on the stock valuation. From 2018 onwards, these amortization charges will strongly decrease and GAAP and non-GAAP earnings will converge towards higher levels, providing a clearer reading and a cheaper valuation. We target $81 by end 2020 (+30%).

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MRK:US MRK.C

$166 billion 2.69 billion

100%

Bloomberg Reuters Market Capitalization Number of shares Float

Merck June 12, 2018

OMNIUM

Omnium forecast 2017 2018 2019 2020Sales ($billion) 40.1 42.3 44.4 47.5Gross margin (%) 72.8% 73.3% 73.9% 74.5%Net profit (%) 20.6% 21.9% 24.0% 26.8%EPS ($) 3.05 3.51 4.13 5.06PE (×) 20.4 17.7 15.1 12.3

Accounting briefing In a nutshell From corporate finance to groundbreaking science Keytruda Financial case Appendices

p3-4 p5-7 p8 p9-16 p17 p18-21

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Disclaimer

²  This research is strictly reserved to our direct recipients or customers.

²  The opinion expressed in this document is prepared and published by Omnium Capital Management for your information only. The analysis contained herein is based on numerous assumptions; different assumptions could lead to different results. Omnium Capital Management accepts no liability whatsoever from any claim arising from the use or distribution of this material.

²  Merck’s Keytruda could be a game changer in the oncology field and a strong financial driver for the group. Competition is intense but Merck is now leading the way and recent clinical study results confirmed the company’s edge.

²  Keytruda growth will more than offset the decline of Merck’s remaining portfolio. The net growth will drive substantial earnings increase, as Keytruda gross margin is above current portfolio’s.

²  More than 750 clinical trials studying Keytruda in monotherapies or in combinations are currently underway, in an effort to both leverage Keytruda potential and diversify the group portfolio. With more than 20 molecules in the oncology pipeline, R&D developments should indeed result in a more balanced portfolio in the long-term.

²  If Merck is pushing hard to become again an intensive R&D biopharmaceutical company, one can also argue that in a medium-term perspective, Merck dependency on its flagship product is high. Any adverse issue such as an important clinical trial failure could have a strong negative impact on Keytruda sales. Given Keytruda financial leverage, actual earnings would be much weaker than our forecast and the stock price performance would be negative.

2Merck June 12, 2018

Merck June 12, 2018 3

Accounting (boring) briefing: GAAP, non-GAAP and underlying earnings (1/2)

Merck 2017 US GAAP EPS = $0.87 / non-GAAP EPS = $3.98. As short-term P&L forecasts should exclude unpredictable and non recurring items, companies usually build their guidance on “non-GAAP” earnings, which are also used as benchmarks by sell-side analysts. But sometimes the GAAP/non-GAAP distortion becomes extreme, which is a problem when the so-called one-offs such as litigation, restructuring and acquisition costs as well as impairment charges are actually a recurring matter.

Investors do not take for granted the non-GAAP EPS and the stock price P/E eventually looks cheap from a non-GAAP perspective and expensive using GAAP earnings.

As far as Merck is concerned, the main “non-recurring” item relates to the amortization of intangible assets, most of which were capitalized at the time of the merger with Schering-Plough (see opposite). Excluded from the non-GAAP costs, these charges are included in the GAAP costs of production, generating a big spread between the two gross margin measures.

Intangible amortization When a pharma company buys another pharma, the main component of the price is the intangible commercial potential of a drug portfolio, instead of tangible assets or brand goodwill. Depending on the drugs stage of development, this underlying value can be accounted as a R&D charge or as an intangible asset, the latter being afterwards amortized on several years, usually between 5 and 15 years depending on each drug commercial profile. Practically: when Merck merged with Schering-Plough in November 2009, the new group balance sheet was credited with $45 billion of intangible asset, amortizable on 15 years (cf. appendix 4 page 21)

In $ billion 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Sales 23.9 27.4 46.0 48.0 46.3 44.0 42.2 39.5 39.8 40.1

GAAP production costs -5.6 -9.0 -15.4 -16.9 -16.4 -17.0 -16.8 -14.9 -13.9 -12.8Non-GAAP production costs -5.6 -8.2 -10.5 -12.0 -11.5 -12.3 -12.6 -10.2 -10.2 -9.7

77%

67% 67% 65% 64%61% 60% 62%

65%68%

77%70%

77% 75% 75%72% 70%

74% 74% 76%

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Gross margin

GAAP Non-GAAP

Tax reform one-off effect In 2017, the GAAP/non-GAAP spread was particularly large, widened by a negative fiscal impact linked to the US tax reform (about -$1.0 effect on GAAP EPS versus no impact on non-GAAP EPS).


Accounting (boring) briefing: GAAP, non-GAAP and underlying earnings (2/2)

However, amortization of intangible assets will sharply drop over the next few years, from $3.1 billion in 2017, to $1.2 billion in 2020 (see appendix 4 page 21). Therefore, GAAP and non GAAP gross margins will converge.

