Merck & Co., Inc.

Good morning. My name is Darla, and I will be your conference operator today. At this time, I would like to welcome everyone to Merck's fourth quarter 2018 sales and earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. To withdraw your question, press the pound key. Thank you. I would now like to turn the call over to Terry Lockson, SVP Investor Relations and Global Communications. Please go ahead.

Thank you, Darlene. Good morning. Welcome to Merck's fourth quarter and full year 2018 conference call. Today I'm joined by Ken Frazier, our Chairman and Chief Executive Officer, Rob Davis, our Chief Financial Officer, and Dr. Roger Perlmutter, President of Merck Research Labs, who will each have prepared remarks. In addition, I am joined by Mike Nally, our new Chief Marketing Officer, and Frank Clyburn, our new Chief Commercial Officer, who will both be available for the Q&A portion of the call. Before I turn the call over to Ken, I'd like to point out a few items. You'll see that we have items in our GAAP results, such as acquisition-related charges, restructuring costs, and certain other items. You should note that we have excluded these from our non-GAAP results and provide a reconciliation of these in our press release. We have also provided a table in our press release to help you understand the sales in the quarter for the business units and products. I would like to remind you that some of the statements that we make during today's call may be considered forward-looking statements within the meaning of the safe harbor provision of the U.S. Private Securities Litigation Reform Act of 1995. Such statements are made based on the current beliefs of Merck's management and are subject to significant risks and uncertainties. If our underlying assumptions prove inaccurate or uncertainties materialize, actual results may differ materially from those set forth in the forward-looking statements. Our SEC filings, including Item 1A in the 2017 10-K, identify certain risk factors and cautionary statements that could cause the company's actual results to differ materially from those projected in any of our forward-looking statements made this morning. Merck undertakes no obligation to publicly update any forward-looking statements. You can see our SEC filing as well as today's earnings release on Merck.com. Finally, similar to last quarter, we have posted a presentation to the investor section of Merck.com, which highlights some of our financials from the quarter and the year. With that, I'd like to turn the call over to Ken.

Thank you, Sherry. Good morning, and thank you all for joining the call. In 2018, Merck distinguished itself through its strong performance across its businesses. Perhaps most significantly, Our full year results demonstrate that our strategy to be the premier research-intensive biopharmaceutical company is working. The investments we've made in R&D over the past several years and our commercial execution have culminated in the highest top and bottom line growth the company has seen in years. And we expect our momentum to carry over into 2019. At its core, Merck is a science-driven organization motivated by a quest to improve human and animal health. We've spent the last several years reinvigorating our labs, investing in three new research centers in South San Francisco, Cambridge, Massachusetts, and London, and refocusing our efforts on creating truly differentiated medicines that help solve big health problems for now and the future. This unwavering commitment to science and innovation enables us to retain the best talent in the industry, to drive our strategic priorities, and to continuously enhance our pipeline of medically significant treatments and vaccines. Our clinical and commercial execution in the I.O. space has further separated Keytruda from its competition, and our leadership in oncology is further bolstered by the growth prospects for Lenparsa and Lenvima. Gardasil is not only driving meaningful growth for the company after a decade on the market, but is also instilling optimism around the world that this vaccine could help prevent and maybe eliminate certain HPV-related cancers. We are confident in our broad portfolio of market-leading products and our diversified high-potential pipeline, which includes significant innovations in oncology, vaccines, and other special and hospital care. along with a robust industry-leading animal health business. In fact, Merck is one of the broadest and most promising pipelines we've had over the past two decades. In summary, we are excited by our progress, our pipeline, and our future. We are energized by the work that we do, and most importantly, by our ability to help patients around the world while also creating sustainable long-term growth and strong shareholder returns. Before I turn the call over to Rob, I'm pleased to announce that we will be hosting an investor event on June 20th, during which we will provide an update on our strategic progress and outline how Merck will continue to deliver innovative science and create value for all of our stakeholders. We will be back to you with the details on location and other logistics, but we ask that you save the date. Now I'd like to turn it over to Rob for more color on our financial and operational performance. Rob?

