Independent Auditor’s Report

To MERCK Kommanditgesellschaft auf Aktien, Darmstadt, Germany

Report on the Audit of the Consolidated Financial ­Statements and of the Combined Management Report

Opinions

We have audited the consolidated financial statements of MERCK Kommanditgesellschaft auf Aktien, Darmstadt, Germany, and its subsidiaries (the Group) – which comprise the consolidated balance sheet as at December 31, 2017, the consolidated income statement, consolidated statement of comprehensive income, consolidated statement of changes in net equity and consolidated cash flow statement for the financial year from January 1, 2017 to December 31, 2017, and notes to the consolidated financial statements, including a summary of significant accounting policies. In addition, we have audited the combined management report at MERCK Kommanditgesellschaft auf Aktien, Darmstadt, Germany, for the financial year from January 1, 2017 to December 31, 2017.

In our opinion, on the basis of the knowledge obtained in the audit,

  • the accompanying consolidated financial statements comply, in all material respects, with the IFRSs as adopted by the EU, and the additional requirements of German commercial law pursuant to Section 315e (1) HGB [Handelsgesetzbuch: German Commercial Code] and, in compliance with these requirements, give a true and fair view of the assets, liabilities, and financial position of the Group as of December 31, 2017 and of its financial performance for the financial year from January 1, 2017 to December 31, 2017, and
  • the accompanying combined management report as a whole provides an appropriate view of the Group’s position. In all material respects, this combined management report is consistent with the consolidated financial statements, complies with German legal requirements and appropriately presents the opportunities and risks of future development.

Pursuant to Section 322 (3) sentence 1 HGB, we declare that our audit has not led to any reservations relating to the legal compliance of the consolidated financial statements and of the combined management report.

Basis for the Opinions

We conducted our audit of the consolidated financial statements and of the combined management report in accordance with Section 317 HGB and the EU Audit Regulation No. 537/2014 (referred to subsequently as ‟EU Audit Regulation”) and in compliance with ­German Generally Accepted Standards for Financial Statement Audits promulgated by the Institut der Wirtschaftsprüfer [Institute of ­Public Auditors in Germany] (IDW). Our responsibilities under those requirements and principles are further described in the ‟­Auditor’s Responsibilities for the Audit of the Consolidated Financial Statements and of the Combined Management Report” section of our auditor’s report. We are independent of the group entities in accordance with the requirements of European law and German commercial and professional law, and we have fulfilled our other German professional responsibilities in accordance with these requirements. In addition, in accordance with Article 10 (2) point (f) of the EU Audit Regulation, we declare that we have not provided non-audit services prohibited under Article 5 (1) of the EU Audit Regulation. We believe that the evidence we have obtained is sufficient and appropriate to provide a basis for our opinions on the consolidated financial statements and on the combined management report.

Key Audit Matters in the Audit of the Consolidated Financial Statements

Key audit matters are those matters that, in our professional judgment, were of most significance in our audit of the consolidated financial statements for the financial year from January 1, 2017 to December 31, 2017. These matters were addressed in the context of our audit of the consolidated financial statements as a whole, and in forming our opinion thereon; we do not provide a separate opinion on these matters.

Measurement of the variable purchase price receivable from the sale of the Biosimilars business activities

Explanatory notes on the sale of the Biosimilars business activities can be found in note 4 and 6 of the notes to the consolidated financial statements.

Financial statement risk

As consideration for the sale of the Biosimilars business activities to subsidiaries of Fresenius SE & Co. KGaA (Fresenius), the Group received a payment of EUR 156 million as well as the right to contingent milestone payments and additional royalties based on future product revenue generated by Fresenius from the Biosimilars business activities. The gain on the disposal of the Biosimilars business activities amounted to EUR 319 million.

