Teri Loxam - IR & Global Communications Ken Frazier - Chairman and Chief Executive Officer Rob Davis - Chief Financial Officer Adam Schechter - President of Global Human Health Dr. Roger Perlmutter - President of Merck Research Labs.

Steve Scala - Cowen Andrew Baum - Citi Jami Rubin - Goldman Sachs Chris Schott - JPMorgan Vamil Divan - Credit Suisse David Risinger - Morgan Stanley Gregg Gilbert - Deutsche Bank Jason Gerberry - Bank of America John Boris - SunTrust Alex Arfaei - BMO Capital Markets.

Good morning. My name is Doherty, and I will be your conference operator today. At this time, I would like to welcome everyone to Merck's Second Quarter 2018 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.

[Operator Instructions] Thank you. I would now like to turn the call over to Teri Loxam. Please go ahead..

Thank you, Doherty, and good morning. Welcome to Merck's Second Quarter 2018 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 have also provided a table in our press release to help you understand the sales in the quarter for the business units and products. I would like to remind you that some of the statements that we make during today's call maybe considered forward-looking statements within the meaning of the Safe Harbor provision of the U.S.

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

Our SEC filings, including Item 1A in the 2017 10-K, identify certain risk factors and cautionary statements that could cause the company's actual results to differ materially from those projected in any of our forward-looking statements made this morning. Merck undertakes no obligation to publicly update any forward-looking statements.

You can see our SEC 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. Hello, everyone, and thank you for joining the call. During the second quarter, Merck delivered strong growth. We also further advanced our leadership in oncology through focused commercial execution, the achievement of important regulatory milestones and the presentation of clinical data at ASCO for KEYTRUDA, Lynparza and LENVIMA.

Following the unprecedented results in first-line non-small cell lung cancer presented at AACR, we followed up with similarly impressive data at ASCO.

This included more than 140 abstracts across 25 tumor types, which is a substantial increase from just five years ago when we’ve presented the first clinical data for KEYTRUDA, a single abstract for advanced melanoma.

KEYTRUDA is becoming foundational for the treatment of cancer and adding Lynparza and LENVIMA as well as our other oncology assets in the pipeline, and we believe that Merck’s oncology portfolio has the breadth and depth to further expand our leadership position. Our vaccines business is also an important growth driver.

We are pleased to see the growing momentum of our HPV vaccination worldwide. The WHO Director General recently called for all countries to take action to help eliminate cervical cancer, which is predominantly caused by HPV.

We've seen several countries offer expanded recommendations and we recently gained approval for GARDASIL in China, all of which contributes to our long-term confidence in this brand. Briefly turning to Animal Health. This business continues to deliver strong results growing faster than Human Health.

In addition to our global scale and the synergies we gained from sharing innovations across the two businesses, it also diversifies our portfolio and is a key pillar of our long-term growth strategy. Delivering innovative products is at the core of who we are as a company.

We will continue to augment our animal and human health pipelines through internal investments as well as externally through business development. As our results have demonstrated so far this year, we have good momentum and we are focused on continuing to execute across our business to drive growth and create long-term shareholder value.

With that, I will now turn the call over to our Chief Financial Officer, Rob Davis, who go through our results in more detail.

Rob?.

Thanks, Ken, and good morning, everyone. Please note that my comments today will be based on a non-GAAP earnings basis. In the second quarter, we deliver strong performance in both are Human and Animal Health businesses, resulting in meaningful revenue and EPS growth. Total company revenues were $10.5 billion, an increase the 5% year-over-year.

Excluding the impact of exchange, second quarter revenues grew 4%. Our Human Health business grew 3% excluding exchange, and Adam will provide more color on those results in a moment. Animal Health sales totaled $1.1 billion in the quarter, an increase of 14%.

Excluding the impact of exchange, sale grew 12%, with livestock sales growing 7% and Companion Animal sales growing 19%. Animal Health segment profits were $450 million in the second quarter, an increase of 14% compared to the prior year or 10% excluding exchange. Turning to the expense lines.

Gross margin was 74.4% in the quarter, a decrease of 290 basis points versus the second quarter of 2017. The decrease reflects increased amortization including a sizable catchup adjustment for an accrued sales milestone related to Adempas.

In addition, gross margin was impacted by unfavorable manufacturing variances, partly due to last year's cyber event as well as FX. Operating expenses were $4.4 billion, increased 4% year-over-year, including a negative two percentage point impact from foreign exchange.

The increase was driven by our continued investment in R&D, primarily for the clinical development of Lynparza and LENVIMA, as well as for early development efforts. The tax rates was 17.9% in the second quarter, reflecting the benefit of tax reform. Pasting together, we earned $1.06 per share, an increase the 6%, excluding exchange.

Turning to the outlook for the year. Based on continued operational strength, we are narrowing our revenue guidance range and narrowing and raising our EPS guidance range for 2018, despite a less favorable exchange environment versus our prior expectations in May.

For the full year, we now expect revenues to be between $42 billion and $42.8 billion, including a slightly positive impact from foreign currency at mid-July rates.

We anticipate our gross margin will now be lower year-over-year by approximately 1 percentage point with the slight change primarily being driven by the Adempas milestone related amortization this quarter. We continue to expect OpEx to increase year-over-year by low to mid-single digits.

We have slightly lowered our tax rate assumption and now expect it to be between 18.5% and 19.5%. We continue to anticipate approximately $2.7 billion in average shares -- or 2.7 billion shares outstanding as of the end of the year.

