Teri Loxam - Merck & Co., Inc. Kenneth C. Frazier - Merck & Co., Inc. Robert M. Davis - Merck & Co., Inc. Adam H. Schechter - Merck & Co., Inc. Roger M. Perlmutter - Merck & Co., Inc..

Timothy Minton Anderson - Sanford C. Bernstein & Co. LLC Colin N. Bristow - Bank of America Merrill Lynch Geoff Meacham - Barclays Capital, Inc. Andrew S. Baum - Citigroup Global Markets Ltd. Vamil K. Divan - Credit Suisse Securities (USA) LLC (Broker) Seamus Fernandez - Leerink Partners LLC Gregg Gilbert - Deutsche Bank Securities, Inc.

John Scotti - Evercore ISI David R. Risinger - Morgan Stanley & Co. LLC Jami Rubin - Goldman Sachs & Co. John T. Boris - SunTrust Robinson Humphrey, Inc. Christopher Schott - JPMorgan Securities LLC Tony Butler - Guggenheim Partners.

Good morning. My name is Darla and I will be your conference operator today. At this time, I'd like to welcome everyone to Merck's Q3 2016 Sales and Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you.

I would now like to turn the call over to Teri Loxam. Please go ahead..

Thank you, Darla, and good morning. Welcome to Merck's third quarter 2016 conference call. Today I'm joined by Ken Frazier, our Chairman and Chief Executive Officer; Rob Davis, our Chief Financial Officer; Adam Schechter, President of Global Human Health; and Dr. Roger Perlmutter, President of Merck Research Labs.

Before I turn the call over to Ken, I'd like to point out a few items. You will see that we have items in our GAAP results such as acquisition-related charges, restructuring costs and certain other items. You should note that we have excluded these from our non-GAAP results and provide a reconciliation of these in our press release.

We've also provided a table in our press release to help you understand the sales in the quarter for the business units and products. I'd like to remind you that some of the statements that we make during today's call may be considered forward-looking statements within the meaning of the Safe Harbor provision of the U.S.

Private Securities Litigation Reform Act of 1995. Such statements are made based on the current beliefs of Merck's management and are subject to significant risks and uncertainties. If our underlying assumptions prove inaccurate or uncertainties materialize, actual results may differ materially from those set forth in the forward-looking statements.

Our SEC filings including item 1A in the 2015 10-K identify certain risk factors and cautionary statements that could cause the company's actual results to differ materially from those projected in any of our forward-looking statements made this morning.

Merck undertakes no obligation to publicly update any forward-looking statements and you can see our SEC filings as well as today's earnings release on Merck.com. With that, I'd like to turn the call over to Ken..

Thank you, Teri. Good morning, everyone. Thank you for joining us on the call today.

Before we discuss our results for the quarter, I would like to take a moment to reflect on the recent ESMO Congress where the latest data were presented from our KEYTRUDA, clinical development program for lung cancer, and simultaneously published in two major scientific journals.

Many have noted the significant implications these results may have for the treatment of lung cancer, the deadliest type of cancer in the United States.

And just yesterday, the FDA approved KEYTRUDA the only PD-1 therapy for the first line treatment of metastatic lung cancer making it an option for tens of thousands of lung cancer patients in the United States. For the first time in decades, the standard of care may change for lung cancer patients offering them renewed hope.

This advancement is what Merck is all about and we are honored to be making a real difference in the fight against cancer. The recent KEYTRUDA achievements are proof of concept, if you will, that our innovation strategy is working.

Our sustained investment in medically important R&D has yielded a number of recent approvals in regulatory milestones across the various therapeutic areas in our human health and animal health businesses. Turning now to the results.

In the third quarter, we reported a strong performance that reflects growth across several priority programs, including our vaccines portfolio and also KEYTRUDA and ZEPATIER which are continuing to launch around the world.

We remain confident in the strength of our portfolio from our JANUVIA franchise which is core to our business and continues to maintain its leadership position in the DPP-4 class to BRIDION, which is quickly contributing to our growth, while still in the launch phase here in the United States.

Looking ahead, we will continue to follow the science, pursuing the best internal and external scientific opportunities that will enable us to take on some of the world's greatest health challenges. That is why business development remains an important priority in achieving our goals. Our appetite for business development has not changed.

We continue to seek the best opportunities and collaborations with the right financial valuation to augment our portfolio and pipeline.

In closing, our performance in the quarter positions us well to continue to invest in our business and to deliver a balanced, differentiated portfolio of medicines and vaccines that will generate long-term growth and sustainable value for shareholders and society. And now I'd like to turn the call over to Rob..

Thanks, Ken, and good morning, everyone. As Ken noted, in the third quarter we delivered solid sales and earnings growth on both a nominal and ex-FX basis. Total company revenues were $10.5 billion, an increase of 5% year-over-year. Excluding the impact of exchange, revenue increased 6%.

Our Human Health and Animal Health businesses contributed 6% and 7% growth respectively, excluding exchange in the quarter and despite an approximately $170 million headwind from sales in Venezuela in the third quarter of 2015.

As a reminder, we went to the SIMADI rate in the fourth quarter of 2015, so this is the last quarter in which we will face this headwind. I should note that the year-over-year increase in Human Health sales in the third quarter includes an approximately $200 million benefit from the pull-forward of customer purchases from the fourth quarter.

These were mainly due to the timing of shipments in Japan in anticipation of an ERP go-live and the timing of CDC vaccine purchases. Taking into account our performance in the first three quarters of 2016 and our expectations through year-end, we are narrowing and raising our full-year revenue guidance to $39.7 billion to $40.2 billion.

We continue to anticipate foreign exchange will have an approximately 2 percentage point negative impact on revenue in 2016. Looking to the other parts of the P&L, non-GAAP gross margin was 75.3%, an increase of 20 basis points. Product mix was the primary driver of the increase versus the prior year.

