10-Q 1 mrk0930201710q.htm 3Q17 FORM 10-Q Document



 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
 
(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
For the quarterly period ended September 30, 2017
OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
For the transition period from ______ to ______
Commission File No. 1-6571
Merck & Co., Inc.
2000 Galloping Hill Road
Kenilworth, N.J. 07033
(908) 740-4000
Incorporated in New Jersey
 
I.R.S. Employer
 
 
Identification No. 22-1918501
The number of shares of common stock outstanding as of the close of business on October 31, 2017: 2,724,436,835
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes     No  
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes     No  
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
Accelerated filer
 
 
 
 
Non-accelerated filer
(Do not check if a smaller reporting company)
Smaller reporting company
 
 
 
 
 
 
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes   No 
 





Part I - Financial Information
Item 1. Financial Statements
MERCK & CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(Unaudited, $ in millions except per share amounts)
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
Sales
$
10,325

 
$
10,536

 
$
29,689

 
$
29,692

Costs, Expenses and Other
 
 
 
 
 
 
 
Materials and production
3,274

 
3,409

 
9,369

 
10,559

Marketing and administrative
2,401

 
2,393

 
7,251

 
7,169

Research and development
4,383

 
1,664

 
7,927

 
5,475

Restructuring costs
153

 
161

 
470

 
386

Other (income) expense, net
(86
)
 
22

 
30

 
88

 
10,125

 
7,649

 
25,047

 
23,677

Income Before Taxes
200

 
2,887

 
4,642

 
6,015

Taxes on Income
251

 
699

 
1,186

 
1,487

Net (Loss) Income
(51
)
 
2,188

 
3,456

 
4,528

Less: Net Income Attributable to Noncontrolling Interests
5

 
4

 
16

 
13

Net (Loss) Income Attributable to Merck & Co., Inc.
$
(56
)
 
$
2,184

 
$
3,440

 
$
4,515

Basic (Loss) Earnings per Common Share Attributable to Merck & Co., Inc. Common Shareholders
$
(0.02
)
 
$
0.79

 
$
1.26

 
$
1.63

(Loss) Earnings per Common Share Assuming Dilution Attributable to Merck & Co., Inc. Common Shareholders
$
(0.02
)
 
$
0.78

 
$
1.25

 
$
1.62

Dividends Declared per Common Share
$
0.47

 
$
0.46

 
$
1.41

 
$
1.38

 
MERCK & CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(Unaudited, $ in millions)
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
Net (Loss) Income Attributable to Merck & Co., Inc.
$
(56
)
 
$
2,184

 
$
3,440

 
$
4,515

Other Comprehensive Income (Loss) Net of Taxes:
 
 
 
 
 
 
 
Net unrealized loss on derivatives, net of reclassifications
(66
)
 
(74
)
 
(441
)
 
(367
)
Net unrealized gain (loss) on investments, net of reclassifications
135

 
(30
)
 
213

 
96

Benefit plan net gain (loss) and prior service credit (cost), net of amortization
13

 
(144
)
 
86

 
(280
)
Cumulative translation adjustment
67

 
82

 
423

 
447

 
149

 
(166
)
 
281

 
(104
)
Comprehensive Income Attributable to Merck & Co., Inc.
$
93

 
$
2,018

 
$
3,721

 
$
4,411

 The accompanying notes are an integral part of these condensed consolidated financial statements.

- 2 -




MERCK & CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(Unaudited, $ in millions except per share amounts)
 
 
September 30, 2017
 
December 31, 2016
Assets
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
7,901

 
$
6,515

Short-term investments
3,294

 
7,826

Accounts receivable (net of allowance for doubtful accounts of $222 in 2017
and $195 in 2016)
7,671

 
7,018

Inventories (excludes inventories of $1,029 in 2017 and $1,117 in 2016
classified in Other assets - see Note 5)
5,263

 
4,866

Other current assets
3,790

 
4,389

Total current assets
27,919

 
30,614

Investments
12,206

 
11,416

Property, Plant and Equipment, at cost, net of accumulated depreciation of $16,661
in 2017 and $15,749 in 2016
12,189

 
12,026

Goodwill
18,340

 
18,162

Other Intangibles, Net
15,138

 
17,305

Other Assets
5,884

 
5,854

 
$
91,676

 
$
95,377

Liabilities and Equity
 
 
 
Current Liabilities
 
 
 
Loans payable and current portion of long-term debt
$
5,157

 
$
568

Trade accounts payable
2,620

 
2,807

Accrued and other current liabilities
9,992

 
10,274

Income taxes payable
396

 
2,239

Dividends payable
1,302

 
1,316

Total current liabilities
19,467

 
17,204

Long-Term Debt
21,838

 
24,274

Deferred Income Taxes
4,159

 
5,077

Other Noncurrent Liabilities
7,713

 
8,514

Merck & Co., Inc. Stockholders’ Equity
 
 
 
Common stock, $0.50 par value
Authorized - 6,500,000,000 shares
Issued - 3,577,103,522 shares in 2017 and 2016
1,788

 
1,788

Other paid-in capital
39,823

 
39,939

Retained earnings
43,701

 
44,133

Accumulated other comprehensive loss
(4,945
)
 
(5,226
)
 
80,367

 
80,634

Less treasury stock, at cost:
850,698,697 shares in 2017 and 828,372,200 shares in 2016
42,119

 
40,546

Total Merck & Co., Inc. stockholders’ equity
38,248

 
40,088

Noncontrolling Interests
251

 
220

Total equity
38,499

 
40,308

 
$
91,676

 
$
95,377

The accompanying notes are an integral part of this condensed consolidated financial statement.

- 3 -




MERCK & CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited, $ in millions)
 
 
Nine Months Ended 
 September 30,
 
2017
 
2016
Cash Flows from Operating Activities
 
 
 
Net income
$
3,456

 
$
4,528

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
3,509

 
4,286

Intangible asset impairment charges
376

 
572

Charge for future payments related to AstraZeneca collaboration license options
750

 

Deferred income taxes
(601
)
 
(65
)
Share-based compensation
232

 
225

Other
(31
)
 
200

Net changes in assets and liabilities
(5,259
)
 
(3,002
)
Net Cash Provided by Operating Activities
2,432

 
6,744

Cash Flows from Investing Activities
 
 
 
Capital expenditures
(1,173
)
 
(1,063
)
Purchases of securities and other investments
(8,397
)
 
(10,084
)
Proceeds from sales of securities and other investments
12,533

 
11,300

Acquisitions of businesses, net of cash acquired
(347
)
 
(778
)
Other
121

 
(22
)
Net Cash Provided by (Used in) Investing Activities
2,737

 
(647
)
Cash Flows from Financing Activities
 
 
 
Net change in short-term borrowings
1,962

 
909

Payments on debt
(301
)
 
(2,386
)
Purchases of treasury stock
(2,312
)
 
(2,418
)
Dividends paid to stockholders
(3,884
)
 
(3,853
)
Proceeds from exercise of stock options
481

 
790

Other
(167
)
 
(109
)
Net Cash Used in Financing Activities
(4,221
)
 
(7,067
)
Effect of Exchange Rate Changes on Cash and Cash Equivalents
438

 
353

Net Increase (Decrease) in Cash and Cash Equivalents
1,386

 
(617
)
Cash and Cash Equivalents at Beginning of Year
6,515

 
8,524

Cash and Cash Equivalents at End of Period
$
7,901

 
$
7,907

The accompanying notes are an integral part of this condensed consolidated financial statement.

- 4 -

Notes to Condensed Consolidated Financial Statements (unaudited)

1.
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of Merck & Co., Inc. (Merck or the Company) have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and disclosures required by accounting principles generally accepted in the United States for complete consolidated financial statements are not included herein. These interim statements should be read in conjunction with the audited financial statements and notes thereto included in Merck’s Form 10-K filed on February 28, 2017.
The results of operations of any interim period are not necessarily indicative of the results of operations for the full year. In the Company’s opinion, all adjustments necessary for a fair statement of these interim statements have been included and are of a normal and recurring nature. Certain reclassifications have been made to prior year amounts to conform to the current presentation.
On December 31, 2016, Merck and Sanofi Pasteur S.A. (Sanofi) terminated their equally-owned joint venture, Sanofi Pasteur MSD (SPMSD), which developed and marketed vaccines in Europe. Beginning in 2017, Merck is recording vaccine sales and incurring costs as a result of operating its vaccines business in the European markets that were previously part of the SPMSD joint venture, which was accounted for as an equity method affiliate.
Recently Issued Accounting Standards
In May 2014, the Financial Accounting Standards Board (FASB) issued amended accounting guidance on revenue recognition that will be applied to all contracts with customers. The objective of the new guidance is to improve comparability of revenue recognition practices across entities and to provide more useful information to users of financial statements through improved disclosure requirements. The new standard permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of adopting the guidance being recognized at the date of initial application (modified retrospective method). The Company will adopt the new standard on January 1, 2018 and currently plans to use the modified retrospective method. The majority of the Company’s business is ship and bill and, on that primary revenue stream, Merck does not expect significant differences. Additionally, the Company has not identified significant changes related to the recognition of revenue for its multiple element arrangements or discount and trade promotion programs when applying the new guidance. However, the Company’s analysis is preliminary and subject to change. The Company anticipates the adoption of the new guidance will result in some additional disclosures.
In January 2016, the FASB issued revised guidance for the accounting and reporting of financial instruments. The new guidance requires that equity investments with readily determinable fair values currently classified as available-for-sale be measured at fair value with changes in fair value recognized in net income. The new guidance also simplifies the impairment testing of equity investments without readily determinable fair values and changes certain disclosure requirements. This guidance is effective for interim and annual periods beginning in 2018. The Company is currently assessing the impact of adoption on its consolidated financial statements. The impact of adoption will be recorded as a cumulative-effect adjustment to retained earnings.
In August 2016, the FASB issued guidance on the classification of certain cash receipts and payments in the statement of cash flows intended to reduce diversity in practice. The guidance is effective for interim and annual periods beginning in 2018. Early adoption is permitted. The guidance is to be applied retrospectively to all periods presented but may be applied prospectively if retrospective application would be impracticable. The Company does not anticipate the adoption of the new guidance will have a material effect on its Consolidated Statement of Cash Flows.
In October 2016, the FASB issued guidance on the accounting for the income tax consequences of intra-entity transfers of assets other than inventory. Under existing guidance, the recognition of current and deferred income taxes for an intra-entity asset transfer is prohibited until the asset has been sold to a third party. The new guidance will require the recognition of the income tax consequences of an intra-entity transfer of an asset (with the exception of inventory) when the intra-entity transfer occurs. The guidance is effective for interim and annual periods beginning in 2018. The new guidance is to be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings in the beginning of the period of adoption. The Company is currently evaluating the impact of adoption on its consolidated financial statements.
In November 2016, the FASB issued guidance requiring that amounts generally described as restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The guidance is effective for interim and annual periods beginning in 2018 and should be applied using a retrospective transition method to each period presented. Early adoption is permitted. The Company does not anticipate the adoption of the new guidance will have a material effect on its Consolidated Statement of Cash Flows.
In March 2017, the FASB amended the guidance related to net periodic benefit cost for defined benefit plans that requires entities to (1) disaggregate the current service cost component from the other components of net benefit cost and present it with other employee compensation costs in the income statement within operations if such a subtotal is presented; (2) present the other components of net benefit cost separately in the income statement and outside of income from operations; and (3) only capitalize the service cost component when applicable. The new guidance is effective for interim and annual periods in 2018.