The other items not included in non-GAAP are litigation costs, restructuring charges, asset or in-process R&D impairments (following a negative clinical trial result for example), as well as R&D acquisitions* and realized gains on asset sales.

Our goal is to forecast the 2020 ”real recurring” earnings, which INCLUDE those costs. Nevertheless, we want to avoid historic P&L swings (to ease comparisons) and therefore use another metric, ”underlying earnings”:✦  Litigation, restructuring, impairment and R&D acquisition* costs are recorded

based on their 2008-2017 average (which avoids P&L swings but is equal, in average, to GAAP measures).

✦  Intangible amortization is recorded using the 2020 expected figure ($1.2 billion). Our 2020 profit forecast therefore includes this GAAP charge. Again, in order to get a comparable basis on previous years, the same figure of $1.2 billion is (uniformly) applied to each fiscal year since the merger.

✦  Past or potential realized gains on asset sales are not considered.

*Acquisition of a drug in pre-commercial stage.

3.63

5.65

0.28

2.02 2.001.47

4.07

1.56 1.41 0.87

3.423.25

3.42 3.71 3.82 3.49

3.49

3.59 3.78 3.98

2.37 2.54 2.702.99 3.09

2.74 2.72 2.80 2.97 3.05

5.06

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Net earnings per share, $

GAAP NON-GAAP Underlying

Merck 2018 guidance ✦  Sales between $41.8 billion and $43.0 billion ✦  GAAP EPS between $2.45 and $2.58 ✦  Non-GAAP EPS between $4.16 and $4.28

à Our 2018 underlying EPS forecast = $3.51

77%

67% 67% 65% 64%61% 60%

62%65%

68% 70%73%

77%

70%

77%75% 75%

72%70%

74% 74% 76% 76% 77% 77%

77%68%

75% 73% 72%69% 67%

71% 71%73% 73%

74%75%

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Gross margin

GAAP Non-GAAP Underlying


In a nutshell (1/3) - Merck’s portfolio

Legacy portfolio - Mature and declining franchises that lost patent exclusivity or face specific situations, such as: ➜  Zepatier is curing Hepatitis C: the virus is no longer

detected in patients blood once the treatment is completed. ➜  Isentress is an antiretroviral agent for the treatment of

HIV-1 infection. Competitive environment and pricing pressures are intense.

➜  Januvia/Janumet are used to lower blood sugar levels in type 2 diabetes. This market is also very competitive and pricing pressure is high. Underlying patents expire in 2022.

These drugs all have once reached the $500 million annual sales threshold but are declining today. Until 2014, this division also included Merck consumer care franchise (roughly $2 billion in annual sales). It was sold to Bayer in May 2014.

Vaccines - A core historical franchise. These products include pediatric combinations or target specific virus or bacteria such as papillomavirus or pneumococcal disease.

Animal health - Another historical field of expertise. Covers a large variety of antibacterial and antiviral drugs and vaccines.

Other - Includes: ✦  A $5 billion (annual sales) of “diversified brands” gathering 50

low revenue drugs from various therapeutic fields. ✦  Specific drugs that do not belong to the other categories

(cumulative ≈$2.5 billion in sales). See appendix 2 page 19. ✦  New potential blockbusters that may come from the R&D

pipeline or from acquisitions. ✦  “Other revenues” mainly deals with sales achieved through

collaborations with other big pharma.

2017 sales = $40.1 billion

Legacyportfolio$18.1 bn

45%

Oncology$3.8 bn10%

Vaccines$6.2 bn15%

Animal health$3.9 bn10%

Other$8.2 bn20%

Our report focuses on the Oncology franchise. Our forecasts regarding the other divisions appear on page 18-20.

Oncology - New division driven by Keytruda (99% of this division sales in 2017)


In a nutshell (2/3) - Portfolio dynamic: growing again thanks to Keytruda

2020 sales forecast = $47.5 billion


23%Oncology$15.5 bn

33%

Vaccines$6.1 bn13%


Other $10.9 bn

24%



62%

Vaccines$3.5 bn

8%

Animal health$3.1 bn

6%



45%

Oncology$3.8 bn

9%Vaccines$6.2 bn15%


Other$8.2 bn20%

Others$10.2 bn

21%


In a nutshell (3/3) – Financial snapshot

Based on 2017 figures, Merck P/E is in line with its sector. However: ✦  Keytruda will drive strong earnings growth while we estimate the total combined

ex-Keytruda portfolio to slowly decrease. ✦  The main factor of GAAP/non-GAAP discrepancy will sharply drop by 2020,

providing a clearer financial reading. ✦  Strong cash flow will support further buybacks (2.5%/year in recent history),

growing dividends (current yield =3.3%) and debt reduction.