Taken together, we now expect EPS to be between $4.22 and $4.30, including a roughly 1 percentage point negative impact from foreign currency at mid-July rates. In summary, we continue to execute well on our strategy driving top and bottom line performance.

Re-allocating resources to effectively support our commercial opportunities in the near term, we’re making the necessary investments in R&D to support long-term growth. With that, I’d like to turn the call over to Adam to provide more detail on our Human Health business.

Adam?.

Thank you, Rob, and good morning, everyone. This morning I’ll provide highlights in the performance of Global Human Health for the second quarter of 2018. My comments will be on a constant currency basis. Global Human Health sales grew 3% to $9.3 billion.

Consistent with last quarter, our key growth drivers including KEYTRUDA, GARDASIL and BRIDION performed very well. Roughly 60% of our sales were from outside of the U.S. and grew 8%, highlighting of our global commercial presence and solid execution around the world. I’ll now focus on a few of our key franchises, and I’ll start with oncology.

Our oncology business is benefiting from a rapid worldwide uptake of KEYTRUDA, Lynparza and LENVIMA. KEYTRUDA with global sales of nearly $1.7 billion is now approved in 12 indications across 8 tumor types in the U.S. and similarly approved a multiple indications across tumor types in countries around the world.

We believe our breath of current indications, with significant opportunities yet to come, will be a competitive advantage and will help us continue to be a leader in this field for many years. In the United States, KEYTRUDA means the leading immunotherapy in new patient starts. We’re looking at all indications combined.

Sales this quarter benefited from accelerated adoption in metastatic lung cancer as well as growth in bladder and MSI high cancers. In patients diagnosed with non-squamous first-line lung cancer, the significant survival benefits demonstrated in KEYNOTE-189 is resulting in sharply broader use of KEYTRUDA in combination chemotherapy.

Physicians now clearly see the benefit of using this combination across all of their first-line patients, regardless of PD-L1 expression. We are currently capturing roughly two-thirds of new patient starts, excluding EGFR and ALK, approximately 20 share points higher than prior to AACR.

We expect continued substantial adoption of this indication in the second half of 2018 and beyond. In addition, the strong survival benefits in patients with squamous non-small cell lung cancer from KEYNOTE-407 to enable us to become standard of care in this population, which represents roughly 20% of the market.

With the strength shown in our clinical program, KEYTRUDA indication should be able to represent roughly 80% of all non-small cell lung cancer patients within its overall survival benefit, which is the gold standard. Outside the U.S., we're seeing significant growth of KEYTRUDA and now represents over 40% of total sales.

We are seeing strong uptake in first-line lung, and we have secured reimbursement in most major markets worldwide for our monotherapy indications. Sales also continued to grow in melanoma, head and neck and bladder cancers.

We continued to be very confident in the near- and long-term growth prospects of KEYTRUDA, driven by continued penetration of approved indications as well as the potential from many additional indications in the future.

The potential benefit of KEYTRUDA in patients with breast, gastric, hepatocellular, renal, head and neck and other, including various adjuvant-stage cancers, are exciting opportunities for us. Now turning to Lymparza, which we’re co-commercializing and co-developing with AstraZeneca.

Oncology business benefitted from the strong performance of Lymparza, which leads the PARP inhibitor class in both new and total prescriptions. U.S. sales grew significantly, driven by continued growth in ovarian cancer as well as the strong launch in the new breast cancer indication. Ex-U.S.

sales benefited from the recent launch in ovarian cancer in Japan. Going forward, we expect the recent breast cancer approval in Japan and expectations for an ovarian cancer approval in China to continue to enable strong growth. Our partnership with Eisai for LENVIMA is also up to advanced fast start.

In the United States, our sales representatives started promoting LENVIMA in renal cell carcinoma in June, and we look forward to the potential hepatocellular carcinoma approval this quarter within August 24 FDUFA date. Over the next six months, we'll begin promoting LENVIMA in many key countries in both Europe and Asia-Pacific.

So as you can see we are very confident about our future growth of Lymparza and LENVIMA, both as a monotherapy and in combination with other agents. Now moving to vaccines, which represents another key pillar of growth. Global vaccines grew 7% and exceed $1.5 billion this quarter, led by GARDASIL, which remains in very high demand.

The transition to two dose regimen in the U.S. is nearly complete, and we continue to see strong underlying demand. Outside of the U.S., growth remains very strong as the benefit of HPV vaccination continue to become more broadly understood by healthcare systems worldwide.

In addition, uptick in China has been particularly robust following a launch there. We're excited about the FDA acceptance of our SPLA for the use of GARDASIL in women and men ages 27 to 45 and believe GARDASIL will remains a significant growth opportunity moving forward. Now moving to diabetes. Our diabetes franchise continues to be relatively stable.

Global sales were nearly $1.6 billion, flat with year ago levels. Trends worldwide remained largely consistent with strong demand-driven growth ex-U.S. markets being largely offset by continued pricing pressure in the U.S. Lastly, in our hospital specialty portfolio, PBM report another very strong quarter of growth both in the U.S. and worldwide.

The neuromuscular blockade market continues to grow because of increases in robotic and minimally invasive surgical procedures. And PBM continues to gain market share as a reversal agent of choice. We recently launched PBM in China and believe our prospects for growth both in the U.S. and ex-U.S. remains strong.

In total, we are pleased by performance of our global Human Health business this quarter and we're very optimistic about our future potential, driven by our key growth areas including oncology, vaccines and hospital specialty. With that, I'll turn it over to Roger..