- 5 -

Notes to Condensed Consolidated Financial Statements (unaudited)

Entities must use a retrospective transition method to adopt the requirement for separate presentation in the income statement of service costs and other components and a prospective transition method to adopt the requirement to limit the capitalization of benefit costs to the service cost component. The Company is currently evaluating the impact of adoption on its consolidated financial statements.
In May 2017, the FASB issued guidance clarifying when to account for a change to the terms or conditions of a share-based payment award as a modification. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. The new guidance is effective prospectively for interim and annual periods beginning in 2018. Early adoption is permitted. The Company does not anticipate the adoption of the new guidance will have a material effect on its consolidated financial statements.
In February 2016, the FASB issued new accounting guidance for the accounting and reporting of leases. The new guidance requires that lessees recognize a right-of-use asset and a lease liability recorded on the balance sheet for each of its leases (other than leases that meet the definition of a short-term lease).  Leases will be classified as either operating or finance. Operating leases will result in straight-line expense in the income statement (similar to current operating leases) while finance leases will result in more expense being recognized in the earlier years of the lease term (similar to current capital leases). The new guidance will be effective for interim and annual periods beginning in 2019. Early adoption is permitted. The Company is currently evaluating the impact of adoption on its consolidated financial statements.
In August 2017, the FASB issued new guidance on hedge accounting that is intended to more closely align hedge accounting with companies’ risk management strategies, simplify the application of hedge accounting, and increase transparency as to the scope and results of hedging programs. The new guidance makes more financial and nonfinancial hedging strategies eligible for hedge accounting, amends the presentation and disclosure requirements, and changes how companies assess effectiveness. The new guidance is effective for interim and annual periods beginning in 2019. Early application is permitted in any interim period. The Company does not anticipate the adoption of the new guidance will have a material effect on its consolidated financial statements and may elect to early adopt this guidance.
In June 2016, the FASB issued amended guidance on the accounting for credit losses on financial instruments. The guidance introduces an expected loss model for estimating credit losses, replacing the incurred loss model. The new guidance also changes the impairment model for available-for-sale debt securities, requiring the use of an allowance to record estimated credit losses (and subsequent recoveries). The new guidance is effective for interim and annual periods beginning in 2020, with earlier application permitted in 2019. The Company is currently evaluating the impact of adoption on its consolidated financial statements.
In January 2017, the FASB issued guidance that provides for the elimination of Step 2 from the goodwill impairment test. Under the new guidance, impairment charges are recognized to the extent the carrying amount of a reporting unit exceeds its fair value with certain limitations. The new guidance is effective for interim and annual periods in 2020. Early adoption is permitted. The Company does not anticipate the adoption of the new guidance will have a material effect on its consolidated financial statements.
2.
Acquisitions, Divestitures, Research Collaborations and License Agreements
The Company continues to pursue the acquisition of businesses and establishment of external alliances such as research collaborations and licensing agreements to complement its internal research capabilities. These arrangements often include upfront payments, as well as expense reimbursements or payments to the third party, and milestone, royalty or profit share arrangements, contingent upon the occurrence of certain future events linked to the success of the asset in development. The Company also reviews its marketed products and pipeline to examine candidates which may provide more value through out-licensing and, as part of its portfolio assessment process, may also divest certain assets. Pro forma financial information for acquired businesses is not presented if the historical financial results of the acquired entity are not significant when compared with the Company’s financial results.
In October 2017, Merck acquired Rigontec GmbH (Rigontec). Rigontec is a leader in accessing the retinoic acid-inducible gene I (RIG-I) pathway, part of the innate immune system, as a novel and distinct approach in cancer immunotherapy to induce both immediate and long-term anti-tumor immunity. Rigontec’s lead candidate, RGT100, is currently in Phase I development evaluating treatment in patients with various tumors. Under the terms of the agreement, Merck made an upfront cash payment of €119 million ($140 million) and may make additional contingent payments of up to €349 million based on the attainment of certain clinical, development, regulatory and commercial milestones. The transaction will be accounted for as an acquisition of an asset and the upfront payment will be reflected within Research and development expenses in the fourth quarter of 2017.
In July 2017, Merck and AstraZeneca entered into a global strategic oncology collaboration to co-develop and co-commercialize AstraZeneca’s Lynparza (olaparib) for multiple cancer types. Lynparza is an oral, poly (ADP-ribose) polymerase (PARP) inhibitor currently approved for certain types of ovarian cancer. The companies will jointly develop and commercialize Lynparza, both as monotherapy and in combination trials with other potential medicines. Independently, Merck

- 6 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

and AstraZeneca will develop and commercialize Lynparza in combinations with their respective PD-1 and PD-L1 medicines, Keytruda (pembrolizumab) and Imfinzi (durvalumab). The companies will also jointly develop and commercialize AstraZeneca’s selumetinib, an oral, potent, selective inhibitor of MEK, part of the mitogen-activated protein kinase (MAPK) pathway, currently being developed for multiple indications including thyroid cancer. Under the terms of the agreement, AstraZeneca and Merck will share the development and commercialization costs for Lynparza and selumetinib monotherapy and non-PD-L1/PD-1 combination therapy opportunities. Gross profits from Lynparza and selumetinib product sales generated through monotherapies or combination therapies will be shared equally. Merck will fund all development and commercialization costs of Keytruda in combination with Lynparza or selumetinib. AstraZeneca will fund all development and commercialization costs of Imfinzi in combination with Lynparza or selumetinib. As part of the agreement, Merck made an upfront payment to AstraZeneca of $1.6 billion and will make payments of $750 million over a multi-year period for certain license options ($250 million in November 2017, $400 million in November 2018 and $100 million in November 2019). The Company recorded an aggregate charge of $2.35 billion in Research and development expenses in the third quarter of 2017 related to the upfront payment and future license options payments. In addition, Merck will pay AstraZeneca up to an additional $6.15 billion contingent upon successful achievement of future regulatory and sales milestones for total aggregate consideration of up to $8.5 billion. Future milestone payments will be capitalized and amortized over the estimated useful life of the corresponding intangible asset. Additionally, Merck will record its share of product sales of Lynparza and selumetinib, net of commercialization costs, as alliance revenue within the Pharmaceutical segment and its share of development costs associated with the collaboration as part of Research and development expenses. Merck may terminate the agreement in its entirety or with respect to a given compound (and all products comprising such compound) upon prior written notice to AstraZeneca of at least 180 days.  If the agreement is terminated with respect to a given compound, the agreement shall remain in full force and effect with respect to the other compounds.  The parties also have the right to terminate the agreement in its entirety or on a product-by-product or country-by-country basis upon mutual written agreement.  The agreement may also be terminated at any time with respect to a given product, upon written notice by a party if the other party is in material breach of the agreement with respect to such product and has not cured such breach within the time periods provided for under the agreement. 
In March 2017, Merck acquired a controlling interest in Vallée S.A. (Vallée), a leading privately held producer of animal health products in Brazil. Vallée has an extensive portfolio of products spanning parasiticides, anti-infectives and vaccines that include products for livestock, horses, and companion animals. Under the terms of the agreement, Merck acquired 93.5% of the shares of Vallée for $358 million. Of the total purchase price, $176 million was placed into escrow pending resolution of certain contingent items. The transaction was accounted for as an acquisition of a business. Merck recognized intangible assets of $291 million related to currently marketed products, net deferred tax liabilities of $93 million, other net assets of $15 million and noncontrolling interest of $25 million. In addition, the Company recorded liabilities of $37 million for contingencies identified at the acquisition date and corresponding indemnification assets of $37 million, representing the amounts to be reimbursed to Merck if and when the contingent liabilities are paid. The excess of the consideration transferred over the fair value of net assets acquired of $170 million was recorded as goodwill. The goodwill was allocated to the Animal Health segment and is not deductible for tax purposes. The estimated fair values of identifiable intangible assets related to currently marketed products were determined using an income approach. The probability-adjusted future net cash flows of each product were then discounted to present value utilizing a discount rate of 15.5%. Actual cash flows are likely to be different than those assumed. The intangible assets related to currently marketed products are being amortized over their estimated useful lives of 15 years.
In July 2016, Merck acquired Afferent Pharmaceuticals (Afferent), a privately held pharmaceutical company focused on the development of therapeutic candidates targeting the P2X3 receptor for the treatment of common, poorly-managed, neurogenic conditions. Afferent’s lead investigational candidate, MK-7264 (formerly AF-219), is a selective, non-narcotic, orally-administered P2X3 antagonist being evaluated in a Phase 2b clinical trial for the treatment of refractory, chronic cough as well as in a Phase 2 clinical trial in idiopathic pulmonary fibrosis with cough. Total consideration transferred of $510 million included cash paid for outstanding Afferent shares of $487 million, as well as share-based compensation payments to settle equity awards attributable to precombination service and cash paid for transaction costs on behalf of Afferent. In addition, former Afferent shareholders are eligible to receive a total of up to an additional $750 million contingent upon the attainment of certain clinical development and commercial milestones for multiple indications and candidates, including MK-7264. This transaction was accounted for as an acquisition of a business. The Company determined the fair value of the contingent consideration was $223 million at the acquisition date utilizing a probability-weighted estimated cash flow stream adjusted for the expected timing of each payment using an appropriate discount rate dependent on the nature and timing of the milestone payment. Merck recognized an intangible asset for in-process research and development (IPR&D) of $832 million, net deferred tax liabilities of $258 million, and other net assets of $29 million (primarily consisting of cash acquired). The excess of the consideration transferred over the fair value of net assets acquired of $130 million was recorded as goodwill that was allocated to the Pharmaceutical segment and is not deductible for tax purposes. The fair value of the identifiable intangible asset related to IPR&D was determined using an income approach. The asset’s probability-adjusted future net cash flows were then discounted to present value using a discount rate of 11.5%. Actual cash flows are likely to be different than those assumed.
Also in July 2016, Merck, through its wholly owned subsidiary Healthcare Services & Solutions, LLC, acquired a majority ownership interest in The StayWell Company LLC (StayWell), a portfolio company of Vestar Capital Partners (Vestar).