Based on our 2020 earnings forecast, the stock P/E comes out cheap at 12.3×.

In $ billion 2017 2018 2019 2020Sales 40.1 42.3 44.4 47.5

Production costs -10.9 -11.3 -11.6 -12.1

Gross margin 29.2 72.8% 31.0 73.3% 32.8 73.9% 35.4 74.5%

Marketing and Administrative -10.3 25.7% -10.4 24.6% -10.7 24.1% -11.0 23.2%

R&D -8.2 20.4% -8.6 20.3% -8.4 18.9% -8.1 17.1%

Others -0.4 -0.4 -0.4 -0.4

Profit before tax 10.3 11.6 13.3 15.9

Income tax -2.1 -2.3 -2.7 -3.2

Net profit 8.3 21.4% 9.3 21.9% 10.6 24.0% 12.7 26.8%

Shares outstanding, diluted (B) 2.71 2.64 2.58 2.51

Underlying EPS ($/share) 3.05 3.51 4.13 5.06

Net debt 14.5 13 11 9Gearing (Net debt/Equity) 42% 38% 32% 26%

20.4

17.7

15.1

12.3

2016 2017 2018 2019 2020 2021

P/E ratio (x)


From corporate finance back to groundbreaking science

The 2009 mega deal In 2008, after 20 years of steady growth, Merck has to manage its first real ”patent cliff” as several blockbusters patent exclusivity are due to expire in 2012 (and subsequently be exposed to generic competition). As the R&D pipeline is not rich enough to offset the expected sales decline, Merck is looking for external growth opportunities. In 2009, the group merges with Schering-Plough, another big US biopharma, in a typical financial mega deal: the group doubles in size and expect to create value through synergies. Productivity is improved: several restructuring plans reduce the headcount by 30%, from 100,000 at the time of the merger to 70,000 in late 2014. But R&D fails to deliver new promising launches, while Keytruda is only in its early stages of clinical development. In 2014, in an effort to focus on its core pillar of biopharmaceuticals, Merck sells its consumer goods portfolio ($2 billion annual sales) to Bayer for $14.2 billion. Several months later, $8.5 billion of the proceeds are deployed to buy US Cubist. However, shortly after the acquisition, a US court invalidates several patents covering the company’s flagship product, Cubicin (an antibiotic used in skin infections): the drug sales eventually drop from $1.13 billion in 2015 to $382 million in 2017, and the asset is largely impaired. Now is the time to deliver new promising therapies. 2015 is the turning point: While Keytruda still does not generate sales and while the competitive environment seems full of players that are either ahead (Bristol-Myers Squibb) or have a deep rooted expertise in Oncology (Roche), Merck decides to step on the accelerator and multiply Keytruda R&D programs. At the time, analysts are puzzled by the move, and rather require short-term value creation through a ”structuring deal” (meaning a new large merger) or a division spin-off (the animal division particular).

23.927.4

46.048.0 47.3

44.0 42.239.8

2008 2009 2010 2011 2012 2013 2014 2015

Sales in $ billion

2.37 2.54 2.702.99 3.09 2.74

2.72 2.80

2008 2009 2010 2011 2012 2013 2014 2015

Earnings per share*, $

*Underlying earnings (cf. page 4)


PD-1 and PD-L1 are two proteins that bind together to switch off the activity of certain cells of the immune system. Typically, cancer cells PD-L1 would bind with T Cells PD-1 and prevent the immune system from attacking cancer cells. From academic research to clinical trials 1992: the PD-1 cell surface receptor (PD for Programmed Death) is isolated in mouse T cells. 1999: discovery of PD-L1, the molecules that bind with PD-1. The compound is shown to inhibit human T cell immune responses. 2000: the PD-1/PD-L1 pathway is specifically described to serve as a mechanism of peripheral immune tolerance through which tumor cells can evade the immune response and develop to become metastatic. 2001: Japan Ono pharmaceutical (back then $0.7 billion in revenue) partners with a team of immunology professors from Kyoto University to develop a monoclonal antibody designed to recognize and block the PD-1/D-L1 interaction. 2005: Ono partners with Medarex (a US mid-size biopharmaceutical company specialized in oncology): Medarex acquires the investigational drug global rights (except for Japan, Korea and Taiwan) and finance the main part of R&D costs. A phase I clinical study is launched in 2006. A steep acceleration 2009: Bristol-Myers Squibb acquires Medarex for $2.4 billion, targeting the Medarex “novel immunotherapy currently in phase III that could be an important contributor to Bristol’s future growth”. 2010-2012: Many big biopharmaceutical companies begin to develop their own molecule, including Merck, Roche and Astra Zeneca. Merck molecule was historically developed by Schering-Plough but the development was discontinued at the time of the acquisition. 2014: First FDA approval for Bristol’s Opdivo (drug commercial name). Several oncologists speak about “the discovery of the century”.