Thanks, Adam. During the second quarter, we had the opportunity to present important data related to our programs in oncology and infectious diseases at multiple scientific meetings and we advanced many of our key programs. Looking first at KEYTRUDA.

Since our last earnings call, we gave US registration for the treatment of relapsed for refractory mediastinal and B-cell lymphoma and for the treatment of recurrent or metastatic cervical cancer in women whose tumors expressed PDL1, that is with CPS greater than or equal to one.

In all, the FDA has now granted approval for the use of KEYTRUDA in 12 different indications, standing eight different tumor types and the broader categories for the patients whose tumors demonstrate microsatellite instability.

Also during the second quarter, the FDA granted priority review to our sBLA submission for the use of KEYTRUDA in the treatment of patients with advanced metastatic carcinoma for the PDUFA date of November 9 and for the use of KEYTRUDA in combination with chemotherapy or the first-line treatment of patients with metastatic renal cell carcinoma of the lung for the PDUFA date of October 30.

The latter submission was based on our recently completed KEYNOTE-407 study, results of which were presented at the American Society for Clinical Oncology or ASCO meeting in June. Now these data were described by the ASCO commentator as representing a new standard of care for patients suffering from advanced renal cell carcinoma to lung.

Similarly, the results of KEYNOTE-189 study, which tested the utility of KEYTRUDA in combination with chemotherapy and patience receiving first-line treatment for non-squamous non-small cell lung cancer were incorporated into a supplementary sBLA that was accepted for priority review for the PDUFA date of September 23 by the FDA earlier in the quarter.

Data supporting the filing showed a greater than 50% improvement in overall survival in patients receiving simultaneous KEYTRUDA plus chemotherapy as compared with those receiving chemotherapy alone.

Separately our supplementary BLA for the use of KEYTRUDA in the adjutant treatment of patients undergoing definitive surgical resection of cutaneous melanoma was also accepted by the FDA with an action date of February 16, 2019.

Outside of the United States, yesterday we announced that KEYTRUDA was approved in China for the second-line treatment of unresectable or advanced melanoma, with first approval of our PD-1 therapies for melanoma in China.

These numerous approvals and filings are really just the beginning of what will be a very robust period of evaluation for KEYTRUDA in both combination therapy and normal therapy settings. At the ASCO meeting in June, my colleagues presented more than 100 abstracts related KEYTRUDA alone.

Many of these represented progress reports that we expect will yield data support of its registration in the not too distant future, including for the treatment of small cell lung cancer and renal cell carcinoma.

At some greater remove, we expect that data will also merge support in the use of KEYTRUDA in the treatment of breast cancer and prostate cancer. Beyond KEYTRUDA, very substantial progress is made in our other oncology programs.

With our colleagues at AstraZeneca, we achieved registration for the use of Lynparza tablets in the maintenance treatment of platinum-sensitive ovarian cancer in the European Union and then the treatment of BRCA-mutated HER2-negative breast cancer in Japan.

Our join efforts on LENVIMA with colleagues at Eisai also yielded in important regulatory actions. The approval of this multi-kinase inhibitor for the treatment of hepatocellular carcinoma in Japan, LENVIMA is under review for the same education in United States. Progress is continued in other areas as well.

Earlier this week, at the 22nd International AIDS Conference in Amsterdam, we presented 96-week data from our DRIVE-FORWARD Study of Doravirine, our investigational non-nucleoside reverse transcriptase inhibitor used in combination with other antiretroviral agency in treatment-naive HIV-infected patients, doing long-term suppression of HIV borrowed burden with this new age.

Doravirine, both as a single agent and as a combination single tablet regimen, is currently under review at the FDA with an action date of October 23. We’re also setting Doravirine in combination with MK-8591, our first-in-class nucleoside derivative that durably blocks both reverse transcriptase translocation as well as polymerase activity.

Data from this Phase II study will become available later this year. Also in the infectious disease arena, as Adam mentioned, the FDA has accepted supplementary BLA and granted priority review for the use of GARDASIL in women and men ages 27 to 45 with an action date of October 6.

Early in the quarter, we announced that GARDASIL 9 is approved in China for use in girls and women 16 to 26 years old. We see these new regulatory actions as emblematic of an increased focus on the impact of Human Papillomavirus-induced diseases, especially cervical cancer.

At the ASCO meeting in June, Doug Lowy of the National Cancer Institute, who shared last year’s at Alaska award for his studies of HPV median diseases both persuasively about the importance of mounting worldwide immunization campaigns against HPV and both the American Cancer Society and the National Cancer Institute in the United States.

Their designated cancer centers have endorsed the goal of eliminating cancers caused by HPV through effective gender-neutral vaccination of adolescence. GARDASIL and especially GARDASIL 9 will play a pivotal role in these worldwide efforts.

We have many other important vaccine initiatives underway, including V114, our 15 valent pneumococcal conjugate vaccine currently under investigation and Phase III trials; and V160, our novel vaccine for the prevention of primary CMV infection in healthy seronegative women, which is currently being evaluated a large Phase II study.

But today, I wish to pay tribute to the many dedicated healthcare workers in the Democratic Republic of the Congo and especially the Congolese Ministry of Health and the World Health Organization for the successful containment of the recent Ebola virus disease upgrades in the Democratic Republic of the Congo.

My colleagues at Merck Research Laboratories works tirelessly to supply nearly 13,000 doses of our investigational V920 vaccine, which we previously demonstrated have protective activity in the 2014-2015 Ebola disease upgrade to any, these data will publish as part of the Ebola Ça Suffit! trial in the Lancet in 2017.

