Fitch Affirms Merck's IDR at 'A'; Outlook Stable

CHICAGO--()--Fitch Ratings has affirmed Merck & Co., Inc.'s (MRK/Merck) Long-Term Issuer Default Rating at 'A'. The Rating Outlook is Stable. A complete list of rating actions follows at the end of this press release.

KEY RATING DRIVERS

The company's 'A' rating reflects the following:

--Recently introduced therapies, an advancing pipeline and manageable patent expiries should support intermediate- to long-term growth.

--Fitch believes that Merck will pursue targeted acquisitions as opposed to large transformative ones. An improving pipeline and narrowing strategic focus reduces the need to do big deals.

--Fitch expects Merck will continue favor share repurchases to deleveraging, with the possibility of further debt-funded stock buybacks.

--Fitch forecasts that Merck will generate solid FCF during the forecast period supported by improving margins and moderate revenue growth.

New Products/ Growth Opportunities: Products approved during the last three years should help to drive intermediate- to long-term, top-line growth for Merck. Most importantly, Keytruda (skin and lung cancer) is gaining traction in the market, supported by an ongoing stream of clinical data, but facing competition from a Bristol-Myers product and potentially similar drugs that may receive approval during the next few years. Merck is also evaluating Keytruda's safety and efficacy in other cancers and in combination with other oncolytics. Bridion (post-surgical recovery), Belsomra (insomnia), Grastek (allergies) and Rawitek (allergies) are unique-acting therapies, which should provide these two drugs competitive positions. Zontivitiy (cardiovascular) and Zepatier (hepatitis C) have entered increasingly crowded segments but should be able to gain some share from both newer and older treatments.

Expanding Late-Stage Pipeline: Fitch expects Merck to continue to build its late-stage pipeline with new molecular entities (NMEs) to treat cancers, bacterial and viral infections, diabetes, cardiovascular disorders, central nervous afflictions, osteoporosis, and other diseases. While the majority of these projects are internally developed, Merck has partnered with other innovator firms to take advantage of technological advancements that were discovered externally. The landscape for drug development is expanding, particularly as developers learn more about how genetics influence the development, prevention and treatment of disease. As such, Fitch believes that it is responsible and strategically advantageous for firms to look externally as well as internally regarding new drug development.

Patent Exposure Manageable: The company has and will continue to face some significant patent expiries during the next year, but Fitch views the risk as manageable with roughly 18% of total firm sales are at risk. In addition, Remicade, which accounts for about 4.2% of total firm sales, is a biologic that has experienced less rapid sales losses to generic competition compared to traditional small-molecule pharmaceuticals. Vytorin and Zetia, however, are small molecules and account for roughly 10% of total revenues. Fitch expects these two products will lose significant sales shortly after their patents expire, as is typically the case for small-molecule drugs.

Solid Free Cash Flow Expected: Fitch forecasts that Merck will generate $5.7 billion - $5.9 billion in free cash flow (FCF) during 2016. Improving margins driven by an improving sales mix and strong cost control should more than offset expected soft near-term, top-line growth. Fitch expects FCF to incrementally increase during the multi-year forecast period.

Targeted Acquisition Most Likely: Fitch looks for Merck to pursue mainly targeted acquisitions in the intermediate term. The company has improved its operational and financial prospects through successfully gaining regulatory approvals on late-stage pipeline projects and has continued to back fill its pipeline with new and advancing projects. An improved growth and profitability profile decreases the need for the company to execute large strategic business combinations.

Share Repurchases to Continue: Fitch assumes continued shareholder friendly actions during the near-term, some of which the company may fund with debt. Merck has occasionally funded its share repurchases with debt. During 2015, the company purchased a net $3.7 billion of its common stock, compared to $6.1 billion during the prior LTM period. The repurchases were executed under a $15 billion program authorized in May 2013 as well as an additional $10 billion authorized in March 2015. As of March 31, 2016, the 2013 allotment was fully utilized, with $7.6 billion remaining on the $10 billion extension.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Merck's 'A' rating include the following:

--Incrementally increasing revenue during the forecast period, driven by newer products, largely offset in the near term by foreign exchange headwinds and select product patent expirations.

--EBITDA operating margin improvement driven by a focus on costs and an improving sales mix.

--Annual FCF (cash flow from operations minus capital expenditures minus dividends) of roughly $5.9 billion during 2016.

--Targeted acquisitions prioritized over strategic, transformative transactions.

--Continued significant share repurchases.

--Leverage to range between 1.7x - 1.9x during the next two years.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include the following:

--Improving operations including new product development that support long-term positive revenue growth and margin stability/increases;

--An operational profile that would consistently generate significantly positive FCF;

--Cash deployment strategy that maintains gross debt leverage below 1.7x, including managing through operational stress such as patent expiries.

Negative: Future developments that may, individually or collectively, lead to negative rating action include the following:

--Material and lasting deterioration in operations and FCF, possibly driven by patent expiries not being offset by new product development;

--Leveraging acquisitions without the prospect of timely debt/leverage reduction;

--Persistent leverage above 2.2x.

LIQUIDITY

Adequate Liquidity: Fitch looks for Merck to maintain adequate liquidity through strong FCF generation and ample access to the credit markets. FCF for the LTM ending March 31, 2016 was $5.8 billion. At the end of the period, Merck had approximately $12.9 billion in cash/short-term investments (US: 10% - 20% of total balances/OUS: 80% - 90% of total balances) and full availability on its $6 billion revolver, maturing in August 2019.

Manageable Debt Maturities: As of March 31, 2016, the company had $25.6 billion in debt outstanding, with $1.7 billion maturing in 2016, $0.3 billion in 2017, $3.0 billion in 2018 and $1.3 billion in 2019. Fitch expects near- to mid-term maturities will be satisfied primarily through refinancing in the public debt markets.

FULL LIST OF RATINGS

Fitch has affirmed the following ratings:

Merck & Co., Inc.

--Long-Term Issuer Default Rating (IDR) at 'A';

--Senior unsecured credit facility at 'A';

-- Senior unsecured debt at 'A';

--Short-term IDR at 'F1';

--Commercial paper at 'F1'.

The Rating Outlook is Stable.

Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:

--Historical and projected EBITDA is adjusted to add back non-cash stock based compensation. During the LTM period ended Mar. 31, 2016, Fitch added back $304 million in non-cash stock based compensation to its EBITDA calculation and $214 million in restructuring costs to gross profit.

Additional information is available on www.fitchratings.com.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1008634

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1008634

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings
Primary Analyst
Bob Kirby, CFA
Director
+1-312-368-3147
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Gregory Dickerson
Director
+1-212-908-0220
or
Committee Chairperson
Megan Neuburger
Managing Director
+1-212-908-0501
or
Media Relations:
Alyssa Castelli, New York, +1 212-908-0540
Email: alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Bob Kirby, CFA
Director
+1-312-368-3147
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Gregory Dickerson
Director
+1-212-908-0220
or
Committee Chairperson
Megan Neuburger
Managing Director
+1-212-908-0501
or
Media Relations:
Alyssa Castelli, New York, +1 212-908-0540
Email: alyssa.castelli@fitchratings.com