- 7 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

StayWell is a health engagement company that helps its clients engage and educate people to improve health and business results. Under the terms of the transaction, Merck paid $150 million for a majority ownership interest. Additionally, Merck provided StayWell with a $150 million intercompany loan to pay down preexisting third-party debt. Merck has an option to buy, and Vestar has an option to require Merck to buy, some or all of Vestar’s remaining ownership interest at fair value beginning three years from the acquisition date. This transaction was accounted for as an acquisition of a business. Merck recognized intangible assets of $238 million, deferred tax liabilities of $84 million, other net liabilities of $5 million and noncontrolling interest of $124 million. The excess of the consideration transferred over the fair value of net assets acquired of $275 million was recorded as goodwill and is largely attributable to anticipated synergies expected to arise after the acquisition. The goodwill was allocated to the Healthcare Services segment and is not deductible for tax purposes. The intangible assets recognized primarily relate to customer relationships, which are being amortized over a 10-year useful life, and medical information and solutions content, which are being amortized over a five-year useful life.
In June 2016, Merck and Moderna Therapeutics (Moderna) entered into a strategic collaboration and license agreement to develop and commercialize novel messenger RNA (mRNA)-based personalized cancer vaccines. The development program will entail multiple studies in several types of cancer and include the evaluation of mRNA-based personalized cancer vaccines in combination with Merck’s Keytruda. Pursuant to the terms of the agreement, Merck made an upfront cash payment to Moderna of $200 million, which was recorded in Research and development expenses. Following human proof of concept studies, Merck has the right to elect to make an additional payment to Moderna. If Merck exercises this right, the two companies will then equally share costs and profits under a worldwide collaboration for the development of personalized cancer vaccines. Moderna will have the right to elect to co-promote the personalized cancer vaccines in the United States. The agreement entails exclusivity around combinations with Keytruda. Moderna and Merck each have the ability to combine mRNA-based personalized cancer vaccines with other (non-PD-1) agents.
In January 2016, Merck acquired IOmet Pharma Ltd (IOmet), a privately held UK-based drug discovery company focused on the development of innovative medicines for the treatment of cancer, with a particular emphasis on the fields of cancer immunotherapy and cancer metabolism. The acquisition provides Merck with IOmet’s preclinical pipeline of IDO (indoleamine-2,3-dioxygenase 1), TDO (tryptophan-2,3-dioxygenase), and dual-acting IDO/TDO inhibitors. The transaction was accounted for as an acquisition of a business. Total purchase consideration in the transaction included a cash payment of $150 million and future additional milestone payments of up to $250 million contingent upon certain clinical and regulatory milestones being achieved. The Company determined the fair value of the contingent consideration was $94 million at the acquisition date utilizing a probability-weighted estimated cash flow stream adjusted for the expected timing of each payment utilizing a discount rate of 10.5%. Merck recognized intangible assets for IPR&D of $155 million and net deferred tax assets of $32 million. The excess of the consideration transferred over the fair value of net assets acquired of $57 million was recorded as goodwill that was allocated to the Pharmaceutical segment and is not deductible for tax purposes. The fair values of the identifiable intangible assets related to IPR&D were determined using an income approach. The assets’ probability-adjusted future net cash flows were then discounted to present value also using a discount rate of 10.5%. Actual cash flows are likely to be different than those assumed. In July 2017, Merck made a $100 million payment as a result of the achievement of a clinical milestone, which was accrued for at estimated fair value at the time of acquisition as noted above.
Additionally, in January 2016, Merck sold the U.S. marketing rights to Cortrophin and Corticotropin Zinc Hydroxide to ANI Pharmaceuticals, Inc. (ANI). Under the terms of the agreement, ANI made a payment of $75 million, which was recorded in Sales, and may make additional payments to the Company based on future sales. Merck does not have any ongoing supply or other performance obligations after the closing date.
3.
Restructuring
The Company incurs substantial costs for restructuring program activities related to Merck’s productivity and cost reduction initiatives, as well as in connection with the integration of certain acquired businesses. In 2010 and 2013, the Company commenced actions under global restructuring programs designed to streamline its cost structure. The actions under these programs include the elimination of positions in sales, administrative and headquarters organizations, as well as the sale or closure of certain manufacturing and research and development sites and the consolidation of office facilities. The Company also continues to reduce its global real estate footprint and improve the efficiency of its manufacturing and supply network.
The Company recorded total pretax costs of $180 million and $212 million in the third quarter of 2017 and 2016, respectively, and $605 million and $759 million for the first nine months of 2017 and 2016, respectively, related to restructuring program activities. Since inception of the programs through September 30, 2017, Merck has recorded total pretax accumulated costs of approximately $13.2 billion and eliminated approximately 42,120 positions comprised of employee separations, as well as the elimination of contractors and vacant positions. The Company expects to substantially complete the remaining actions under these programs by the end of 2017 and incur approximately $250 million of additional pretax costs. The Company estimates that approximately two-thirds of the cumulative pretax costs are cash outlays, primarily related to employee separation expense.

- 8 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Approximately one-third of the cumulative pretax costs are non-cash, relating primarily to the accelerated depreciation of facilities to be closed or divested.
For segment reporting, restructuring charges are unallocated expenses.
The following tables summarize the charges related to restructuring program activities by type of cost:
 
Three Months Ended September 30, 2017
 
Nine Months Ended September 30, 2017
($ in millions)
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
 
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
Materials and production
$

 
$
5

 
$
20

 
$
25

 
$

 
$
52

 
$
69

 
$
121

Marketing and administrative

 

 

 

 

 
2

 
1

 
3

Research and development

 
1

 
1

 
2

 

 
7

 
4

 
11

Restructuring costs
100

 

 
53

 
153

 
302

 

 
168

 
470

 
$
100

 
$
6

 
$
74

 
$
180

 
$
302

 
$
61

 
$
242

 
$
605

 
Three Months Ended September 30, 2016
 
Nine Months Ended September 30, 2016
($ in millions)
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
 
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
Materials and production
$

 
$
18

 
$
18

 
$
36

 
$

 
$
69

 
$
80

 
$
149

Marketing and administrative

 
1

 

 
1

 

 
8

 
83

 
91

Research and development

 
14

 

 
14

 

 
133

 

 
133

Restructuring costs
61

 

 
100

 
161

 
172

 

 
214

 
386

 
$
61

 
$
33

 
$
118

 
$
212

 
$
172

 
$
210

 
$
377

 
$
759

Separation costs are associated with actual headcount reductions, as well as those headcount reductions which were probable and could be reasonably estimated. In the third quarter of 2017 and 2016, approximately 205 positions and 300 positions, respectively, and for the first nine months of 2017 and 2016, approximately 1,225 positions and 1,355 positions, respectively, were eliminated under restructuring program activities.
Accelerated depreciation costs primarily relate to manufacturing, research and administrative facilities and equipment to be sold or closed as part of the programs. Accelerated depreciation costs represent the difference between the depreciation expense to be recognized over the revised useful life of the asset, based upon the anticipated date the site will be closed or divested or the equipment disposed of, and depreciation expense as determined utilizing the useful life prior to the restructuring actions. All of the sites have and will continue to operate up through the respective closure dates and, since future undiscounted cash flows were sufficient to recover the respective book values, Merck is recording accelerated depreciation over the revised useful life of the site assets. Anticipated site closure dates, particularly related to manufacturing locations, have been and may continue to be adjusted to reflect changes resulting from regulatory or other factors.
Other activity in 2017 and 2016 includes asset abandonment, shut-down and other related costs, as well as pretax gains and losses resulting from sales of facilities and related assets. Additionally, other activity includes certain employee-related costs associated with pension and other postretirement benefit plans (see Note 10) and share-based compensation.
The following table summarizes the charges and spending relating to restructuring program activities for the nine months ended September 30, 2017:
($ in millions)
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
Restructuring reserves January 1, 2017
$
395

 
$

 
$
146

 
$
541

Expense
302

 
61

 
242

 
605

(Payments) receipts, net
(224
)
 

 
(339
)
 
(563
)
Non-cash activity

 
(61
)
 
74

 
13

Restructuring reserves September 30, 2017 (1)
$
473

 
$

 
$
123

 
$
596

(1) 
The remaining cash outlays are expected to be substantially completed by the end of 2020.


