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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 key performance indicator (KPI) 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: Group, Business, and Projects, each of which require the use of different indicators.

Abbreviations
EBITDA pre1 = earnings before interest, income tax, depreciation and amortization, as well as adjustments
EPS = earnings per share.
EPS pre1 = earnings per share before adjustments.
MEVA1 = Value added of Merck KGaA, Darmstadt, Germany.
BFCF1 = business free cash flow.
ROCE1 = return on capital employed.
NPV1 = net present value.
IRR1 = internal rate of return.
eNPV1 = expected net present value.
PoS1 = probability of success.
M&A = mergers and acquisitions.
1 Not defined by International Financial Reporting Standards (IFRSs).

Key performance indicators of the Group and its businesses

The three key performance indicators of net sales, EBITDA pre, and business free cash flow 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 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, organic sales growth is 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 sales        
Change
€ million 2019 2018 € million %
Net sales 16,152 14,836 1,315 8.9

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 expenses, IT expenses for selected projects, restructuring expenses, gains/losses on the divestment of businesses, acquisition expenses, 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 necessary changes or restructuring without penalizing the performance of the operating business. The following table shows the composition of EBITDA pre in fiscal 2019 compared to the previous year. These figures were adjusted in accordance with IFRSs by the adjustments included in the functional costs.

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Group
Reconciliation EBITDA pre1
2019 2018² Change
€ million IFRSs Elimination
of adjustments
Pre1 IFRSs Elimination
of adjustments
Pre1 Pre1
Net sales 16,152 16,152 14,836 14,836 8.9%
Cost of sales -6,006 56 -5,950 -5,382 45 -5,337 11.5%
Gross profit 10,145 56 10,202 9,454 45 9,499 7.4%
Marketing and selling expenses -4,576 10 -4,566 -4,396 13 -4,384 4.2%
Administration expenses -1,154 109 -1,045 -1,183 190 -993 5.2%
Research and development costs -2,268 29 -2,239 -2,227 2 -2,225 0.7%
Impairment losses and reversal of impairment losses on financial assets (net) -8 -8 27 27 > 100.0%
Other operating income and expenses -19 123 104 52 78 129 19.6%
Operating result (EBIT)1 2,120     1,727      
Depreciation/amortization/impairment losses/reversals of impairment losses 1,946 -9 1,937 1,801 -55 1,746 11.0%
EBITDA1 4,066     3,528      
Restructuring expenses 120 -120 46 -46  
Integration expenses/IT expenses 95 -95 142 -142  
Gains (-)/losses (+) on the divestment of businesses 6 -6 25 -25  
Acquisition-related adjustments 84 -84 2 -2  
Other adjustments 13 -13 58 -58  
EBITDA pre1 4,385 4,385 3,800 3,800 15.4%
thereof: organic growth1             11.3%
thereof: exchange rate effects             2.5%
thereof: acquisitions/divestments             1.6%
1 Not defined by International Financial Reporting Standard (IFRSs).
2 Previous year’s figures have been adjusted, see Note “Effects from new accounting standards and other presentation changes” in the Notes to the Consolidated Financial Statements.

Business free cash flow (BFCF)

Business free cash flow comprises the major cash-relevant items that the operating businesses can influence and that are under their full control. It comprises EBITDA pre less investments in property, plant, equipment, software, advance payments for intangible assets, changes in inventories, trade accounts receivable, and 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 2019 2018 € million %
EBITDA pre1 4,385 3,800 585 15.4%
Investments in property, plant, equipment and software, as well as advance payments for intangible assets -1,026 -932 -94 10.1%
Changes in inventories -577 -214 -363 > 100.0%
Changes in trade accounts receivable as well as receivables from royalties and licenses -259 -145 -114 78.6%
Lease payments2 -136      
Elimination of first-time consolidations 346      
Business free cash flow1 2,732 2,508 224 8.9%
1 Not defined by International Financial Reporting Standard (IFRSs).
2 Excluding payments for low-value leases and interest components included in lease payments.

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 (NPV)

The main criterion for the prioritization of investment opportunities is the 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 markups 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 markups.

Return on capital employed (ROCE)

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

Payback period

An additional parameter to prioritize investments in property, plant, equipment, and 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.

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

Earnings per share are calculated by dividing profit after tax attributable 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 expenses, IT expenses for selected projects, restructuring expenses, gains/losses on the divestment of businesses, acquisition expenses, and other adjustments. Moreover, amortization of acquired intangible assets as well as impairment losses on property, plant, 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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GROUP
Reconciliation of net income to net income pre1
  Change
€ million 2019 2018 € million %
Net income 1,320 3,374 -2,053 -60.9%
Non-controlling interests 3 22 -19 -85.1%
Profit after tax from discontinued operation -28 -2,303 2,275 -98.8%
Income tax 440 368 72 19.7%
Amortization of acquired intangible assets 1,119 1,175 -55 -4.7%
Adjustments1 369 327 42 12.7%
Income taxes on the basis of the underlying tax rate1 -807 -741 -66 8.9%
Non-controlling interests to be adjusted   -3 3 100.0%
Net income pre1 2,417 2,219 198 8.9%
Earnings per share pre1 (€) 5.56 5.10 0.46 9.0%
1 Not defined by International Financial Reporting Standards (IFRSs).

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, innovations in the businesses as well as the promotion of a diverse workforce, especially at the leadership level, and sustained planning for the filling of company-critical positions, are of particular importance.

Innovation

Innovations are the foundation of our business and will also be the prerequisite for future success in changing markets. We are continuously 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.

Sustained employee development

We believe that a diverse workforce strengthens our ability to innovate. We actively promote diversity among our leaders to create an integrative culture that reflects our values and enables every employee to fulfill their potential. We ensure that our ambitious corporate goals can be realized through strategic succession planning for company-critical positions. To gauge the success of the related measures, we have introduced these two focus issues as non-financial indicators.