Thanks, Ken, and good morning, everyone. Please note that my comments today will be on a non-GAAP basis. Our results in 2018 reflect strong execution across our key growth pillars, focused investment in our pipeline, and disciplined expense management. We achieved meaningful top and bottom line growth, and we also executed important business development transactions, initiated an expanded capital expenditure program to increase our manufacturing capacity, and returned additional value to shareholders through increased dividends and share purchases. We believe our company is well positioned to achieve future growth, and as our 2019 guidance shows, we expect the recent momentum in our business to continue as we execute on our growth pillars and invest in R&D while remaining disciplined in our allocation of resources. Turning to our fourth quarter results. Total company revenues were $11 billion, an increase of 8% year-over-year excluding exchange, with strong growth in both our human health and animal health businesses. Human health revenues increased 8% ex-exchange to $9.8 billion, led by key products in our oncology, vaccines, and hospital and specialty businesses. In oncology, Katruta's sales exceeded $2.1 billion this quarter, extending the unprecedented launch of this foundational therapy and solidifying Merck as the clear market leader in immuno-oncology with continued strong future growth prospects. Global growth was primarily driven by higher use in first-line non-small-cell lung cancer, and utilization remained strong across the breadth of our indications, including melanoma, head and neck, bladder, and MSI-high cancers. We are seeing strong uptake in squamous non-small-cell lung cancer in the U.S., where a good portion of newly diagnosed patients are now receiving either Keytruda as monotherapy or in combination with chemotherapy following the approval of Keynote 407 in October. In total, in the U.S., we now have 15 approved indications and are approved in 10 different tumor types overall, plus a pan-tumor approval in MSI-high patients. In ex-U.S. markets, first-line lung is the key driver of growth. mostly due to further uptake of our monotherapy indication and PD-L1 high expressors following reimbursement approvals around the world. In Europe, we're off to a great start launching the chemo combo in non-squamous patients following approval of Keynote 189 last September. We are already seeing adoption in select markets, such as Germany, where reimbursement begins upon approval, and we will be working through the reimbursement process in other major European markets throughout this year. Growth in Japan remains robust, and we are very pleased with the recent approval of five new indications across lung, adjuvant melanoma, and MSI-high cancers. Finally, in September, we launched Katruta in metastatic melanoma in China, which will be an important market for the brand going forward as we pursue additional indications. Overall, we remain very confident in the long-term growth potential for Katruta based on increased utilization and currently approved indications, and our expectation of additional approvals worldwide. We also remain very encouraged by the progress and potential of both LIMPARSA and LIMVIMA, in partnership with AstraZeneca and eSci, respectively. LIMPARSA growth this quarter was driven by continued uptake in ovarian and breast cancers, as well as launches in new markets such as Japan and China. In the United States, across all tumors, Limparza leads the PARP inhibitor class with over 50% total patient share. We're excited by the earlier than expected U.S. approval of SOLO1 and look forward to bringing this treatment to more women with ovarian cancer. Growth for Linvima reflected strong performance in hepatocellular cancer following recent launches in the U.S., Europe, and more recently, China. Performance in Japan remains strong, with Lanvima being used in the vast majority of hepatocellular patients. Turning to vaccines, we have a significant and innovative portfolio. Our vaccines business reflected strong worldwide demand for Gardasil, which achieved sales of over $800 million this quarter. Health systems worldwide continue to support increased immunization with Gardasil, with the goal of reducing the incidence of certain HPV-related cancers. Growth this quarter was driven by strong uptake from our recent launch in China, as well as increased demand in Europe, given the move towards more gender-neutral vaccination programs. Sales of Gardasil also grew in the US, mostly reflecting the difference in quarterly phasing of public sector purchases last year. Our hospital and specialty business was led by Brideon, where growth in the US reflects continued strong demand. Brideon sales approached $1 billion for the year, and we remain confident in the potential for additional future growth. Looking now at our animal health business, we again saw strong growth this quarter with revenues increasing 11% to $1 billion excluding exchange. Growth was driven by our broad portfolio of inline and newly launched products, with companion animal products growing 16% and livestock sales growing 8%, both excluding exchange. Companion animal growth was driven by sales of vaccines, while livestock benefited from increased sales of swine and poultry products. Animal health segment profits were at $387 million in the fourth quarter, an increase of 16%, excluding exchange, compared to the prior year. Our animal health business continues to perform well, and we view it as a key pillar of New York's future growth. We continue to invest in new product development and launches and recently announced the acquisition of Antelic, which will establish Merck as a leader in animal identification and monitoring, one of the fastest growing parts of the animal health industry. Turning to the rest of our P&L, gross margin was 75% in the quarter. The increase of 70 basis points versus the fourth quarter of 2017 was largely due to the favorable impacts of product mix this year and manufacturing variances related to the cyber attack that negatively impacted last year. This increase was partially offset by other headwinds, such as lower prices and catch-up amortization of sales milestones, primarily related to the earlier-than-expected approval of Solo 1. Operating expenses of $4.8 billion increased 1% year-over-year, including a favorable 1 percentage point impact from foreign exchange. Investments in our oncology and vaccines clinical development portfolios, as well as our discovery efforts, drove the increase in R&D, while SG&A remained relatively flat. Our tax rate of 22.5% for the quarter was 720 basis points higher year over year, reflecting a true-up of our full-year tax rate due to our mix of earnings. Taken together, we delivered earnings of $1.04 per share, an increase of 11%, excluding exchange. Now let's turn to our outlook for 2019. We remain confident in both our near and long-term prospects for revenue growth, notwithstanding expected headwinds from price, foreign exchange, and pressures on our mature and LOE products. For 2019, we expect four-year revenues of $43.2 billion to $44.7 billion, which represents 2% to 6% growth, driven by strength in our key growth pillars across oncology, vaccines, hospital and specialty, as well as animal health. This range assumes an approximately one percentage point negative impact on foreign exchange using mid-January rates. We expect our gross margin to be roughly flat year over year. As we've previously communicated, we believe tailwinds, including improved product mix, will generally be offset by headwinds, including lower prices, royalty payments, fluctuations in FX, and the continued amortization of collaboration milestones. We expect our operating expenses to increase year-over-year at a low to mid-single-digit rate, with continued disciplined management of SG&A allowing for meaningful further investment in R&D to capitalize on our pipeline opportunities. We expect our tax rate to be between 18.5% and 19.5% for the full year. We project average diluted shares outstanding to be approximately $2.58 billion for 2019. Taken together, we expect EPS to be between $4.57 and $4.72, including an approximately 1 percentage point positive impact from foreign exchange at mid-January rates. This would represent approximately 5% to 9% bottom line growth. Before concluding, it's worth mentioning that our 2019 EPS guidance assumes that our other income and expense line will be roughly zero in 2019. Due to an accounting standard implemented in 2018, we now recognize unrealized gains and losses related to our investments in equity securities and other income and expense. Based on current market conditions for our investment portfolio, we have assumed a negative impact from our equity investments in OIE in our guidance. We also expect higher net interest expense given our cash and debt balances and given current interest rates. Market movements could create additional volatility as we move through the year, and we will continue to give you updates as we move forward. In summary, we delivered strong performance in 2018. While 2019 continues to be another important investment year for R&D, We expect operational momentum across our growth pillars, combined with disciplined resource allocation, to deliver another year of meaningful top and bottom line growth, as well as operating leverage. Longer term, we remain confident in our ability to drive strong sales growth and meaningful operating margin expansion. Our dedication to innovation and continued execution allow us to sustainably deliver for the patients we serve and, in turn, create significant shareholder value. With that, I'd like to turn the call over to Roger.