This permitted vaccination in healthcare workers and people at high risks contracting the Ebola virus disease during this most recent outbreak.

We’ve proud to have been able to contribute to this effort and are continuing to make rapid progress towards the registration of V920, which has been described as a game-changer in this control of Ebola virus infection. I will now turn the call back over to Teri. .

Thanks, Roger. Doherty, we’ll move on the question-and-answer session. I'd like to remind everyone on the phone to try to limit your questions to a maximum of two or one question with two parts so that we can try to get as many people on as possible.

So, Doherty, if we can move on please?.

[Operator Instructions] Your first question comes from the line of Steve Scala with Cowen. .

Thank you very much. Roger, what is Merck's strategy in Stage III unresectable lung cancer where Astra has done well with Pacific. At the ASCO meeting, you were asked the question but not answer suggesting that Merck is pursuing approval perhaps on its single-arm trial. So I'm wondering if you can update us there.

And secondly, Adam, could you provide us KEYTRUDA's market share by tumor type in the U.S. and EU? Thank you very much. .

Yeah, Steve. The specific registrational strategy, we were pursuing different aspects of lung cancer approval is not something that we generate comment on. Suffice it to say that we do have some data available in advanced cancer, non-resectable cancer that is non-metastatic.

And we expect that there will be additional data that will come forward in the months and years ahead that will permit a specific indication, but we're not commenting on the regulatory strategy. .

Hi, Steve. I hope all is going well. Just with regard to your question, I'll give you a rough estimate as you know the data is not perfect in this area. But if you start with the U.S., the rough estimate is about 60% to 65% is in lung, about 15% melanoma, about 5% in bladder, about 5% in MSI High and then the rest is in all other indications.

And then if you look at Europe, the data is even harder to get exact numbers on. What I would say is if you look at Europe and Japan, lung is the majority of revenue; and then followed by melanoma, which is the second largest contributor; and then all the other tumor types like head and neck, and bladder, are the rest of the numbers in there.

But it's clearly lung followed by melanoma and then all others. .

Thanks.

We'll move on to the next question please?.

Your next question comes from the line of Andrew Baum with Citi. .

Thank you. A question for Adam and then one for Roger. So I guess you might have seen this coming. Could you comment on the puzzles that have been made by HHF, the White House, to either remove or significantly amend the – structure by taking way the Lymparza.

In particular, could you comment on your understanding of under the rages whether this has been it's just a federal plans or do you believe that there could be direct or indirect impact on commercial book of business either through the action of administration or more likely to the PBM’s activity down? And then separately, potential timing whether we should expect something for this 12 months now, but do you think there is any possibility that could happen faster than that.

So I know there is lot of uncertainty there, but anything you could add would be helpful? And then to Roger. As far as I can see, the anticipation of expansion of the -- trial that was spoke about previously hasn't happened yet, unless I’ve missed them.

So I was wondering whether this is just the challenges of dealing with a partner company rather than your own internal assets or whether it's being compounded by the departure of some of your senior employees meeting for your resource constraints..

Well, thank you, Andrew. Let me start with your first question about the proposal to remove the Safe Harbor for rebates plans and PBMs. So I have to start by saying it's rather difficult to comment on specifics at this point.

As you know there's so many different proposals being considered to address the high out-of-pocket cost or drugs to patients, what I would say as we will work with the administration and the Congress to help find appropriate solutions to these issues.

We do think it's important to make sure that patients to have meaningful access and lowering out-of-pockets across the patients is something that we're strongly and support of. .

And Andrew, with respect to the expansion of the olaparib trial, well as you know and as I’ve described we've done quite a lot with Lynparza since the partnership with AstraZeneca plus consummate.

We have a lot of new studies that we've gone through and it's taken a little bit longer than we wanted to for the two organizations to come together and agree on exactly what we should study and where we should study it. But you'll be seeing a lot of those trials grow a lot very soon in response to your question.

It is not because we are in any way constrained by personnel and we have our clinical team is really firing in all cylinders, no doubt. .

Thanks for your question, Andrew.

Next question please?.

Your next question comes from a line of Jami Rubin with Goldman Sachs..

Thank you. I have a couple of questions. First, just wondering, Ken and Rob, if you're comfortable with the way the Street is thinking about the cadence of KEYTRUDA uptake, given the stickiness in the second-line lung market as reported by Russell Myers, we really have yet to see an inflection point in KEYTRUDA.

Yes, it's doing well, but we haven't really seen a meaningful impact from KEYNOTE-189. And even more importantly, when do you expect to see the operating margin pull-through from KEYTRUDA. Even this quarter if you adjust to the Adempas milestone, operating margins are below where they were a year ago despite KEYTRUDA sales up over $800 million.

So -- I mean are we thinking about operating margins correctly? Should they go up? And when do they go up? And then, Ken, for you a question on Animal Health. We heard you loud and clear in your opening comments, fully committed to Animal Health toward your growth, et cetera, et cetera.

But I'm sure you've noticed outside of Merck this wave of corporate simplification that is going across the industry. We've seen it with Lilly, with Novartis, et cetera, et cetera. Investors are rewarding companies that are unlocking values through spinning off assets, such as animal health.

And I'm sure you've also noticed the big difference in valuation between Merck’s and so other.

So while we understand that’s an important growth driver, I think if a company is fully committed to KEYTRUDA and confident in KEYTRUDA and that business, I'm not sure I understand why this deigning on Animal House? So if you could address those two questions, I'd appreciate it. Thanks..

Thanks, Jami. So we'll start with Adam talk about the commercial uptake of KEYTRUDA, then go to Rob for the operating margins and then follow-up with Ken on Animal Health..

