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Rating action

Scope Ratings GmbH (Scope) has affirmed the A- issuer ratings of Merck KGaA and its financing subsidiaries Merck Financial Services GmbH and EMD Finance LLC and changed the Outlook to Positive from Stable. Senior unsecured debt has been affirmed at A- and contractually subordinated debt (hybrid) affirmed at BBB. The short-term rating for Merck KGaA has also been affirmed at S-1.

Rating rationale

The Positive Outlook reflects Scope’s view of the strong likelihood that Merck’s credit metrics will continue to improve in the next few years, based on the strong growth anticipated for Merck’s Life Sciences division and pharma pipeline delivering. The issuer rating benefits from the portfolio realignment over recent years, which resulted in the growth of semiconductors and organic light-emitting diode products replacing the declining volumes in liquid crystals, as well as from newly approved pharma products, mainly Mavenclad and Bavencio. Merck increased its guidance for 2021¹ while setting growth targets until 2025, showing outperformance of its three divisions (Life Sciences, Healthcare and Electronics). Scope thus expects leverage as expressed by Scope-adjusted debt (SaD) to EBITDA to improve to below 2x by the end of 2021 and to remain at that level into the medium term, assuming no large M&A. While Scope does not expect new management to deviate from the conservative financial policy, the rating case leaves some cushion for medium-sized deals from 2022.

The issuer rating continues to benefit from Merck’s business risk profile assessed at A, which mostly consists of the stable and cash-generative business models of its three divisions. In addition, Scope continues to see the group’s structure as reflecting the owning family’s philosophy to achieve a strong diversified group. Merck’s Healthcare division still somewhat depends on the stability provided by its mature products, although its pharma pipeline has started to deliver. Management expects newly approved drugs to add EUR 1.6bn-1.8bn of revenues into the medium term, compared with EUR 2bn assumed before the Covid pandemic hit. Recent sales of key drug Bavencio (anti-PD-L1), jointly developed and marketed with Pfizer Inc, have been modest, based on the drug’s achieved approvals for smaller indications (bladder cancer/second-line and Merkel cell carcinoma), but this is likely to change with the approval in January 2021 of larger indication urothelial (bladder first-line). The underlying molecule Avelumab is being developed in one further phase 3 pipeline project for non-small cell lung cancer – another sizeable market – and is expected to be launched within the next months. US approval was also received for MET inhibitor Tepmetko, intended for adults with metastatic non-small cell lung cancer, while two phase 3 trials with bintrafusp alfa (jointly developed with GSK plc) failed and the collaboration with GSK was ended recently. Despite delivery delays, Merck’s new multiple sclerosis drug Mavenclad has the potential to become a blockbuster in an already crowded market. This would be a good achievement given that 2020 sales were significantly held back by the Covid crisis’ impacts.

Demand for Life Sciences products accelerated significantly during the past 15 months, driven not only by the successful integration of Sigma Aldrich (acquired in 2015) but also by two very positive operational trends. The first relates to the Covid crisis, which increased demand for laboratory testing equipment and led to high R&D demands being placed on the industry. The second relates to strong activity to develop monoclonal antibodies and biosimilars for the fast-growing treatment areas of oncology and immunology. These translated into significant growth for Life Sciences in 2020 (+12%, year-on-year) and in the first half of 2021 (+27% organic growth, year-on-year). Scope believes these developments are likely permanent as the crisis made many European governments, research institutions and hospitals acknowledge the need to prepare for future health crises. The EBITDA margin also strengthened as a result of these factors, reaching 36% in the first half of 2021 from 32% in 2020 and 30% in 2019.

Merck’s Electronics division (formerly Performance Materials) showed a stabilised top line and operating profitability. This balanced out the strongly declining profitability in Merck’s former flagship activity of Liquid Crystals, a consequence of competitive pressures. This development was attributed to cost measures at Liquid Crystals (division now maintained to generate cash and has limited growth potential going forward) and the increased semiconductor exposure (chiefly through the acquisition of Versum at the end of 2019) that compensates for weakening performance in Liquid Crystals. Together with organic light-emitting diodes (OLED) activity, semiconductor services are providing growth potential for the newly structured Electronics division.

Most of Merck’s activities were not adversely affected by Covid; some in Life Sciences even benefitted. The larger exposure to semiconductors is also a positive factor: a supply-demand imbalance is causing significant bottlenecks and strong price increases that are likely to continue into the medium term. This imbalance is due to two factors: i) a production contraction driven by the Covid crisis followed by strongly recovering demand from internet and mobile communications; and ii) the fresh source of sustainable demand from a new generation of automobiles requiring more semiconductors for communication and navigation.