- 9 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

4.
Financial Instruments
Derivative Instruments and Hedging Activities
The Company manages the impact of foreign exchange rate movements and interest rate movements on its earnings, cash flows and fair values of assets and liabilities through operational means and through the use of various financial instruments, including derivative instruments.
A significant portion of the Company’s revenues and earnings in foreign affiliates is exposed to changes in foreign exchange rates. The objectives and accounting related to the Company’s foreign currency risk management program, as well as its interest rate risk management activities are discussed below.
Foreign Currency Risk Management
The Company has established revenue hedging, balance sheet risk management and net investment hedging programs to protect against volatility of future foreign currency cash flows and changes in fair value caused by volatility in foreign exchange rates.
The objective of the revenue hedging program is to reduce the variability caused by changes in foreign exchange rates that would affect the U.S. dollar value of future cash flows derived from foreign currency denominated sales, primarily the euro and Japanese yen. To achieve this objective, the Company will hedge a portion of its forecasted foreign currency denominated third-party and intercompany distributor entity sales (forecasted sales) that are expected to occur over its planning cycle, typically no more than two years into the future. The Company will layer in hedges over time, increasing the portion of forecasted sales hedged as it gets closer to the expected date of the forecasted sales. The portion of forecasted sales hedged is based on assessments of cost-benefit profiles that consider natural offsetting exposures, revenue and exchange rate volatilities and correlations, and the cost of hedging instruments. The Company manages its anticipated transaction exposure principally with purchased local currency put options, forward contracts and purchased collar options.
The fair values of these derivative contracts are recorded as either assets (gain positions) or liabilities (loss positions) in the Condensed Consolidated Balance Sheet. Changes in the fair value of derivative contracts are recorded each period in either current earnings or Other comprehensive income (OCI), depending on whether the derivative is designated as part of a hedge transaction and, if so, the type of hedge transaction. For derivatives that are designated as cash flow hedges, the effective portion of the unrealized gains or losses on these contracts is recorded in Accumulated other comprehensive income (AOCI) and reclassified into Sales when the hedged anticipated revenue is recognized. The hedge relationship is highly effective and hedge ineffectiveness has been de minimis. For those derivatives which are not designated as cash flow hedges, but serve as economic hedges of forecasted sales, unrealized gains or losses are recorded in Sales each period. The cash flows from both designated and non-designated contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows. The Company does not enter into derivatives for trading or speculative purposes.
The Company manages operating activities and net asset positions at each local subsidiary in order to mitigate the effects of exchange on monetary assets and liabilities. The Company also uses a balance sheet risk management program to mitigate the exposure of net monetary assets that are denominated in a currency other than a subsidiary’s functional currency from the effects of volatility in foreign exchange. In these instances, Merck principally utilizes forward exchange contracts to offset the effects of exchange on exposures denominated in developed country currencies, primarily the euro and Japanese yen. For exposures in developing country currencies, the Company will enter into forward contracts to partially offset the effects of exchange on exposures when it is deemed economical to do so based on a cost-benefit analysis that considers the magnitude of the exposure, the volatility of the exchange rate and the cost of the hedging instrument. The cash flows from these contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows.
Monetary assets and liabilities denominated in a currency other than the functional currency of a given subsidiary are remeasured at spot rates in effect on the balance sheet date with the effects of changes in spot rates reported in Other (income) expense, net. The forward contracts are not designated as hedges and are marked to market through Other (income) expense, net. Accordingly, fair value changes in the forward contracts help mitigate the changes in the value of the remeasured assets and liabilities attributable to changes in foreign currency exchange rates, except to the extent of the spot-forward differences. These differences are not significant due to the short-term nature of the contracts, which typically have average maturities at inception of less than one year.
The Company may also use forward exchange contracts to hedge its net investment in foreign operations against movements in exchange rates. The forward contracts are designated as hedges of the net investment in a foreign operation. The Company hedges a portion of the net investment in certain of its foreign operations and measures ineffectiveness based upon changes in spot foreign exchange rates that are recorded in Other (income) expense, net. The effective portion of the unrealized gains or losses on these contracts is recorded in foreign currency translation adjustment within OCI, and remains in AOCI until either the sale or complete or substantially complete liquidation of the subsidiary. The cash flows from these contracts are reported as investing activities in the Condensed Consolidated Statement of Cash Flows.

- 10 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Foreign exchange risk is also managed through the use of foreign currency debt. The Company’s senior unsecured euro-denominated notes have been designated as, and are effective as, economic hedges of the net investment in a foreign operation. Accordingly, foreign currency transaction gains or losses due to spot rate fluctuations on the euro-denominated debt instruments are included in foreign currency translation adjustment within OCI. Included in the cumulative translation adjustment are pretax losses of $467 million and $60 million for the first nine months of 2017 and 2016, respectively, from the euro-denominated notes.
Interest Rate Risk Management
The Company may use interest rate swap contracts on certain investing and borrowing transactions to manage its net exposure to interest rate changes and to reduce its overall cost of borrowing. The Company does not use leveraged swaps and, in general, does not leverage any of its investment activities that would put principal capital at risk.
At September 30, 2017, the Company was a party to 26 pay-floating, receive-fixed interest rate swap contracts designated as fair value hedges of fixed-rate notes in which the notional amounts match the amount of the hedged fixed-rate notes as detailed in the table below.
($ in millions)
September 30, 2017
Debt Instrument
Par Value of Debt
 
Number of Interest Rate Swaps Held
 
Total Swap Notional Amount
1.30% notes due 2018
$
1,000

 
4

 
$
1,000

5.00% notes due 2019
1,250

 
3

 
550

1.85% notes due 2020
1,250

 
5

 
1,250

3.875% notes due 2021
1,150

 
5

 
1,150

2.40% notes due 2022
1,000

 
4

 
1,000

2.35% notes due 2022
1,250

 
5

 
1,250

The interest rate swap contracts are designated hedges of the fair value changes in the notes attributable to changes in the benchmark London Interbank Offered Rate (LIBOR) swap rate. The fair value changes in the notes attributable to changes in the LIBOR swap rate are recorded in interest expense and offset by the fair value changes in the swap contracts. The cash flows from these contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows.
Presented in the table below is the fair value of derivatives on a gross basis segregated between those derivatives that are designated as hedging instruments and those that are not designated as hedging instruments:
 
 
September 30, 2017
 
December 31, 2016
 
 
Fair Value of Derivative
 
U.S. Dollar
Notional
 
Fair Value of Derivative
 
U.S. Dollar
Notional
($ in millions)
Balance Sheet Caption
Asset
 
Liability
 
Asset
 
Liability
 
Derivatives Designated as Hedging Instruments
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate swap contracts
Other assets
$
15

 
$

 
$
2,700

 
$
20

 
$

 
$
2,700

Interest rate swap contracts
Accrued and other current liabilities

 
3

 
1,000

 

 

 

Interest rate swap contracts
Other noncurrent liabilities

 
23

 
2,500

 

 
29

 
3,500

Foreign exchange contracts
Other current assets
83

 

 
4,385

 
616

 

 
6,063

Foreign exchange contracts
Other assets
46

 

 
1,979

 
129

 

 
2,075

Foreign exchange contracts
Accrued and other current liabilities

 
88

 
1,574

 

 
1

 
48

Foreign exchange contracts
Other noncurrent liabilities

 
1

 
25

 

 
1

 
12

 
 
$
144


$
115


$
14,163


$
765


$
31


$
14,398

Derivatives Not Designated as Hedging Instruments
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
$
77

 
$

 
$
3,927

 
$
230

 
$

 
$
8,210

Foreign exchange contracts
Accrued and other current liabilities

 
112

 
6,383

 

 
103

 
2,931

 
 
$
77

 
$
112

 
$
10,310

 
$
230

 
$
103

 
$
11,141

 
 
$
221


$
227


$
24,473


$
995


$
134


$
25,539

As noted above, the Company records its derivatives on a gross basis in the Condensed Consolidated Balance Sheet. The Company has master netting agreements with several of its financial institution counterparties (see Concentrations of Credit Risk below). The following table provides information on the Company’s derivative positions subject to these master netting arrangements as if they were presented on a net basis, allowing for the right of offset by counterparty and cash collateral exchanged per the master agreements and related credit support annexes:

- 11 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

 
September 30, 2017
 
December 31, 2016
($ in millions)
Asset
 
Liability
 
Asset
 
Liability
Gross amounts recognized in the consolidated balance sheet
$
221

 
$
227

 
$
995

 
$
134

Gross amount subject to offset in master netting arrangements not offset in the consolidated
balance sheet
(137
)
 
(137
)
 
(131
)
 
(131
)
Cash collateral received
(8
)
 

 
(529
)
 

Net amounts
$
76

 
$
90

 
$
335

 
$
3

The table below provides information on the location and pretax gain or loss amounts for derivatives that are: (i) designated in a fair value hedging relationship, (ii) designated in a foreign currency cash flow hedging relationship and (iii) not designated in a hedging relationship:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
($ in millions)
2017
 
2016
 
2017
 
2016
Derivatives designated in a fair value hedging relationship
 
 
 
 
 
 
 
Interest rate swap contracts
 
 
 
 
 
 
 
Amount of loss (gain) recognized in Other (income) expense, net on derivatives (1)
$
8

 
$
59

 
$
2

 
$
(139
)
Amount of (gain) loss recognized in Other (income) expense, net on hedged item (1)
(9
)
 
(60
)
 
(5
)
 
135

Derivatives designated in foreign currency cash flow hedging relationships
 
 
 
 
 
 
 
Foreign exchange contracts
 
 
 
 
 
 
 
Amount of gain reclassified from AOCI to Sales
(13
)
 
(44
)
 
(157
)
 
(251
)
Amount of loss recognized in OCI on derivatives
88

 
69

 
520

 
311

Derivatives not designated in a hedging relationship
 
 
 
 
 
 
 
Foreign exchange contracts
 
 
 
 
 
 
 
Amount of loss (gain) recognized in Other (income) expense, net on derivatives (2)
119

 
29

 
70

 
(87
)
(1) There was $1 million of ineffectiveness on the hedge during both the third quarter of 2017 and 2016, and $3 million and $4 million, respectively, of ineffectiveness on the hedge during the first nine months of 2017 and 2016, respectively.
(2) These derivative contracts mitigate changes in the value of remeasured foreign currency denominated monetary assets and liabilities attributable to changes in foreign currency exchange rates.
At September 30, 2017, the Company estimates $164 million of pretax net unrealized losses on derivatives maturing within the next 12 months that hedge foreign currency denominated sales over that same period will be reclassified from AOCI to Sales. The amount ultimately reclassified to Sales may differ as foreign exchange rates change. Realized gains and losses are ultimately determined by actual exchange rates at maturity.

