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 segment is the only reportable segment.

The Pharmaceutical segment includes human health pharmaceutical and vaccine products marketed either directly by the Company or through joint ventures. 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. 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. Sales of vaccines in most major European markets were marketed through the Company’s Sanofi Pasteur MSD (SPMSD) joint venture until its termination on December 31, 2016. Beginning in 2017, Merck will record vaccine sales in the European markets that were previously part of the joint venture.

The Company also has animal health operations that discover, develop, manufacture and market animal health products, including vaccines, which the Company sells to veterinarians, distributors and animal producers. The Company’s 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. Merck’s Alliances segment primarily includes results from the Company’s relationship with AstraZeneca LP until the termination of that relationship on June 30, 2014. On October 1, 2014, the Company divested its Consumer Care segment that developed, manufactured and marketed over-the-counter, foot care and sun care products.

Overview

During 2016, Merck continued to execute its innovation strategy and the Company’s sustained investment in research yielded a number of recent approvals and regulatory milestones across various therapeutic areas. The Company received several approvals in 2016 that include expanded indications for Keytruda , the Company’s anti-PD-1 (programmed death receptor-1) therapy, which was approved by the U.S. Food and Drug Administration (FDA) for the first-line treatment of metastatic non-small-cell lung cancer (NSCLC), as well as for the treatment of head and neck cancer. Additionally, in 2016, both the FDA and the European Commission (EC) approved Zepatier , a once-daily, single tablet combination therapy for the treatment of chronic hepatitis C virus (HCV) genotype (GT) 1 or GT4 infection, with ribavirin in certain patient populations.

Worldwide sales were $39.8 billion in 2016 , an increase of 1% compared with 2015 , including a 2% unfavorable effect from foreign exchange. Sales growth was driven by oncology, HCV, vaccine, and hospital acute care products, reflecting in part the ongoing launches of Keytruda , Zepatier and Bridion , as well as positive performance from Merck’s Animal Health business. Growth in these areas was largely offset by the effects of generic and biosimilar competition that resulted in declines for products such as Remicade and Nasonex .

Business development remains an important component of the Company’s overall strategy as Merck seeks to identify the best external innovation to augment its portfolio and pipeline, with a particular focus on early-to-mid-stage pipeline assets. Merck looks for growth opportunities that meet the Company’s strategic criteria. While looking for the best scientific opportunities, Merck remains financially disciplined, pursuing those business opportunities that the Company believes can contribute to long-term growth and sustainable value for shareholders.

In January 2016, Merck acquired IOmet Pharma Ltd (IOmet), a drug discovery company focused on the development of innovative medicines for the treatment of cancer, with a particular emphasis on the fields of cancer immunotherapy and cancer metabolism. In July 2016, Merck acquired Afferent Pharmaceuticals (Afferent), a privately held pharmaceutical company focused on the development of therapeutic candidates targeting the P2X3 receptor for the treatment of common, poorly-managed, neurogenic conditions, such as chronic cough. In addition, in 2016, Merck entered into a strategic collaboration and license agreement with Moderna Therapeutics (Moderna) to develop and commercialize novel messenger RNA (mRNA)-based personalized cancer vaccines.

Merck continues to support its in-line portfolio, as well as ongoing and upcoming product launches. Keytruda is launching around the world in multiple indications. In 2016, Merck achieved multiple additional regulatory milestones for Keytruda including approval from the FDA for the first-line treatment of patients with NSCLC whose tumors have high PD-L1 expression (tumor proportion score [TPS] of 50% or more) as determined by an FDA-approved test, with no EGFR or ALK genomic tumor aberrations and also for the treatment of patients with recurrent or metastatic head and neck squamous cell carcinoma with disease progression on or after platinum-containing chemotherapy. Additionally, in 2016, the EC approved Keytruda for the treatment of locally advanced or metastatic NSCLC in patients whose tumors express PD-L1 and who have received at least one prior chemotherapy regimen. In January 2017, the EC approved Keytruda for the first-line treatment of metastatic NSCLC in adults whose tumors have high PD-L1 expression (TPS of 50% or more) with no EGFR or ALK positive tumor mutations. Additionally, the Company is continuing its launch of Zepatier in the United States and in emerging markets and is now launching in the European Union (EU) and in Japan.