Scope has upgraded its assessment of Merck’s financial risk profile to A- from BBB based on the good deleveraging progress following the Versum acquisition in 2019. Efforts are strengthened by the supportive financial policy and the improving operational background, especially with the adequate operating cash flows in Life Sciences and Healthcare. In 2020, deleveraging was significant as it was the first financial year incorporating 12 months of cash flow from Versum. The leverage ratio as measured by SaD/EBITDA was down to 2.4x in 2020 from 3x in 2019, even with the weaker demand for certain products in the first half, mostly a result of Covid. Deleveraging continued in the second half of 2020, driven by recovering business trends combined with good control of working capital. Key credit metrics thus performed slightly better than Scope’s expectations for 2020. In 2021, deleveraging even accelerated in the first half through the stellar performance of Life Sciences resulting from strong demand for biopharmaceutical products and laboratory equipment, with the latter induced by the pandemic. Reinforced by management’s strong ratings commitment (cost control, no large acquisitions, stable dividend), credit metrics improved in the first half of 2021 on a rolling 12-month basis. Assuming that the Life Sciences developments are permanent and newly approved drugs expand pharma sales (which is likely), Scope believes SaD/EBITDA will fall below 2x by the end of this year. For 2022, the ratio may even go towards 1.5x, based on the recently announced medium term guidance showing annual organic growth with no big acquisitions while opting for bolt-on acquisitions.

Scope continues to consider financial policy as generally conservative based on management’s long-proven deleveraging commitment. Scope also has no reason to believe new management will deviate from this position, supported by a recent management statement confirming a potential bolt-on acquisition policy. For technical reasons, Scope has removed the one-notch rating uplift for financial policy as it is already reflected in the improving credit metrics.

The rating assessment includes a negative rating driver regarding the high regulatory and reputational risks in the pharmaceutical industry (ESG-related rating driver).
One or more key drivers of the credit rating action are considered ESG factors.

Outlook and rating-change drivers

The Positive Outlook reflects our expectation of a SaD/EBITDA trending towards 1.5x, bolstered by the strong growth in Merck’s major business divisions and the strengthening of its balance sheet through cash accruals after capex and discretionary spending.

A positive rating action is possible upon a SaD/EBITDA sustained at around 1.5x.

A negative rating action, such as the return to a Stable Outlook, could result from a more aggressive financial policy related to larger debt-funded acquisitions that again weigh on leverage, resulting in a SaD/EBITDA of significantly above 1.5x.

Long-term and short-term debt ratings

Senior unsecured debt has been rated at the same level as the issuer rating.

Contractually subordinated debt that qualifies as hybrid debt (deferability of coupon payments, structural subordination, perpetual duration) has been affirmed at BBB, two notches below the issuer rating.
The short-term rating of S-1 reflects Merck’s sound credit quality and is supported by adequate internal liquidity and reflecting strong access to external funding through capital markets and bank debt as signalled by the frequent issuance of bonds, commercial paper and hybrid debt.

Rating driver references
1. 9 September 2021 Merck Group Capital Market Day

Stress testing & cash flow analysis
No stress testing was performed. Scope Ratings performed its standard cash flow forecasting for the company.

Methodology
The methodologies used for these Credit Ratings and/or Outlooks, (Corporate Rating Methodology, 6 July 2021; Rating Methodology: European Pharmaceuticals, 11 January 2021; Rating Methodology: Chemical Corporates, 23 April 2021), are available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Ratings: public domain, the Rated Entity and Scope Ratings' internal sources.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting the Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Azza Chammem, Senior Analyst
Person responsible for approval of the Credit Ratings: Sebastian Zank, Executive Director
The Merck KGaA issuer Credit Rating/Outlook was first released by Scope Ratings on 19 October 2016. The Credit Rating/Outlook was last updated on 9 October 2020.
The Merck KGaA short-term Credit Rating was first released by Scope Ratings on 19 October 2016. The Credit Rating was last updated on 9 October 2020.
The Merck KGaA senior unsecured debt Credit Rating was first released by Scope Ratings on 19 April 2018. The Credit Rating was last updated on 9 October 2020.
The Merck KGaA subordinated debt Credit Rating was first released by Scope Ratings on 19 April 2018.The Credit Rating was last updated on 9 October 2020.
The Merck Financial Services GmbH issuer Credit Rating/Outlook was first released by Scope Ratings on 19 April 2018. The Credit Rating/Outlook was last updated on 9 October 2020.
The Merck Financial Services GmbH senior unsecured debt Credit Rating was first released by Scope Ratings on 19 April 2018. The Credit Rating was last updated on 9 October 2020.
The Merck Financial Services GmbH subordinated debt Credit Rating was first released by Scope Ratings on 19 April 2018.The Credit Rating was last updated on 9 October 2020.
The EMD Finance LLC issuer Credit Rating/Outlook was first released by Scope Ratings on 19 April 2018.The Credit Ratings/Outlooks were last updated on 9 October 2020.
The EMD Finance LLC senior unsecured debt Credit Rating was first released by Scope Ratings on 19 April 2018.The Credit Rating was last updated on 9 October 2020.
The EMD Finance LLC subordinated debt Credit Rating was first released by Scope Ratings on 19 April 2018. The Credit Rating was last updated on 9 October 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use/exclusion of liability
© 2021 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.