For the full year, we continue to expect non-GAAP gross margin to be roughly flat versus last year with margins in the fourth quarter expected to be lower on a year-over-year basis as we see the mix impact of generic competition for CUBICIN and ZETIA in the U.S. market and declines in FX hedge gains year-on-year which flow 100% to gross margin.

Non-GAAP operating expenses of $4 billion were roughly flat versus the third quarter of 2015 as declines in marketing and administrative expenses largely offset an increase in research and development expenses in the quarter.

While we are committed to delivering a leveraged P&L over the long-term, it may be more challenging in the near-term, given the impending loss of market exclusivity for ZETIA and VYTORIN in the U.S. and investments that we need to make to support the growing opportunity for KEYTRUDA.

That being said, we remain disciplined and continue to look for opportunities to reallocate resources across the portfolio. Our non-GAAP effective tax rate was 23.8% this quarter. We expect the full-year rate to trend to the higher end of our previously communicated range of 21.5% and 22.5% which includes the impact of the R&D tax credit.

Taken together, we earned $1.07 per share on a non-GAAP basis, delivering 11% growth versus the prior year. Excluding the impact of foreign exchange, non-GAAP EPS increased 8%. Of the $0.11 increase in non-GAAP EPS this quarter compared to Q3 2015, approximately $0.04 were related to the customer purchases in Japan that I mentioned earlier.

On a GAAP basis, we earned $0.78 this quarter. Given our results in the first nine months of the year, we are also narrowing and raising our full-year non-GAAP EPS range. We now expect to earn $3.71 to $3.78 per share with foreign exchange still expected to have an approximately one percentage point negative impact.

On a GAAP basis, we now expect to earn $2.02 to $2.09 per share for the full year. Altogether, our top and bottom-line growth in the quarter, driven by solid operational performance, sets us up for a strong 2016 overall. With that, I will turn the call over to Adam..

Thank you, Rob, and good morning, everyone. This morning I'll provide highlights in the performance of Global Human Health for the third quarter, and my comments will be on a constant currency basis. Global Human Health delivered another strong quarter with sales of $9.4 billion or an increase of 6%.

We drove growth across many of our core areas including oncology, vaccines and hospital and specialty care. I'll highlight now a few of our key franchises and product launches and I'll start with oncology. We continued to execute on a launch of KEYTRUDA and we are excited by the long-term potential for this important brand.

KEYTRUDA generated $356 million in sales in the third quarter with about half of the sales generated outside of the United States. In the U.S., sales were driven primarily from melanoma where KEYTRUDA continues to be the leading immuno-oncology therapy, as well as from the ongoing launch in second-line lung cancer.

In August, we also gained approval for recurrent or metastatic head and neck cancer and we began to launch that indication immediately. This represents the first new treatment option for these patients in almost a decade.

In addition, and very importantly, we are ready to launch in first-line lung cancer where we just received FDA approval for the high PD-L1 expressing patients, those who express PD-L1 greater than or equal to 50%.

We know from several data sources including our own clinical trials that this patient population represents about 25% to 30% of non-small cell lung cancer patients. In addition, we received expanded labeling for second-line lung cancer based upon our KEYNOTE-010 data.

So now, patients that express any level of PD-L1 are eligible for KEYTRUDA in a second-line setting. Based upon these two new patient populations for KEYTRUDA in lung cancer, we have already begun to see an acceleration of testing for PD-L1 at diagnosis.

Outside of the United States, we've launched our melanoma indication in more than 50 markets and we continue to see broad adoption of KEYTRUDA as a leading metastatic melanoma treatment. We've also recently gained EMA approval in second-line lung cancer for all PD-L1 positive patients.

We're working through the reimbursements process in each country which, as you know, can take some time. But we expect that we'll start to ramp up nicely in Europe once reimbursement comes through. In addition, we're preparing for the upcoming launch of KEYTRUDA in Japan where we recently received an indication for melanoma.

While we've already achieved a number of milestones for KEYTRUDA, this is just the beginning. We remain dedicated to establishing KEYTRUDA as the leader in lung cancer. In addition, we are very optimistic about the long-term potential for KEYTRUDA across many different tumor types. Moving now to primary care.

The JANUVIA franchise generated sales of almost $1.6 billion this quarter, a 2% decline compared to the same quarter last year. Outside of the United States, we saw strong growth of 9%.

This included favorable impact of about $30 million from the timing of customer purchases in Japan, which was offset by an unfavorable impact of roughly the same magnitude from sales in Venezuela. In the U.S., we saw a decline of 10%, which was anticipated given the tough comparison to third quarter of 2015, where we saw a large buy-in.

TRx trends remain strong in the United States with growth of 4%, and JANUVIA continues to be the leading DPP-4 treatment of choice in the market. We expect revenue growth in the United States in the fourth quarter of this year versus fourth quarter of 2015.

Formulary discussions for 2017 are nearly complete and we expect similar access in the United States for JANUVIA to what we've had this year.

We've seen and expect to continue to see increased pricing pressure in the United States for JANUVIA but we are pleased by the continued strong volume growth, and thus far, we've been able to offset most of the pricing pressures. We remain confident in our diabetes franchise and we're pleased with our continued strength in this brand globally.

Now moving to our vaccine business. We had another strong quarter with sales of $2 billion or 27% growth. The increase was primarily driven by GARDASIL, pediatric vaccines and PNEUMOVAX. GARDASIL sales were $860 million globally, a 38% increase versus last year.

In the United States, GARDASIL sales grew 33% driven by the timing of public sector purchases but also higher demand. On October 7, the FDA approved a two-dose regimen for 9 to 14-year-olds, and just last week, ACIP voted to recommend two doses for certain of these patients.