Investments in Debt and Equity Securities
Information on investments in debt and equity securities is as follows:
 
September 30, 2017
 
December 31, 2016
 
Fair
Value
 
Amortized
Cost
 
Gross Unrealized
 
Fair
Value
 
Amortized
Cost
 
Gross Unrealized
($ in millions)
Gains
 
Losses
 
Gains
 
Losses
Corporate notes and bonds
$
10,259

 
$
10,242

 
$
31

 
$
(14
)
 
$
10,577

 
$
10,601

 
$
15

 
$
(39
)
U.S. government and agency securities
1,924

 
1,934

 

 
(10
)
 
2,232

 
2,244

 
1

 
(13
)
Asset-backed securities
1,473

 
1,473

 
2

 
(2
)
 
1,376

 
1,380

 
1

 
(5
)
Mortgage-backed securities
704

 
708

 
1

 
(5
)
 
796

 
801

 
1

 
(6
)
Commercial paper
695

 
695

 

 

 
4,330

 
4,330

 

 

Foreign government bonds
640

 
642

 

 
(2
)
 
519

 
521

 

 
(2
)
Equity securities
539

 
309

 
233

 
(3
)
 
349

 
281

 
71

 
(3
)
 
$
16,234

 
$
16,003

 
$
267

 
$
(36
)
 
$
20,179

 
$
20,158

 
$
89

 
$
(68
)
Available-for-sale debt securities included in Short-term investments totaled $3.0 billion at September 30, 2017. Of the remaining debt securities, $11.2 billion mature within five years. At September 30, 2017 and December 31, 2016, there were no debt securities pledged as collateral.
Fair Value Measurements
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company uses a fair value hierarchy which maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. There are three levels of inputs used to measure fair value with Level 1

- 12 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

having the highest priority and Level 3 having the lowest: Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities, Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities, Level 3 - Unobservable inputs that are supported by little or no market activity. Level 3 assets or liabilities are those whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques with significant unobservable inputs, as well as assets or liabilities for which the determination of fair value requires significant judgment or estimation. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.
Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis
Financial assets and liabilities measured at fair value on a recurring basis are summarized below:
 
Fair Value Measurements Using
 
Fair Value Measurements Using
 
Quoted Prices
In Active
Markets for
Identical Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Total
 
Quoted Prices
In Active
Markets for
Identical Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Total
($ in millions)
September 30, 2017
 
December 31, 2016
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investments
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate notes and bonds
$

 
$
10,110

 
$

 
$
10,110

 
$

 
$
10,389

 
$

 
$
10,389

U.S. government and agency securities
68

 
1,622

 

 
1,690

 
29

 
1,890

 

 
1,919

Asset-backed securities (1)

 
1,395

 

 
1,395

 

 
1,257

 

 
1,257

Commercial paper

 
695

 

 
695

 

 
4,330

 

 
4,330

Foreign government bonds

 
639

 

 
639

 

 
518

 

 
518

Mortgage-backed securities (1)

 
603

 

 
603

 

 
628

 

 
628

Equity securities
368

 

 

 
368

 
201

 

 

 
201

 
436

 
15,064

 

 
15,500

 
230

 
19,012

 

 
19,242

Other assets (2)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government and agency securities

 
234

 

 
234

 

 
313

 

 
313

Corporate notes and bonds

 
149

 

 
149

 

 
188

 

 
188

Mortgage-backed securities (1)

 
101

 

 
101

 

 
168

 

 
168

Asset-backed securities (1)

 
78

 

 
78

 

 
119

 

 
119

Foreign government bonds

 
1

 

 
1

 

 
1

 

 
1

Equity securities
171

 

 

 
171

 
148

 

 

 
148

 
171


563




734


148


789




937

Derivative assets (3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Purchased currency options

 
119

 

 
119

 

 
644

 

 
644

Forward exchange contracts

 
87

 

 
87

 

 
331

 

 
331

Interest rate swaps

 
15

 

 
15

 

 
20

 

 
20

 

 
221

 

 
221

 

 
995

 

 
995

Total assets
$
607


$
15,848


$


$
16,455


$
378


$
20,796


$


$
21,174

Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Contingent consideration
$

 
$

 
$
945

 
$
945

 
$

 
$

 
$
891

 
$
891

Derivative liabilities (3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Forward exchange contracts

 
201

 

 
201

 

 
93

 

 
93

Interest rate swaps

 
26

 

 
26

 

 
29

 

 
29

Written currency options

 

 

 

 

 
12

 

 
12

 

 
227

 

 
227

 

 
134

 

 
134

Total liabilities
$


$
227


$
945


$
1,172


$


$
134


$
891


$
1,025

(1) 
Primarily all of the asset-backed securities are highly-rated (Standard & Poor’s rating of AAA and Moody’s Investors Service rating of Aaa), secured primarily by auto loan, credit card and student loan receivables, with weighted-average lives of primarily 5 years or less. Mortgage-backed securities represent AAA-rated securities issued or unconditionally guaranteed as to payment of principal and interest by U.S. government agencies.
(2) 
Investments included in other assets are restricted for the payment of benefits under employee benefit plans.
(3) 
The fair value determination of derivatives includes the impact of the credit risk of counterparties to the derivatives and the Company’s own credit risk, the effects of which were not significant.

- 13 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

There were no transfers between Level 1 and Level 2 during the first nine months of 2017. As of September 30, 2017, Cash and cash equivalents of $7.9 billion included $7.1 billion of cash equivalents (which would be considered Level 2 in the fair value hierarchy).
Contingent Consideration
Summarized information about the changes in liabilities for contingent consideration is as follows:
 
Nine Months Ended September 30,
($ in millions)
2017
 
2016
Fair value January 1
$
891

 
$
590

Changes in fair value (1)
151

 
29

Additions
3

 
300

Payments
(100
)
 
(25
)
Fair value September 30 (2)
$
945

 
$
894

(1) Recorded in Research and development expenses, Materials and production costs and Other (income) expense, net. Includes cumulative translation adjustments.
(2) Includes $234 million recorded as a current liability for amounts expected to be paid within the next 12 months.
The additions to contingent consideration reflected in the table above in the first nine months of 2016 relate to the acquisitions of Afferent and IOmet (see Note 2). The payments of contingent consideration in 2017 relate to the achievement of a clinical milestone in connection with the acquisition of IOmet (see Note 2) and in 2016 relate to the first commercial sale of Zerbaxa in the European Union.
Other Fair Value Measurements
Some of the Company’s financial instruments, such as cash and cash equivalents, receivables and payables, are reflected in the balance sheet at carrying value, which approximates fair value due to their short-term nature.
The estimated fair value of loans payable and long-term debt (including current portion) at September 30, 2017, was $28.3 billion compared with a carrying value of $27.0 billion and at December 31, 2016, was $25.7 billion compared with a carrying value of $24.8 billion. Fair value was estimated using recent observable market prices and would be considered Level 2 in the fair value hierarchy.
Concentrations of Credit Risk
On an ongoing basis, the Company monitors concentrations of credit risk associated with corporate and government issuers of securities and financial institutions with which it conducts business. Credit exposure limits are established to limit a concentration with any single issuer or institution. Cash and investments are placed in instruments that meet high credit quality standards as specified in the Company’s investment policy guidelines.
The majority of the Company’s accounts receivable arise from product sales in the United States and Europe and are primarily due from drug wholesalers and retailers, hospitals, government agencies, managed health care providers and pharmacy benefit managers. The Company monitors the financial performance and creditworthiness of its customers so that it can properly assess and respond to changes in their credit profile. The Company also continues to monitor economic conditions, including the volatility associated with international sovereign economies, and associated impacts on the financial markets and its business, taking into consideration global economic conditions and the ongoing sovereign debt issues in certain European countries. At September 30, 2017, the Company’s total net accounts receivable outstanding for more than one year were approximately $190 million. The Company does not expect to have write-offs or adjustments to accounts receivable which would have a material adverse effect on its financial position, liquidity or results of operations.
Derivative financial instruments are executed under International Swaps and Derivatives Association master agreements. The master agreements with several of the Company’s financial institution counterparties also include credit support annexes. These annexes contain provisions that require collateral to be exchanged depending on the value of the derivative assets and liabilities, the Company’s credit rating, and the credit rating of the counterparty. As of September 30, 2017 and December 31, 2016, the Company had received cash collateral of $8 million and $529 million, respectively, from various counterparties and the obligation to return such collateral is recorded in Accrued and other current liabilities. The Company had not advanced any cash collateral to counterparties as of September 30, 2017 or December 31, 2016.