Keytruda (1/8) – The genesis: immunotherapy and anti PD-1/PD-L1

Anti PD-1/ PD-L1 binding

A slow start for immunotherapy From 2002, representatives from Ono Pharmaceutical approach a long list of potential partners to co-sponsor a trial and also went from hospital to hospital, attempting to convince doctors to test a new drug under development that helped the body’s immune system fight cancer. But nobody would listen: immunotherapy was another fad, they were told. The treatment probably offered no bigger benefit than eating mushrooms to fight cancer, one critic opined. Another said he’d shave his head if it worked…

Main competitors drug name

Bristol-Myers Squibb à Opdivo Roche à Tecentriq Astra Zeneca à Imfinzy


Bristol-Myers Squibb is the first company to present several phase III results: In September 2014, Bristol releases its checkmate-037 results, a phase III trial that evaluates Opdivo vs. chemotherapy in 2nd line advanced melanoma: the ORR is 37% vs. 11% in the chemotherapy arm. In particular, the ORR in patients with tumors expressing a positive PD-L1 reaches 44% (vs. 20% for PD-L1 negative). à  The results submission is quickly followed by an FDA approval. Two months later, the drug is approved in a 1st line combo for advanced melanoma: when treated with Opdivo + Yervoy*, 73% of patients were alive after one year vs. 42% when treated with chemo.

* Yervoy: standard care in front-line advanced melanoma. Developed by Bristol as well. Merck quickly follows with impressive results in advanced melanoma Nevertheless, Opdivo has clearly taken the lead: additionally to being first to market, the combo with Yervoy, which shows strong health benefits, is exclusive to Bristol (Yervoy being a proprietary drug covered by a patent). Roche (Tecentriq) and Astra Zeneca (Imfinzi) are lagging. They choose to target sub-markets, or focus on combinations.

Keytruda (2/8) – Anti PD-1/PD-L1 first clinical breakthrough and regulatory approvals

Oncology clinical trial glossary

Overall Survival (OS): number of treated patients alive after a predefined period of time. Can be declined in survival rate: percentage of patients alive after a predefined period of time. Progression Free Survival (PFS): length of time during which the disease stops to progress, after the beginning of the treatment. Overall Response Rate (ORR): proportion of patients with tumor size reduction after a predefined time period. Study primary endpoint: reference output of the clinical trial (OS, PFS or ORR). Clinical studies often have co-primary endpoints.

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20 56 81

Q1 15 Q2 15 Q3 15 Q4 15 Q1 16 Q2 16 Q3 16 Q4 16

OpdivoKeytrudaTecentriq

Sales by quarter ($ million) and main regulatory approvals

2nd line lung cancer

✦  Head and neck cancer ✦  Hodgkin Lymphoma


Both drugs target the same agents and have the same therapeutic mechanisms and the first trials do not suggest any meaningful difference. The discussion is focused on the new immunotherapy mechanism: ✦  The treatment seems more effective for tumors expressing high level of PD-L1,

but nevertheless shows benefits in low or even negative PD-L1 expressions. ✦  The groundbreaking results are associated with much less frequent adverse

effects than chemotherapy.

In October 2016, however, Bristol reports a failure on a major phase III trial: in front-line lung cancer, Opdivo did not show any OS benefit compared to chemotherapy, in patients with PD-L1>1%. Merck on its side designed its 1st line lung cancer phase III differently (keynote- 024), enrolling only patients whose tumors expressed a high level of PD-L1 (>50%). The results, reported in December 2017 are impressive: Keytruda arm OS median is 31 months vs. 14 months for chemotherapy: in average, patients lived twice longer on Keytruda. Merck gets an FDA approval in front-line lung cancer (the most killing cancer in the world).

Keytruda (3/8) – Keytruda takes on Opdivo, part 1

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39 110160 214 249 314 356

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20 56 81 120 130 122 136 1471 18 62

Q1 15 Q2 15 Q3 15 Q4 15 Q1 16 Q2 16 Q3 16 Q4 16 Q1 17 Q2 17 Q3 17 Q4 17 Q1 18

OpdivoKeytrudaTecentriqImfinzi Front-line lung cancer

Trial design strategies By designing its trial regardless of the PD-L1 status, Bristol was expecting to capture a larger part of the front-line lung cancer indication. The trial failure was a big surprise and a strong disappointment among oncologists and analysts (stock price fell by 12% that day). Merck on the other side played more defensive, targeting tumors on which they knew the drug would have a stronger effect.

Second line lung cancer

Sales by quarter ($ million) and main regulatory approvals


Following trials give a fundamental advantage to Keytruda: ✦  In April 2018, Merck’s keynote-189, evaluating Keytruda + chemo vs. chemo in

1st line lung cancer, shows an impressive survival rate: after 1 year, 69% of the patients on Keytruda + chemo. were alive vs. 49% for chemo. alone. If the response was stronger in high PD-L1, it was nevertheless significant in low or negative PD-L1 tumor expression.