This is aligned with the dosing already adopted in some markets outside of the U.S. And it will have a negative impact on sales for GARDASIL moving forward. PNEUMOVAX delivered another strong quarter with 24% growth versus prior year.

The United States growth was primarily driven by demand with better follow-through from ACIP recommendations for patients 65 and above to receive PNEUMOVAX one year after Prevnar. Outside of the U.S., growth was largely driven by Japan. Finally, in hospital and specialty care, sales grew 5% to $2.2 billion.

Growth in acute care and contributions from launch products were partially offset by declines in REMICADE. REMICADE sales were down 28% this quarter as tenders and new patient starts increasingly go to biosimilars. We expect the declines in REMICADE to continue given the competitive pressures, but also increased switching. Now moving to ZEPATIER.

We are encouraged by the progress we are making in the first year of launch. ZEPATIER's product profile and positioning are resonating well with both healthcare professionals and payers. As we continued to communicate last quarter, we have seen some early wins in both the public and private sectors for 2016 and 2017.

This includes priority access in the VA, favorable access within the Medicaid segment and key wins in the Medicare Part D and commercial segments. It is important to note though, that some of our major formulary wins had effective dates of either July 1 of this year or January 1 of next year.

So we don't expect to see the full effect of these wins immediately. Given the time it takes from formulary success to getting patients on drug, we're only just beginning to see the impact from those plans that became effective this summer. We are also looking forward to launching ZEPATIER in Japan this quarter where it was recently approved.

On the hospital side, we had a stronger-than-expected quarter with CUBICIN as generics only entered the market at the end of the quarter. Now that there are two generics in the market, we experienced a decline for CUBICIN which appears to be similar to fast erosion rates that we've seen for other hospital products once generics launched in the U.S.

Finally, BRIDION had another good quarter with almost 50% growth driven by strong demand across ex-U.S. markets as well as a good ramp-up in the U.S. following our launch earlier this year. While Japan is currently our largest market in the world, over time we believe that the U.S. market will become the biggest for BRIDION.

In closing, we continue to deliver solid performance across many products. We have good momentum and good execution across our core focus areas. And although we'll have to contend with the ZETIA and VYTORIN patent expiry in fourth quarter of this year into next year, we believe we are well positioned for the long term.

With that, I'll turn the call over to Roger..

ZERBAXA, for the treatment of hospital-acquired pneumonia; relebactam to broaden the spectrum of our antibiotic, PRIMAXIN; and doravirine, a non-nucleosidal HIV reverse transcriptase inhibitor, with what we believe to be improved characteristics versus currently available therapies.

As Adam mentioned, we continue to demonstrate impressive activity for ZEPATIER, our hepatitis C virus therapy, including in patients known to have used intravenous drugs.

We're also making progress in advancing our triplet therapy for HCV infection, with presentations describing the efficacy of this combination across genotypes to be presented at the upcoming AASLD meeting. But much of the excitement during the past quarter focused on KEYTRUDA, our PD-1 specific antibody for the treatment of malignant disease.

As Ken and Adam mentioned, the FDA has just announced an updated label for KEYTRUDA which includes our KEYNOTE-010 study demonstrating that KEYTRUDA is superior to traditional chemotherapy in the second-line treatment of patients with metastatic non-small cell lung cancer, including those patients whose tumors expressed PD-L1 in as few as 1% of cells.

The revised label also includes our KEYNOTE-024 study which was presented at the European Society for Medical Oncology meetings earlier this month and simultaneously published in the New England Journal of Medicine.

In brief, KEYNOTE-024 was a randomized active comparator controlled Phase III study demonstrating that KEYTRUDA, when used for the first-line treatment of patients with metastatic, non-small cell lung cancer whose tumors express high levels of PD-L1 and who lack mutations in the EGF receptor or ALK genes, is superior to traditional platinum-based chemotherapy of the type that has been the standard of care in this disease for more than two decades.

These data are important because KEYTRUDA treatment, at a fixed dose of 200 milligrams every three weeks, reduced the risk of tumor progression or death by 50% and reduced the overall risk of death by 40%. Moreover, KEYTRUDA treatment was associated with a lower rate of serious adverse effects than was observed in the chemotherapy treatment arm.

We believe, as Bruce Johnson suggested in an accompanying editorial in the New England Journal of Medicine, that KEYTRUDA will come to represent a new standard of care for appropriate lung cancer patients whose tumors express high levels of PD-L1, a population that represents between 25% to 30% of those presenting with advanced non-small cell lung cancers.

Also in the third quarter, we received approval for the use of KEYTRUDA in lung cancer in the European Union, again based on our KEYNOTE-010 data. Review of the KEYNOTE-024 study is ongoing by the Committee for Human Medical Products (sic) [Committee for Medicinal Products for Human Use] for the European Medicines Agency.

Beyond these very important results, during the third quarter we also obtained data from our KEYNOTE-021 and cohort G study demonstrating that KEYTRUDA can be used in combination with traditional platinum doublet-based chemotherapy to yield objective response rates far superior to what we've seen with chemotherapy alone.

In this study, patients with metastatic, non-squamous, non-small cell lung cancer whose tumors expressed any level of PD-L1 were enrolled provided they lacked EGF receptor or ALK gene mutations. Progression pre-survival nearly doubled in the KEYTRUDA-containing treatment arm. The results of this study were published simultaneously in Lancet Oncology.

While this was a Phase II study in a relatively small cohort, including just 123 patients, the results complement an earlier single-arm study employing the same combination regimen which we presented at the American Society for Clinical Oncology in June.

Patients in that cohort achieved an objective response rate of 71% and the objective response rate was 55% in cohort G.

