Internal Management System

As a global company with a diverse portfolio of products and services, we use a comprehensive framework of indicators to manage performance. The most important KPI (key performance indicator) to measure performance is EBITDA pre1.

The Value Creation and Financial KPI Pyramid, which summarizes the important financial performance measures of the Group, reflects the comprehensive framework of financial KPIs to steer the businesses and prioritize the allocation of cash resources. It consists of three managerial dimensions, namely Group, ­Business and Projects, each of which require the use of different indicators.


Abbreviations

EBITDA pre = Earnings before interest, income tax, depreciation and amortization as well as adjustments
EPS = Earnings per share
MEVA = Value added of Merck KGaA, Darmstadt, Germany
BFCF = Business Free Cash Flow
ROCE = Return on capital employed
NPV = Net present value
IRR = Internal rate of return
eNPV = expected Net present value
PoS = Probability of success
M&A = Mergers & Acquisitions

1Not defined by International Financial Reporting Standards (IFRS).

Key performance indicators of the Group and its businesses

The three key performance indicators net sales, EBITDA pre1, and business free cash flow1 are the most important factors for assessing operational performance. Therefore, we refer to these KPIs in the Report on Economic Position, the Report on Risks and Opportunities, and in the Report on Expected Developments. As the most important indicators of financial business performance, the KPIs are key elements of our performance management system.

Net sales

Net sales are defined as the revenues from the sale of goods, services rendered to external customers, commission income and profit-­sharing from collaborations, net of value added tax and after sales deductions such as rebates or discounts. Net sales are the main indicator of our business growth and therefore an important parameter of external as well as internal performance measurement. In addition, acquisition- and currency-adjusted sales are used for internal performance management. Organic sales growth shows the percentage change in net sales versus a comparative period, adjusted for exchange rate and portfolio effects. Exchange rate effects may arise as a result of foreign exchange fluctuation between the functional non-euro currency of a consolidated company and the reporting currency (euro). By contrast, portfolio effects reflect sales changes due to acquisitions and divestments of consolidated companies or businesses.

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GROUP

Net sale

Change
€ million 2017 2016 € million in %
Net sales 15,327 15,024 303 2.0 %

EBITDA pre

EBITDA pre is the main performance indicator measuring ongoing operational profitability and is used internally and externally. To provide an alternative understanding of the under­lying operational performance, it excludes from the operating result depreciation and amortization, impairment losses and reversals of impairment losses as well as adjustments. These adjustments are restricted to the following categories: integration costs, IT costs for selected projects, restructuring costs, gains/losses on the divestment of business, acquisition costs, and other adjustments. The classification of specific income and expenses as adjustments follows clear rules and underlies strict governance at Group level. Within the scope of internal performance management, EBITDA pre allows for the necessary changes or restructuring without penalizing the performance of the operating business.

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GROUP

Reconciliation EBIT to EBITDA pre1

Change
€ million 2017 2016 € million in %
Operating result (EBIT)1 2,525 2,481 44 1.8%
Depreciation and amortization 1,758 1,805 – 47 – 2.6%
Impairment losses/reversals of impairment losses – 1 129 – 130 > 100.0%
EBITDA1 4,282 4,415 – 133 – 3.0%
Restructuring costs 84 22 63 > 100.0%
Integration costs/IT costs 189 193 – 4 – 2.2%
Gains (–)/losses (+) on the divestment of businesses – 310 – 304 – 6 2.1%
Acquisition-related adjustments 63 153 – 90 – 59.0%
Other adjustments 106 11 96 > 100.0%
EBITDA pre1 4,414 4,490 – 76 – 1.7%
1
Not defined by International Financial Reporting Standards (IFRS).

Business Free Cash Flow (BFCF)

Business free cash flow comprises the major cash-relevant items that the operating businesses can influence and are under their full control.It comprises EBITDA pre less investments in property, plant and equipment, software, advance payments for intangible assets, changes in inventories, trade accounts receivable as well as receivables from royalties and licenses. To manage working capital on a regional and local level, the businesses use the two indicators days sales outstanding and days in inventory.

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GROUP

Business free cash flow1

Change
€ million 2017 2016 € million in %
EBITDA pre1 4,414 4,490 – 76 – 1.7%
Investments in property, plant and equipment,software as well as
advance payments for intangible assets
– 1,047 – 859 – 188 21.9%
Changes in inventories according to the consolidated balance sheet2 – 23 1 – 24 > 100.0%
Changes in trade accounts receivable as well as receivablesfrom royalties and licenses according to the consolidated balance sheet – 24 – 177 153 – 86.3%
Elimination first-time consolidation of Sigma-Aldrich – 149 149 – 100.0%
Elimination first-time consolidation of BioControl Systems2 – 2 12 – 14 > 100.0%
Business free Cash flow1 3,318 3,318
1
Not defined by International Financial Reporting Standards (IFRS).
2
Previous year’s figures have been adjusted, see Note (4) ‟Acquisitions and divestments”

Investments and value management

Sustainable value creation is essential to secure the long-term ­success of the company. To optimize the allocation of financial resources, we use a defined set of parameters as criteria for the prioritization of investment opportunities and portfolio decisions.