Yeah. Hi, Jamie. So it's our first reward, we're very pleased with the performance of KEYTRUDA. And if you look at the sales for the first half of '18, it's doubled versus the first half of 2017. And we’ve seen robust growth sequentially every single quarter since launch both in the U.S. and outside the US.

And I think people sometimes don’t recognize is the fact that 40%, more than 40% of our sales are outside the U.S. And we’ve only launched the immunotherapy there. We have not yet launched the combination therapy. But I can tell you the feedback on the chemo combo in the U.S. use has been very well received.

And as I mentioned, about two-thirds of new patients are now starting on KEYTRUDA, when you exclude EGFR and ALK, and that’s a 20 points share increase since AACR. I’ve always said this is not going to be a big bolus of patients because these are patients coming into the market as are diagnosed each and every day and month.

But as you continue to grow new patients share, those patients become part of the RF base and that represents a very large opportunity for growth for us for moving forward. And in addition to that, we’ve done really well with had head and neck, bladder and MSI-high, and we’re looking forward to all patients that Roger has spoken about..

Good morning, Jami. And to your question about operating margin, obviously as we look at the profile of the company, I think we’ve been fairly consistent with this. Clearly, as we look to long term, we intend and expect to see both the leverage P&L and operating margin expansion over time.

But as we’ve said previously, in the near term, as we look at 2018, we are continuing through a period of pretty meaningful investment both in the ongoing clinical studies for KEYTRUDA, but as you saw this quarter, we’re now starting to see the clinical studies for Lynparza and LENVIMA also start to pick up and that is driving a lot of the growth in R&D you’re seeing the quarter as well as continue to advance several programs through our vaccines portfolio.

So obviously we’re very cognizant of the need to get operating leverage and to margin expansion, but we also want to make sure we’re making appropriate investments for the long term. And so you’re probably not going to see that type of expansion you’re looking for until we get through this bolus spend over the next year or so.

And then on the gross margin line, you mentioned Adempas. Recall that as we came into the quarter, we did expect -- or into the year actually, we did expect to see a slight decline in our gross margins year-on-year. This is really due to the fact that we did have coming into the year of the expectation of larger negative manufacturing variances.

Part of that was due to the carryover effect of cyber and part of it is due to the fact that a few years ago we actually benefited quite a bit from the start-up of commercialization of KEYTRUDA that brought with us very positive one-time manufacturing variances as we converted from our pilot plans to our commercial plans.

So you are seeing that happening through the gross margin line. As we’ve said in the past, well, we’re not getting specific guidance on gross margin as you look forward long term.

We do see both the tailwinds of margin expansion from important products like the KEYTRUDA, BRIDION other new products launching, which are margin-positive, being offset by the LOEs, ZETIA being an important one had a very high margin, and then products like ZEPATIER coming down, which also had a high margin.

So those headwinds and tailwinds are largely offsetting. And as we look forward, whether or not we end up with a slightly higher margin or slightly lower margin will really depend on how product mix and currency play themselves through as we look forward.

So that hopefully gives you a sense of what’s happening both of the gross and operating margin line. .

And, Jami, thanks for your question about Animal Health. Let me start by letting you know and showing you that we consistently reevaluate our corporate portfolio in light of various facts, including the environment, to determine how we can generate the highest value for our shareholders over the long term.

You mentioned the growth impact that we talked about earlier in the call of animal health. In addition to growth, we believe our Animal health business provides us diversification from KEYTRUDA in the rest of our human health portfolio.

And we also think it's important to note the important synergies of having animal and human health together within Merck.

We’ll point out though our animal health business is growing more quickly than its industry peers and a great deal of that has to do with the fact that we are able to achieve synergies between our animal health R&D and our human health R&D. For example, we have innovative protein and vaccine technology that is shared across that portfolio.

Animal health have access to our human health catalog, which has led to innovations on the animal health side. Right now they're investigating oncology and diabetes where our companion animals, and their other examples of human health leveraging discovery from animal health as well.

So we see all of those reasons, as we sit here today, we see animal health still fitting with our strategy intent and our intrinsic capabilities as a research-based pharmaceutical company, and we believe these synergies will help our animal health business grow faster in its market and will also have an impact on overall Merck. .

Great. Thanks for your question, Jami.

We'll move on to the next question please?.

Your next question comes from the line of Chris Schott with JPMorgan. .

Great. Thanks very much for the questions. Just had two here. Maybe first on KEYTRUDA. Where do you think penetration rates can go for PD-1s in frontline lung when we think about those non-AL to non-EGFR patients? As you mentioned, you're right now at two-thirds of new starts.

Where is that go over sight? It now go to 75% at 85%, just any color there would be appreciated? My second quarter, GARDASIL. You got $2.4 billion or $2.5 billion kind of run-rate business now. You’re talking about significant growth. I guess my question here is how much larger could this product to be overtime.

I mean as part of that whether you think as growth markets how quickly can you hit to those markets. And just a little bit there we’re trying to get our hands on how we should think about the ramp of the product from here. Thank you so much. .

Hi, Chris. This is Adam. First of all, with regard to KEYTRUDA penetration rates in first-line lung, a couple of things to note. First of all the two-thirds and 20 share point increase have happened very quickly and we believe that there is still substantial opportunity for that to grow even further.

And as I mentioned that if you exclude ALK and EGFR, we now have survival benefits in 80% of the markets. So we believe that we continue to see good growth. Outside the U.S., the opportunity remains very big because we've only launched for monotherapy, we have not yet launched the chemo combo therapy and some other data.