✦  In early June 2018, Merck Keynote-042, evaluating Keytruda in 1st line lung monotherapy vs. chemo in PD-L1>1% cases shows strong results, extending the scope of its previous Keynote-024 (only focused on PD-L1>50%).

à These news indications are currently under review for FDA approvals.

On the other side, several Opdivo trial follow-ups show disappointing results: ✦  In an attempt to mitigate its first line melanoma trial failure, Bristol examined

patients with tumors expressing PD-L1>50%, hoping these patients would respond better to Opdivo, just like they did for Keytruda. But they did not, there were no difference in survival between Opdivo and chemotherapy. Surprisingly the news was not reported by BMS, but by a biotech blogger that quoted Fouad Namouni, Bristol’s oncology drug development chief.

✦  When Bristol’s checkmate-037 results were reported back in September 2014 (as

the ORR co-primary endpoint was met, cf. page 10), the release mentioned that “an interim OS analysis had not taken place at the time of the ORR analysis”. The follow-up was nevertheless discussed at the 2017 ASCO meeting (American Society of Clinical Oncology): Opdivo did not show significant difference with chemotherapy in terms of survival.

During the 2018 ASCO meeting (3-5th of June), Merck has presented more than 140 trial results related to Keytruda (compared to 1 five years ago). Among the main results, an evaluation of Keytruda vs. chemo. in front-line squamous lung cancer (≃25% of the lung cancers) showed not only positive results, but also superior results to a comparable trial from Roche’s Tecentriq.

Keytruda (4/8) – Keytruda takes on Opdivo, part 2

Opdivo

Keytruda

Opdivo

Different molecular structure could explain different efficacies?

Roger M. Perlmutter, President, Merck Research Laboratories ¨Keyturda and Opdivo bind differently. They have different binding affinities. They can behave differently. If you ask me to gin up a preclinical experiment that showed that Keytruda was better than Opdivo, I can get that done for you. But preclinical experiments don't have a lot of predictive value for clinical results”. April 18 American Association for Cancer Research annual meeting


Fact 1 – Merck is doubling down Merck currently has more than 750 ongoing clinical trials that include Keytruda, among which 400 are combos. We estimate that between 2016 and 2020, Keytruda total R&D spending will represent more than $14 billion, which is almost equal to all competitors combined. ➜  Merck R&D expenses will increase in 2018, remain high in 2019 and decrease

thereafter.

Keytruda (5/8) – Keytruda dominates the anti PD-1/PD-L1 market – A few quotes and facts

Robert Davis, CFO, Merck ”Many of the oncologists I engage with are basically saying that they are not sure if there is a difference between the two antibodies, but they clearly see the benefit of Keytruda and are very comfortable with using it and very clear on overall survival advantage that we now have shown across multiple different cancer types”. May 2018 Deutsche Bank health care conference

David Querry, President of Navicor, oncology consultant “Anything Opdivo does, there is going to be a natural assumption that Keytruda does it better”.

Giovanni Caforio, CEO, Bristol Myers Squibb ”I acknowledge the competitive dynamics coming out from recent data”. Q1 2018 earnings conference call Q&A, referring to recent Keytruda’s trial results

Fact 2 – Other players begin to play defensive ✦  AstraZeneca last trials target Asian patients as the group seeks to be first to market in China. ✦  Roche is targeting submarkets (squamous lung cancer for example) and focuses on

combinations with other drugs of its portfolio (Avastin…). ✦  Bristol is targeting alternative biomarkers (than PD-L1), seeking better results on low PD-L1

expressions: they currently test Opdivo on tumors expressing a high level of TMB (Tumor Mutational Burden). Clinical results are expected by the end of 2018.


Keytruda (6/8) – Merck’s Oncology pipeline

Keytruda has shown activity with regards to more than 25 tumors and is currently approved in 10 indications, while several others should be approved soon: regarding the main pending approval, front-line lung cancer in combo with chemotherapy (based on Keynote-189), the FDA decision is expected for September 23rd à Based on current dynamic, potential approvals and underlying market sizes, we forecast Keytruda sales to reach $12.6 billion by 2020 vs. $3.8 billion in 2017: Merck is also adding new molecules to its pipeline, both to diversify its portfolio and to enhance Keytruda potential in combination with other drugs: ✦  In Q3 17, Merck secured 50% of the rights on Lynparza (AstraZeneca), a drug

targeting DNA repair mechanisms and approved by the FDA in maintenance treatment of ovarian and breast cancers (resp. in August 2017 and January 2018). Several combination trials with Keytruda are ongoing.

✦  In Q1 2018, Merck acquired from Eisai 50% of the rights covering Lenvima, a kinaze inhibitor recently approved in thyroid cancer, renal and hepatocellular carcinomas. Promising results have already been shown with Keytruda.