Hence, there is reason to believe that combinations of traditional chemotherapeutic agents, perhaps acting through an immune activation mechanism, will work in concert with KEYTRUDA to provide superior responses in advanced lung cancer patients in the future.

Additional confirmatory studies, including our KEYNOTE-189 and KEYNOTE-407 studies, are already underway.

Finally, last week we announced that the independent data monitoring committee supervising our KEYNOTE-045 study in second-line urothelial cancer involving patients with relapsed or refractory bladder or related uroepithelial cancer, recommended that the study be stopped on the basis of improved overall survival in the KEYTRUDA treatment arm.

KEYNOTE-045 is a Phase III, active comparator-controlled, monotherapy study in a very sick patient population; however, the results obtained in this setting mimic results from the first-line KEYNOTE-052 study that we presented at the European Society for Medical Oncology meeting earlier this month, which showed impressive response rates in the treatment of urothelial malignancy.

In sum, KEYTRUDA is changing the cancer treatment landscape. Already approved for the treatment of advanced melanoma, second-line non-small cell lung cancer, first-line non-small cell lung cancer and squamous cell carcinoma of the head and neck for which we obtained FDA approval in August.

We have obtained what we believe to be registration-worthy data in urothelial cancer, have more than 30 registration-appropriate studies underway, have developed data supporting the activity of KEYTRUDA in 22 different malignancies and have more than 360 clinical studies currently underway, including more than 200 combination studies evaluating responses in more than 30 different tumor types.

Needless to say, we anticipate additional regulatory filings in the fourth quarter and of course in 2017. Finally, I note that we're making good progress in our diabetes programs. Our insulin glargine filing was accepted for review by the FDA.

And with our colleagues at Pfizer, we expect to file for approval of ertugliflozin as monotherapy and as a fixed-dose combination with metformin or with sitagliptin before the end of the year. Now I'll turn the call back to Teri..

Thanks, Roger. Darla, we're going to get onto our Q&A process. Analysts, if you'll please limit your questions to one or two so that we can get as many questions in as possible, that would be appreciated. Darla, over to you..

Thank you. Your first question is from Tim Anderson with Bernstein..

Thank you. Couple of questions. On business development, you mentioned it remains an important priority. It's a message you've had throughout the year. Two questions on this. I'm wondering how the news of August 5 had suddenly changed the outlook for KEYTRUDA, might change how you think about M&A.

You could argue that doing a bigger deal now runs a risk of disrupting the focus that you'll need on immuno-oncology for example.

And kind of related to that, can you give us some idea of the upper limit to deals you might be considering? Is everything on the table? Are you looking more at mid-sized deals or smaller? And then second question is on KEYTRUDA and IDO and the timing for making a possible go, no go decision for Phase III in lung cancer.

Is that something that we would learn about maybe in the next six months or so?.

Good morning, Tim. Ken Frazier here. Let me start on the business development question. So I said that it remains an important priority, and you should know we're actively engaged and looking for ways of augmenting our pipeline. And in so doing, it's important to remember that we are not limited by size or by phase.

We're going to continue to look for the best partnerships and collaborations. But fundamentally, we're looking for bolt-on opportunities as a company. Your question about whether or not KEYTRUDA changes our approach to business development, not really. We need to augment our pipeline. We continue to be active in that area.

But I would not say that the August 5 news has changed our fundamental approach to business development..

And, Tim, it's Roger. With respect to IDO1 and decision-making in lung, we continue to pursue the melanoma study with our colleagues at Incyte, and we are very interested in the IDO1 combination. As we develop more data for that, we'll be able to make a decision. And your timeframe is probably about right.

I can't say specifically because these are event-driven studies. But sometime I would imagine towards the middle of next year we'd be in a position where we'd be able to make decisions about how much activity we're seeing and whether or not we should proceed in a registration-enabling study using that molecule..

Thank you..

Thanks, Roger. Darla, next question, please..

It's from Colin Bristow, Bank of America Merrill Lynch..

Good morning, and thanks for taking the questions, and congrats on the quarter. So first on KEYTRUDA in lung, clearly you're going to be a lone and dominant player in first-line for the next 18 months.

But how do you view the level of competitive threats from Bristol and Astra's IO-IO combos? And then just what are the combinations you are evaluating which you're most excited about in terms of the potential in the lung setting? And then second on KEYTRUDA's share in second-line lung, can you just talk about how much of a headwind to sales your requirement for PD-L1 testing has been and then what your expectations are for share sales in this setting, given the testing's now going to become standard? Thanks..

Yeah, so let me start. First of all, we are thrilled to be the first to launch in first line lung. And I give Roger and his team a lot of credit for the design of the trials and the ability for us to actually be the first to have approval there. We are always looking at competition. We are always mindful of competition.

And we want to make sure that we do everything we can to get as much utilization, appropriate utilization obviously, for the indication that we have, as quickly as possible and to really cement our product, KEYTRUDA, as foundational in the treatment of first-line lung cancer.

With regard to second-line lung, right now we have about a 10% market share of the second-line lung market in the United States. But if you look at patients that have PD-L1 greater than or equal to 50, that's where the majority of our market share is. And our market share is much, much higher in that group.

With the new data that we have in first-line lung and a new indication, there's no doubt that PD-L1 testing will become standard. We're already seeing very significant increases in PD-L1 testing since the ESMO meeting. So I believe that the barrier of needing to be tested in second line for PD-L1 will be removed to a very large degree.

And the fact that we now have an indication for all PD-L1 positive patients in the second-line setting, I believe that we should be a leader in not just first line, but second-line as well over time..

And, Colin, it's Roger. Standing back from this, I think one has to be impressed by the general efficacy of combinations of KEYTRUDA with other agents. And that's true with respect to PD-1 blockade and other agents pre-clinically, but also clinically.