For the purpose of determining the fair value of these variable payments, the Group made assumptions about the progress and expected completion of clinical studies, on the success of potential product launches, and on the potential earnings development of these pro­ducts. In addition to the assessment of whether these events will occur at all, the Group made assumptions about the timing of such events. Furthermore, a distinction had to be made for the different components of potentially realizable variable payments, namely whether they represent payments for services still to be rendered by the Group, or elements of the purchase price for the Biosimilars business activities that were sold. The allocation of the purchase price receivable (including variable components) to the respective contractual components is to be made at relative fair values and the determination of the relative fair values is subject to judgment. An external expert engaged by the Group reflected the contractual agreements and the assumptions made in a binomial valuation model suitable for this purpose.

In light of the extent of estimates and judgment included in the assumptions as well as the complexity of the valuation model, there is a risk for the consolidated financial statements that the reported variable purchase price receivable and the resulting gain on disposal from the sale of the Biosimilars business activities were not accurately determined.

Our audit approach

In our audit of the variable purchase price receivable from the sale of the Biosimilars business activities, we involved our valuation experts.

In a first step, we scrutinized the distinction whether the variable earn-out payments represent payments for services still to be rendered by the Group, or whether they represent components of the purchase price for the Biosimilars business activities that were sold. For this purpose, we referred to the contractual agreements to assess whether the services to be rendered had been fully identified and whether the purchase price components allocated to the services still to be rendered were in line with their respective relative fair values.

In another step, we assessed the reasonableness of the key assumptions used for the measurement of the variable purchase price receivable. In assessing the assumptions used to predict the progress and the expected completion of clinical studies as well as the success of potential product launches, we inspected external studies on the subject matter of valuation of biosimilars development activities, inspected documents on the clinical studies that were transferred to Fresenius, and we performed inquiries of management and of employees in the Company’s controlling and the alliance management departments. We used general and sector-specific market expectations and market studies to assess the revenue forecasts used in the valuation model. We compared the assumptions and parameters underlying the capital costs used in the valuation model, in particular the risk-free interest rate, the market risk premium and the unlevered beta factor, with our own assumptions and publicly available data.

To ensure the arithmetical accuracy of the valuation model and conformity of the applied valuation method with the applicable valuation principles, we used a risk-based audit approach to recalculate the Company’s calculations on a sample basis. We also assessed whether the contractual components were appropriately reflected in the valuation model. Furthermore, we assessed the competence, capabilities and objectivity of the external experts engaged by the Group.

Our conclusions

The valuation method used to determine and measure the variable purchase price receivable from the sale of the Biosimilars business activities is appropriate. The assumptions underlying the valuation model are reasonable.

Recognition and measurement of income tax ­liabilities and deferred tax liabilities

Explanatory notes on the recognition and measurement of income tax liabilities and deferred tax liabilities can be found in notes 6, 14, 31 and 40 of the notes to the consolidated financial statements.

Financial statement risk

As of December 31, 2017, the balance sheet of the Company includes current income tax liabilities in the amount of EUR 1,059 million and deferred tax liabilities of EUR 1,489 million. In addition, other non-­current liabilities include EUR 99 million of income tax liabilities.

The Group operates in different jurisdictions with different legal systems. The application of local regulations on income tax, tax incentives and transfer pricing rules is complex. The recognition and measurement of income tax liabilities require the Group to exercise judgment in assessing tax matters and to make estimates regarding uncertain tax positions.

The measurement of income tax liabilities as well as the assessment of unrecognized contingent tax liabilities are subject to judgment and estimation uncertainty. Among others, this relates to intra-group business transfers, legal disputes attributable to the determination of earnings under tax law, and transfer pricing adjustments. The Group routinely engages external experts to support its own risk assessment with expert opinions from tax specialists.

In particular, the US tax reform, which was enacted on December 22, 2017, had a significant impact on the recognition and measurement of income tax liabilities and deferred tax liabilities as of December 31, 2017. The revaluation of deferred tax liabilities resulted in a tax benefit of EUR 1,020 million. However, the US tax reform also gave rise to an additional income tax liability in the amount of EUR 114 million due to the new rules on the taxation of profits of foreign subsidiaries.