Besides Keytruda, Merck pipeline includes 20+ molecules designed to improve cancer therapy. Although we do not expect any material sales from most of these drugs before 2020, we expect some of them to emerge as potential blockbusters by then, improving visibility and mitigating the risks surrounding Keytruda patent expiries in 2026.

1.65 1.95

2.15 2.35 2.50 2.65 2.83 3.00 3.10 3.20 3.30

Q2 18 Q3 18 Q4 18 Q1 19 Q2 19 Q3 19 Q4 19 Q1 20 Q2 20 Q3 20 Q4 20

Keytruda sales forecast by quarter ($ billion)

Lynparza: a $2.35 billion payment were recorded as R&D. Based on potential approval and sales milestones, Merck could additionally pay up to $4 billion (that would be recognized as intangible assets and subsequently amortized).

Lenvima: $1.35 billion payment recorded as R&D. Based on potential approval and sales milestones, Merck could additionally pay up to $4.35 billion (that would be recognized as intangible assets and subsequently amortized).

Financial considerations

Cancer: incidence and mortality

2015 2016 2017 2018 2019 2020

Merck oncology sales forecast ($ billion)

Keytruda Total oncology

0.57 1.4 3.8 7.2

7.9 10.3

12.6

11.7 15.5


We estimate Keytruda gross margin to be close to 85%, after deduction of the 6.5% royalty charge paid to Bristol on every sale. Indeed, in 2011, Bristol sued Merck claiming patents infringements regarding Opdivo and its PD-1/PD-L1 developments. The case was settled in 2016, with Merck paying an upfront $650 million plus a 6.5% royalty on sales from January 2017 through December 2023. The rate will drop to 2.5% for the following three years. Over the next three years, we assume gross margin on Merck’s portfolio ex-Keytruda to be flat. As the Keytruda part of the portfolio will grow from 10% to 28%, the group gross margin should increase by almost 2%:

Keytruda (7/8) – Keytuda revenue increase will boost gross margins…

Robert Davis, Merck CFO ”Keytruda gross margin, even with the royalty, is above, well above the corporate gross margins”. “Keytruda is clearly one of the larger tailwinds for our overall gross margin into the future, even with the royalty included“. Q4 2016 earnings conference call Q&A

77%

67% 67% 65% 64%61% 60%

62%65%

68% 70%73%

77%

70%

77%75% 75%

72%70%

74% 74% 76% 76% 77% 77%

77%68%75% 73% 72%

69% 67%71% 71% 73% 73%

74%75%

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Gross margin

GAAP Non-GAAP Underlying


R&D lagging effect The ramping-up phase of a major blockbuster is associated with heavy R&D that create value with a time lag. When the drug becomes more mature, the associated R&D costs decrease, providing incremental leverage on earnings. 1: Example: Lynparza collaboration (rights acquisition) with AstraZeneca in Q3 2017 2: Animal health R&D, Support functions (in-trial drugs production, admin…).

The Research Lab expense is the segment that refers to human R&D. These expenses have increased by $0.9 billion since 2014, pushed by Keytruda, that currently represents roughly 70% of this segment (our estimation).

Keytruda (8/8) – And bring additional leverage in the mid-term

Robert Davis, CFO, Merck “As we have been talking about over the last several quarters, we've been in the period of heavy investment, particularly into the clinical studies behind KEYTRUDA and just the vast oncology portfolio we have in total moving through the clinics. So that, obviously, has been putting some pressure on our ability to drive leverage in the near term and will continue to make leverage more challenging over the near term. But long term, we are focused on driving operating margin improvements, so you should see that”. Q1 2018 earnings conference call Q&A

GAAP R&D costs ($ billion)2014 2015 2016 2017

Research Lab 3.7 4.0 4.3 4.6R&DAcquisitions1 0.7 0.0 0.0 2.4In-process R&D impairments 0.0 0.1 3.6 0.5Others2 2.8 2.6 2.2 2.8Total 7.2 6.7 10.1 10.2

In $ billion 2014 2015 2016 2017 2018 2019 2020Sales 42.2 39.5 39.8 40.1 42.3 44.4 47.5Production costs -13.8 -10.9 -11.4 -10.9 -11.3 -11.6 -12.1Gross margin 28.5 67.4% 28.6 72.4% 28.4 71.4% 29.2 72.8% 31.0 73.3% 32.8 73.9% 35.4 74.5%Marketing and Administrative -10.9 25.8% -10.3 26.1% -10.4 26.1% -10.3 25.7% -10.4 24.6% -10.7 24.1% -11.0 23.2%R&D -7.3 17.3% -7.4 18.7% -7.3 18.3% -8.2 20.4% -8.6 20.3% -8.4 18.9% -8.2 17.3%Others -0.3 -0.9 -0.4 -0.4 -0.4 -0.4 -0.4Profit before tax 10.0 10.0 10.3 10.3 11.6 13.3 15.8Income tax -2.0 -2.0 -2.1 -2.1 -2.3 -2.7 -3.2Net profit 8.0 18.9% 8.0 20.2% 8.3 20.7% 8.3 21.4% 9.3 21.9% 10.6 24.0% 12.6 26.6%

Keytruda sales growth are not yet sufficient to offset the legacy portfolio decline. But the impact on corporate gross margin is already positive.