So if you look at combinations, for example, with immune-active agents like T-VEC, there's impressive evidence of activity. There's evidence of activity with other immunologic agents, but there's also, as we've talked about, very impressive combination activity with chemotherapy.

And in a way, the 021G results in lung cancer basically put a floor on what to expect from these combinations. At a minimum, you're going to have to see the kinds of response rates and progression-free survival results that we've seen in 021G.

Keep in mind, that study, as you know, is just 123 patients and nevertheless a highly significant result with respect to progression-free survival. Over time, we'll see if an overall survival result is obtained there. Of course the crossover is so large in those populations, it may not be possible to see it.

But I think that there is reason to believe that KEYTRUDA can be used in combination with a lot of things, and oncologists have a lot of experience using traditional cytotoxic chemotherapy. So there's reason to believe that those kinds of combinations will work well.

That said, one shouldn't discount other kinds of immunologic combinations, including combinations with CTLA-4 directed agents. We've done those studies and shown that there is activity for those combinations. The question is ultimately what provides the best balance in terms of therapeutic efficacy and safety and tolerability? It's early days.

It will take some time to sort that out, but we'll be pursuing all of those things. And we are..

Great. Next question, please, Darla..

It's from Geoff Meacham with Barclays..

Morning, guys, and thanks for taking the question. I have a couple related ones. Payer question on first-line lung. So what limitations would you guys expect on both duration or patients below the 50% cut point? Are there lessons to be learned from the second-line experience? And then, Roger, you mention crossover.

So, some have talked about the lower rate of crossover for 024 as being a major contributor to the OS benefit. Just want to get your perspective on this with an eye towards the crossover rates that we could see in 189 or 407. Thanks..

Yeah, Geoff. So this is Adam. First of all, if you look at payers in first-line lung, we haven't seen any limitations on duration, and I don't think we'll see any limitations. With regard to people below PD-L1 greater than or equal to 50, we'll have to see what happens there.

What we've seen in second-line is as long as they're PD-L1 positive that the payers are not pushing back very much on the physicians. So the physicians still have a lot of control if they're PD-L1 positive. I would assume it'll be the same in lung for first-line, but it's obviously early to tell..

And, Geoff, it's Roger. With respect to crossover, clearly, if you have 100% crossover and it occurs early, then you're simply testing the treatment a few weeks apart, and under those circumstances, it's unlikely you'd be able to demonstrate an overall survival benefit.

That said, patients in a chemotherapy-controlled study – chemotherapy does have effect, and so crossover tends to occur later as a result. And under those circumstances, it will be possible to demonstrate an overall survival effect.

It's a fairly complicated set of differential equations one would have to apply to this to understand exactly what the puts and takes are. But my guess is that because the treatment effects seem to be really quite large in the 024 study, my guess is that we'll be able to see those kinds of treatment effects as well in the chemotherapy combinations.

Time will tell..

Thanks. Darla, next question, please..

It's from Andrew Baum with Citi..

Hello?.

Hi, Andrew..

Good morning..

Good morning.

Just following on from the earlier question, could you just update us in relation to your collaboration with NanoString in terms of when this could be an approvable diagnostic that could drive broader usage in patients who may not have the higher expression levels of PD-L1?.

Right, Andrew. So the collaboration with NanoString is designed to obtain better, really better diagnostic mechanisms because we know that PD-L1 expression is an imperfect biomarker. That said, the NanoString test does not exclude PD-L1 expression.

PD-L1 expression is an indicator of an inflammatory response because the PD-L1 transcriptional unit is under the control of cytokines like gamma interferon, and wherever there's an immune response, you'll see PD-L1 up-regulation. Much of the NanoString signature involves other genes that are similarly regulated.

So it isn't the case that the NanoString test will look totally different from a PD-L1 test. It will just have a better receiver-operator characteristics so that you will have better sensitivity and specificity. So I guess we continue to refine that signature.

It's working quite well actually, but it'll take a while before we can actually reduce it in practice..

Next question, please, Darla?.

It's from Vamil Divan with Credit Suisse..

Hi. Thanks so much for taking my questions. I appreciate the comments you made in the prepared remarks about the leverage and it may take time given the investment.

Can you just maybe give a little more color? We get a lot of questions on how to think about 2017 versus 2016, and I know you're not ready to give guidance, but just would you expect any degree of margin expansion as we look at this point on how 2017 would look relative to this year?.

Yeah, no..

If I could just throw one second question in, this is actually, maybe just moving away from KEYTRUDA now. There's a lot of great news there.

Just beyond KEYTRUDA and everything you're working on there in oncology, maybe, Roger, if you could just highlight what are the other key pipeline assets that you think people may be overlooking? I know obviously you have the base and the CTP coming out next year, but I think people view those as higher risk.

So are there other ones that you could point to that people should keep an eye out to think about diversification beyond KEYTRUDA? Thanks..

Yeah, Vamil. This is Rob. Thanks for the question. Obviously we're not in a position to give guidance for 2017 this morning, but just directionally, as I said in the prepared comments, we're moving into a period where we will have the pressure from ZETIA VYTORIN coming.

And that being said, we have the growing opportunity clinically we see with KEYTRUDA, and that's why we made the specific comments we did, which is while we remain committed to leverage long term, we recognize that in specific periods we may not be able to achieve that given the level of investment we need to make in R&D and the cost we've already taken out elsewhere in the organization.

So more to come as we get through the next quarter and we give specific guidance. But that was the purpose of the comment I made in the prepared remarks, to highlight what we see as a great opportunity with KEYTRUDA, and we're going to invest behind it appropriately..

And, Vamil, with respect to key pipeline assets, obviously all the Phase III programs and those that are proceeding through registration investors are aware of.