Thanks, Rob. As outlined in our press release, the fourth quarter was an especially productive period for Merck Research Laboratories, marking the climax of what was an extremely busy year. Beginning first with Keytruda, during the fourth quarter, we obtained three new indications in the United States. First, for the first-line treatment for patients with metastatic squamous non-small-cell lung cancer in combination with carboplatin and either piclitaxel or nab piclitaxel, based upon the results of the Keynote 407 trial. Second, for the second-line treatment of hepatocellular carcinoma in patients who have previously been treated with serapinib. And third, for the treatment of adult and pediatric patients with recurrent locally advanced or metastatic Merkel cell carcinoma, a rare skin cancer. Separately, and based on the results of our Keynote 054 study, which was conducted with the European Organization for the Research and Treatment of Cancer, The European Commission approved Keytruda for the adjuvant treatment of stage 3 melanoma with lymph node involvement in patients who have undergone successful tumor resection. Meanwhile, in Japan, we obtained five new Keytruda approvals at the end of December, including the first approval, based on our Keynote 042 trial, for Keytruda monotherapy in patients with non-small cell lung cancer whose tumors contain greater than or equal to 1% of malignant cells expressing the PD-L1 biomark. Data from Keynote 042 are also under review in the EU and in the United States, where submission of additional data resulted in an extension of the PDUCA date by three months to April 11th of this year. Our other cancer programs also advanced meaningfully in the fourth quarter. In collaboration with our colleagues at AstraZeneca, we gained FDA approval for Linparza as maintenance treatment for patients with advanced ovarian fallopian tube or primary peritoneal cancer who experienced complete or partial response the first-line platinum-based therapy, and whose tumors contain deleterious or suspected deleterious germline or somatic mutations in BRCA1 or BRCA2 genes. This approval was based on data presented last fall at the European Society for Medical Oncology meetings from the SOLO1 trial. We continue to see very positive results across our oncology portfolio, including the success of our Keynote 181 trial, testing Keytruda monotherapy in the second-line treatment of advanced or metastatic esophageal or gastroesophageal junction carcinoma with a 31% reduction in the risk of death as compared to traditional chemotherapy in patients whose tumors expressed the PD-L1 biomarker with a combined proportion score of greater than or equal to 10. This is the first demonstration of an improvement in overall survival in esophagogastric malignancy through immunotherapy. Data from the study were presented at the ASCO GI meeting in January and have been submitted for regulatory review. During the fourth quarter, we also announced the results of our Keynote 426 trial, combining Keytruda with Pfizer's Axitinib in the first-line treatment of renal cell cancer as compared with serafinib treatment. Data from this study, in which improvements in overall survival, progression pre-survival, and overall response rate were demonstrated, have also been submitted for regulatory review. Progress has been made in other disease categories as well. For example, the FDA granted priority review with the PDUCA date of July 16th for our novel antimicrobial agent MK-7655A, which combines a new chemical entity, relabactam, with imipenem, thus blocking the activity of a bacterially expressed beta-lactamase that would otherwise inactivate imipenem. This represents an important advance in the struggle to control antibiotic resistance. We're also active on the business development front, joining with colleagues at MGM Biopharmaceuticals to advance MK3655, a highly selective Phase II monoclonal antibody directed against the FGF receptor 1C beta-clotha receptor complex for the potential treatment of non-alcoholic steatohepatitis. Our vaccine programs also progressed during the fourth quarter. At the end of the quarter, for example, we announced a collaboration with Instituto Butantan on the development of vaccines to protect against dengue virus infection. Instituto Butantan is currently conducting a Phase 3 study in Brazil with their vaccine candidate, while our own related dengue virus vaccine showed promise in earlier Phase 1 studies. Finally, we commenced a rolling BLA submission for V920, our investigational vaccine designed to protect against infection with the Zaire strain of Ebola virus. We continue to provide tens of thousands of doses of this vaccine to the World Health Organization to assist in the battle to contain an Ebola outbreak in the Democratic Republic of the Congo. We hope that through the important work of governmental and non-governmental agencies, and in part as a result of our B920 vaccine, it will be possible to bring this very serious Ebola outbreak under control in the near future. Now my colleagues and I will take your questions.

Thanks, Roger. Darla, we will get started on questions. I just wanted to remind everyone to try to keep your questions to a maximum of one to two so we can get as many people on the call as possible. So with that, we'll turn it over to questions.

If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. Your first question is from Seamus Fernandez with Guggenheim.

Thanks very much for the question. So my first question is for Ken, and my second is for Frank and Roger. Ken, can you just help us understand the core areas of focus for potential M&A or business development to bolster the Merck pipeline? And maybe if you could just kind of give us a general sense of areas of interest and perhaps even the range, obviously lots of questions around the current mega cap M&A that's occurred in recent days. And then for Frank and Roger, can you just maybe each of you kind of characterize the key opportunities near and longer term to sustain or perhaps even accelerate the Keytruda opportunity We're seeing amazing growth in that franchise, but again, we're just trying to get a sense of the key new opportunities, whether it be kidney cancer as a core opportunity or perhaps somewhat longer term in the adjuvant setting. Thanks so much.

Thanks, Seamus. Let me start by saying again that business development remains an important priority for us. First and foremost, we look for those scientific innovations that we believe will enhance our pipeline because we believe that's what's important ultimately to drive long-term growth and value for shareholders. In that regard, we don't try to predetermine what therapeutic areas are best. We want to find the best science, match it up to the best opportunities to help people, and that's how we go about it. And I'll remind you that we were very active last year in BD. We did about 60 transactions spanning licensing and technology deals, clinical collaborations, We did the collaboration with ESI. We did the acquisition of Virolytics, which expands our early immuno-oncology type R. We did the Antelic acquisition. So, again, I think what we want to do, given our strong balance sheet, is to actively look across the entire spectrum of assets, across therapeutic areas to create the strongest portfolio. I'll close by saying we continue, as we've said for years, to want to focus on the kinds of deals that we can add with the minimum of disruption to our ongoing scientific efforts so we have not really been focusing primarily on the large mega mergers that you referred to.

Roger, why don't you start on the second question around Keytruda, key opportunities, and we can turn it over to Frank for the commercial portion.

Right, Seamus, thanks for the question. First of all, I think it's important from a context point of view, and you know this, that we're still at an early point in the development of Keytruda. So keep in mind that it's just a little over four years since the first indication was obtained in the United States in 2014. And in that sense, the indications are still rolling out. Keytruda, as I've said and as you know, is the first truly broad-spectrum antineoplastic agent introduced into clinical practice with 15 indications and more coming. And many of those indications have not yet been broadened around the world, and Frank will have a chance to talk about that. So there's a great deal of opportunity to do good in helping patients around the world. But beyond that, we've... continue to work on a strategy in which we first demonstrate activity with monotherapy in different tumor types. And the monotherapy studies are essentially complete. We have a few more studies coming through. But then move forward in combination studies while simultaneously advancing from salvage therapy, third line, second line, to first line, adjuvant, neoadjuvant, and all of those studies are going on. And We are expanding into new areas, and in addition, in combination with other agents, both those that have already been introduced into practice, axitinib and renal cell carcinoma, and in addition, our own pipeline. So there's just a huge set of opportunities. Looking forward, I think, as I mentioned, the data that we presented in esophageal gastric cancer in January at ASCO-GI, And the renal cell data, which will be presented in mid-Debruary from the Keynote 426 study, are special highlights. But there are going to be a lot of presentations coming forward. There's a lot of new data coming up. And we'll have a chance to talk about some of that, for example, in advance of ASCO. It's early days, but a lot of expansion opportunities. And, Frank, I think you can talk about that.

Seamus, good morning. To echo Roger's point, we have actually a very early stage launch going on, and I just wanted to reiterate, especially outside the U.S. for lung cancer. We are right now launching Keynote 189, and we're just in the early stages of that launch. So if you look at our ex-U.S. growth, in fact, this quarter our ex-U.S. growth was over 86%. And that just shows the early progress that we're making, not only with our monotherapy, but early on with our combination in lung. In addition, we have a number of other opportunities. You heard us announce the approvals in Japan. We're very excited about the opportunity that we have in China with our second-line melanoma indication, and we have a broad program that we are building in China. In addition to that, we have significant opportunities, as you've heard from Roger, with regards to our renal cell carcinoma data that we're looking forward to presenting Keynote 426 at ASCO-GU. We're also excited about triple negative breast cancer. We've presented our data now for Keynote 48 for head and neck cancer with first-line chemo combination, gastric cancer, and others. So we're very excited about our current indications and expanding those around the world, as well as the significant amount of data readouts that are going to be coming in the future that we think will provide very significant growth, not only this year, but in the long run.

Great. Thanks for the question, Seamus. Darla, we'll move on to the next one, please.

This is from the line of Steve Scala with Cowan.

Thank you. A couple questions. Ken, I was interested in your comment that Merck has one of the most broad pipelines in the past two decades. And this is quite a statement given Merck's rich research history. What are we missing externally that Merck sees internally? And will June 20th be the opportunity for us to learn a lot more about the pipeline? And secondly, Merck's pneumococcal vaccine, I believe, received breakthrough designation in children but not adults. Is this an issue of timing, or did FDA deliberately not grant the 15-valent product breakthrough in adults? Thank you.

So thank you for your question, Steve. I continue to believe that Merck's longer-term revenue growth prospects are underappreciated, in large part because people don't see the pipeline the way we do. So let me try to answer your question. So we see tremendous future growth, not only in Keytruda, Lindfors, and in Lendema, but we have behind it a formidable internal pipeline of assets in oncology, over 20 unique mechanisms. In the vaccine world, we think the Gardasil opportunity is really significant going forward, but behind that are opportunities in next-generation pneumococcal, RSV, CMV, dengue, and other areas are ones that we look forward to. As we also look beyond that, We just announced positive phase three data for Zerbaxa, our antibiotic for hospital-acquired ventilator-acquired pneumonia, which we believe could be a very sizable opportunity to go with our leading portfolio of hospital products, including Viridian. The Afrin compound, which we acquired a couple years ago, is now being studied in phase three in chronic cough. And Verisiquat, in our buyer collaboration, is just another example of that, not to mention great novel assets in HIV and neuroscience. So to answer your question, I actually look forward to the June opportunity for us to talk about what it is that we see in our pipeline. I will say that we are genuinely excited. We see the opportunities for us to invest across a broad area. And again, we look forward to speaking to you in more detail on June 20th.

Right. And with respect, Roger, with respect to the Breakthrough designation, yes, we did receive breakthrough designation in pediatrics for the Keynote 114, sorry, the D114 pneumococcal conjugate vaccine. And the reason was because of the very meaningful clinical data that we obtained demonstrating the balanced response across all 15 serotypes represented in that vaccine. We have very strong data in the adult segment as well, and it's really a matter of timing with respect to how we interact with the agency. Just to remind you, Breakthrough Designation provides a mechanism whereby you can have more frequent consultation interaction with the agency on late stage trials, and keep in mind that V114 is already in eight phase three studies that we'll be reading out this year, next year. So there's already a very substantial head of steam on this program.

Great, thank you. We'll move on to the next question, please, Darla.

It's from Andrew Baum, Wood City.

Many thanks. A couple of questions, please. Pharma, the industry lobby, has championed net pricing. Given the announcement last night to Frank and Ken, could you talk to the Merck assessments of the proposal, particularly probability goes through, how you see the risks, as well as the potential positives, and the spillover in terms of the commercial book of business, when. And then secondly, to Roger, I note that you recently initiated a trial of a laparate in tissue agnostic setting with HRR-mutated tumors who are resistant to refractory to all gold standard treatment. The question is, number one, is that trial fileable, given the the advanced nature of the patients? And number two, the size of that patient population, depending on what biomarker you use, could be very substantial. Could you talk to how large that population may be in the percentage of addressable relapsed refractory patients? Many thanks.

Thank you, Andrew. Let me start with your first question about the HHS rebate proposal. Let me start by saying we share the administration's goal of lowering out-of-pocket costs for patients. That's critical for patients. It's critical for our business. As you know, unfortunately, the current pharmaceutical supply chain includes various misaligned incentives that serve to support middlemen while often neglecting patients. We are evaluating the specific proposal released by the administration late yesterday, and we're hopeful that it will achieve this shared goal of ensuring patients have affordable access to innovative medicines.

Yeah, and Andrew, I think you were asking a question. I'm having a little bit of trouble hearing you here, but you were asking a question about a LinPARSA study, which was a tissue agnostic study. And again, this is part of the broader rollout of our LinPARSA analysis because, you know, what we found with LinPARSA, as I think everyone recognizes, is that the breadth of activity of lymparza is greater than we expected. First of all, any DNA repair, a variety of DNA repair defects, defects in homologous recombination, seem to sensitize cells to lymparza. But even in cell types in which those defects are not recognizable, there is evidence, accumulating evidence, that we're seeing clinical responses. So we're beginning to think of LinPARSA having much broader activity, and that's particularly the case when we look at LinPARSA in combination with Keytruda and other agents. So you can expect to see broader studies of LinPARSA in a variety of different settings, both outside of the hormone-responsive tumors and as well in combination with other agents. I hope that helps.

Great. Thanks, Andrew. We'll move on to the next question, please, Farla.

Your next question is from Chris Shot with J.P. Morgan.

Great. Thanks very much for the questions. My first question was just on longer term margin expansion and just expenses in general, I guess. So we think about the low to mid single digit OPEX growth in 2019. Is that a reasonable growth rate to think about on a go forward basis for Merck? Or should we think about spending starting to moderate as we look out to 2020 and beyond? I know in general, there's been a lot of discussion around kind of the magnitude of operating margin expansion. So any color on that front would be helpful. And my second question was just focusing a little bit more on the launch dynamics in first-line lung, specifically in the U.S. I guess, can you just give us a sense of where we are at this point in terms of share of new starts, and are there any additional areas for growth within the lung market, and I guess where you must focus on from a commercial standpoint as we think about just that indication playing through in the U.S.? Thanks very much.

Thanks, Chris. So let's start with Rob. Thanks, Chris. And to your question on long-term success, margin expansion. So as I said in the prepared remarks, we continue to believe we will see meaningful margin expansion, operating margin expansion as we go forward. But as we've been talking about, given the fact that we have such a wealth of opportunity right now in R&D, you know, you start with Keytruda and look at just what this drug could be and how unprecedented it is, we want to make sure we're investing fully behind that as well as with the LIMPARSA and LIMBEMA, those programs are now in full swing, not to mention our vaccines program. So as we've indicated, we do think you're going to see sales growth continue. And with that, you're going to see R&D grow in the near term faster than sales over the next couple of years as we really get through the bolus of that with R&D slowing down to a rate slower than sales thereafter. And SG&A will continue to be managed very tightly. You know, it's nice to see, frankly, that even despite the fact that we're making meaningful investments in R&D in 2019, we're actually going to see operating margin expansion in 2019. So that actually is really, I think, a result of what we've done from discipline expense management you pull it tightly, and then you'll see R&D slow down after you get out of the next couple of years. So that's really what will drive it.

Great. Thanks, Rob. Frank, we'll have you comment on the first-line lung market.

Chris, we are seeing significant share of newly diagnosed first-line non-squamous, non-small cell lung cancer patients that do not have an abnormal EGF or out gene. Based off of Keynote 189, we've seen that penetration increase very rapidly in the majority of the segments in the non-squamous, non-small cell lung cancer setting. We do have room for further penetration, in particular in the PD-L1 patient population in the U.S., and that's where the team is focused. And also, we are seeing very rapid uptake with our Keynote 407 approval the end of October. And we're penetrating the squamous cell carcinoma patient also very significantly. So I think in the U.S., I would say it's really in the PD-L1 negative population where there's opportunity for further growth in the non-squamous patients. I would highlight outside the U.S. and just to reiterate that we're very early on in the launch outside the U.S. in lung cancer. In fact, most of our growth outside the U.S. is primarily being driven off of the PD-L1 high express patient population in Keynote 24. So we're just rolling out our chemo combinations around the world and anticipate significant growth outside the U.S. and long.

Great. Thanks for your questions, Chris. We'll move on to the next caller, please.

This is from David Reisinger with Morgan Stanley.

Thanks very much. So I just wanted to go back to the margin opportunities beyond 2019. It seems like Merck is increasingly becoming more of a specialty-focused company. And to that end, many specialty biopharma companies can generate higher margins simply because they don't need the primary care infrastructure and the other costs associated with a much broader portfolio. And so could you discuss opportunities to further streamline Merck's cost structure in future years as you continue to pivot the company? And then second, with respect to the data on February 16th, the abstracts are coming out on Monday the 11th at 5 p.m. So will we see the key data in the abstract release or will we really have to wait for the data on the 16th? Thank you.

All right, Dave, thanks for the question. Maybe I'll take the first part and then Roger can take the second part. So, you know, as you look at the profile of the business, given the mix of our portfolio, you are correct. that as we go forward, we continue to believe that there is an opportunity to shift as we move to the more specialty-focused business to continue to optimize the resources we have around primary care. I think the important point, though, is this isn't a new thing for us. In fact, you know, when we pointed this out in the past, we've actually been able to grow on an EPS basis through the years even when we didn't have sales growth at the same time We were standing up an oncology franchise from scratch and investing meaningfully into R&D. And so we did that because we have already started really harvesting some of the primary care resources we have in the marketplace, primarily through selling forces. We've been reducing selling forces over the last several years to be able to do that. And there's opportunity for us to continue to do that going forward. That's why we do believe that we're going to continue to see SG&A get better as a percentage of sales, despite the fact that we're already at an industry best-in-class position with the fact that we still have the primary care resources in place, although less than they used to be. So that is an opportunity that's out there, and we're going to be driving it over the next couple of years as we move forward. So that is something you should look for as you go forward. I think the thing that's important to note is while we're getting the favorable impact from mix, obviously given the strong volume growth and margin you get from positive mix, we do have the headwinds at the gross margin line that we've talked about that's going to cause gross margin to be roughly flat. So the operating margin expansion we're going to see will come from that SG&A leveraging we're talking about as well as the R&D I mentioned earlier.

Roger, you want to comment on our feedback? Right.

And, David, you're referring on February 16th to the renal cell carcinoma data from Keynote 426. Of course, on February 16th is also the PDUFA date for the 054 study in adjuvant melanoma. But I think you're referring to the 426 data. And the complete data, of course, will be presented then. There will be an abstract that appears beforehand. The abstract has some data. There's some material in it. We're eager to gain publication also of the complete analysis just as soon as we can. So there will be various different parts of the data coming out, but the main presentation on the 16th is the part that I would focus on.

Thanks for your questions, Dave. Sharla, we'll move on to the next caller, please.

It's from Emma Rafat with Evercore ISI.

Good morning. Thanks so much for taking my questions. First, perhaps, Roger, I feel like there's a trial which hasn't come up very much at all on Merck Conversations, which is your Stage 3 lung trial, Keynote 799. And it's my understanding that it's a first-line trial within Stage 3, which would potentially position Keytruda before the current label for Infinzi. However, what I noticed was your slide today calls it a second-line trial. So I just wanted to clarify that, A, And B, on the pneumococcal vaccine side, I know there's a couple of Pfizer patents which you guys have prosecuted in the past and now appealing. And my question is, as it stands currently, and let's say the appeal doesn't go favorably, do you have the freedom to operate? Thank you very much.

Okay, with respect to Keynote 799, just to provide a higher altitude context for this, From the very beginning, our concern with respect to administering Keytruda in the setting of radiotherapy has been pneumonitis. And we know that from a variety of different studies previously that we had come to associate proximity of radiotherapy with Keytruda administration with pneumonitis. more inflammation in the lungs. So 799 has a safety, an important safety component, which is the administration of Keytruda in combination with chemotherapy plus radiotherapy in different cohorts for the question of whether or not pneumonitis feeds 10%, because that's really an important issue. These are patients, the actual study population is a population that has undergone resection, but is not widely disseminated. Sorry, let me get this right. The actual population is a population of individuals who have lung cancer that is radio responsive, potentially radio responsive, and who can receive that in a first line environment because they won't have received prior systemic chemotherapy. So that was your question.

And your question with respect to V114, let me say that we continue to believe that we will have freedom to operate in that space. And recently, the IPR ruling from the PTAB was in our favor on a number of the patents that we had challenged. So we'll see what goes on as we move forward.

Great. Thanks. We'll move on to the next question, please.

It's from Tim Anderson with Wolf Research.

Thank you. A couple of questions. Going back to the very first line of questioning on your pipeline and the perception by investors that at least late-stage enemies it tends to run on the thin side, here you and Bristol potentially share a common thread, which is all the heavy spending in I.O. has maybe crowded out other R&D programs. So the question I have in this context is, something that we asked you maybe about a year ago. When is R&D spending on Keytruda going to peak? About a year ago, you suggested that wasn't very far off qualitatively, but it was never quite clear to me what that meant. I know with all the combination programs, maybe it doesn't peak anytime soon. So that's the first question. Second question is just on your triple negative breast adjuvant trial. update on timing of seeing those results and how would you characterize the riskiness of that trial in terms of achieving a positive readout? Would you say it's low or medium or high risk?

We'll start with Rob to talk about the cost first.

Morning, Tim. With R&D, so if you look at what's driving the bulk of our clinical spend right now, it is still Keytruda, but it's actually now more combination studies than it is monotherapy studies. A lot of the monotherapy clinical studies are already starting to peak and come off. So really, right now, what's driving it is the combination studies. And then in addition to that, importantly, the investments in Lenparsa and Lenvima will be peaking over the next couple of years, too. So, you know, if you look at total R&D, it is being driven by those, and then obviously our vaccines programs are contributing as well. So those are the main group categories, and we do think, though, the bolus of Keytruda-related studies and the broader Lenpars and Lenvima studies will peak in the next couple of years. So when we've been talking about that threshold happening, it's really those programs that are driving that change where we do think you'll see R&D slow down as we move forward. Obviously, though, you know, the good news from a long-term perspective is Roger keeps turning over new positive things. So we always have to moderate as we have opportunity to invest. But the good news is we have a great pipeline. We're investing behind and we're going to invest fully. You should see a peak in the next couple of years.

Right. And Roger, do you want to address the second question?

Right. I believe, Tim, that you're referring to the Keynote 522 study, which is a neoadjuvant study. And we did have the opportunity to see early data from the 522 study and We had the chance to share those data with the agency, and we and they agree that it is important to get additional data with a longer-term follow-up. So that's what we're waiting for for that study. And once we have those data available, we'll have a chance to look at it more carefully and then, of course, share it with you.

Great. Thanks for your questions, Tim. We'll move on to the next question.

It's from Ramon Devon with Credit Suisse.

Hi, great. Thanks so much for taking my question. So one, I appreciate the color you gave on the lung cancer side and the commercial uptake there. I'm just trying to understand the adjuvant melanoma and also the frontline renal indications. Obviously, we need to see the full data and the labels. Was anything specific or unique with those two indications that may make the uptake faster or slower than what we've seen so far in lung cancer? And then the second one, just going back to the topic of drug pricing, If you can just share sort of what you're assuming in terms of net pricing growth in the U.S. in 2019 for your guidance and also sort of related to that question in terms of Keytruda, if you can just sort of share your net pricing of assumptions, U.S., Europe, and also China would be very helpful. Thanks.

So we'll start with Frank on the adjuvant Mellon RCC, and maybe you can just comment broadly on pricing for Keytruda before we turn it over to Rob for the other pricing questions, Frank.

Well, on adjuvant melanoma, as I mentioned, we're actually just starting the approval in Europe for adjuvant melanoma. We do think this is a good opportunity for us. We have established a very strong foothold in metastatic melanoma, so we think this is a good opportunity to expand into adjuvant melanoma. As Roger mentioned, we're waiting on our PDUFA date for adjuvant melanoma in the U.S., and we think we will be competitive there as well. With regards to RCC, we're excited about the opportunity. The study was done across all risk groups, and we're looking forward to sharing the data in the next several weeks, but we think that this will be a very important opportunity in RCC upon approval. As far as Katruda goes with regards to pricing, we don't give out specific guidance from a pricing perspective, but in the ex-U.S. markets, we're seeing very strong reimbursement for CATRUDA based off of the very strong value proposition that we have, and we feel as though we're positioned very well from a reimbursement perspective outside the U.S. And then in the U.S., we also feel as though we're positioned very well with regards to reimbursement, especially because CATRUDA is reimbursed in Part B currently.

Morning, Brian. Well, to your question on the guidance, you know, while our guidance range does assume multiple scenarios, We don't require any additional pricing in the United States to meet our guidance range.

Right. And we're going to try to squeeze in a few more questions here. I know we're close to the top of the hour. Next question, please, Darla.

This is from Jason Garberry with Bank of America.

Hey, good morning, and thanks for taking my question. Maybe just, Frank, just to follow up on a couple of Amal's questions there. So in adjuvant melanoma, just curious, you know, in lung you enjoy a first mover advantage. In adjuvant melanoma, Bristol already has roughly 70% share, so just kind of curious how you think you can make inroads if you think the first mover advantage is really that important or if you think you can actually capture share. And then my second question, just on frontline renal, in the U.S., and maybe drawing from your experience in other tumor settings, are payers mandating that they'll only reimburse the specific studied combinations? And the reason I ask is I'm wondering if there's an advantage at all you know, in terms of how all these different TKI combinations will be used. Will physicians ultimately migrate to using different TKIs, which they're more familiar with and more commonly used? Or if there's going to be a winner-takes-all with potentially the study that gets there first with TKI? Thanks.

All things being equal, you would like to be first in most of the indications. However, we have experience in several cancer types where we were not first. So I'll point you to bladder, where we actually launched fifth in the U.S., and we now have the leading market share in bladder cancer. And really, it was because of the strong data with Keynote 45 and the overall survival benefits. So really the oncologists are going to look first and foremost to the data, and we feel as though Keynote 54 is a very strong data set, and we feel as though it will be competitive. The other thing I would also say is that in the community, especially in the U.S., because of the breadth of our program and because of the use in lung cancer, in head and neck, and now in gastric and other cancer types, we feel as though the community is very familiar with using Keynote 54. They're giving us very strong feedback on the profile of Keytruda, and we think that's going to help us not only in adjuvant MEL, but also being second in renal cell carcinoma. And then the last point I mentioned on renal cell carcinoma is, you know, when we share the data in the next several weeks, we feel as though, as Roger has highlighted, we've top-line having overall survival benefit, progression-free survival benefit, and strong response rate. So usually the oncologists will make a choice based off of the data they see, and we're looking forward to, upon approval, competing in RCC.

Great. Let's move on to the next question, please.

It's from Alex Arfa with BMO Capital Markets.

Great. Thank you, and good morning, Ben and Roger. Could you please provide your thoughts or comments on key to the lifecycle planning? Obviously, after Genuvio's upcoming LOE, you'll be more dependent on Keytruda. I realize we're a few years away, but given your valuation and potential size of this product, it does become an important investment consideration. And then for Frank, could you please provide your estimates of Keytruda sales by indication in both U.S. and ex-U.S.? Thank you.

So the first question about Keytruda, so obviously, Keytruda has been a winning franchise, obviously, for us, and an important growth driver across all the opportunities that we have, both as monotherapy as well as combination. But we continue to stress the fact that as we look at our future, we don't see ourselves as just a Keytruda story. So I've emphasized before the other pillars of growth, including lymphocytes and lymphedema and oncology, what comes after that with 20 unique mechanisms, the vaccines programs that we have, We continue to think that even when we see an important drug like Genuvia, that Merck will have multiple sources of growth going forward. Then, of course, it's really important to recognize that in addition to our internal pipeline, we're continuing to seek to augment that pipeline with value, creating innovative external assets in business development. We feel very confident about our ability to drive sustained revenue growth going forward, recognizing that a major patent expiration is coming.

Great. We'll turn it over to Frank next.

So in the U.S., and this is very directional data due to the claims data lagging several months behind, but approximately 65% to 70% of our use is non-small cell lung cancer. Melanoma represents about 10%. Head and neck is approximately 5%. The latter approximately 5%. And then we also are seeing good growth in the MSI high agnostic indication. That represents about 5% of our business. And then the all other category or other indications represents about 10%. Outside the U.S., it's really hard to get specific breakdowns, but the majority of our use right now is in lung cancer.

Great. Thanks, Frank. Try to get to our last question.

It's from Jeff Machen with Barclays.

Good morning, guys. Thanks for the question. Frank, I want to get a bit more detail about the OUS dynamics for Keytruda and Lung. You guys saw good trends in 4Q, but I wasn't sure if we're already at an inflection point based on the cadence of reimbursement. Maybe just be helpful to go through how you see the pace of share gains in Europe and Lung over the balance of the year. And then, Roger, at a higher level, how are you guys thinking about the balance of therapeutic areas in the pipeline? I mean, obviously, you want to press your advantage in oncology, but is expanding Other existing category is a strategic priority, or is there capacity for a new therapeutic category? Thank you.

Start with Frank.

Sure. So, in Europe, I'll give an example. So, right now, we have reimbursement in most of the European Union for Kino24, and that's where you're seeing a lot of the growth on our monotherapy indication. With 189, we have reimbursement in Germany, Austria, Netherlands, and a couple of other markets, but we're very early on in getting an uptake for 189 broadly in Europe, and I anticipate that will come throughout the year. Very similar ramp to what we saw back when we launched Keynote 24, so think of that the timing you should be thinking about for that ramp. In addition to that, as mentioned, Japan we think is a very significant opportunity now with not only the approval of 189 but 407 and also Keynote 42. So we think Japan provides a very good opportunity outside the U.S. And then as mentioned, we're in the very early stages in China with just our first launch in second-line melanoma. So we see also outside the U.S. significant opportunities for growth there.

Yeah, and this is Roger. If I might, I'd say also today the THMP announced that they adopted a positive opinion with respect to 407 in Europe. So that, of course, reimbursement will be required in most markets. It will take some time, but it's going to advance that still further. In terms of balance of therapeutic areas, Jeff, our interest, certainly my interest, is in having the greatest possible impact on improving and extending human life, wherever we see that. And so we're not going to be bound to any particular therapeutic area. If you look at the kinds of things that we're doing, you know, look at the work that's taking place in HIV right now. MK8591 is an extraordinary molecule with Phase II data. In combination with Duraverine, we hope we'll have an opportunity to present those data, you know, probably sometime around the middle of the year. And, you know, this is really a remarkable compound in terms of its potency, the durability of the treatment effect, and it changes the landscape in a lot of ways in terms of how you think about HIV treatment. That's a therapeutic area which doesn't get an enormous amount of attention externally, but which we're putting a lot of effort into, just as we're putting a lot of effort into other areas and effects.

So there's a lot of work going on. So let me close by thanking you for joining us. We had a strong 2018 We're confident going forward in our execution and our pipeline and our future. We believe that we're well positioned to drive sustained revenue growth, and we also expect meaningful operating margin expansion over time. And that's largely the result of a differentiated pipeline that we believe will actually position Merck well going forward. So thank you.

That'll conclude our call. Thank you, Darla.

Thank you. Thanks, everyone. This concludes the Merck 4th Quarter 2018 Sales and Earnings Conference Call. You may now disconnect.