Merck KGaA. Credit Opinion Update. CREDIT OPINION 1 September Update. Summary Rating Rationale. Credit Strengths

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1 CREDIT OPINION Merck KGaA Credit Opinion Update Update Summary Rating Rationale RATINGS Merck KGaA Domicile Germany Long Term Rating Baa1 Type LT Issuer Rating - Fgn Curr Outlook Stable Please see the ratings section at the end of this report for more information. The ratings and outlook shown reflect information as of the publication date. Contacts Knut Slatten Vice President knut.slatten@moodys.com Yasmina Serghini Associate Managing Director yasmina.serghini@moodys.com Merck KGaA's rating reflects 1) the group's good diversification, which has been strengthened by the Millipore and Sigma-Aldrich acquisitions and is based on the differing dynamics of its businesses, Healthcare (Biopharma and Consumer Health), Performance Materials (incl. AZ) and Life Science (Merck Millipore and Sigma-Aldrich (SIAL)); (2) the group's track record in maintaining its leadership position in the liquid crystals segment; (3) the fairly good cash flow generation, (4) visibility of the group's drug portfolio, which is heavily skewed towards biopharmaceuticals and consequently less exposed to generic competition; and (5) a good liquidity profile. The rating also takes into account (1) increasing competitive pressures for the group's largestselling drug, Rebif (accounting for 14% of Merck's group sales in 2015), following the launch of oral treatments (more convenient for patients) and the expected launch of Ocrevus from Roche sometime in 2017, which has shown strong efficacy in a head-to-head phase 3 study against Rebif; (2) a modest pharmaceutical late-stage pipeline, which may burden the medium-term performance of the group's pharmaceuticals segment; (3) increased competition in Merck's highly profitable liquid crystals division, which has resulted in pricing pressures; and (4) a high leverage (measured as Moody's adjusted debt/ebitda) ratio of 3.7x as per LTM June 2016 and expected to be around 3.0x by year-end Exhibit 1 Credit metrics have deteriorated markedly with Sigma Aldrich acquisition but will recover gradually Cash Flow from Operations/debt ratio (in %) Source: Merck KGaA; Moody's estimates Credit Strengths Strong business, product and geographic diversification with mostly non cyclical end markets (75% of group turnover considered non cyclical)

2 Focus on biotech drugs, which are difficult to copy and less exposed to generic competition Agreement with Pfizer for development of Avelumab reduces development cost and gives access to new molecules for combination trials Long-standing leadership position in liquid crystals, which generate high margins Healthy free cash flow generation and good liquidity profile Credit Challenges Pipeline replenishment needed to ensure Biopharma's medium-term growth Investments in pipeline and product launches will slow down deleveraging path in the medium term Pro-forma credit metrics post Sigma-Aldrich acquisition have weakened substantially Liquid crystals is a cyclical business, high inventory levels in flat panels to be monitored Rating Outlook The stable outlook is supported by Moody s expectation that Merck will remain focused on deleveraging and bringing back credit metrics more in line with our expectations for the current rating over the next 12 to 18 months. The stable outlook also incorporates Moody s assumption that Merck will de-leverage towards its self-imposed leverage target of a net leverage below 2x by Factors that Could Lead to an Upgrade Positive rating pressure not expected over the next 2-3 years due to debt load from Sigma-Aldrich acquisition Longer term positive rating pressure if cash flow from operating activities (CFO)/debt above 45%. Factors that Could Lead to a Downgrade Any deviation from bringing back CFO/debt to around 30% by 2018 and to the mid thirties by 2019 Failure to bring back leverage to below 2.5x debt/ EBITDA Key Indicators Detailed Rating Considerations GOOD DIVERSIFICATION ACROSS DIVISIONS AND END MARKETS THAT FOLLOW DIFFERENT DYNAMICS Over the past decade, Merck has undertaken several transformational restructuring steps of its activities, with the acquisition of Millipore in 2010, AZ Materials in May 2014 and the acquisition of Sigma Aldrich (SIAL) in November 2015 being the latest major cornerstones. The acquisitions reshaped Merck's activities and emphasized its strategic profile as an integrated company operating This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. 2