We're very excited about the work that we're doing overall in infectious diseases which includes the antibacterial programs, as I mentioned, relebactam of course pretty interesting, and doravirine in the HIV area. We actually have quite a large HIV program which is pretty exciting, and obviously the HCV program and triplet data are very important.

And beyond that, of course, the ertu [ertugliflozin] filing with our colleagues at Pfizer. Given our traditional strength now in diabetes and the opportunity to combine a really very well-behaved SGLT-2 inhibitor with JANUVIA, that can be an important opportunity as well.

Nothing there that investors necessarily have missed, but I think important things to pay attention to. Early in the pipeline, there's an awful lot going on, but time doesn't permit me to really review that stuff..

Thanks. Next question, please, Darla..

It's from Seamus Fernandez with Leerink..

Oh, thanks for the questions. So couple of quick ones.

First off, can you talk to us a little bit how the PD-L1 testing dynamic is actually shaking out percentage of basically lung cancer patients that are being tested with PD-L1 today? And where do you see that sort of maxing out in the next 12 months or so? And maybe can you give us a little bit of a sense of where you're seeing the majority of that uptake? Is it really starting at the academic hospitals or are the academic hospitals relatively fully penetrated and then the community's going to take a bit longer? Just trying to get a better sense of how the PD-L1 testing dynamic works.

And then secondly, how do the tests actually come back, and in what timeframe? Maybe you can just help us understand what information is provided to the physician when they request a PD-L1 test and how that information come backs? And then a last question is biosimilars.

Can you just give us a sense of how you are thinking about the opportunity for biosimilars for Merck specifically? And how you would encourage investors to think about that? Thanks so much..

Okay. So let me address the questions on PD-L1 testing. I'll focus first on the U.S. because the dynamics are a little bit different in some other markets in the world. In the United States, about 60% of physicians are testing PD-L1. This was prior to ESMO. We don't have any new data on that percentage after ESMO.

At the same time, we estimated that about 40% of non-small cell lung cancer new patients were being tested prior to ESMO. I get weekly data, and it's not perfect but you can certainly see a trend break where there's a significant increase in the number of patients that are being tested for PD-L1 right after ESMO data was released.

So I expect the numbers I just provided you will increase significantly, but I think it's important to remember that even if you look at EGFR testing, it took a while for that to become standard. And even today, after years, about 80% to 85% of patients are routinely tested.

So I think there's probably a ceiling of somewhere between 80% to 85% of PD-L1 testing that'll occur over time. But with that said, it does take a little while to ramp up, albeit it's ramping up faster. If you look at the length of time it takes to be tested, it's about the same as all other testing for lung cancer.

So if a physician asks for PD-L1 testing, they can get it back within a week, typically as fast as they can get ALK testing or EGFR testing. So it's very fast. In terms of the way it comes back to physicians, it's not always consistent.

Different labs and then academic institutions, they may give it differently, but right now most of them come back with a number that says PD-L1, 55 or 48, as opposed to just a positive or a negative sign, and we think that that's the way it'll probably continue over time.

We're seeing it in academic hospitals, but we're also seeing it, much more utilization even outside of those academic centers as well. With regard to biosimilar opportunity, the bottom line is that we think it is a real commercial opportunity. It's not our strategy.

Our strategy remains on innovation, but with $40 billion on a global basis of drugs that are biologics going off patent or at least biosimilars being able to enter the market over the next five years, we think there's a real opportunity for us commercially..

Great. Next question, please, Darla..

It's from Gregg Gilbert with Deutsche Bank..

Thank you.

Assuming KEYTRUDA and ALIMTA as a combo won't be reimbursed soon, Roger and Adam, based on your interaction with physicians and payers considering the label and compendium listing, how are you expecting patients that are strong expressers, somewhat below 50%, to be treated in the near term – 35%, 40%, 45%, et cetera? And then on diabetes, Adam, can you talk more about the JANUVIA pricing pressure that you're seeing? What's driving it? And how sustained do you think it will be? Thanks..

Well, I would just say, Gregg, that in my discussions, I think people are wondering about those patients who are younger, otherwise healthy patients without significant comorbidities who present with a diagnosis of advanced lung cancer, and far too often when people present with lung cancer, it is already at a quite advanced stage, and the question of how to give those people the greatest possible benefit.

Whether they will choose to use chemotherapy combinations, obviously these are approved drugs, I don't know, but certainly I've heard physicians discuss that. They've wanted to discuss that with me and with others. So I think there is some consideration of that kind of issue.

I think in the population of individuals who have significant comorbidities, of course the generally more favorable tolerability of KEYTRUDA as monotherapy will drive decision making..

And, Gregg, with regard to JANUVIA, as I mentioned in my remarks, we expect to still have very good managed care coverage in 2017 that's consistent with what we had in 2016. So we will have good access.

The pricing pressure in the United States, it's certainly increased over the last few years, and there's new in-class competitors that have had significant discounts. And every year, the rebates and discounts have increased, and the same time will be true in 2017.

But at the same time with our strong position in terms of market share and our ability to grow our demand, in particular TRx volume, we've been able to offset most of the pricing pressures with the increase in demand. So I think that 2017 of course there'll be more pressure than 2016, but we're optimistic as we move into the year..

Thanks. We'll go to the next question..

It's from John Scotti with Evercore ISI..

Hi. Good morning. Thank you for taking the questions. Just a couple on KEYTRUDA and one on hep C. So I was wondering if you could characterize a bit more your base case for what you see the ramp is into the first-line.