Net present value

The main criterion for the prioritization of investment opportunities is net present value. It is based on the discounted cash flow method and is calculated as the sum of the discounted free cash flows over the projection period of a project. The weighted average cost of capital (WACC), representing the weighted average of the cost of equity and cost of debt, is used as the discount rate. Depending on the type and location of a project different mark-ups are applied to the WACC.

Internal rate of return (IRR)

The internal rate of return is a further important criterion for the assessment of acquisition projects and investments in property, plant and equipment as well as intangible assets. It is the discount rate that makes the present value of all future free cash flows equal to the initial investment or the ­purchase price of an acquisition. A project adds value if the internal rate of return is higher than the weighted cost of capital including mark-ups.

Return on capital employed (ROCE)

In addition to NPV and IRR, when looking at individual accounting periods, ROCE is an important metric for the assessment of invest- ment projects. It is calculated as the adjusted operating result (EBIT) pre divided by the sum of property, plant and equipment, intangible assets, trade accounts receivable and trade accounts payable, as well as inventories.

Payback period

An additional parameter to prioritize investments in property, plant and equipment as well as intangible assets is the payback period, which indicates the time in years after which an investment will generate positive net cash flow.

Value added of Merck KGaA, Darmstadt, Germany (MEVA)

MEVA gives information about the financial value created in a period. Value is created when the return on capital employed (ROCE) of the company or the business is higher than the weighted average cost of capital (WACC). MEVA metrics provide us with a powerful tool to weigh investment and spending decisions against capital requirements and investors’ expectations.

Capital market-related parameters

Net income, earnings per share (EPS) and earnings per share pre (EPS pre)1

Earnings per share are calculated by dividing profit after tax attri- butable to the shareholders of Merck KGaA, Darmstadt, Germany, (net income) by the weighted average number of theoretical shares outstanding. The use of a theoretical number of shares takes into account the fact that the general partner’s capital is not represented by shares. To provide an alternative view, we also report earnings per share pre, in other words after the elimination of the effects of integration costs, IT costs for selected projects, restructuring costs, gains/losses on the divestment of businesses, acquisition costs and other adjustments. Moreover, amortization of acquired intangible assets as well as impairment losses on property, plant and equipment and intangible assets are eliminated. The adjustment excludes impairment losses on intangible assets for acquired research and development (R&D) projects below a threshold value of € 50 million. Income tax is calculated on the basis of the company’s underlying tax rate. The following table presents the reconciliation of net income to net income pre for the calculation of EPS pre.

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RECONCILIATION OF NET INCOME TO NET INCOME pre1

Change
€ million 2017 2016 € million in %
Net income 2,600 1,629 972 59.7%
Income taxes – 386 521 – 907 > 100.0%
Income taxes on the basis of the underlying tax rate – 849 – 855 6 – 0.7%
Amortization of acquired intangible assets 1,201 1,218 – 16 – 1.3%
Adjustments1 114 191 – 77 – 40.4%
Net income pre1 2,680 2,703 – 24 – 0.9%
Earnings per share pre (€)1 6.16 6.21 – 0.05 – 0.8%
1
Not defined by International Financial Reporting Standards (IFRS).

Credit rating

The rating of our creditworthiness by external agencies is an important indicator with respect to our ability to raise debt capital at attractive market conditions. The capital market makes use of the assessments published by independent rating agencies in order to assist debt providers in estimating the risks associated with a financial instrument. We are currently assessed by Moody’s, Standard & Poor’s and Scope. The most important factor for the credit rating is the ability to repay debt, which is determined in particular by the ratio of operating cash flow to (net) financial debt.

Dividend ratio

With the aim of ensuring an attractive return for our shareholders, we are pursuing a reliable dividend policy with a target payout ratio based on EPS pre (see definition above).

Other relevant/non-financial performance measures

Apart from the indicators of the financial performance of the businesses, non-financial measures also play an important role in furthering the success of the company. From a Group perspective, specifically innovations in the businesses as well as the attraction and retention of highly qualified employees are of central importance.

Innovation

Innovations are the foundation of our business and will also be the prerequisite for future success in changing markets. We are con- tinuously working to develop new products and service innovations for patients and customers. Indicators for the degree of innovation are defined individually depending on the specifics of the respective businesses.

Talent retention

Employing a highly qualified and motivated workforce is the basis for achieving our ambitious business goals. Therefore, we put a strong focus on establishing the processes and the environment needed to attract and retain the right talent with the right capabilities at the right time. To measure the success of the related measures, we have implemented talent retention as an important non-financial indicator.