3 in Healthcare (54% of the group's 2015 revenues), Performance Materials (20% of the group revenues) and Life Science with Merck Millipore and Sigma-Aldrich (26%, this share will be significantly higher following closing of the SIAL acquisition), which benefit from different dynamics and risk characteristics. With Millipore, Merck has not only improved its product diversification and geographic footprint, but also diversified its exposure to end-markets, although we note that Merck Millipore's performance is linked to the pharmaceutical and biotechnology industries. With the acquisition of SIAL, Merck's Life Science business has broadened its customer and product basis and has increased its market access with the combined entity securing a n 2 market position in the consolidating life science industry. The transaction has somewhat reduced Merck's dependency on its healthcare division and reinforces the defensiveness of Merck's business profile because demand for life science products is very resilient. SIAL has increased Merck's scale by adding around $2.8 billion of revenues to Merck's top line and rebalances the group revenues which were previously strongly focused on Merck Healthcare. Pro forma for the transaction Merck's Life Science Business revenue share will increase to >35% from around 25%. In addition, Sigma is a very well-managed, highly profitable (i.e., EBITDA margin in excess of 30% and return on invested capital (ROIC) of around 20%) and free cash flow generative (i.e., free cash flow/ebitda of around 50%) life science company (all ratios as reported by Sigma). The deal offers strong synergy potential of around EUR260 million in three years and will be margin accretive to Merck's Life Science segment and the Merck group (if we include the expected synergies). As Merck's pharmaceutical business continues to be the largest profit contributor, we use the Global Pharmaceutical Industry rating methodology (published December 2012) as an input to our analysis. Merck's methodology grid-indicated rating for the next months indicates a Baa1, which is in line with the rating assigned. We expect Merck to continue focusing on deleveraging following the SIAL acquisition, which should bring its capital structure closer to metrics required for the Baa1 rating over time. SOME PRODUCT CONCENTRATION REMAINS Merck's product mix has improved as a result of the Millipore acquisition, which provided the former with an additional EUR1.2 billion of revenues in 2010 and reduced its overall product concentration. This has further improved with the AZ acquisition, adding another $730 million (around EUR 530 million) of sales and with the SIAL acquisition, adding around $2.8 billion (around EUR 2.1 billion). However, there remains substantial concentration of sales within Biopharma, with its two largest-selling drugs, Rebif (for the treatment of multiple sclerosis, or MS) and Erbitux (oncology), in total contributing 39% to Merck's Healthcare business in 2015 and, hence around 21% of Merck's overall sales. As regards Performance Materials, liquid crystals benefit from margins significantly above the group average and therefore increase Merck's overall concentration in terms of earnings. FOCUS ON SPECIALITY PRODUCTS WITH MODERATE EXPOSURE TO GENERIC COMPETITION SUPPORTS CASH FLOW VISIBILITY, BUT COMPETITION IS INCREASING Although Merck's two main drugs have already faced patent expirations on their active ingredients, and will continue to do so over the next few years, we note that the group has employed active life-cycle management, notably with the new formulation of Rebif (patent expiry in 2024) and Rebidose, a new single-use pre-filled pen for the self-administration of Rebif. In addition, both, Erbitux (EU patent expired in June 2014) and Rebif, are biological drugs, which are difficult to copy, and the regulatory pathway to bring biosimilars (i.e., copies of biological drugs) to the market remains work-in-progress in some key markets, particularly the US. We also note that Erbitux is distributed by BMS in the US. We do not expect there to be any immediate threat to Merck's flagship drugs from competitors copying these compounds, as any regulatory approval of such a follow-on product is likely to require clinical trials in order to demonstrate bioequivalence; however, we note that biosimilars no longer appear to be as remote a possibility as they did only a few years ago. Pressures on Biopharma's earnings are more likely to arise as a result of competition from new, more efficacious or convenient treatments. This is particularly true for MS, with Biogen Idec's oral treatment Tecfidera launched in March 2013, which has shown strong efficacy in phase 3 studies. Rebif also faces competition from two other treatments for MS: Gilenya by Novartis (Aa3 stable), the first oral treatment launched for the disease, and Aubagio, another oral treatment, developed by Sanofi (A1 stable). In addition, Sanofi launched Lemtrada, another treatment for MS, in October 2013 in Europe and received FDA approval in November Lemtrada is injected, has good efficacy and a substantially reduced frequency of administration. Last but not least Roche Holding (A1 stable) may 3