There is a risk for the financial statements that income tax liabilities and deferred tax liabilities are not fully recognized or not appropriately measured.

Our audit approach

We involved our own specialists in international, particularly US tax law into the audit team in order to evaluate the Group’s assessment of tax risks, the related opinions of external experts engaged by the Group and the impact of the US tax reform.

We obtained an understanding of existing tax risks through inquiry of management of the affected group companies and employees of the tax department. We assessed the competence, capabilities and objectivity of the external experts and evaluated their expert opinions.

In addition, we analyzed correspondence with the relevant tax authorities and assessed the assumptions underlying the determination of income tax liabilities based on our knowledge and experience of how the relevant legal requirements are currently applied by the tax authorities and courts. We have scrutinized the Group’s approach regarding the recognition and measurement of deferred tax liabilities, based on laws and regulations enacted as of the reporting date, and performed recalculations.

Our conclusions

The valuation model and assumptions underlying the recognition and measurement of income tax liabilities are reasonable. The approach regarding the recognition and measurement of deferred tax liabilities (in particular, with respect to the impact of the US tax reform) is adequate.

Impairment testing of goodwill

Explanatory notes on the impairment tests can be found in note 6 of the notes to the consolidated financial statements.

Financial statement risk

Due to the acquisition of Sigma-Aldrich Corporation, USA, in November 2015, goodwill, in particular for the cash-generating unit Life Science, increased significantly. In aggregate, goodwill amounts to EUR 13,582 million and thus represents 38% of the Group’s total assets as of December 31, 2017, with EUR 10,519 million of this attributable to Life Science.

Goodwill is to be tested for impairment at least once a year, and may need to be tested ad hoc if necessary. In performing the goodwill impairment test, the Group primarily determines the value in use by means of a discounted cash flow method. The valuation model used to determine the value in use is complex and the result of this valuation is highly dependent on the projection of future net cash flows (taking into account future revenue growth, profit margins, exchange rates and long-term growth rates) and the discount factor used, and therefore is subject to significant estimation uncertainty.

There is a risk for the financial statements that an existing goodwill impairment loss was not recognized as of the reporting date. In addition, there is a risk that the related disclosures in the notes to the consolidated financial statements are not complete and appropriate.

Our audit approach

We applied a risk-based approach to our audit. Using our own sensitivity analyses, we assessed the extent to which the goodwill of each cash generating unit would still be sufficiently covered by the respective values in use if assumptions and parameters underlying the calculations were to change in a manner that is deemed possible. On the basis of these analyses, our audit particularly focused on the cash-generating unit Life Science.

We reconciled the expected net cash flows underlying the value in use calculations with the current medium-term plan approved by management. To assess the assumptions used in preparing the medium-­term plan, we obtained an understanding of the planning process through discussions with company representatives, including corporate management and representatives from the corporate divisions and the research and development department, we assessed the plausibility and consistency of the explanations received with the projections, and we compared the assumptions used with the expectations of external analysts and sources.

As part of our audit of the discount factor, we analyzed the peer group used. With regard to other assumptions and parameters (e.g. risk-free interest rate, beta factor, market risk premium), we compared those assumptions and parameters with our own assumptions and publicly available data to assess whether these were appropriate and whether they were within the range of external recommendations, to the extent available. In addition, we verified the calculation model used to determine the discount factor.

We assessed the appropriateness of the valuation model used. To ensure arithmetical accuracy, we used a risk-based audit approach to recalculate the Company’s calculations on a sample basis.

In addition, we assessed whether the Company’s disclosures regarding the goodwill impairment test in the notes to the consolidated financial statements are complete and appropriate.