Merck is focusing its research efforts on the therapeutic areas that it believes can have the most impact on human health, such as oncology, diabetes, cardiometabolic disease, resistant microbial infection and Alzheimer’s disease. In addition to the recent regulatory approvals discussed above, the Company has continued to advance other programs in its late-stage pipeline with several regulatory submissions. Merck has five supplemental biologics license applications (sBLA) under Priority Review with the FDA for Keytruda including: for use in combination with chemotherapy for the first-line treatment of patients with metastatic or advanced non-squamous NSCLC regardless of PD-L1 expression and with no EGFR or ALK genomic tumor aberrations; for the treatment of patients with classical Hodgkin lymphoma; for the treatment of previously treated patients with advanced microsatellite instability-high cancer; for the first-line treatment of patients with locally advanced or metastatic urothelial cancer, including most bladder cancers; and for the second-line treatment of patients with locally advanced or metastatic urothelial cancer with disease progression on or after platinum-containing chemotherapy. Merck is driving a broad immuno-oncology development program and investing in the long-term potential for Keytruda to become foundational in the treatment of a range of cancers. The Keytruda clinical development program includes more than 400 clinical trials in more than 30 tumor types; over 200 of these trials combine Keytruda with other cancer treatments. MK-1293, an insulin glargine candidate for the treatment of patients with type 1 and type 2 diabetes being developed in a collaboration, is also under review with the FDA.

In addition to Phase 3 programs for Keytruda in the therapeutic areas of breast, colorectal, esophageal, gastric, hepatocellular, multiple myeloma, and renal cancers, the Company also has candidates in Phase 3 clinical development in several other therapeutic areas (see “Research and Development” below).

During the past year, the Company continued its focus on productivity improvements, looking for opportunities to reallocate resources across the portfolio to grow its strongest brands and to support the most promising assets in its pipeline. Marketing and administrative expenses declined in 2016 as compared with 2015 reflecting in part this continued focus by the Company on prioritizing its resources to the highest growth areas. Research and development expenses in 2016 reflect increased clinical development spending as the Company continues to invest in the pipeline.

In November 2016, Merck’s Board of Directors raised the Company’s quarterly dividend to $0.47 per share from $0.46 per share. During 2016, the Company returned $8.6 billion to shareholders through dividends and share repurchases.

In January 2017, Merck entered into a settlement and license agreement to resolve worldwide patent infringement litigation related to Keytruda . In connection with the settlement, Merck recorded a pretax charge of $625 million in the fourth quarter of 2016 (see Note 10 to the consolidated financial statements).

Earnings per common share assuming dilution attributable to common shareholders (EPS) for 2016 were $1.41 compared with $1.56 in 2015 . EPS in both years reflect the impact of acquisition and divestiture-related costs, including a charge in 2016 related to the uprifosbuvir clinical development program, as well as restructuring costs and certain other items. Non-GAAP EPS, which excludes these items, were $3.78 in 2016 and $3.59 in 2015 (see “Non-GAAP Income and Non-GAAP EPS” below).

Operating Results

Sales

Worldwide sales were $39.8 billion in 2016, an increase of 1% compared with 2015. Foreign exchange unfavorably affected global sales performance by 2% in 2016, which includes a lower benefit from revenue hedging activities as compared with 2015. Revenue growth primarily reflects higher sales in the oncology franchise largely from Keytruda , the launch of the HCV treatment Zepatier, and growth in vaccine products, including Gardasil/Gardasil  9, Varivax and Pneumovax 23. Also contributing to sales growth in 2016 were higher sales of hospital acute care products including Bridion and Noxafil , growth within the diabetes franchise of Januvia and Janumet , as well as higher sales of Animal Health products, particularly Bravecto . These increases were partially offset by sales declines attributable to the ongoing effects of generic and biosimilar competition for certain products, including Remicade and Nasonex , along with other products within Diversified Brands. Declines in Isentress , PegIntron and Dulera Inhalation Aerosol also partially offset revenue growth in 2016. Sales performance in 2016 reflects a decline of approximately $625 million due to reduced operations by the Company in Venezuela as a result of evolving economic conditions and volatility in that country.