Higher R&D mitigate the effect on the bottom-line

Keytruda growth impact should become more material, while R&D expenses should stabilize: ➜  Strong profit increase.

Underlying profits


Higher profits will support cash-flow: ✦ We expect Merck to hike its dividend more materially than in the recent past. ✦ Recent buyback rhythm is clearly sustainable. Over the last 5 years, Merck has repurchased an average 2.5% of its outstanding shares. We estimate Merck free cash flow to reach $13 billion in 2020. After dividends and buybacks, the group will roughly have $2 billion left in cash for acquisitions or debt reimbursements à The balance-sheet should remain healthy (current net debt = $14.5 billion, Gearing = 42%). Higher profits and more buybacks means even higher EPS: The case also becomes more simple: Focusing on proprietary science is a simple strategy that does not deal with intangible asset acquisition or administrative synergies. The trade-off is an increased portfolio concentration and a potential dependency to Keytruda. But as the first patent exclusivity expires in late 2026, Merck has enough time to implement its diversification strategy and strengthen its oncology portfolio. Along with GAAP/non-GAAP earnings convergence, the case becomes ”clearer”. A simple case, backed by rising profits and strong cash returns deserve a higher valuation. If our 2020 earnings estimation is correct, MRK currently trades at 12.3x 2020 earnings, against 16.0x for the sector’s average

à We see 30% upside by end 2020.

Financial case

2012 2013 2014 2015 2016 2017Dividend 1.69 1.73 1.77 1.81 1.85 1.89Yield 4.0% 3.6% 3.1% 3.5% 3.1% 3.3%

Buybacks 0.3% 2.6% 2.3% 2.7% 2.5% 2.5%

2014 2015 2016 2017 2018 2019 2020Net profit, $ billion 8.0 8.0 8.3 8.3 9.3 10.6 12.7Diluted share number, billion 2.93 2.85 2.78 2.71 2.64 2.58 2.51Underlying EPS, $ 2.72 2.80 2.97 3.05 3.51 4.13 5.06

Recent dividends and buybacks

2.97 3.05 3.51 4.135.06

2016 2017 2018 2019 2020

EPS forecast ($/share)

62.267.1

81.0

2018 2019 2020

Stock price forecast ($)


Appendix 1: legacy portfolio

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Immunology Remicade 2,714 2,667 2,076 2,271 2,372 1,794 1,268 837 600 450 350 Respiratory Singulair 4,987 5,479 3,853 1,196 1,092 931 915 732 600 500 400Nasonex 1,219 1,286 1,268 1,335 1,099 858 537 387 330 275 225 General Medicine and Women’s Health NuvaRing 559 623 623 686 723 732 777 761 550 350 250Follistin 528 530 468 481 412 383 355 298 250 175 125Dulera 8 96 207 324 460 536 436 287 250 200 150Fosamax 926 855 676 560 470 359 284 241 225 180 150Cozaar 2,104 1,284 1,006 806 511 667 511 484 450 400 350 Legacy Oncology (were part of Schering-Plough) Emend 378 419 489 507 553 535 549 556 530 450 400Temodar 1,065 935 917 708 350 312 283 271 260 250 240 Neurosciences Maxalt 550 639 638 149 35 0 0 0 0 0 0Cosopt 484 477 444 416 257 61 22 0 0 0 0 Cardiovascular Zetia/Vytorin 4,311 4,310 4,314 4,301 4,166 3,777 3,701 2,095 1,500 1,100 700 Hospital acute care Cubicin 25 1,127 1,087 382 300 200 150Noxafil 198 230 258 309 402 487 595 636 650 450 300Cancidas 610 640 619 660 681 573 558 422 300 200 130Invanz 362 406 445 488 529 569 561 602 450 350 200Primaxin 610 515 384 335 329 313 297 280 300 270 260 Hepatitis and HIV Zepatier 555 1,670 800 500 300Isentress 1,090 1,359 1,515 1,643 1,673 1,511 1,387 1,204 1,000 800 600PegIntron 737 657 653 496 381 182 63 25 0 0 0

Diabetes Januvia/janumet 3,339 4,687 5,745 5,833 6,002 6,014 6,109 5,896 5,800 5,500 5,250

Consumer care 1,750 1,840 1,952 1,900 600

TOTAL LEGACY PORTFOLIO ($ million) 28,529 29,934 28,550 25,404 23,122 21,721 20,850 18,066 15,245 12,800 10,830