Our conclusions

The calculation method used for the goodwill impairment test is appropriate and in line with the applicable valuation principles. Overall, the assumptions and parameters used by management are balanced. The disclosures in the notes to the consolidated financial statements are complete and properly depict the judgment associated with the subsequent measurement of goodwill.

Measurement of provisions for patent disputes

Explanatory notes on the provisions for patent disputes can be found in notes 6 and 27 of the notes to the consolidated financial statements.

Financial statement risk

As of December 31, 2017, provisions for legal disputes amount to EUR 526 million, which among others include provisions for patent disputes.

The amount of the provisions for patent disputes is determined based on the best estimate of the expenditure required to settle the dispute. Consequently, the measurement of related provisions is based on estimates and judgment of external lawyers and management.

There is a risk for the financial statements that the provisions for patent disputes were not measured appropriately as of the balance sheet date. There is also a risk that the notes to the consolidated financial statements do not contain the required disclosures on the key assumptions.

Our audit approach

As supporting evidence for the estimated expenditure required to settle the patent disputes, we obtained written confirmations from external legal counsel engaged by the Group to obtain an understanding of the current status of the pending legal proceedings, reviewed correspondence with the plaintiffs and relevant courts and other authorities, and also assessed underlying documents and minutes. In this context we also interviewed the Company’s in-house patent counsel, employees in the Group’s controlling and accounting departments, and verified the plausibility and consistency of the explanations obtained with the determination of the best estimate of the expenditure required to settle the disputes.

To ensure arithmetical accuracy of the valuation model used, we used a risk-based audit approach to recalculate the Company’s calculations on a sample basis.

In addition, we assessed whether the Company’s explanations on the measurement of provisions for patent disputes in the notes to the consolidated financial statements include appropriate and complete disclosures on the key assumptions.

Our conclusions

The assumptions for the measurement of the provisions for patent disputes are reasonable. The disclosures in the notes to the consolidated financial statements appropriately illustrate the key assumptions.

Other Information

Management is responsible for the other information. The other information comprises the annual report, with the exception of the audited consolidated financial statements and combined management report and our auditor’s report.

Our opinions on the consolidated financial statements and on the combined management report do not cover the other information, and consequently we do not express an opinion or any other form of assurance conclusion thereon.

In connection with our audit, our responsibility is to read the other information and, in so doing, consider whether the other information

  • is materially inconsistent with the consolidated financial statements, with the combined management report or our knowledge obtained in the audit, or
  • otherwise appears to be materially misstated.

Responsibilities of Management and the Supervisory Board for the ­Consolidated Financial Statements and the Combined Management Report

Management is responsible for the preparation of the consolidated financial statements that comply, in all material respects, with IFRSs as adopted by the EU and the additional requirements of German commercial law pursuant to Section 315e (1) HGB and that the consolidated financial statements, in compliance with these requirements, give a true and fair view of the assets, liabilities, financial position, and financial performance of the Group. In addition, management is responsible for such internal control as they have determined necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.

In preparing the consolidated financial statements, management is responsible for assessing the Group’s ability to continue as a going concern. They also have the responsibility for disclosing, as applicable, matters related to going concern. In addition, they are responsible for financial reporting based on the going concern basis of accounting unless there is an intention to liquidate the Group or to cease operations, or there is no realistic alternative but to do so.

Furthermore, management is responsible for the preparation of the combined management report that, as a whole, provides an appropriate view of the Group’s position and is, in all material respects, consistent with the consolidated financial statements, complies with German legal requirements, and appropriately presents the opportunities and risks of future development. In addition, management is responsible for such arrangements and measures (systems) as they have considered necessary to enable the preparation of a combined management report that is in accordance with the applicable German legal requirements, and to be able to provide sufficient appropriate evidence for the assertions in the combined management report.

The supervisory board is responsible for overseeing the Group’s financial reporting process for the preparation of the consolidated financial statements and of the combined management report.