So I think the growth opportunity there remains significant. So there is no doubt that our lung indication will continue to be a good driver of growth for us in the future, but as I said before, all the new indications that we're expecting and some of those to be rather large, we're excited about the potential future opportunity.

And the two-thirds as I talked about, new patients, those are patients that are just been diagnosed coming into the market. So I do believe that there is significant opportunity there moving forward. With regard to GARDASIL, there is opportunity frankly globally.

In the United States, there still opportunity to increase vaccination rates in 11-12 years old but also in the 19 to 26 years old. I also believe the opportunity for the 27 to 46-year olds, as we discussed with that indication, will represent another very important opportunity for us in the United States.

Outside the United States, there is opportunity in new geographies, and China is an exemplar of that. And the uptake in China continues to be very strong. And then with new data that's been introduced in countries like Australia, there really is a lot of talk about elimination campaigns in markets around the world.

So I believe that the opportunity for GARDASIL in the short term and long term for growth remains very significant..

Thanks for your questions, Chris. Move on to the next one please. .

Your next question comes from the line of Vamil Divan with Credit Suisse..

Great. Thanks for taking my question. Maybe just following up on Christopher. Just think I forgot that 80% of overall survival benefit now of the frontline market in the lung cancer.

I guess what is a reasonable sort of penetration rate do you think? If we look out, say, 12 to 18 months, I think from the comments from Bristol yesterday suggests maybe the penetration will be as high as people think.

So maybe you can just give your sense of out of that 80%, what would you be satisfied with it? We looked at 12 to 18 months in terms of how much KEYTRUDA alone or maybe PD-1, PD-L1 combined can penetrate? And then my second question is more for Ken and is on the business development on a presuming that remains a priority.

I think investors maybe have been a little bit surprised that I've been more active. You've done some of these collaborations, which I think might be a little bit appreciated.

But just in terms of business development as you look out now, thoughts around maybe a larger deal or any change in your perspective on the focus on innovation and being the commentary about what's held you back and but all my change and getting more rest of going forward? Thanks..

So this is Adam. So we're currently capturing, as I said, roughly two-thirds of the new patient starts when you said EGFR and ALK. I also said that’s about a 20 share point higher increase than what we had prior to AACR. But I would expect continued substantial adoption is indicating as we go through the rest of this year.

So I do believe it will continue to grow. Also, if you look at patients with squamous non-small cell lung cancer from KEYNOTE-407, that should enable us to become the standard of care in this population as well, and that's about 20% of the market.

So again, with strength that we've seen in the clinical program or indications to be able to represent about 80% of all non-small cell lung cancer patients with overall survival. And overall survival is the gold standard. So that's why I believe there's still significant opportunity there.

And on business development, I'd start by again reinforces how important that priority is for the company, and we are actively looking for the best opportunities across all kinds of structures, including acquisitions and partnerships, collaboration and licensing.

And with respect to acquisitions, over the past couple years, as I said previously, we can't looked at some that didn't can out either because of the target was just not a willing seller. Well, because it was for kind of competition for the asset that made the price untenable based on our assumptions.

I think, as you’ve seen, there has also been generally a terrific of M&A across the industry recently. There's been significant funding flowing in the small biotech, including the IPO, which are at multiyear highs.

So as a result, biotechs have access to ample capital and they have perhaps less need or desire to sell right now and the deals that are getting done are being done at very high prices and premium. But I want to assure you that augmenting our pipeline to business development nevertheless remains an important priority.

So we'll continue to scour the landscape carefully. .

Your next question comes from the line of David Risinger from Morgan Stanley..

So I have two questions. First, when do you expect to provide more clarity on the longer-term outlook? And I guess that that includes the early- to mid-stage pipeline and the financial prospects beyond 2018. And then second. With respect to GARDASIL, could you just discuss the things that are holding it back right now supply sort of shortages.

I’m assuming the 3 to 2 dose conversion is over. And then finally, and I’m sorry for all the questions, but just China, could you comment on net pricing there versus the U.S.? Thank you..

David, I’ll take your first question, which has to do with explaining or helping people to understand a longer term prospect. So we continue to evaluate the best way to do that, including perhaps the possibility of giving longer term guidance as we appreciate the desire investors for additional insights into our own internal expectations.

Obviously we want investors to understand why we’re so confident in our long-term prospect. So that they continue to evaluate Merck versus other investments, they can do that. I will say that we are thinking about the best way to do that, and we will get back to you in that regard..

And with regard to GARDASIL. Again, we remain optimistic about the long-term growth opportunity there. We’re still in the beginning, frankly at the launch in China and we’re excited about that opportunity. Regarding the U.S., the transition to the 2-dose regimen is nearly completed.

It’s not entirely complete, so we are overlapping the vast majority of that change. So I think we’ll start to see some growth there as we finalize the 2-dose transition. And then lastly, I would say that and showing that we’ve got the right amount of products in the right parts of the world will always be something that we’re going to be working on.

And frankly, the update in China has been larger than what we would have initially anticipated, and we’re still trying to ensure that we understand what the demand there, because this is such a large opportunity. There are so many people there that we’ve got to understand how much product will need to get into that country..

Your next question comes from the line of Gregg Gilbert with Deutsche Bank..

I want to start with Roger. The pneumococcal vaccine front, obviously, the stakes are pretty huge, albeit a few years out from things changing. But it appears that you could leapfrog Pfizer in a few years and then possibly get re-leapfrogged by them with their 20-valent product. Obviously the studies have to be done.

