Merck Group

Overview – Q2 2014

• First-time consolidation of AZ Electronic Materials as of May 2, 2014
• Solid organic growth and acquisition-related increases lead to higher sales despite ongoing currency headwinds
• Emerging Markets contribute significantly to organic growth
• Higher EBITDA pre one-time items driven by first-time consolidation of AZ and contribution from Merck Millipore
• Earnings per share pre one-time items up 2.7% to € 1.16

Development of sales and results of operations

In the second quarter of 2014, sales of the Merck Group grew organically by 3.4%. Acquisitions/divestments increased sales overall by 3.0% or € 83 million. The first-time consolidation of AZ Electronic Materials in the Performance Materials division as of May 2, 2014 made a positive contribution of € 89 million to Group sales (see also “Acquisition of AZ Electronic Materials S.A.” in the Notes to the Consolidated Financial Statements). Owing to the divestment of the Merck Millipore division’s Discovery and Development Solutions business field, which became effective on March 31, 2014, sales declined in comparison with the year-earlier quarter by € 6 million (see also “Divestment of the Discovery and Development Solutions business field” in the Notes to the Consolidated Financial Statements). The continued strength of the euro led to negative exchange rate effects of –4.5% in the second quarter of 2014, which mainly stemmed from the U.S. dollar, the Japanese yen, and Latin American currencies. Overall, sales thus increased slightly by € 52 million or 1.9% to € 2,796 million in the second quarter of 2014 (Q2 2013: € 2,744 million).

All four divisions of the Merck Group posted organic sales increases as well as negative exchange rate effects in the second quarter of 2014. Delivering an absolute increase of € 44 million, which corresponded to an organic growth rate of 3.0%, Merck Serono made the strongest absolute contribution to organic sales growth, followed by Merck Millipore with organic sales growth of € 27 million equivalent to a growth rate of 4.0%, and Consumer Health with organic sales growth of € 15 million or 8.5%. The Performance Materials division achieved an organic sales growth rate of 1.8%, corresponding to an absolute organic sales increase of € 8 million.

Merck Group | Sales by region – Q2 2014

From a regional perspective, the dynamic business performance in the Emerging Markets region, which encompasses Latin America and Asia excluding Japan, contributed first and foremost to the organic growth of the Merck Group. At 11.1%, which corresponded to an increase of € 107 million, the region delivered very strong organic growth, which was primarily driven by the Merck Serono and Merck Millipore divisions. Including currency headwinds of –8.5% and acquisition-related effects of 5.9%, Merck generated sales of € 1,048 million in the Emerging Markets region (Q2 2013: € 967 million). In the second quarter of 2014, the Emerging Market region’s share of Group sales thus grew to 37% (Q2 2013: 35%).

In Europe, slight organic sales growth of 0.5% and the acquisition-related sales increase of 0.5% were partly offset by negative currency effects of –0.2%. Consequently, sales in Europe increased slightly by 0.8% to € 1,006 million (Q2 2013: € 998 million). Europe’s percentage contribution to Group sales thus remained steady at 36%.

Sales in North America amounted to € 528 million (Q2 2013: € 563 million), which represents a year-on-year decrease of –6.3%. With an organic decline in sales of –3.3%, which was mainly due to lower sales of Rebif® in the Merck Serono division, as well as negative exchange rate effects of –4.5%, and acquisition-related sales increases of 1.6%, the contribution of the North America region to Group sales was 19% (Q2 2013: 21%).

The Rest of World region, i.e. Japan, Africa and Australia/Oceania, generated € 213 million (Q2 2013: € 216 million) or 8% of Group sales (Q2 2013: 8%). The decline in sales compared with the year-earlier period was largely the outcome of a negative foreign exchange impact of –7.1%, which stemmed mainly from the Japanese yen. Along with an organic sales increase of 0.5% and acquisition-related increases of 5.2%, the region registered an overall decline in sales of –1.4%.

In the first six months of 2014, sales of the Merck Group increased by 0.1% to € 5,409 million (January-June 2013: € 5,404 million). Organic growth and acquisitions/divestments accounted for 3.6% and 1.5%, respectively. Exchange rate changes resulting particularly from the developments of both the U.S. dollar and the Japanese yen, were responsible for a –5.0% decline in sales in the first half of 2014. All four divisions generated positive organic growth rates in the first six months of 2014. In particular, the Consumer Health division achieved a solid 7.1% organic increase in sales. Owing to the first-time consolidation of AZ, the Performance Materials division delivered the highest absolute sales increase of all divisions, generating sales of € 908 million in the first half of 2014 (January-June 2013: € 852 million). Regionally, Group sales showed the strongest organic growth in the Emerging Markets and Rest of World regions, with growth rates of 8.4% and 4.0%, respectively. Europe generated organic growth of 1.1%, whereas sales in North America slipped organically by –0.5%.

The consolidated income statement of the Merck Group is as follows:

Royalty, license and commission income declined by –30.4% to € 68 million in the second quarter of 2014 (Q2 2013: € 97 million). This sharp drop of around € –30 million was mainly due to the decrease in royalty, license and commission income in the Merck Serono division. Total revenues (sales plus royalty, license and commission income) rose slightly by 0.8% to € 2,863 million (Q2 2013: € 2,841 million).