- 14 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

5.
Inventories
Inventories consisted of:
($ in millions)
September 30, 2017
 
December 31, 2016
Finished goods
$
1,364

 
$
1,304

Raw materials and work in process
4,588

 
4,222

Supplies
198

 
155

Total (approximates current cost)
6,150

 
5,681

Increase to LIFO costs
142

 
302

 
$
6,292

 
$
5,983

Recognized as:
 
 
 
Inventories
$
5,263

 
$
4,866

Other assets
1,029

 
1,117

Amounts recognized as Other assets are comprised almost entirely of raw materials and work in process inventories. At September 30, 2017 and December 31, 2016, these amounts included $957 million and $1.0 billion, respectively, of inventories not expected to be sold within one year. In addition, these amounts included $72 million and $80 million at September 30, 2017 and December 31, 2016, respectively, of inventories produced in preparation for product launches.
6.
Other Intangibles
In connection with acquisitions, the Company measures the fair value of marketed products and research and development pipeline programs and capitalizes these amounts. See Note 2 for information on intangible assets acquired as a result of business acquisitions in the first nine months of 2017 and 2016.
During the first nine months of 2017, the Company recorded an intangible asset impairment charge of $47 million within Materials and production costs related to Intron A, a treatment for certain types of cancers. Sales of Intron A are being adversely affected by the availability of new therapeutic options. During the second quarter, sales of Intron A in the United States eroded more rapidly than previously anticipated by the Company, which led to changes in the cash flow assumptions for Intron A. These revisions to cash flows indicated that the Intron A intangible asset value was not fully recoverable on an undiscounted cash flows basis. The Company utilized market participant assumptions to determine its best estimate of the fair value of the intangible asset related to Intron A that, when compared with its related carrying value, resulted in the impairment charge noted above. The remaining intangible asset value for Intron A at September 30, 2017 was $19 million.
During the first nine months of 2016, the Company recorded intangible asset impairment charges related to marketed products of $347 million. Of this amount, $252 million relates to Zontivity, a product for the reduction of thrombotic cardiovascular events in patients with a history of myocardial infarction or with peripheral arterial disease. In March 2016, following several business decisions that reduced sales expectations for Zontivity in the United States and Europe, the Company lowered its cash flow projections for Zontivity. The Company utilized market participant assumptions and considered several different scenarios to determine the fair value of the intangible asset related to Zontivity that, when compared with its related carrying value, resulted in the impairment charge noted above. In addition, the Company wrote-off $95 million that had been capitalized in connection with in-licensed products that, for business reasons, the Company returned to the licensor.
Also, during the third quarter and first nine months of 2017, the Company recorded $245 million and $253 million, respectively, of IPR&D impairment charges within Research and development expenses. In the third quarter of 2017, Merck made a strategic decision to discontinue the development of the investigational combination regimens MK-3682B (grazoprevir/ruzasvir/uprifosbuvir) and MK-3682C (ruzasvir/uprifosbuvir) for the treatment of chronic hepatitis C virus (HCV) infection. This decision was made based on a review of available Phase 2 efficacy data and in consideration of the evolving marketplace and the growing number of treatment options available for patients with chronic HCV infection, including Zepatier (elbasvir and grazoprevir), which is currently marketed by the Company for the treatment of chronic HCV infection. As a result of this decision, the Company recorded an IPR&D impairment charge of $240 million in the third quarter and first nine months of 2017 to write-off the intangible asset related to uprifosbuvir.
During the first nine months of 2016, the Company recorded $225 million of IPR&D impairment charges. Of this amount, $112 million relates to an in-licensed program that, for business reasons, was returned to the licensor. The remaining IPR&D impairment charges in 2016 primarily relate to deprioritized pipeline programs that were deemed to have no alternative use during the period.

- 15 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

The Company may recognize additional non-cash impairment charges in the future related to other marketed products or pipeline programs and such charges could be material.
7.
Contingencies
The Company is involved in various claims and legal proceedings of a nature considered normal to its business, including product liability, intellectual property, and commercial litigation, as well as certain additional matters including governmental and environmental matters. In the opinion of the Company, it is unlikely that the resolution of these matters will be material to the Company’s financial position, results of operations or cash flows.
Given the nature of the litigation discussed below and the complexities involved in these matters, the Company is unable to reasonably estimate a possible loss or range of possible loss for such matters until the Company knows, among other factors, (i) what claims, if any, will survive dispositive motion practice, (ii) the extent of the claims, including the size of any potential class, particularly when damages are not specified or are indeterminate, (iii) how the discovery process will affect the litigation, (iv) the settlement posture of the other parties to the litigation and (v) any other factors that may have a material effect on the litigation.
The Company records accruals for contingencies when it is probable that a liability has been incurred and the amount can be reasonably estimated. These accruals are adjusted periodically as assessments change or additional information becomes available. For product liability claims, a portion of the overall accrual is actuarially determined and considers such factors as past experience, number of claims reported and estimates of claims incurred but not yet reported. Individually significant contingent losses are accrued when probable and reasonably estimable. Legal defense costs expected to be incurred in connection with a loss contingency are accrued when probable and reasonably estimable.
The Company’s decision to obtain insurance coverage is dependent on market conditions, including cost and availability, existing at the time such decisions are made. The Company has evaluated its risks and has determined that the cost of obtaining product liability insurance outweighs the likely benefits of the coverage that is available and, as such, has no insurance for most product liabilities effective August 1, 2004.
Product Liability Litigation
Fosamax
As previously disclosed, Merck is a defendant in product liability lawsuits in the United States involving Fosamax (Fosamax Litigation). As of September 30, 2017, approximately 4,125 cases are filed and pending against Merck in either federal or state court. In approximately 15 of these actions, plaintiffs allege, among other things, that they have suffered osteonecrosis of the jaw (ONJ), generally subsequent to invasive dental procedures, such as tooth extraction or dental implants and/or delayed healing, in association with the use of Fosamax. In addition, plaintiffs in approximately 4,110 of these actions generally allege that they sustained femur fractures and/or other bone injuries (Femur Fractures) in association with the use of Fosamax.
Cases Alleging ONJ and/or Other Jaw Related Injuries
In August 2006, the Judicial Panel on Multidistrict Litigation (JPML) ordered that certain Fosamax product liability cases pending in federal courts nationwide should be transferred and consolidated into one multidistrict litigation (Fosamax ONJ MDL) for coordinated pre-trial proceedings.
In December 2013, Merck reached an agreement in principle with the Plaintiffs’ Steering Committee (PSC) in the Fosamax ONJ MDL to resolve pending ONJ cases not on appeal in the Fosamax ONJ MDL and in the state courts for an aggregate amount of $27.7 million. Merck and the PSC subsequently formalized the terms of this agreement in a Master Settlement Agreement (ONJ Master Settlement Agreement) that was executed in April 2014 and included over 1,200 plaintiffs. In July 2014, Merck elected to proceed with the ONJ Master Settlement Agreement at a reduced funding level of $27.3 million since the participation level was approximately 95%. Merck has fully funded the ONJ Master Settlement Agreement and the escrow agent under the agreement has been making settlement payments to qualifying plaintiffs. The ONJ Master Settlement Agreement has no effect on the cases alleging Femur Fractures discussed below.
Discovery is currently ongoing in some of the approximately 15 remaining ONJ cases that are pending in various federal and state courts and the Company intends to defend against these lawsuits.
Cases Alleging Femur Fractures
In March 2011, Merck submitted a Motion to Transfer to the JPML seeking to have all federal cases alleging Femur Fractures consolidated into one multidistrict litigation for coordinated pre-trial proceedings. The Motion to Transfer was granted in May 2011, and all federal cases involving allegations of Femur Fracture have been or will be transferred to a multidistrict litigation in the District of New Jersey (Femur Fracture MDL). In the only bellwether case tried to date in the Femur Fracture

- 16 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

MDL, Glynn v. Merck, the jury returned a verdict in Merck’s favor. In addition, in June 2013, the Femur Fracture MDL court granted Merck’s motion for judgment as a matter of law in the Glynn case and held that the plaintiff’s failure to warn claim was preempted by federal law. The Glynn decision was not appealed by plaintiff.
In August 2013, the Femur Fracture MDL court entered an order requiring plaintiffs in the Femur Fracture MDL to show cause why those cases asserting claims for a femur fracture injury that took place prior to September 14, 2010, should not be dismissed based on the court’s preemption decision in the Glynn case. Pursuant to the show cause order, in March 2014, the Femur Fracture MDL court dismissed with prejudice approximately 650 cases on preemption grounds. Plaintiffs in approximately 515 of those cases appealed that decision to the U.S. Court of Appeals for the Third Circuit (Third Circuit). The Femur Fracture MDL court has also dismissed without prejudice another approximately 510 cases pending plaintiffs’ appeal of the preemption ruling to the Third Circuit. On March 22, 2017, the Third Circuit issued a decision reversing the Femur Fracture MDL court’s preemption ruling and remanding the appealed cases back to the Femur Fracture MDL court. On April 5, 2017, Merck filed a petition seeking a rehearing on the Third Circuit’s March 22, 2017 decision, which was denied on April 24, 2017. Merck filed a petition for a writ of certiorari to the U.S. Supreme Court on August 22, 2017, seeking review of the Third Circuit’s decision.
In addition, in June 2014, the Femur Fracture MDL court granted Merck summary judgment in the Gaynor v. Merck case and found that Merck’s updates in January 2011 to the Fosamax label regarding atypical femur fractures were adequate as a matter of law and that Merck adequately communicated those changes. The plaintiffs in Gaynor did not appeal the Femur Fracture MDL court’s findings with respect to the adequacy of the 2011 label change but did appeal the dismissal of their case based on preemption grounds, and the Third Circuit subsequently reversed that dismissal in its March 22, 2017 decision. In August 2014, Merck filed a motion requesting that the Femur Fracture MDL court enter a further order requiring all plaintiffs in the Femur Fracture MDL who claim that the 2011 Fosamax label is inadequate and the proximate cause of their alleged injuries to show cause why their cases should not be dismissed based on the court’s preemption decision and its ruling in the Gaynor case. In November 2014, the court granted Merck’s motion and entered the requested show cause order. No plaintiffs responded to or appealed the November 2014 show cause order.
As of September 30, 2017, approximately 520 cases were pending in the Femur Fracture MDL following the reinstatement of the cases that had been on appeal to the Third Circuit. The 510 cases dismissed without prejudice that were also pending the final resolution of the aforementioned appeal have not yet been reinstated.
As of September 30, 2017, approximately 2,795 cases alleging Femur Fractures have been filed in New Jersey state court and are pending before Judge James Hyland in Middlesex County. The parties selected an initial group of 30 cases to be reviewed through fact discovery. Two additional groups of 50 cases each to be reviewed through fact discovery were selected in November 2013 and March 2014, respectively. A further group of 25 cases to be reviewed through fact discovery was selected by Merck in July 2015, and Merck has continued to select additional cases to be reviewed through fact discovery during 2016 and 2017.
As of September 30, 2017, approximately 280 cases alleging Femur Fractures have been filed and are pending in California state court. A petition was filed seeking to coordinate all Femur Fracture cases filed in California state court before a single judge in Orange County, California. The petition was granted and Judge Thierry Colaw is currently presiding over the coordinated proceedings. In March 2014, the court directed that a group of 10 discovery pool cases be reviewed through fact discovery and subsequently scheduled the Galper v. Merck case, which plaintiffs selected, as the first trial. The Galper trial began in February 2015 and the jury returned a verdict in Merck’s favor in April 2015, and plaintiff appealed that verdict to the California appellate court. Oral argument on plaintiff’s appeal in Galper was held in November 2016 and, on April 24, 2017, the California appellate court issued a decision affirming the lower court’s judgment in favor of Merck. The next Femur Fracture trial in California that was scheduled to begin in April 2016 was stayed at plaintiffs’ request and a new trial date has not been set.
Additionally, there are five Femur Fracture cases pending in other state courts.
Discovery is ongoing in the Femur Fracture MDL and in state courts where Femur Fracture cases are pending and the Company intends to defend against these lawsuits.
Januvia/Janumet
As previously disclosed, Merck is a defendant in product liability lawsuits in the United States involving Januvia and/or Janumet. As of September 30, 2017, Merck is aware of approximately 1,225 product user claims alleging generally that use of Januvia and/or Janumet caused the development of pancreatic cancer and other injuries. These complaints were filed in several different state and federal courts.
Most of the claims were filed in a consolidated multidistrict litigation proceeding in the U.S. District Court for the Southern District of California called “In re Incretin-Based Therapies Products Liability Litigation” (MDL). The MDL includes federal lawsuits alleging pancreatic cancer due to use of the following medicines: Januvia, Janumet, Byetta and Victoza, the latter two of which are products manufactured by other pharmaceutical companies. The majority of claims not filed in the MDL were filed in the Superior Court of California, County of Los Angeles (California State Court).