But can you shed some light on your views on how that space will evolve and any other nuances we should be aware of in terms of the potential for differentiation other than sort of whose is bigger than whose? And then, Adam, can you talk about the commercial opportunity for Duravarin? It seems to be something where there’s a disconnect between them the company’s enthusiasm the Streets focus? Thanks..

Well, thanks, Gregg. On pneumococcal vaccine. Clearly, I think this is an area where we’ve been very active for a long time.

With PNEUMOVAX, we have a lot of understanding of the marketplace and the needs in terms of invasive pneumococcal disease continue to evolve because of the availability of vaccines, particularly in the younger susceptible population.

So as new vaccines are introduced, there are changes in the epidemiology of pneumococcal serotypes, which we follow quite closely. My expectation is that there will be need in the marketplace for multiple – vaccines to lead advanced chemo moving forward but advancing – there will be other things that will be coming forward.

There will be others in the marketplace. Obviously our colleagues and competitors advisor are hard at work in these two. And we'll see how it plays out, but I think there is clear need for many vaccines in this extremely important area given the bread of the -- disease and its impact on human population. .

And with regard to doravirine, it's important to have options outside the integration inhibitor class and that is the most frequently described class at the moment. But RKI based regimens are one of the most commonly used treatment regimens in a wholly lung patient populations.

And if you look at the -- profile it would improve on some of the limitations with the NNRTI class more favorable CNS side effect profile and they're put it back. But I look at it more as a bridge and so we've to continue to build on our legacy in HIV upgrades to that product that Roger talked about which is the MKE --1 novel product.

So I would look at it as a near term way for us to continue to be relevant in the market but a real growth opportunity as we bridge into the future with our pipeline. .

Thanks for the question.

We'll move on to the next?.

Your next question comes from the line of Omar Saad with Evercore..

Hi, thanks so much for taking my questions. I wanted to focus on KEYTRUDA and maybe start off a little broader and perhaps a bit more specific. So first on KEYTRUDA experience to-date across all the indications that you have commercially, my question is how does the duration of therapy track relative to the PFS you’ve put in each of those indications.

Both I'm trying to understand that for our own modeling purposes. Is it two thirds of PFS which is been the proxy you mentioned by some other companies in the past or is it similar to the PFS in for KEYTRUDA or even higher than PFS. Just wanted to understand that.

Secondly, I wanted to focus a bit more on KEYNOTE-522, the neoadjuvant, and adjuvant trial in the triple negative breast.

And my question was what's the bar for a very competitive profile? And perhaps, Roger, if you could speak to the variety of PCR definitions incorporated in the secondary endpoints and whether you would sort of focused as more on one definition over the other. And perhaps, Adam, could speak to the commercial opportunity in that indication as well.

Thank you. .

Yeah so with regard to KEYTRUDA, it's very hard to get data and you've really do need to have a quite a bit of data overtime to understand the exact duration of therapy. So I would, I'd be hesitant to give any specific numbers. We are collecting real world evidence data, we are working on various data sources to have better estimates of that.

And over time, we may be able to provide more specific information on that. .

And with respect to the Neoadjuvant breasts, we are first of all, I mean, just wait and see we are very excited about the opportunities that exists for adjuvant and neoadjuvant therapy with KEYTRUDA across the broad range of tumor types.

And I think the neoadjuvant experience is particularly instructive because of the pro-inflammatory effect of surgery in a variety of contexts. I draw your attention and you don't need your attention because you already know it very well to the I-SPY 2 data that we've got the opportunity to present previously.

And the pathology of complete response results there are extremely impressive without going into any attempting any way to compare different definitions of pathologic complete response.

I think there was a good understanding in breast cancer in particular about the relationship between pathologic complete response as studied a nice by two and outcomes. And that's the kind of analysis that we are using or will use in KEYNOTE-042 and with other studies going forward I'm very enthusiastic about where that could lead. .

And with regard to the indication, I mean as I've mentioned before, having a whole host of indications just reinforces how foundational KEYTRUDA is to overall cancer care. So every indication is important.

With regard to this one, we're excited to get into the breast cancer market, but we're also starting to call this but this is already with Lynparza. So we are ready to launch with KEYTRUDA as soon as the data would be available or indication available. .

Okay. Thanks for the question.

Move on to the next one please?.

Your next question comes from the line of Jason Gerberry from Bank of America..

Hi, good morning and thanks for taking my questions. Firstly, on we talked about U.S. KEYTRUDA alone, can you talk a little bit about in terms of regulatory and then pricing and reimbursement? When do you actually expect to see meaningful contribution from KEYTRUDA in lung ex-U.S.

outside of the monotherapy, PD-L1 high group? And then my second question just on JANUVIA/JANUMET, a little bit higher than we were expecting for the quarter. Can you talk a little bit about the pricing environment? It seems as though oral antibiotic drugs were we're continuing to see grows to net adjustments spike and pricing pressure.

But maybe it has it stabilized a little bit or are you guys just including your SGLT combo in that line? Any clarity just around have had to think about that would be helpful? Thanks..

So, I'll start with a JANUVIA question. As I said before, outside of U.S. we continue to see strong growth in the innumerous offset by the pricing pressure that we see in the U.S. And as I said, the last couple years, each year is tougher than the last year, this year, there is more pricing pressure than it was last year.