Given the level of PD-L1 testing you're seeing already, should we expect a fast ramp into the 4Q? Is there a warehouse of patients ready to get on therapy? And then given the exclusion criteria in 024, so brain mets [metastases], autoimmune, EGFR, ALK, et cetera, should we think about the real world addressable population of KEYNOTE-024 as perhaps lower than the 25%, 30% of first-line lung that has PD-L1 expression? Or does that number bake into excluded patients? And then quickly, are there any interims built into the Phase III KEYNOTE-189 and KEYNOTE-407 chemo combo studies that have the potential to stop early? So do we have a sense for when those may be? And then briefly on ZEPATIER, can you characterize what you're seeing out there in terms of discounting? And is discounting increasing? And then you mentioned that new formulary position will take into effect in January of next year and I was just wondering if those are parity contracts or are there any exclusive contracts there? Thanks so much..

Yeah. So let me start with first-line lung. There are no bolus of patients that we would expect in first line lung. We expect that as patients are newly diagnosed, that's when they would be considered for utilization for KEYTRUDA. So I would not expect a big bolus that would come into the marketplace in fourth quarter.

It's going to be new patient by new patient. Over a year in the United States, Japan and the EU there's about 250,000 patients that are new patients with non-small cell lung cancer, and based on everything that we've seen we believe that 25% to 30% is the right number for you to think about as we look at those patients in the marketplace.

And then the last thing I'd say is if you look at ZEPATIER, as I mentioned on previous calls, the marketplace had very significant discounting that was occurring. In fact, the pressure on the rebates and discounts before we even launched into the market was very significant. Despite that, we feel like we've gotten good formulary access.

We're doing very well in the VA, Medicare Part D, also in some commercial plans, particularly in the regional plans.

As we look at 2017, beginning of January, we do have some new contracts, many of them are at parity, but I think there will be one or two that we'll be able to discuss in the not-too-distant future where we will have a preferred position..

And, John, it's Roger. With respect to the exclusion criteria in KEYNOTE-024, I don't think you should worry about that too much. Patients with active brain metastases are treated typically with radiation directed towards those metastases as a medical emergency. Those are the same kinds of patients that we enrolled in the study.

There weren't really significant exclusion criteria that are different from what appears in routine practice though. The number that we're quoting is pretty much what you should expect. Our studies are aligned with what's been seen epidemiologically. And for KEYNOTE-189, the ClinicalTrials.gov dates are the dates you should probably use.

That study, final data entry's listed in September, and that's probably a good time to think about the 189 study..

Great. We'll move onto our next question, please..

It's from David Risinger with Morgan Stanley..

Yes. Thanks very much.

Regarding GARDASIL, could you just tell us what the recent price increase was? And how we should think about the potential decline in sales next year, as there's the shift from three doses to two doses for treatment? So specifically how we should think about netting out the positive benefit of the price increase as we think about the reduction of dosing? And then with respect to KEYTRUDA, could you just tell us what the U.S.

sales were by indication in the third quarter so we have a sense of the business mix in the third quarter? Thank you..

Yeah, sure. Dave, let me start with GARDASIL. If you look at GARDASIL, there's a couple things to think about. First of all, we've had price increases similar to the price increases that we've had in the past so that you haven't seen any difference or acceleration per se. But you also have to realize that the 9-valent costs a bit more than the 4-valent.

And most of the patients are moving to the 9-valent vaccine. So I'd net the price increase plus the difference in price between those two, the 4-valent and the 9-valent.

The thing that is hard for us to understand right now is if you have two doses, will the doses be given in the same year? Or, for example, if a person presents themselves in August before back-to-school, do they get one dose next year in August? But they don't get the second dose until the following year in August.

So there's still some things that we're going to have to wait to see in terms of how physicians treat those patients. Some might get the first dose in January, the second dose in July or August. Some might just get August dose, the one, and then the following year be the second dose. So there's certainly going to be an impact.

The magnitude right now we can't be certain of. And if you look at the sales by indication, just to give you a rough amount, about 50% to 55% of our sales were melanoma. About 25% or so was in lung, 5% or so was in head and neck cancer. This is for the U.S. specifically, and then the rest was in all other..

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

It's from Jami Rubin with Goldman Sachs..

Thank you. Just a couple of follow-up questions on issues that were already addressed. Again, Adam, in the biomarker testing process, I'm still unclear about something.

You said that there's about 60% testing, but is that 60% including PD-1 or is that 60% testing in general for EGFR and ALK? And where are we with – in front-line, how many docs or how much of that testing is for PD-1? And again, I know we've been trying to get a sense for timeline, but can you elaborate a little bit longer on how long that's going to take for the market to be prepared for a large penetration of KEYTRUDA in front-line just given that PD-1 testing is probably in its early stages? But if you can elaborate on that.

And also, Roger, just on the compendia listing issue for KEYNOTE-021 which we learned was rejected, there was a lot of enthusiasm expressed about that at ESMO. What is the process now? Do you have another opportunity to get that on the compendia listing? Or do we need to wait for the full Phase III trials? Thanks very much..

First – so Jami, this is Adam. First of all, I want to be clear on the 60% number that I provided. What I said was approximately 60% of U.S. physicians are testing for PD-L1, not that 60% of patients are being tested. So right now if you look at physicians across the U.S.

that treat lung cancer, we believe about 60% of them test at least sometimes for PD-L1. We also believe that about 40% of non-small cell lung cancer new patients are being tested for PD-L1. So that should give you a better idea of what's happening prior to ESMO.

Since ESMO, I don't have updates to these numbers because it takes time to have these updated, but I do see a very significant increase in the total number of tests that are being ordered for PD-L1. I don't believe that there's any rate-limiting ability of the labs or the institutions to do the testing, so that's not the issue.

The question is how quickly will physicians adopt testing for all patients? And the reason I capped that at about 80% to 85% is because even today, for EGFR testing, we see only about 80% to 85% of patients that are treated.

So if we're at 40%, the cap is at 80%, the question is how fast do we go from 40% to the 80% or 85%, and that's what we're working on. With regard to a ramp up for lung, there's not going to be a bolus of patients.