- 17 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

In November 2015, the MDL and California State Court - in separate opinions - granted summary judgment to defendants on grounds of preemption. Of the approximately 1,225 product user claims, these rulings resulted in the dismissal of approximately 1,175 product user claims.
Plaintiffs are appealing the MDL and California State Court preemption rulings.
As of September 30, 2017, seven product users have claims pending against Merck in state courts other than the California State Court, including four active product user claims pending in Illinois state court. On June 30, 2017, the Illinois court denied Merck’s motion for summary judgment on grounds of preemption. Merck has sought permission to appeal that order on an interlocutory basis and was granted a stay of proceedings in the trial court. As a result, trials for certain of the product users in Illinois have been delayed.
In addition to the claims noted above, the Company has agreed to toll the statute of limitations for approximately 50 additional claims. The Company intends to continue defending against these lawsuits.
Propecia/Proscar
As previously disclosed, Merck is a defendant in product liability lawsuits in the United States involving Propecia and/or Proscar. As of September 30, 2017, approximately 915 lawsuits have been filed by plaintiffs who allege that they have experienced persistent sexual side effects following cessation of treatment with Propecia and/or Proscar. Approximately 20 of the plaintiffs also allege that Propecia or Proscar has caused or can cause prostate cancer, testicular cancer or male breast cancer. The lawsuits have been filed in various federal courts and in state court in New Jersey. The federal lawsuits have been consolidated for pretrial purposes in a federal multidistrict litigation before Judge Brian Cogan of the Eastern District of New York. The matters pending in state court in New Jersey have been consolidated before Judge Hyland in Middlesex County. In addition, there is one matter pending in state court in California, one matter pending in state court in Ohio, and one matter on appeal in the Massachusetts Supreme Judicial Court. The Company intends to defend against these lawsuits.
Governmental Proceedings
In July 2017, the Company learned that the Prosecution Office of Milan, Italy is investigating interactions between the Company’s Italian subsidiary, certain employees of the subsidiary and certain Italian healthcare providers. The Company understands that this is part of a larger investigation involving engagements between various healthcare companies and those healthcare providers. The Company is cooperating with the investigation.
From time to time, the Company receives inquiries and is the subject of preliminary investigation activities from competition and other governmental authorities in markets outside the United States. These authorities may include regulators, administrative authorities, and law enforcement and other similar officials, and these preliminary investigation activities may include site visits, formal or informal requests or demands for documents or materials, inquiries or interviews and similar matters. Certain of these preliminary inquiries or activities may lead to the commencement of formal proceedings. Should those proceedings be determined adversely to the Company, monetary fines and/or remedial undertakings may be required.
Commercial and Other Litigation
K-DUR Antitrust Litigation
In June 1997 and January 1998, Schering-Plough Corporation (Schering-Plough) settled patent litigation with Upsher-Smith, Inc. (Upsher-Smith) and ESI Lederle, Inc. (Lederle), respectively, relating to generic versions of Schering-Plough’s long-acting potassium chloride product supplement used by cardiac patients, for which Lederle and Upsher-Smith had filed Abbreviated New Drug Applications (ANDAs). Putative class and non-class action suits were then filed on behalf of direct and indirect purchasers of K‑DUR against Schering-Plough, Upsher-Smith and Lederle and were consolidated in a multidistrict litigation in the U.S. District Court for the District of New Jersey. In February 2016, the court denied the Company’s motion for summary judgment relating to all of the direct purchasers’ claims concerning the settlement with Upsher-Smith and granted the Company’s motion for summary judgment relating to all of the direct purchasers’ claims concerning the settlement with Lederle.
As previously disclosed, in February 2017, Merck and Upsher-Smith reached a settlement in principle with the class of direct purchasers and the opt-outs to the class. Merck will contribute approximately $80 million in the aggregate towards the overall settlement. On April 5, 2017, the claims of the opt-outs were dismissed with prejudice pursuant to a written settlement agreement with those parties. On May 15, 2017, Merck and the class executed a settlement agreement, which received preliminary approval from the court on May 23, 2017. On October 5, 2017, the court entered a Final Judgment and Order of Dismissal approving the settlement agreement with the direct purchaser class and dismissing the claims of the class with prejudice.

- 18 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Patent Litigation
From time to time, generic manufacturers of pharmaceutical products file ANDAs with the U.S. Food and Drug Administration (FDA) seeking to market generic forms of the Company’s products prior to the expiration of relevant patents owned by the Company. To protect its patent rights, the Company may file patent infringement lawsuits against such generic companies. Certain products of the Company (or products marketed via agreements with other companies) currently involved in such patent infringement litigation in the United States include: Invanz, Noxafil, and NuvaRing. Similar lawsuits defending the Company’s patent rights may exist in other countries. The Company intends to vigorously defend its patents, which it believes are valid, against infringement by companies attempting to market products prior to the expiration of such patents. As with any litigation, there can be no assurance of the outcomes, which, if adverse, could result in significantly shortened periods of exclusivity for these products and, with respect to products acquired through acquisitions, potentially significant intangible asset impairment charges.
Invanz — In July 2014, a patent infringement lawsuit was filed in the United States against Hospira, Inc. (Hospira) in respect of Hospira’s application to the FDA seeking pre-patent expiry approval to market a generic version of Invanz. The trial in this matter was held in April 2016 and, in October 2016, the district court ruled that the patent is valid and infringed. In August 2015, a patent infringement lawsuit was filed in the United States against Savior Lifetec Corporation (Savior) in respect of Savior’s application to the FDA seeking pre-patent expiry approval to market a generic version of Invanz. The Company will lose the right to market exclusivity in the United States for Invanz on November 15, 2017.
Noxafil In August 2015, the Company filed a lawsuit against Actavis Laboratories Fl, Inc. (Actavis) in the United States in respect of that company’s application to the FDA seeking pre-patent expiry approval to sell a generic version of Noxafil. In October 2017, the district court held the patent valid and infringed. Actavis can appeal this decision. In March 2016, the Company filed a lawsuit against Roxane Laboratories, Inc. (Roxane) in the United States in respect of that company’s application to the FDA seeking pre-patent expiry approval to sell a generic version of Noxafil. In October 2017, the parties reached a settlement whereby Roxane can launch its generic version upon expiry of the patent, or earlier under certain conditions. In February 2016, the Company filed a lawsuit against Par Sterile Products LLC, Par Pharmaceutical, Inc., Par Pharmaceutical Companies, Inc. and Par Pharmaceutical Holdings, Inc. (collectively, Par) in the United States in respect of that company’s application to the FDA seeking pre-patent expiry approval to sell a generic version of Noxafil. In October 2016, the parties reached a settlement whereby Par can launch its generic version in January 2023, or earlier under certain conditions.
NuvaRing — In December 2013, the Company filed a lawsuit against a subsidiary of Allergan plc in the United States in respect of that company’s application to the FDA seeking pre-patent expiry approval to sell a generic version of NuvaRing. The trial in this matter was held in January 2016. In August 2016, the district court ruled that the patent was invalid and the Company appealed this decision. In October 2017, the appellate court reversed the district court decision and found the patent to be valid. Allergan may seek further review of this decision. In September 2015, the Company filed a lawsuit against Teva Pharma in the United States in respect of that company’s application to the FDA seeking pre-patent expiry approval to sell a generic version of NuvaRing. Based on its ruling in the Allergan plc matter, the district court dismissed the Company’s lawsuit in December 2016. The Company has appealed this decision and the matter is currently stayed.
Anti-PD-1 Antibody Patent Oppositions and Litigation
As previously disclosed, Ono Pharmaceutical Co. (Ono) has a European patent (EP 1 537 878) (’878) that broadly claims the use of an anti-PD-1 antibody, such as the Company’s immunotherapy, Keytruda, for the treatment of cancer. Ono has previously licensed its commercial rights to an anti-PD-1 antibody to Bristol-Myers Squibb (BMS) in certain markets. BMS and Ono also own European Patent EP 2 161 336 (’336) that, as granted, broadly claimed anti-PD-1 antibodies that could include Keytruda.
As previously disclosed, the Company and BMS and Ono were engaged in worldwide litigation, including in the United States, over the validity and infringement of the ’878 patent, the ’336 patent and their equivalents.
In January 2017, the Company announced that it had entered into a settlement and license agreement with BMS and Ono resolving the worldwide patent infringement litigation related to the use of an anti-PD-1 antibody for the treatment of cancer, such as Keytruda. Under the settlement and license agreement, the Company made a one-time payment of $625 million (which was recorded as an expense in the Company’s 2016 financial results) to BMS and will pay royalties on the worldwide sales of Keytruda for a non-exclusive license to market Keytruda in any market in which it is approved. For global net sales of Keytruda, the Company will pay royalties of 6.5% of net sales occurring from January 1, 2017 through and including December 31, 2023; and 2.5% of net sales occurring from January 1, 2024 through and including December 31, 2026. The parties also agreed to dismiss all claims worldwide in the relevant legal proceedings.

- 19 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Gilead Patent Litigation and Opposition
In August 2013, Gilead Sciences, Inc. (Gilead) filed a lawsuit in the U.S. District Court for the Northern District of California seeking a declaration that two Company patents were invalid and not infringed by the sale of their two sofosbuvir containing products, Sovaldi and Harvoni. The Company filed a counterclaim that the sale of these products did infringe these two patents and sought a reasonable royalty for the past, present and future sales of these products. In March 2016, at the conclusion of a jury trial, the patents were found to be not invalid and infringed. The jury awarded the Company $200 million as a royalty for sales of these products up to December 2015. After the conclusion of the jury trial, the court held a bench trial on the equitable defenses raised by Gilead. In June 2016, the court found for Gilead and determined that Merck could not collect the jury award and that the patents were unenforceable with respect to Gilead. The Company has appealed the court’s decision. Gilead has also asked the court to overturn the jury’s decision on validity. The court held a hearing on Gilead’s motion in August 2016, and the court subsequently rejected Gilead’s request. The Company will pay 20%, net of legal fees, of damages or royalties, if any, that it receives to Ionis Pharmaceuticals, Inc.
The Company, through its Idenix Pharmaceuticals, Inc. subsidiary, has pending litigation against Gilead in the United States, the UK, Norway, Canada, Germany, France, and Australia based on different patent estates that would also be infringed by Gilead’s sales of these two products. Gilead has opposed the European patent at the European Patent Office (EPO). Trial in the United States was held in December 2016 and the jury returned a verdict for the Company, awarding damages of $2.54 billion. The Company submitted post-trial motions, including on the issues of enhanced damages and future royalties. Gilead submitted post-trial motions for judgment as a matter of law. A hearing on the motions was held in September 2017. Also, in September 2017, the court denied the Company’s motion on enhanced damages, granted its motion on prejudgment interest and deferred its motion on future royalties. The Company is currently awaiting the court’s decision on Gilead’s post-trial motions for judgment as a matter of law. In Australia, the Company was initially unsuccessful and that case is currently under appeal. In Canada, the Company was initially unsuccessful and the Federal Court of Appeals has affirmed the lower court decision. The Company has sought leave to the Supreme Court of Canada for further review. In the UK and Norway, the patent was held invalid and no further appeal was filed. The EPO opposition division revoked the European patent, and the Company has appealed this decision. The cases in France and Germany have been stayed pending the final decision of the EPO.
Other Litigation
There are various other pending legal proceedings involving the Company, principally product liability and intellectual property lawsuits. While it is not feasible to predict the outcome of such proceedings, in the opinion of the Company, either the likelihood of loss is remote or any reasonably possible loss associated with the resolution of such proceedings is not expected to be material to the Company’s financial position, results of operations or cash flows either individually or in the aggregate.
Legal Defense Reserves
Legal defense costs expected to be incurred in connection with a loss contingency are accrued when probable and reasonably estimable. Some of the significant factors considered in the review of these legal defense reserves are as follows: the actual costs incurred by the Company; the development of the Company’s legal defense strategy and structure in light of the scope of its litigation; the number of cases being brought against the Company; the costs and outcomes of completed trials and the most current information regarding anticipated timing, progression, and related costs of pre-trial activities and trials in the associated litigation. The amount of legal defense reserves as of September 30, 2017 and December 31, 2016 of approximately $170 million and $185 million, respectively, represents the Company’s best estimate of the minimum amount of defense costs to be incurred in connection with its outstanding litigation; however, events such as additional trials and other events that could arise in the course of its litigation could affect the ultimate amount of legal defense costs to be incurred by the Company. The Company will continue to monitor its legal defense costs and review the adequacy of the associated reserves and may determine to increase the reserves at any time in the future if, based upon the factors set forth, it believes it would be appropriate to do so.


- 20 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

8.
Equity
 
  
Common Stock
Other
Paid-In
Capital
Retained
Earnings
Accumulated
Other
Comprehensive
Loss
 
Treasury Stock
Non-
Controlling
Interests
Total
($ and shares in millions)
Shares
Par Value
Shares
Cost
Balance at January 1, 2016
3,577

$
1,788

$
40,222

$
45,348

$
(4,148
)
796

$
(38,534
)
$
91

$
44,767

Net income attributable to Merck & Co., Inc.



4,515





4,515

Other comprehensive loss, net of taxes




(104
)



(104
)
Cash dividends declared on common stock



(3,835
)




(3,835
)
Treasury stock shares purchased





44

(2,418
)

(2,418
)
Share-based compensation plans and other


(325
)


(25
)
1,235


910

Changes in noncontrolling ownership interests







124

124

Net income attributable to noncontrolling interests







13

13

Distributions attributable to noncontrolling interests







(15
)
(15
)
Balance at September 30, 2016
3,577

$
1,788

$
39,897

$
46,028

$
(4,252
)
815

$
(39,717
)
$
213

$
43,957

Balance at January 1, 2017
3,577

$
1,788

$
39,939

$
44,133

$
(5,226
)
828

$
(40,546
)
$
220

$
40,308

Net income attributable to Merck & Co., Inc.



3,440





3,440

Other comprehensive income, net of taxes




281




281

Cash dividends declared on common stock



(3,872
)




(3,872
)
Treasury stock shares purchased





36

(2,312
)

(2,312
)
Share-based compensation plans and other


(116
)


(13
)
739


623

Acquisition of Vallée







25

25

Net income attributable to noncontrolling interests







16

16

Distributions attributable to noncontrolling interests







(10
)
(10
)
Balance at September 30, 2017
3,577

1,788

39,823

43,701

(4,945
)
851

(42,119
)
251

38,499

9.
Share-Based Compensation Plans
The Company has share-based compensation plans under which the Company grants restricted stock units (RSUs) and performance share units (PSUs) to certain management level employees. In addition, employees and non-employee directors may be granted options to purchase shares of Company common stock at the fair market value at the time of grant.
The following table provides the amounts of share-based compensation cost recorded in the Condensed Consolidated Statement of Income:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
($ in millions)
2017
 
2016
 
2017
 
2016
Pretax share-based compensation expense
$
76

 
$
77

 
$
232

 
$
225

Income tax benefit
(23
)
 
(24
)
 
(70
)
 
(69
)
Total share-based compensation expense, net of taxes
$
53

 
$
53

 
$
162

 
$
156

During the first nine months of 2017 and 2016, the Company granted 5 million RSUs with a weighted-average grant date fair value of $63.96 per RSU and 6 million RSUs with a weighted-average grant date fair value of $54.61 per RSU, respectively. During the first nine months of 2017 and 2016, the Company granted 4 million stock options with a weighted-average exercise price of $63.96 per option and 6 million stock options with a weighted-average exercise price of $54.62 per option, respectively. The weighted-average fair value of options granted for the first nine months of 2017 and 2016 was $7.04 and $5.89 per option, respectively, and was determined using the following assumptions:
  
Nine Months Ended 
 September 30,
 
2017
 
2016
Expected dividend yield
3.6
%
 
3.8
%
Risk-free interest rate
2.0
%
 
1.4
%
Expected volatility
17.8
%
 
19.6
%
Expected life (years)
6.1

 
6.2


- 21 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

At September 30, 2017, there was $549 million of total pretax unrecognized compensation expense related to nonvested stock options, RSU and PSU awards which will be recognized over a weighted-average period of 2.1 years. For segment reporting, share-based compensation costs are unallocated expenses.
10.
Pension and Other Postretirement Benefit Plans
The Company has defined benefit pension plans covering eligible employees in the United States and in certain of its international subsidiaries. The net periodic benefit cost (credit) of such plans consisted of the following components: 
  
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2017
 
2016
 
2017
 
2016
($ in millions)
U.S.
 
International
 
U.S.
 
International
 
U.S.
 
International
 
U.S.
 
International
Service cost
$
80

 
$
66

 
$
66

 
$
59

 
$
234

 
$
189

 
$
212

 
$
179

Interest cost
114

 
44

 
116

 
51

 
341

 
127

 
342

 
155

Expected return on plan assets
(210
)
 
(101
)
 
(203
)
 
(95
)
 
(646
)
 
(292
)
 
(623
)
 
(288
)
Amortization of unrecognized prior service credit
(13
)
 
(3
)
 
(14
)
 
(3
)
 
(40
)
 
(8
)
 
(41
)
 
(9
)
Net loss amortization
46

 
25

 
32

 
21

 
135

 
72

 
89

 
64

Termination benefits
3

 
1

 
6

 
1

 
11

 
2

 
11

 
2

Curtailments
4

 
(1
)
 
3

 
(2
)
 
8

 
(1
)
 
3

 
(1
)
 
$
24

 
$
31

 
$
6

 
$
32

 
$
43

 
$
89

 
$
(7
)
 
$
102

The Company provides medical benefits, principally to its eligible U.S. retirees and similar benefits to their dependents, through its other postretirement benefit plans. The net cost (credit) of such plans consisted of the following components: 
  
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
($ in millions)
2017
 
2016
 
2017
 
2016
Service cost
$
15

 
$
14

 
$
43