Sales in the United States were $18.5 billion in 2016 , an increase of 5% compared with $17.5 billion in 2015 . Within the Pharmaceutical segment, sales in the United States grew 5% in 2016 driven primarily by the launches of Zepatier and Bridion , along with higher sales of Keytruda and Gardasil/Gardasil 9, partially offset by lower sales of Nasonex , Cubicin , Dulera Inhalation Aerosol, and Isentress .

International sales were $21.3 billion in 2016 , a decline of 3% compared with $22.0 billion in 2015 . Foreign exchange unfavorably affected international sales performance by 4% in 2016 . International sales within the Pharmaceutical segment declined 3% in 2016, including a 3% unfavorable effect from foreign exchange, largely reflecting declines in certain emerging markets, offset by an increase in Japan. Sales in emerging markets were $6.7 billion in 2016 , a decline of 9% including a 6% unfavorable effect from foreign exchange, driven primarily by reduced operations in Venezuela, partially offset by growth in other markets. Sales in Japan grew 6% in 2016 , to $2.8 billion, which includes a 10% favorable effect from foreign exchange. Excluding the favorable effect of foreign exchange, the sales decline in Japan was largely driven by the loss of market exclusivity for Singulair combined with the ongoing generic erosion for products within Diversified Brands, partially offset by higher sales of Belsomra . Sales in Europe were $7.7 billion in 2016 , essentially flat as compared with 2015, including a 2% unfavorable effect from foreign exchange. Excluding the unfavorable effect of foreign exchange, sales performance in Europe primarily reflects volume growth in Keytruda , Cubicin , Simponi , Adempas, Liptruzet , and the Januvia franchise, partially offset by ongoing biosimilar competition and generic erosion for certain products, particularly Remicade, and other pricing pressures in this region. Total international sales represented 54% and 56% of total sales in 2016 and 2015 , respectively.

Global efforts toward health care cost containment continue to exert pressure on product pricing and market access worldwide. In the United States, health care reform is contributing to an increase in the number of patients in the Medicaid program under which sales of pharmaceutical products are subject to substantial rebates. In many international markets, government-mandated pricing actions have reduced prices of generic and patented drugs. In addition, other austerity measures negatively affected the Company’s revenue performance in 2016 . The Company anticipates these pricing actions and other austerity measures will continue to negatively affect revenue performance in 2017 .

Worldwide sales were $39.5 billion in 2015, a decline of 6% compared with 2014 including a 6% unfavorable effect from foreign exchange. The acquisition of Cubist Pharmaceuticals, Inc. (Cubist) in 2015, the divestiture of Merck’s Consumer Care (MCC) business in 2014, as well as product divestitures and the termination of the Company’s relationship with AstraZeneca LP (AZLP) also in 2014, as discussed below, had a net unfavorable impact to sales of approximately 3%. In addition, sales performance in 2015 reflects declines in PegIntron and Victrelis , Remicade , Pneumovax 23, Nasonex , and Vytorin . These declines were partially offset by volume growth in Keytruda , Januvia and Janumet , Gardasil/Gardasil 9, Noxafil , Simponi , Implanon/Nexplanon , Invanz , Dulera Inhalation Aerosol, and Bridion , as well as volume growth in Animal Health products and higher third-party manufacturing sales.

In January 2015, the Company acquired Cubist, which contributed sales of $1.3 billion to Merck’s revenues in 2015. In 2014, the Company divested certain ophthalmic products in several international markets (most of which closed on July 1, 2014). In addition, on October 1, 2014, the Company divested its MCC business including the prescription rights to Claritin and Afrin. The sales decline in 2015 attributable to these divestitures was approximately $1.9 billion of which $1.5 billion related to the Consumer Care segment and $400 million related to the Pharmaceutical segment. Also, in 2014, the Company sold the U.S. marketing rights to Saphris , an antipsychotic indicated for the treatment of schizophrenia and bipolar I disorder in adults, which resulted in revenue of $232 million. Additionally, the Company’s relationship with AZLP terminated on June 30, 2014; therefore, effective July 1, 2014, the Company no longer records supply sales to AZLP. These supply sales were $463 million in 2014 through the termination date and were reflected in the Alliances segment.

Sales of the Company’s products were as follows: