Annual Report 2014 Annual Report 2014
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Report on Risks and Opportunities

Risks and opportunities are inherent to entrepreneurial activity. Merck has put systems and processes in place to identify risks at an early stage and to counteract them by taking appropriate action. At Merck, opportunity management is an integral component of internal decision-making processes such as short- and medium-term operational planning and intra-year business plans.

Risk and opportunity management

Merck is part of a complex, global business world and is therefore exposed to a multitude of external and internal influences. Every business decision is therefore based on the associated risks and opportunities.

In our internal risk reporting, risks are defined as possible future events or developments that could lead to a negative deviation from our forecast (financial) targets. In parallel, opportunities are defined as possible events or developments that imply a positive deviation from our planned (financial) targets. Identified future events and expected developments are taken into account in internal planning provided that it can be assumed that their occurrence is likely in the planning period. The risks and opportunities presented in the following risk and opportunities report are those possible future events that could respectively lead to a negative or positive deviation from the topics covered by planning.

Risk management process

The objective of our risk management activities is to recognize, assess and manage risks early on and to implement appropriate measures to minimize them. The responsibilities, objectives and process of risk management are described in our internal risk management guideline. The business heads, managing directors of Merck subsidiaries, and the heads of Group functions are specified as employees with responsibility for risks. The group of consolidated companies for risk reporting purposes is the same as the group of consolidated companies for the consolidated financial statements. Every six months, the risk owners assess their risk status and report their risk portfolio to Risk Management. Merck uses special risk management software in the context of these activities.

If risk-mitigating measures can be taken, their impact on risk is also assessed. The residual risk after the implementation of mitigation measures is presented in the internal risk report as net risk. The planned timeframe for implementation and the assumed mitigation effect are tracked by Group Risk Management.

Group Controlling & Risk Management forms the organizational framework for risk management and reports directly to the Group Chief Financial Officer. Group Risk Management uses the information reported to determine the current risk portfolio for the Merck Group, presenting this in a report to the Executive Board, the Supervisory Board and the Finance Committee with detailed explanations twice per year. Furthermore, significant changes in the assessment of the risks already known and new significant risks can be reported at any time and are communicated to the corporate bodies on an ad hoc basis.

For the standard process, a lower limit for reporting risks is set at a value of € 5 million and for the ad hoc process at a value of € 25 million. Risks below these limits are steered independently within the business sectors. The relevant timeframe for internal risk reporting is five years. The effects of risks described in this Report on Risks and Opportunities are presented as annual values. The assessment of the risks presented relates to December 31, 2014. There were no relevant changes after the end of the reporting period that would have necessitated an amended presentation of the risk situation of the Group.

Within the scope of audits, Group Internal Auditing regularly reviews the performance of risk management processes within the units and, at the same time, the communication of relevant risks from the operating units to Group Risk Management.

Opportunity management process

The risk management system described concentrates on business risks, and not on opportunities at the same time. The Merck Group’s opportunity management process is integrated into our internal controlling processes and carried out in the operating units on the basis of the Group strategy. The divisions analyze and assess potential market opportunities as part of strategy and planning processes. In this connection, investment opportunities are examined and prioritized in terms of their potential value proposition to Merck in order to ensure an effective allocation of resources. Merck selectively invests in growth markets to leverage the opportunities of dynamic development and customer proximity at a local level.

If the occurrence of the identified opportunities is rated as likely, they are incorporated into the business plans and the short-term forecasts. Trends going beyond this or events that could lead to a positive development of the net assets, financial position and results of operations are presented in the following report as opportunities. These could have a positive effect on Merck’s medium-term prospects and lead to a positive deviation from forecasts.

Risk and opportunity assessment

Risks

The significance of risks to Merck is calculated on the basis of their possible negative impact on the forecast financial targets in conjunction with the probability of occurrence of the respective risk. In line with these two factors, risks are classified as “high”, “medium” or “low”. The underlying scales for measuring these factors are shown below:

Probability of occurrence

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Probability of occurrence Explanation
   
< 20 % Unlikely
20 – 50 % Possible
51 – 80 % Likely
> 80 % Very likely

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Degree of impact

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Degree of impact Explanation
   
> € 50 million Critical negative impact on the net assets, financial position and results of operation
€ 20 – 50 million Substantial negative impact on the net assets, financial position and results of operations
€ 5 – 20 million Moderate negative impact on the net assets, financial position and results of operations
< € 5 million Insignificant negative impact on the net assets, financial position and results of operations

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The combination of the two factors results in the risk matrix below, which shows the individual risks and their significance to Merck.

Risk matrix

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Impact Risk matrix
         
> € 50 million Medium Medium High High
€ 20 – 50 million Medium Medium Medium High
€ 5 – 20 million Low Medium Medium Medium
< € 5 million Low Low Low Low
Probability of occurrence < 20 % 20 – 50 % 51 – 80 % > 80 %

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Opportunities

Opportunities are assessed in their respective specific business environment. Marketing measures for operational planning are usually quantified in relation to sales, EBITDA pre one-time items and business free cash flow. Net present value, the internal rate of return (IRR), the return on capital employed (ROCE) and the amortization period of the investment are primarily used to assess and prioritize investment opportunities. Similarly, scenarios are frequently set up to simulate the influence of possible fluctuations and changes in the respective factors on results. There is no overarching, systematic classification of the probability of occurrence and impact of opportunities.

Internal control system for the consolidated accounting process

The objective of the internal control system for accounting is to implement controls that provide assurance that the financial statements are prepared in compliance with the relevant accounting laws and standards. It covers measures designed to ensure the complete, correct and timely conveyance and presentation of information that is relevant for the preparation of the consolidated financial statements and the management report of the Merck Group.

The control system is subject to continuous further development and is an integral component of the accounting and financial reporting processes in all relevant local units and Merck Group functions.

With respect to the accounting process, the internal control system measures are intended to reduce the risk of material false statements in the consolidated accounting process of the Merck Group.

Key tools

The internal control system is geared to ensuring the accuracy of the consolidated accounting process and the implementation of internal controls for the preparation of compliant financial statements with reasonable assurance. The Group Accounting function centrally steers the preparation of the consolidated financial statements of Merck KGaA as the parent company of the Merck Group. This Group function defines the reporting requirements that the Merck subsidiaries must meet as a minimum requirement. At the same time, this function steers and monitors the scheduling and process-related requirements of the consolidated financial statements. The Group-wide accounting guidelines form the basis for the preparation of the statutory financial statements of the parent company and of the subsidiaries, which are reported to Group Accounting; the guidelines are adapted to reflect changes in the financial regulatory environment and are updated in accordance with internal reporting requirements. Intra-group transactions are eliminated during the consolidation process. This gives rise to the need for a mirrored entry at the corresponding subsidiaries that is monitored during the consolidation process.

Group Accounting also ensures the timely central management of changes to the equity holding structure and correspondingly adapts the Merck Group’s scope of consolidation. The individual companies have a local internal control system. Where financial processes are handled by a Shared Service Center, the internal control system of the Shared Service Center is additionally applied. Both ensure that accounting complies with IFRS (International Financial Reporting Standards) and with the Merck Group accounting guidelines.

Group Accounting provides support to the local contacts and ensures a consistently high quality of reporting throughout the entire reporting process.

The accounting process is designed at all levels to ensure a clearly defined segregation of duties and assignment of responsibilities to the units involved in the accounting process at all times within the scope of dual control.

For the assessment of balance sheet items, Group Accounting closely cooperates with Group Risk Management in order to correctly present potential balance sheet risks. For special issues, such as the measurement of intangible assets within the scope of company acquisitions or pension obligations, external experts are additionally involved where necessary. For the Group accounting process, Merck uses a standard SAP software tool in most countries. Via a detailed authorization concept to limit user rights on a need-to-have basis, and in line with the principles of the separation of duties, the system contains both single-entity reporting and the consolidated financial statements.

The effectiveness of Merck’s internal control system with regard to accounting and the compliance of financial reporting by the individual companies is confirmed by both the local managing director and the local chief financial officer when they sign the single-entity reporting. All the structures and processes described are subject to regular review by Group Internal Auditing based on an annual audit plan set out by the Executive Board. The results of these audits are dealt with by the Executive Board, the Supervisory Board and the Finance Committee.

The internal control system at Merck makes it possible to lower the risk of material misstatements in accounting to a minimum. However, no internal control system – regardless of its design – can entirely rule out a residual risk.

Business-related risks and opportunities

Political and regulatory risks and opportunities

As a global company, Merck faces political and regulatory changes in a large number of countries and markets.

Risk of more restrictive regulatory requirements regarding drug pricing, reimbursement and approval

In the Healthcare business sector, the familiar trend towards increasingly restrictive requirements in terms of drug pricing, reimbursement and approval is continuing. These requirements can negatively influence the profitability of Merck’s products, also through market referencing between countries, and jeopardize the success of market launches and new approvals. Close communication with health and regulatory agencies serves as a preventive measure to avert risks. An estimation of the risks is market- and product-specific; overall the risk is seen as being likely for Merck and could have a critical negative impact on the net assets, financial position and result of operations. It is therefore classified as a medium risk.

Risk of stricter regulations for the manufacture, testing and marketing of products

Likewise, in its Life Science and Performance Materials business sectors, Merck must adhere to a multitude of regulatory specifications regarding the manufacture, testing and marketing of many of its products. Specifically in the European Union, Merck is subject to the European chemicals regulation REACH. It demands comprehensive tests for chemical products. Test procedures can be costly and time-intensive, and lead to a rise in manufacturing costs. Moreover, the use of chemicals in production could be restricted, which would make it impossible to continue manufacturing certain products. Merck is constantly pursuing research and development in substance characterization, and in the possible substitution of critical substances in order to reduce the occurrence of this risk and therefore views it as unlikely. Nevertheless, it is still classified as a medium risk given its potential critical negative impact on the net assets, financial position and results of operations.

Risk of destabilization of political systems and the establishment of trade barriers

The destabilization of political systems (as for example in Ukraine and the Middle East) and the possible establishment of trade barriers as well as foreign exchange policy changes can lead to declines in sales in certain countries and regions. Diversification in terms of products, industries and regions serves to mitigate potential negative effects. The effects of corresponding risks are taken into account to the best of ability in the business plans for the countries and regions concerned. In particular, our business can furthermore be affected by macroeconomic developments in, for example, Venezuela, Argentina, Russia, and Greece. Corresponding sales strategy measures have been introduced in these countries to minimize the impact on business.

Nevertheless, the residual net risk could have critical negative effects on the net assets, financial position and results of operations and its occurrence is considered possible. Merck rates this as a medium risk overall.

Market risks and opportunities

Merck competes with numerous companies in the pharmaceutical, chemical and life science sectors. Rising competitive pressure can have a significant impact on the quantities sold and prices attainable for Merck products.

Opportunities due to the further development of the Biosimilars business unit

The possibilities offered by the development and approval of biosimilars represent opportunities for Merck. For instance, over the past two and a half years, Merck has moved forward with the development of its own Biosimilars business unit and has entered into partnerships with Dr. Reddy’s Laboratories Ltd., India, among others, to co-develop a portfolio of biosimilars in oncology. Moreover, in April 2014, a Brazilian market partnership was established with Bionovis SA, Brazil, (Bionovis SA) for a portfolio of biosimilars. Although a significant contribution to sales is not to be expected before the medium to long term, the expenditure required for this has already been taken into account in Merck’s planning.

Opportunities due to a new technology in the manufacture of OLED displays

Merck is building on more than ten years of experience in manufacturing organic light-emitting diode (OLED) materials as well as a strong portfolio of worldwide patents in order to develop ultrapure and extremely stable materials that are precisely tailored to customer requirements. The development in the OLED market is being driven by the diversification of applications for OLED displays. While OLED displays are mainly used today in small-area displays, for example smartphones, more and more large-area displays could also be based on OLED technology in the future. In order to overcome the technical and financial obstacles of the mass production of large-area OLED displays, Merck has been cooperating since the end of 2012 with Seiko Epson Corporation, Japan (Seiko Epson). This cooperation has opened up new avenues in the manufacture of OLED displays. The combination of durable OLED materials from Merck and inkjet printing technology from Seiko Epson makes it possible to quickly and precisely produce high-resolution OLED displays using inkjet technology. The inkjet printing of large OLED displays can resolve the productivity problems of the conventional vapor-deposition processes. In addition, this technique deposits material only in the areas where diodes are actually created, thus enabling the optimal use of materials and energy. Merck thus sees the possibility of significant market growth for OLED applications in the medium to long term and thus related opportunities for Merck.

Opportunities due to new application possibilities for liquid crystals

Merck is pursuing a strategy of leveraging its expertise as the global market leader in liquid crystals in order to develop new fields of application for innovative liquid crystal technology, e.g. liquid crystal windows (LCW) or mobile antennas. With the acquisition of its long-standing cooperation partner Peer+ B.V., Netherlands, (Peer+ B.V.) Merck is further advancing the development of the future-oriented market for LCW. Thanks to licrivision™ technology, LCW create new architectural possibilities. Through progressive brightness control, they can for example increase a building’s energy efficiency. In 2015, the first pilot projects for LCW will begin, meaning that the technology will require intensive development work prior to market readiness. Consequently, Merck expects that the potential positive effects on the results of the Performance Materials business will only materialize in the medium to long term.

Antennas that can receive signals transmitted in the high frequency range (e.g. Ka and Ku band) can also be realized with the aid of corresponding liquid crystal mixtures. As a result, mobile data exchange could improve significantly in a wide variety of fields of application. Since liquid crystal materials for antennas are currently being developed, the market launch of liquid crystal antennas could still take a few years. Consequently, positive effects on the financial results of the Performance Materials business may only materialize in the medium to long term.

Risk due to increased competition and customer technology changes

In the pharmaceutical sector, both Merck’s biopharmaceutical products and classical pharmaceutical businesses are exposed to increased competition from competing products. In the chemical sector, risks are posed by not only cyclical business fluctuations but also, particularly with respect to liquid crystals, changes in the technologies used or customer sourcing strategies. Merck uses close customer relationships and in-house further developments as well as precise market analyses as mitigating measures.

Merck is in negotiations with a competitor regarding potential patent infringements in the Performance Materials division. Merck maintains that the competitor’s patent infringement assertion is invalid owing to relevant prior art. The competitor has threatened to file patent infringement lawsuits. Merck is prepared for a confrontation in this issue and will conduct negotiations with the aim of clarifying the situation.

Nevertheless, the market risk is still classified overall as a medium risk owing to its likely probability of occurrence and critical negative impact.

Risks and opportunities of research and development

For Merck, innovation is a major element of the Group strategy. Research and development projects can experience delays, expected budgets can be exceeded, or targets remain unmet. Research and development are of special importance to the Pharmaceuticals business. In the course of portfolio management, Merck regularly evaluates and, if necessary, refocuses research areas and all R&D pipeline projects.

Special mention should be made of the strategic alliance between Merck and Pfizer Inc., USA, (Pfizer Inc.) as a research and development opportunity in the Pharmaceuticals business. By making the required investments jointly and combining their strengths and expertise, the two companies will maximize the potential value of the research compound MSB0010718C, an anti-PD-L1 antibody from Merck. Owing to the relatively long cycles in active ingredient development, Merck expects that the positive effects of its anti-PD-L1 antibody will be reflected in the results of the Healthcare business sector in the medium to long term and sees opportunities for an increase in future sales and profitability.

Risks of discontinuing development projects and regulatory approval of developed medicines

Sometimes development projects are discontinued after high levels of investment at a late phase of clinical development. Decisions – such as those relating to the transition to the next clinical phase – are taken with a view to minimizing risk. Furthermore, there is a risk that the regulatory authorities either do not grant or delay approval, which can have an impact on earnings. Additionally, there is the danger that undesirable side effects of a pharmaceutical product could remain undetected until after approval or registration, which could result in a restriction of approval or withdrawal from the market.

In 2014, the risk-benefit profile of individual development projects in the R&D portfolio was analyzed, leading to the prioritization of projects. This prioritization resulted in the termination of multiple development projects. Overall, the termination of the projects had a critical negative impact on the net assets, financial position and results of operations.

Risks and opportunities of product quality and availability

Risk of a temporary ban on products / production facilities or of non-registration of products due to non-compliance with quality standards

Merck is required to comply with the highest standards of quality in the manufacture of pharmaceutical products (Good Manufacturing Practice). In this regard Merck is subject to the supervision of the regulatory authorities.

Conditions imposed by national regulatory authorities could result in a temporary ban on products/production facilities, and possibly affect new registrations with the respective authority. Merck takes the utmost effort to ensure compliance with regulations, regularly performs its own internal inspections and carries out external audits. Thanks to these quality assurance processes, the occurrence of a risk is unlikely, however cannot be entirely ruled out. Depending on the product concerned and the severity of the objection, such a risk can have a critical negative impact on the net assets, financial position and results of operations. Therefore, Merck rates this as a medium risk.

On a positive note in comparison with 2013, the FDA warning letter received in 2011 was closed, thus eliminating the risk resulting from this warning letter of a ban on importing products to the United States.

Risks of dependency on suppliers

Quality controls along the entire value chain reduce the risks related to product quality and availability. This starts with the qualification of our suppliers. Quality controls also include comprehensive quality requirements for raw materials, purchased semi-finished products and plants, as well as long-term strategic alliances in the case of supply- and price-critical precursor products. Merck is dependent on individual suppliers of precursor products for some of its main products. In the event that one of these suppliers curtails or discontinues production, or supply is disrupted, this could possibly have a critical negative impact on the Merck business concerned. With long-term strategic alliances for precursor products critical to supply and price as well as alternative sourcing strategies, Merck reduces the probability of occurrence of these risks and rates them as unlikely. Overall, these are classified as medium risks.

Damage and product liability risks

Further risks include the risk of operational failures due to force majeure, for example natural disasters such as floods or earthquakes, which could lead to a substantial interruption or restriction of business activities. Insofar as it is possible and economical to do so, the Group limits its damage risks with insurance coverage, the nature and extent of which is constantly adapted to current requirements. Although the occurrence of these risks is considered unlikely, an individual event could have a critical negative effect on the net assets, financial position and results of operations and is therefore classified as a medium risk.

Companies in the chemical and pharmaceutical industries are exposed to product liability risks in particular. Product liability risks can lead to considerable claims for damages and costs to avert damages. Merck has taken out the liability insurance that is standard in the industry for such risks. However, it could be that the insurance coverage available is insufficient for individual cases. Although the occurrence of product liability claims in excess of the existing insurance coverage is considered unlikely, individual cases could still have a critical negative effect on the net assets, financial position and results of operations. Merck therefore rates potential product liability risk as a medium risk.

Risks due to product-related crime and espionage

Owing to its portfolio, Merck is exposed to a number of sector-specific crime risks. This relates primarily to products, including, among other things, counterfeiting, illegal channeling, misuse as well as all types of property crime, including attempts at these crimes. Crime phenomena such as cybercrime and espionage could equally affect our innovations or innovation ability as such; this includes in particular undesirable losses of information in all relevant possible ways, both in the IT area as well as with respect to non-IT-based threats.

To combat product-related crime, Merck established an internal coordination network covering all functions and businesses (“Merck Anti-Counterfeiting Operational Network”) several years ago. In addition, security measures are in use to protect products against counterfeiting. Innovative technical security solutions and defined preventive approaches are used to ward off dangers relating to cybercrime and espionage. Measures to prevent risks and to prosecute identified offenses are conducted in all the relevant crime areas in close and trustworthy cooperation with the responsible authorities.

The impact of these risks on business operations depends on the respective individual case, product-specific factors, the value chain, as well as on regional aspects in particular. Group Security is responsible for the overall coordination of all measures in this area. Overall, the threat resulting from crime in general is seen as being likely for Merck and is classified as a medium risk.

Opportunities due to an expanding local presence in high-growth markets

In the coming years, Merck still anticipates above-average growth for all its business sectors in the markets of Latin America, the Middle East and Africa as well as Asia. In order to further enable this growth, Merck has moved forward with several investment projects, such as the construction of new production facilities for liquid crystals and the establishment of a new Merck Serono site in China. Moreover, Merck is strengthening its activities in Africa through strategic investments as well as geographic expansion in selected regions. The greater local presence and customer proximity could lend Merck a key competitive edge and, in the medium to long term, offer the opportunity for significant additional growth in sales and EBITDA pre one-time items.

Financial risks and opportunities

As a corporate group that operates internationally and due to its presence in the capital market, Merck is exposed to various financial risks and opportunities. Above all, these are liquidity and counterparty risks, financial market risks and opportunities, risks of fluctuations in the market values of operational tangible and intangible assets, as well as risks and opportunities from pension obligations.

Risk and opportunity management in relation to the use of financial instruments

In the area of financial risks and opportunities, Merck uses an active management strategy to reduce the effects of fluctuations in exchange and interest rates. The management of financial risks and opportunities by using derivatives in particular is regulated by extensive guidelines. There is a ban on speculation and derivative transactions entered into are subject to ongoing risk management procedures. Trading, settlement and control functions are strictly separated.

Liquidity risks

In order to ensure its continued existence, a company must be able to fulfill its commitments from operating and financial activities at all times. Merck therefore has a central Group-wide liquidity management process to reduce potential liquidity risks. Furthermore, Merck has a multi-currency revolving credit facility of € 2 billion with a term of five years and an extension option of one year that, above and beyond the Group’s positive operating cash flow, ensures continuing solvency if any liquidity bottlenecks occur. As our loan agreements do not contain any financial covenants, these agreed lines of credit can be accessed even if Merck’s credit rating should deteriorate. Additionally, Merck has a commercial paper program with a maximum volume of € 2 billion as well as a debt issuance program that forms the contractual basis for the issue of bonds with a nominal volume of up to € 15 billion.

A purchase price of US$ 17 billion is payable for the planned acquisition of Sigma-Aldrich. This is covered by cash on hand as well as further syndicated credit lines with a bank consortium and currency hedging. Some of the credit lines are being successively replaced by the issuance of bonds.

Overall, the liquidity risk is rated as unlikely.

Counterparty risks

Counterparty risks arise from the potential default by a partner in connection with financial investments, loans and financing commitments on the one hand and receivables in operating business on the other.

As for counterparty risks from financial transactions, Merck reviews all positions relating to trading partners and their credit ratings on a daily basis. Merck manages financial risks of default by diversifying its financial positions and thereby by the active management of its trading partners. Significant financial transactions involving credit risk are entered into with banks and industrial companies that have a good credit rating. Moreover, Merck’s large banking syndicate – the multi-currency revolving credit facility of € 2 billion was syndicated by 19 banks – reduces possible losses in the event of default.

The solvency and operational development of trading partners are regularly reviewed as part of the management of operational counterparty risks. Sovereign risks are also analyzed. The volume of receivables of each customer is capped in line with their credit ratings. Risk-mitigating measures, such as credit insurance, are utilized as appropriate. Nevertheless, defaults by isolated trading partners, even those with outstanding credit ratings, cannot be entirely ruled out, although rated as unlikely (further information can be found in “Credit risks” under “Management of financial risks” in the Notes to the Group accounts).

Counterparty risk is classified as a medium risk overall owing to the unlikely probability of occurrence with a potential critical negative effect.

Financial market opportunities and risks

As a result of its international business activities and global corporate structure, Merck is exposed to risks and opportunities from fluctuations in exchange rates. These result from financial transactions, operating receivables and liabilities, forecast future cash flows from sales and costs in foreign currency. Merck uses derivatives to manage and reduce the aforementioned risks and opportunities (further information can be found in “Derivative financial instruments” in the Notes to the Group accounts). Foreign exchange risks with a potential critical negative effect on the net assets, financial position and results of operations are rated as possible.

Future refinancing, particularly the financing of the Sigma-Aldrich acquisition, and monetary deposits are subject to the risks and opportunities of interest rate fluctuations. These are also managed and reduced using derivatives. Interest rate risks with a potentially significantly negative impact are considered unlikely and pose medium risks overall.

Risks of impairment on balance sheet items

The carrying amounts of individual balance sheet items are subject to the risk of changing market and business conditions and thus to changes in fair values as well. The need for write-downs could lead to significant non-cash profit burdens and changes in balance sheet ratios. This applies in particular to the high level of intangible assets including goodwill, which mainly derive from the purchase price allocations made in connection with past acquisitions (further information can be found under “Intangible assets” in the Notes to the Group accounts). All relevant risks were assessed during the preparation of the consolidated financial statements and taken into account accordingly. Merck rates risks beyond this as low.

Risk and opportunities from pension obligations

Merck has commitments in connection with pension obligations. The present value of defined benefit obligations can be significantly increased or reduced by changes in the relevant valuation parameters, e.g. the interest rate or future salary increases. Pension obligations are regularly assessed as part of annual actuarial reports. Some of these obligations are covered by the pension provisions reported in the balance sheet, while other obligations are externally funded (further information can be found under “Provisions for pensions and other post-employment benefits” in the Notes to the Group accounts). To the extent that pension obligations are covered by plan assets consisting of interest-bearing securities, shares, real estate, and other financial assets, decreasing or negative returns on these assets can adversely affect the fair value of plan assets and thus result in further additions to pension provisions. By contrast, rising returns increase the value of plan assets, thereby resulting in excess cover of plan liabilities. Merck increases the opportunities of fluctuations in the market value of plan assets on the one hand and reduces the risks on the other by using a diversified investment strategy. The risk due to pension obligations is possible, could moderately impact the net assets, financial position and result of operations, and is considered to be medium.

Assessments by independent rating agencies

The capital market uses the assessments published by rating agencies to help lenders assess the risks of a financial instrument. Merck is currently rated by the agencies Standard & Poor’s and Moody’s. While Standard & Poor’s issued a long-term rating of A with a negative outlook, Moody’s issued it a Baa1 rating with a negative outlook. The drop in the Moody’s rating by one grade in comparison with the previous year as well as the negative outlook of both rating agencies is due to the expected higher debt level in the course of the Sigma-Aldrich transaction. In line with market procedures, Merck’s financing conditions are closely tied to its rating. The better a rating, the more favorably Merck can generally raise funds on the capital market or from banks.

REPORT ON RISKS AND OPPORTUNITIES → OVERVIEW OF RATING DEVELOPMENT:

Source: Own illustration.

Legal risks

Merck generally strives to minimize and control its legal risks. Merck has taken the necessary precautions to identify threats and defend its rights where necessary.

Nevertheless, Merck is still exposed to litigation risks or legal proceedings. These include in particular risks in the areas of product liability, competition and antitrust law, pharmaceutical law, patent law, tax law, and environmental protection. As a research-based company, Merck has a valuable portfolio of industrial property rights, patents and brands that could become the target of attacks and infringements. The outcome of future proceedings or those currently pending is difficult to foresee. Generally, it is not possible to rule out that Merck will face third-party claims arising from the same issue despite the conclusion of legal proceedings. Court or official rulings or settlements can lead to expenses with a significant impact on our business and earnings.