Taking into account cost of sales, which increased by 7.9% to € 829 million in the second quarter of 2014 (Q2 2013: € 768 million), the Merck Group recorded gross profit of € 2,035 million (Q2 2013: € 2,073 million). The strong increase in cost of sales was mainly due to the first-time consolidation of AZ. As part of the purchase price allocation, the acquired inventories of AZ were stepped up to fair values on the date of first-time consolidation. For the period from May 2, 2014 to June 30, 2014, € 30 million of this step-up was included as an expense in cost of sales. Gross margin, i.e. gross profit as a percentage of sales, declined accordingly by nearly three percentage points to 72.8% (Q2 2013: 75.6%). Apart from the first-time consolidation effect, the considerable decline in royalty, license and commission income as well as the negative foreign exchange impact on sales played a role.

In the second quarter of 2014, other operating expenses included impairment losses on intangible assetsin connection with the return of ceralifimod amounting to € 14 million (see also “License rights to ceralifimod returned” in the Notes to the Consolidated Financial Statements). The decline in other operating expenses (net) was among other things due to lower litigation expenses as well as gains from operational currency hedges.

The increase in research and development costs was mainly attributable to Merck Serono, which accounted for 79.1% (Q2 2013: 78.8%) of Group-wide research and development spending. The Group research spending ratio (research and development costs as a percentage of sales) rose accordingly to 14.1% (Q2 2013: 13.6%).

Lower amortization of intangible assets resulted mainly from the expiration of the useful life of an intangible asset in the Merck Serono division.

The operating result (EBIT) of the Merck Group declined by € 24 million to € 441 million in the second quarter of 2014. This was largely due to the higher level of one-time items, lower royalty, license and commission income in comparison with the year-earlier period, as well as negative exchange rate effects. The stable operating business and the efficiency improvement measures implemented within the scope of the “Fit for 2018” transformation and growth program had a positive effect.

The slight increase in the negative financial result to € –50 million mainly stemmed from the one-time expense in connection with the early retirement of AZ debt and to a negative measurement effect from taking into account the time value of Merck Share Units (MSUs). MSUs are virtual Merck shares that eligible executives and employees could receive at the end of a three-year performance period within the scope of the Merck Long-Term Incentive Plan.

Income tax expenses of € 85 million (Q2 2013: € 101 million) led to a tax ratio of 21.7% (Q2 2013: 24.2%).

Net income, i.e. profit after tax attributable to Merck shareholders, was € 303 million in the second quarter of 2014 (Q2 2013: € 316 million). Taking the share split into account, this resulted in earnings per share of € 0.70 (Q2 2013: € 0.73).

After adjusting for depreciation, amortization and one-time expenses, EBITDA pre one-time items, the key financial indicator used to steer operating business, rose slightly to € 846 million (Q2 2013: € 826 million), resulting in an EBITDA margin pre one-time items relative to sales of 30.3% (Q2 2013: 30.1%). Taking into account the share split, earnings per share pre one-time items (earnings per share adjusted by net of tax effect of one-time items and amortization of purchased intangible assets) amounted to € 1.16 in the second quarter of 2014 (Q2 2013: € 1.13).

In the first half of 2014, the Merck Group reported EBITDA pre one-time items of € 1,653 million (January-June 2013: € 1,627 million). This represented a slight improvement on the good half-year result reported in 2013. The EBITDA pre margin increased by half a percentage point to 30.6% (January-June 2013: 30.1%). Earnings per share pre one-time items for the first half of 2014 rose by 5.9% to € 2.32 (January-June 2013: € 2.19).

Net assets and financial position

The total assets of the Merck Group amounted to € 21,476 million as of June 30, 2014. This represents an increase of 3.2% over December 31, 2013 (€ 20,819 million). The change in the balance sheet structure mainly reflects the first-time consolidation of AZ Electronic Materials S.A. as of May 2, 2014. The payment of the purchase price totaling € 1,872 million was made fully in cash. Consequently, as of June 30, 2014, cash decreased to € 847 million (December 31, 2013: € 981 million) and current financial assets dropped to € 956 million (December 31, 2013: € 2,410 million). As part of the purchase price allocation for the AZ acquisition, the acquired assets, liabilities and contingent liabilities were measured at fair values in the balance sheet. On the date of first-time consolidation, this led to an increase in intangible assets (excluding goodwill) by € 1,059 million. The goodwill from the transaction amounted to € 841 million. More information about the purchase price allocation for the AZ acquisition can be found under “Acquisition of AZ Electronic Materials S.A.” in the Notes to the Consolidated Financial Statements. Likewise, the increase in working capital of the Merck Group to € 2,434 million (December 31, 2013: € 2,132 million) was related to the first-time consolidation of AZ, among other things. The change in non-current and current financial liabilities was primarily due to the maturity in March 2015 of a bond issued by Merck Financial Services with a nominal volume of € 1,350 million. Owing to the payment of the purchase price for AZ, net financial debt increased to € 2,220 million (December 31, 2013: € 307 million). At 52.2% (December 31, 2013: 53.2%), the equity ratio remained at a consistently high level.

Business free cash flow of the Merck Group was € 632 million in the second quarter of 2014 (Q2 2013: € 784 million). This represented a decline of € –152 million or –19.3%, which was primarily the outcome of higher inventories and trade accounts receivable. The increase in these two balance sheet items in connection with the first-time consolidation of AZ was neutralized by the corresponding adjustment. Nevertheless, the development of both items led to cash outflows, which lower investments and higher EBITDA pre one-time items could not compensate for.

In the first half of 2014, the Merck Group generated business free cash flow of € 1,316 million (January-June 2013: € 1,377 million, thus reaching the very high year-earlier level.