Auditor’s Responsibilities for the Audit of the Consolidated Financial Statements and of the Combined ­Management Report

Our objectives are to obtain reasonable assurance about whether the consolidated financial statements as a whole are free from material misstatement, whether due to fraud or error, and whether the combined management report as a whole provides an appropriate view of the Group’s position and, in all material respects, is consistent with the consolidated financial statements and the knowledge obtained in the audit, complies with the German legal requirements and appropriately presents the opportunities and risks of future development, as well as to issue an auditor’s report that includes our opinions on the consolidated financial statements and on the combined management report.

Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with Section 317 HGB and the EU Audit Regulation and in compliance with German Generally Accepted Standards for Financial Statement Audits promulgated by the Institut der Wirtschaftsprüfer (IDW) will always detect a material misstatement. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these consolidated financial statements and this combined management report. We exercise professional judgment and maintain professional skepticism throughout the audit. We also:

  • Identify and assess the risks of material misstatement of the consolidated financial statements and of the combined management report, whether due to fraud or error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinions. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control.
  • Obtain an understanding of internal control relevant to the audit of the consolidated financial statements and of arrangements and measures (systems) relevant to the audit of the combined management report in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of these systems. Evaluate the appropriateness of accounting policies used by management and the reasonableness of estimates made by management and related disclosures.
  • Conclude on the appropriateness of management’s use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Group’s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in the auditor’s report to the related disclosures in the consolidated financial statements and in the combined management report or, if such disclosures are inadequate, to modify our respective opinions. Our conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However, future events or conditions may cause the Group to cease to be able to continue as a going concern.
  • Evaluate the overall presentation, structure and content of the consolidated financial statements, including the disclosures, and whether the consolidated financial statements present the underlying transactions and events in a manner that the consolidated financial statements give a true and fair view of the assets, liabilities, financial position and financial performance of the Group in compliance with IFRSs as adopted by the EU and the additional requirements of German commercial law pursuant to Section 315e (1) HGB.
  • Obtain sufficient appropriate audit evidence regarding the financial information of the entities or business activities within the Group to express opinions on the consolidated financial statements and on the combined management report. We are responsible for the direction, supervision and performance of the group audit. We remain solely responsible for our opinions. Evaluate the consistency of the combined management report with the consolidated financial statements, its conformity with [German] law, and the view of the Group’s position it provides.
  • Perform audit procedures on the prospective information presented by management in the combined management report. On the basis of sufficient appropriate audit evidence we evaluate, in particular, the significant assumptions used by management as a basis for the prospective information, and evaluate the proper derivation of the prospective information from these assumptions. We do not express a separate opinion on the prospective information and on the assumptions used as a basis. There is a substantial unavoidable risk that future events will differ materially from the prospective information.

We communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that we identify during our audit.

We also provide those charged with governance with a statement that we have complied with the relevant independence requirements, and communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, the related safeguards.

From the matters communicated with those charged with governance, we determine those matters that were of most significance in the audit of the consolidated financial statements of the current period and are therefore the key audit matters. We describe these matters in our auditor’s report unless law or regulation precludes public disclosure about the matter.

Other Legal and Regulatory Requirements

Further Information pursuant to Article 10 of the EU Audit Regulation

We were elected as group auditor by the annual general meeting on April 28, 2017. We were engaged by the supervisory board on June 1, 2017. We have been the group auditor of MERCK Kommanditgesell­schaft auf Aktien, Darmstadt, Germany, without interruption since the financial year 1995.

We declare that the opinions expressed in this auditor’s report are consistent with the additional report to the audit committee pursuant to Article 11 of the EU Audit Regulation (long-form audit report).

German Public Auditor Responsible for the Engagement

Frankfurt am Main, February 15, 2018

KPMG AG
Wirtschaftsprüfungsgesellschaft

Braun

Wirtschaftsprüfer
(German Public Auditor)

Rackwitz

Wirtschaftsprüfer
(German Public Auditor)