And I believe next year, they'll be more pricing pressure than there is this year. So I believe that that will continue. The good news is we are seeing growth outside of the U.S. and we're in the middle of launching in China, for example, where we think there is still a growth opportunity there. So what's happening is the growth outside of U.S.

is offset by the U.S. pricing pressure, I'll be in the U.S. we still continue to see good volume there. With regards to KEYTRUDA outside the United States, I mean lung cancer is the majority of revenue already outside of U.S. Even though it's coming from the monotherapy, we already have most of the major markets reimbursing for lung for the monotherapy.

We're waiting to be able to promote the combo and I think that will represent an additional opportunity for us outside of the U.S. moving forward..

Move on to the next question. .

Your next question comes from the line of John Boris with SunTrust..

Thanks for taking the questions, and congratulations on the results. My question for Ken on at the conclusion of the last call, Ken, you mentioned that Mark was transitioning from a primary care to a specialty care business and that the three most important franchises would be certainly oncology, vaccines and Animal Health going forward.

When we look at the revenue generated from those businesses. It's basically two-thirds of your revenue around the time of loss of exclusivity of JANUVIA in the U.S.

And when we benchmark the incremental revenue that you're driving from those three businesses and benchmark oncology versus Roche vaccines versus GSK and Animal Health versus Zoetis, it certainly implies that operating margins expand quite substantially, especially beyond 2022.

Can you provide any color on magnitude of operating margin expansion going forward, especially when the benchmark against those key players? Second question for Rob.

If you look at the 35% tail of revenue, there’s some old legacy assets, respiratory assets within healthcare assets and I expected assets that carry high fixed cost, most notably women’s health and animal health, because you need dedicated manufacturing facilities. Any thoughts about divestitures added that tail? Thanks..

So maybe I’ll jump on the operating margin question and I can hit the second question. Or did you want to….

So to your question what we think long-term operating margin. We’re not going to give specific guidance that we have been consistent to say in general, we do believe we’re going to see operating margins expand as we move forward.

As a result of what you pointed out, which is if you look at the mix of businesses with oncology and vaccines relative to what you would think that was a traditional primary care infrastructure, clearly those are more efficient businesses. But I would point out, as you look at this, maybe just some in general thoughts to give context.

As you think about a pure specialty, we are a little bit different and what you think of as a pure specialty type company for a couple reasons.

Starting with oncology, you really have never seen a situation in oncology, like what we have right now, with KEYTRUDA because this is the first time you have a drug that is crossing so many different tumor types, so many different indications.

And as a result of that, you’re really dealing with the needs to promote and to sell to multiple different specialists. So the infrastructure burden for product like the KEYTRUDA probably is going to be more than what you would see for traditional oncology companies, just given that. Although still is very beneficial to where we are today.

So we are going to expand that I just would say, be cautious not to look at a pure ontology play with a more limited indication profile as a competitor. And then likewise, in vaccines.

If you look at our vaccines portfolio, several the products in our vaccines portfolio and as we look forward to some of the products in our pipeline, actually, several those will not only go to specialists, but also will be marketed to the primary care doctors. So that in and of itself will mean a little bit more of a footprint.

So I just want to give you a sense of that to say that while we do expect to see margins expand, it’s. I think it’s hard to think in terms of what a pure stuff for the company would look like. And then with regards to the portfolio, and what we’re thinking about.

As Ken mentioned in his earlier comments at the beginning of the call, we are always reevaluating our portfolio. And so we are not before close to any opportunity to optimize the portfolio. If it makes sense for both the short-term and long-term, I think that’s the important thing. In everything we look at.

We try to measure, what is the long-term path is sustainable value creation, sustainable growth and make the decisions balancing that relative to what we see in the short-term.

But to your point, as we look across diversified brands, and in particular, and products like women’s health, we’re always asking the question, would it be more valuable in someone else’s hands, including the manufacturing assets and if we see something that makes sense from a deal perspective. We would consider it. .

And we’re going to try to get one more and if we can. .

Our next question comes from the line of Alex Arfaei with BMO Capital Markets. .

Okay, thank you and good morning. Adam, follow up on your commentary on KEYTRUDA. You mentioned a number of future indications for growth opportunities.

Could you please prioritize those in terms of which ones you think have greater commercial potential? And then a follow up on animal health, obviously very strong growth that used to be growing above the market rate. Just wondering how long you think that is sustainable.

When should we expect this to I guess gets larger to return closer to the market growth rate? Thank you. .

Yeah so as I look at KEYTRUDA as I said. Each of these indications is important that represents value to patients the patients suffering from cancer.

As I look at the size and our quarter entry and those types of things, obviously the breast cancer indication the gastric cancer indication are important to power those cellular is important to be able to compete in renal as well. And again as we look even further out the adjuvant stage cancer are very exciting opportunities for us. .

And then with your question to animal health. You are right, as you look at the quarter, we have very strong growth in the quarter and if you look back over the last couple of years we've been consistently outpacing the markets animal health market in our growth.

And as Tim mentioned earlier, this is largely due to the fact that we have both a robust in line portfolio products but also we're having meaningful new product launches across vaccines across in animals. So it really is a story of innovation that is driving the above market growth. And as we look forward.

We expect we're not going to give specific guidance but I would say as we look forward over the next several years I would expect to continue to see above market growth on the basis of the new products as well as the strength of them on products we have which really ties to the whole nature of the innovation story and the innovation synergies that Ken mentioned earlier.

.

Okay. Thank you all for participating in today's call. I want to reiterate that we are focused on commercial execution and continuing to advance our portfolio. I'm very optimistic about the rest of the year and our long term outlook. And I want to thank you and have a good day. .

Thank you ladies and gentlemen. That does conclude today's conference call. You may now disconnect..