Tax risks are reviewed regularly and systematically by Group Tax. Corresponding standards and guidelines are used in order to identify tax risks at an early stage as well as to review, evaluate and correspondingly minimize them. Measures to reduce risks are coordinated by Group Tax together with the subsidiaries abroad.

Merck views the legal matters described below as the most significant legal risks. This should not be seen as an exhaustive list of all legal disputes currently ongoing.

Risks from product-related and patent law disputes

The litigation risk with Israel Bio-Engineering Project Limited Partnership (“IBEP”) was eliminated as of the end of 2014. IBEP asserted claims for property rights and the payment of license fees for the past and the future. The legal disputes were connected to the financing of the development of medical research projects in the early 1980s. Merck had taken appropriate accounting measures for these legal disputes in the past. In 2014, Merck achieved a settlement with IBEP according to which the legal disputes were settled in exchange for a sum of money. The settlement led to lower cash payments than previously expected.

Merck is involved in a patent dispute in the United States with Biogen IDEC Inc. (Massachusetts, USA) (“Biogen”). Biogen claims that the sale of Rebif® in the United States infringes on a Biogen patent. The patent in question was granted to Biogen in 2009 in the United States. Subsequently, Biogen sued Merck and other pharmaceutical companies for infringement of this patent. Merck defended itself against all allegations and brought a countersuit with the claim that the patent was invalid and not infringed on by Merck’s actions. A Markman hearing took place in January 2012, however a decision has not yet been announced. The parties are currently engaged in court-ordered mediation proceedings that have not yet officially ended. It is currently not clear when a first-instance decision will be made. Merck has taken appropriate accounting measures. Given the potential critical negative effects of the legal dispute on the financial position in case of a negative decision, Merck nevertheless classifies this as a high risk.

Risks due to antitrust and other government proceedings

Raptiva®: In December 2011, the federal state of São Paulo sued Merck for damages because of alleged collusion between various pharmaceutical companies and an association of patients suffering from psoriasis and vitiligo. This collusion is alleged to have been intended to increase sales of the medicines from the companies involved to the detriment of patients and state coffers. Moreover, patients are also suing for damages in connection with the product Raptiva®. Merck has taken appropriate accounting measures for these issues. Risks in excess of this with a substantial negative effect on the net assets, financial position and results of operations cannot be ruled out, but are considered unlikely. This is rated as a medium risk.

In one jurisdiction, Merck is subject to a government investigation regarding compliance with foreign exchange transfer restrictions. In this connection, the responsible authorities are investigating whether import prices led to impermissibly high foreign exchange transfers. Appropriate accounting measures have been taken for repayments and fines that are estimated to be probable due to the uncertain legal situation in the affected country. Merck rates this as a medium risk since significant negative effects on the financial position cannot be ruled out.

Risks from drug pricing by the divested Generics Group

Paroxetine: In connection with the divested generics business, Merck is subject to antitrust investigations by the British Competition and Market Authority (CMA) in the United Kingdom. In March 2013, the authorities informed Merck of the assumption that a settlement agreement entered into in 2002 between Generics (UK) Ltd. and several GlaxoSmithKline companies in connection with the antidepressant drug paroxetine violates British and European competition law. Merck, the then owner of Generics (UK) Ltd., was allegedly involved in the negotiations for the settlement agreement and is therefore liable. The investigations into Generics (UK) Ltd. started in 2011, without Merck being aware of this. It is considered likely that the CMA will impose a fine on Merck. Merck has taken appropriate accounting measures. Given the lawsuit’s potential substantial negative impact on the financial position, Merck classifies this as a medium risk.

Human resources risks

Merck’s future growth is highly dependent on its innovativeness. Therefore, the expertise and engagement of employees in all sectors in which Merck operates are crucial to the success of the company.

The markets relevant to Merck are characterized by intensive competition for qualified specialists and by demographic challenges. Staff turnover risks specific to countries and industries have to be identified ahead of time and specifically addressed in order to keep the skills and expertise critical to success and business within the company.

Recruiting and retaining specialists and talent at Merck are therefore one of the key priorities for the company and are managed through the targeted use of, for instance, employer branding initiatives, global talent and succession management processes as well as competitive compensation packages. Nevertheless, employee-related risks that affect business activities are possible, even though their impact is difficult to assess. Merck rates this as a medium risk.

Information technology risks

Merck uses a variety of IT systems and processes in order to optimally focus and adequately support its globalization. Trends in information technology offer various opportunities but also harbor risks for Merck.

Risks due to cybercrime and the failure of business-critical IT applications

Increasing international networking and the related possibility of IT system abuse are resulting in cybercrime risks for Merck, such as the failure of central IT systems, the disclosure of confidential research and business development data, the manipulation of IT systems in chemical process control, or an increased burden or adverse impact on IT systems as a result of virus attacks. The entire Merck Group has global security guidelines and information protection management for IT and non-IT areas, each with organizational and technical standards for access rights as well as information and data protection, based on ISO 27001.

Additionally, IT applications used globally form the basis for the contractual delivery of products and solutions. The failure of business-critical IT applications could therefore have a direct influence on Merck’s ability to deliver; likewise this applies to the failure of a data center. To achieve the required service quality, Merck uses a quality management system certified to ISO 20000:2011. In addition, to reduce the risk of failure, Merck operates several redundantly designed data centers.

Despite the mitigating measures taken and functional continuity plans, the effects of cybercrime or the failure of business-critical IT applications and their influence on the net assets, financial position and results of operations are considered a medium risk owing to potentially significant negative effects.

Environmental and safety risks

As a company with global production operations, Merck is exposed to risks of possible damage to people, goods and its reputation. Audits, consulting and training on environmental protection and occupational health and safety minimize these risks to people and the environment. In order to ensure the continuity of plant and equipment, Merck monitors these risks both at its own sites as well as at suppliers and contract manufacturers. By adhering to high technical standards, our rules of conduct and all legal requirements in environmental protection and occupational health and safety, Merck ensures the preservation of goods and assets. Sufficient appropriate accounting measures have been taken for the environmental risks known to us. Nevertheless, Merck classifies these as a high risk since a critical negative impact on the financial position cannot be ruled out.

Acquisition risks

Irrespective of the fact that Merck has successfully completed acquisitions made in the past, the risk of conducting the acquisition and integration exists for future transactions. This includes among other things the inability to meet sales volume targets and higher integration costs than expected, as well as the failure to meet synergy goals. In addition, the currently planned acquisition of Sigma-Aldrich is subject to antitrust clearance and if the acquisition is not conducted, fines could become payable to the acquisition target. Thanks to strong due diligence processes and closely managed integration processes, Merck rates the probability of occurrence of this risk as unlikely. However, owing to the amount of potential fines, the overall risk could have a critical negative effect on the net assets, financial position and results of operations and is therefore classified as a medium risk.

Overall view of the risk and opportunity situation and management assessment

Although the number of risks reported is higher than the identified specific opportunities, Merck considers the distribution of risks and opportunities to be balanced. A balanced overall view within the Group is also supported by the fact that total revenues and business success are built on a diversity of pharmaceutical and chemical products for a variety of industries. As the markets differ in their structure and economic cycles, this diversification helps to lower risk. This diversification will be strengthened by the takeover of AZ, which has already occurred, the planned acquisition of Sigma-Aldrich and the alliance with Pfizer. It is also an expression of Merck’s strategy to further develop Merck as a leading company for innovative and top-quality high-tech products in healthcare, life science and performance materials.

The most significant individual risks in the divisions have been named in the report above, with business-related risks being the most significant to Merck alongside the legal risks.

The successful closing of the FDA warning letter and the settlement of patent litigation with Israel Bio-Engineering Project Limited Partnership (IBEP) had a positive effect on the risk situation of the Merck Group. Above and beyond this, with respect to high and medium risks Merck has determined only minor changes although the assessment of the individual risks has of course altered over the fiscal year as a result of changing external conditions. Thanks to the risk reduction measures taken – such as the consistent implementation of management action (organizational responsibility and process improvements), existing insurance coverage and accounting precautions – Merck’s significant risks in particular have been further minimized in net terms.

The overall view of the risk situation of the Group, which is derived from the summary of the risks described on the basis of their impact and probability of occurrence, leads Merck to the assessment that the risks are not of a nature to threaten the existence of the Group as a going concern, either individually or collectively. Merck is confident that it will continue to successfully master the challenges arising from the above risks in the future as well.

In terms of opportunities, Merck believes that the greatest potential lies in the business-related topics of the operational areas. Thanks in particular to the expansion of our business in Latin America, the Middle East and Africa as well as in Asia, the further intensification and focusing of research and development activities, for instance the collaboration with Pfizer Inc., Bionovis SA, Peer+ B.V. and Seiko Epson, and other activities as part of the “Fit for 2018” transformation and growth program, Merck has launched changes that hold significant opportunities in the medium to long term beyond the underlying forecast period.

Merck is pursuing the possibilities that are arising and takes the expected effects into account in the forecast development of its key performance indicators, namely sales, EBITDA pre one-time items and business free cash flow. Merck will actively seek opportunities above and beyond these and move ahead with their implementation. In the event that opportunities arise in addition to the forecast developments, or that these occur more quickly than anticipated, this could have correspondingly positive effects on Merck’s net assets, financial position and results of operations.

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