Omnium forecastPatent expired


Appendix 2: other pharmaceuticals

Omnium forecast

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Specific drugsImplanon1 236 294 348 403 502 588 606 686 700 750 800Simponi2 97 264 331 500 689 690 766 819 850 900 1,000Bridion3 103 201 261 288 340 353 482 704 850 900 1,000

Diversified brands 8,548 8,556 8,327 7,558 6,694 5,550 5,254 5,147 5,000 4,750 4,500

Other revenues 1,870 1,668 1,324 1,336 2,095 1,386 1,176 852 800 700 500

New drugs 300 1,000 2,400 Total other pharmaceuticals 10,854 10,983 10,591 10,085 10,320 8,567 8,284 8,208 8,500 9,000 10,200

1- Implanon: etonogestrel contraceptive implant (no patent). 2- Simponi: subcutaneous treatment for certain inflammatory diseases (patent expires in 2024). 3- Bridion: used to reverse neuromuscular blocking agents administered during surgery (patent expires in 2026).


Appendix 3: vaccines and animal health

Omnium forecastPatent expired

1- Gardasil: Human Papillomavirus. The vaccine was launched in China in H2-2017 following regulatory approval2- ProQuad/M-M-R II/Varivax: Measles, Mumps, Rubella and Varicella 3- Pneumovax: pneumococcal

*Sales in 2017 benefited from the December 31, 2016 termination of SPMSD, an equally-owned joint venture with Sanofi Pasteur, which marketed vaccines in most major European markets. In 2017, Merck began recording vaccine sales in markets that were previously part of the SPMSD joint venture (that were booked using equity method affiliate). The change resulted in incremental vaccine sales of approximately $400 million during 2017.

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Vaccines Gardasil1 988 1,209 1,631 1,831 1,731 1,908 2,173 2,308 2,550 2,600 2,650RotaTeq 519 651 601 636 659 610 652 686 700 450 300ProQuad/M-M-R II/Varivax2 1,378 1,202 1,273 1,306 1,394 1,505 1,640 1,676 1,800 1,900 2,000Pneumovax3 376 486 580 653 746 542 641 821 900 1,000 1,100Zostavax 243 332 651 758 765 749 685 668 200 100 50Total vaccines 3,504 3,880 4,736 5,184 5,295 5,314 5,791 6,159* 6,150 6,050 6,100 Animal health 3,100 3,250 3,390 3,360 3,500 3,330 3,480 3,880 4,200 4,500 4,900

Non recurring items


Appendix 4: GAAP, non-GAAP and Underlying profits

1: Litigation costs: include class action settlements, patent arbitrations…2: R&D acquisitions: pre-commercial stage drug acquisition. 3: In-process R&D impairments: usually when a clinical trial fails or a new drug does not receive a regulatory approval.

In $ billion 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Schering-Plough -0.8 -4.6 -4.6 -4.6 -4.4 -4.0 -3.9 -3.1 -2.3 -2.1 -0.9 -0.6Other 0.0 0.0 0 -0.3 -0.3 -0.2 -0.8 -0.6 -0.8 -0.7 -0.6 -0.6Total Intangible amortization -0.8 -4.6 -4.6 -4.9 -4.7 -4.2 -4.7 -3.7 -3.1 -2.8 -1.5 -1.2

in $ billion 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Litigation costs1 0.0 0.0 -1.0 -0.5 -0.5 0.0 0.0 -0.7 -0.6 0.0Restructuring -1.3 -2.3 -2.0 -1.9 -1.0 -2.4 -2.0 -1.1 -1.1 -0.9R&D acquisitions2 0.0 0.0 0.0 0.0 0.0 0.0 -0.7 0.0 0.0 -2.4In-process R&D impairments3 0.0 0.0 0.0 -0.6 -0.2 -0.3 -0.0 -0.1 -3.6 -0.5Intangible amortization4 0.0 -0.8 -4.6 -4.6 -4.9 -4.7 -4.2 -4.7 -3.7 -3.1Realized gains on asset sales +2.3 +10.6 +0.5 0.0 +0.3 0.0 +12.3 +0.4 0.0 0.0Impact on GAAP earnings +1.0 +7.5 -7.1 -7.6 -6.3 -7.4 +6.1 -6.1 -9.0 -6.9

Impact on non-GAAP earnings 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Average 2008-2017

4: Most part of intangible asset amortization is related to the Schering-Plough merger in 2009

Amortization plan disclosed in the annual report 2017

Impact on underlying profits From 2009 to 2020

-0.3-1.2-0.2-0.6-1.20.0

-3.5-2.8

-0.3-1.2-0.2-0.6

The goal is to forecast 2020 GAAP profit

We do not expect asset sales (conservative assumption)

Pre-Tax total After tax total

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