The 250,000 patients in the top seven markets around the world come in throughout the entire year, and the question will be, as they come in, how quickly will they be put onto KEYTRUDA if they have PD-L1 greater than or equal to 50?.

And, Jami, it's Roger. With respect to compendium listings, the process is completely independent, of course, and it is simply groups of experts who look at available data and make decisions about guidelines, in essence, so there's no real basis for readdressing that question with the KEYNOTE-021G data which they've already looked at.

The compendium analysis I would think would be informed by the availability of more data. Now other things could change, but I think what we would expect is that with the availability of KEYNOTE-189 and others, there'll be the opportunity to pursue it, presuming that those data are actually confirmatory, to pursue labeling for that.

And that's probably the next thing that happens in that general area..

Next question, please..

It's from John Boris with SunTrust..

Thanks for taking the questions. Just one related to pricing for Ken. Just on Proposition 61, Ken, which will be on the November 8 ballot in California as a proposed statute, just your thoughts on that proposal since it would create possibly a price ceiling on prescription drug cost paid by state programs, predominantly Medicaid.

And can you just remind us what percent of your business is in Medicaid? Second question relates to the one asked by Jami. Can we just get an update on where you are on enrollment on KEYNOTE-189 and any thoughts on interim analyses on that program? Thanks..

So let me start with Proposition 61. So first of all, we don't break out our sales by channel, but I will say as an overall comment, we have very serious concerns about this measure and its potential impact on patients.

And that's why we're part of a growing coalition of groups that are actively opposing that ballot measure in California, because we think it will negatively impact millions of California patients. So we're very active in opposing it..

And John, on KEYNOTE-189 as I said, the thing to think about is the ClinicalTrials.gov date of September of next year is about the time one should expect a data readout. We're not anticipating that we'll have anything before then..

Next question, please, Darla..

It's from Chris Schott with JPMorgan..

Great. Thanks very much. First one here just following up on John's question, more broadly on drug pricing and public scrutiny. Just seems like there's a lot more focus on drug pricing than any time in recent memory, whether it's Prop 61, the EpiPen hearings, et cetera. So maybe just a question for Ken.

Just how do you see this playing out for the industry? Are you guys thinking about price differently than in the past? Should we be thinking about a more challenging pricing environment going forward? Would love to just hear your thoughts on that topic.

And then a second one just coming back to some of the business development priorities, I know the focus is on bolt-ons, but when we're thinking about larger details specifically, would Merck be willing to take on single program or product risk in a larger deal? As we're thinking about those, if a sizeable component evaluation were tied to one or two core programs, is that something that fits what Merck's looking for? Or should we be thinking about more diversified assets as we think about things that are beyond bolt-ons? Thanks very much..

Let me start with the business development question. I would start by saying that I think we will look at each deal based on its particular merits, and so I don't think there is a way for me to respond to that.

I think what our past experience has been is we've tried to look for those deals where we believe we're going to get scientific assets going forward, and if we can get good assets that are in the marketplace now, that's something that we would be willing to do.

But I don't think I can say categorically that we wouldn't take the kind of deal that has a concentration in one product versus another. Obviously concentration is one of the factors that you weigh when you think about the risk inherent in the deal.

As it relates to pricing, we also are very concerned about the whole issue of pricing and affordability for patients. It's a significant one. It's been amplified in this year's political season. We find it unfortunate that a lot of times the focus is on affordability and pricing rather than the long term benefit that these therapies provide.

So from our perspective, we think that going forward we don't think these environmental pricing pressures will ease, and that's why we continue to focus on our strategy of investing in innovative R&D for products like KEYTRUDA because we think those are the kinds of products that will help Merck weather some of the pricing risks and pricing pressures that we will be facing as an industry going forward..

Thanks. We're going to try to squeeze in one last question, Darla..

It's from Tony Butler with Guggenheim Partners..

Yes. Thank you very much. Roger, just a very quick question on 189, 407. As patients move over or change overall therapy, those from chemo onto pembro [pembrolizumab] plus chemo – and this question I think is really important because there may be a hypothesis around duration, and I'm curious if you think that's possible.

That is, the longer we look, we actually don't see – even if patients cross over, on the other side of that crossover they may not totally separate. And I'm just wondering if you think that's a possibility. Thanks very much for your time, and also congrats on a good roll you're on..

Well thanks, Tony. I do think again as I said, at the limit if the crossover occurs early, I mean, you're just comparing a single chemotherapy regimen to chemotherapy plus KEYTRUDA given earlier lay. If they're only weeks apart, I don't see how, under those circumstances, how overall survival would separate.

And of course that's a traditional problem in the development of chemotherapeutic agents and the reason why progression-free survival has been accepted as an endpoint in a variety of different tumor types.

On the other hand, chemotherapy is active, and for individuals whose disease is controlled by chemotherapy, then the crossover will inherently occur later.

Because we believe that KEYTRUDA provides a more durable benefit to patients with lung cancer, and the data from that are clear across a variety of tumor types, under those circumstances, I would expect separation for overall survival. And as I indicated, it's a fairly complicated set of equations to try and estimate what that's going to look like.

I think we probably have to wait for the data..

KEYTRUDA, ZEPATIER, BRIDION as examples. We think those building on the firm foundation we have with products like JANUVIA and our vaccines give us a great opportunity in the long term.

We know that we're facing some headwinds from loss of exclusivity in the next year, but we continue to be confident in our ability to actually invest in some of these high-potential programs going forward.

And you should know that we will continue to look for ways to help offset some of the incremental spend that we'll have to make in order to support a product like KEYTRUDA to ensure that this company provides the best short and long term proposition for its shareholders. Thank you very much..

And, ladies and gentlemen, this concludes today's conference call. You may now disconnect..