4 launch Ocrevus, a monoclonal antibody during the course of Ocrevus has showed strong phase 3 clinical trial results in a headto-head study with Merck's Rebif. The growing market competition in the treatment of MS will likely exert pressure on Rebif's sales and profits. In order to protect its pharmaceutical franchise focusing on oncology, immunology, multiple sclerosis, fertility, and general medicine markets, Merck is actively managing the life-cycle of Rebif and Erbitux and increasing its presence in Emerging Markets. We also note that Merck has been able to compensate volume pressures on Rebif by several price increases in the US during the last 12 to 18 months. In addition, Merck expands into adjacent areas such as medical devices and biosimilars. THE PERFORMANCE MATERIALS DIVISION BENEFITS FROM HIGH MARGINS, BUT REMAINS CYCLICAL The group's liquid crystals franchise is affected by cyclical swings in demand, as seen during the economic downturn, when revenues and margins were severely hit. There was, however, a strong rebound in demand and profitability in Merck had warned on high inventory levels across the value chain although the performance of the business has remained sound so far. PIPELINE REPLENISHMENT NEEDED TO ENSURE BIOPHARMA'S GROWTH OVER THE LONG TERM Biopharma has struggled with the productivity of its late-stage pipeline over recent years. Setbacks in the pipeline have concerned the non-approval of Erbitux in non-small cell lung cancer (NSCLC) in Europe, the failure to bring oral Cladribine, an oral treatment for MS, to market in both the US and Europe, the discontinuation of the development of Safinamide (a treatment for Parkinson's disease), and the removal from the pipeline of Cilengitide (glioblastoma) and mixed phase 3 results recorded on Stimuvax in NSCLC. Most recently, Merck announced the discontinuation of clinical development for Evofosfamide in Soft Tissue Sarcoma and Pancreatic Cancer. Merck currently focuses on two main products in its late stage pipeline: 1) Cladribine Tablets for the treatment of relapsing-remitting multiple sclerosis is currently under review of the Marketing Authorization Application at the European Medicines Agency (EMA); 2) Avelumab, an anti PD-L1 monoclonal antibody, is currently investigated alongside Merck s partner Pfizer in several phase 3 studies in different tumor types. In addition, Avelumab has received breakthrough therapy and orphan drug designation from the FDA for Merkel Cell carcinoma. INVESTMENT IN PIPELINE AND SIAL SYNERGY IMPLEMENTATION COSTS TO PRESSURE MARGINS IN THE SHORT TERM Various factors will impact margin levels of Merck in the short to medium term. Over the period high investments in R&D, the synergy cost implementation for SIAL especially in 2016, mix effects on the pharma portfolio (most likely related to operating pressures on Rebif and to a lesser extent on Erbitux) will lead to modest margin compression. From 2019 onwards margin should increase supported by increased revenues from new product launches and a normalisation of R&D spent levels. CREDIT METRICS HAVE DETERIORATED FOLLOWING THE CLOSING OF THE SIAL ACQUISITION Following the closing of the Sigma-Aldrich acquisition in November 2015, credit metrics of Merck KGaA have deteriorated markedly with CFO/debt dropping from 40.9% at year-end 2014 to 16.2% at year-end Credit metrics are expected to improve strongly in 2016 supported by the first full-year consolidation of Sigma Aldrich and the application of free cash flow to debt reduction. We expect CFO/debt to increase to around 20%-25% in The pace of deleveraging will however slow down beyond 2016 as the company will continue to invest materially in its late stage pipeline and especially in Avelumab, which is currently trialed in seven phase 3 clinical trials. This will slow down the progression in operating cash flow generation and hence the improvement in credit metrics from our initial anticipation especially in 2017 and Merck will however keep strong discretion in the level of R&D spent and will only invest for sustainable and meaningful earnings accretion in 2019 and beyond. Moody s views these investments as critical for the long term success of Merck s healthcare franchise and will therefore tolerate a modest deviation from our initially anticipated deleveraging path. However we expect CFO/debt to reach the low to mid thirties by late , a level more commensurate with the current rating. Liquidity Analysis The liquidity profile of Merck is good. The group had EUR827 million of cash available on balance sheet at 30th June 2016 as well as EUR2 billion availability under a EUR2 billion 5-year RCF maturing in This facility has no financial covenants or repeating 4

5 MAC. Alongside the group s expected Funds from Operations for the next 12 months of EUR 3 to 3.5 billion this should be more than sufficient to cover capex of around EUR billion, debt repayments of EUR0.2 billion (USD250 million) as well as dividends and working capital consumption. Structural Considerations The Baa3 rating assigned to the hybrid notes is two notches below Merck's Baa1 senior unsecured issuer rating. This reflects the deeply subordinated nature of the new hybrid securities in relation to the existing senior unsecured backed obligations of Merck KGaA and its subsidiaries, while the new hybrid securities is only senior to common shares. The hybrid security has a maturity of at least 60 years and has no events of default. The hybrid notes qualify for the basket C and a 50% equity treatment of the borrowing for the calculation of the credit ratios by Moody's (please refer to Moody's Cross-Sector Rating Methodology 'Revisions to Moody's Hybrid Tool Kit' of July 2010). Corporate Profile Founded in 1668 and based in Darmstadt, Germany, Merck KGaA ( Merck ) is a diversified global healthcare, life sciences and performance materials company. The company develops and manufactures original drugs, health care products, specialty valueadded chemicals and life sciences solutions. Merck acquired Millipore Corporation, a life science tools business, in 2010, AZ Electronic Materials (AZ) in 2014, a high-tech materials and functional chemicals supplier, and Sigma-Aldrich Corporation ( SIAL ), a leading life science and high technology company in November These acquisitions lead to a more balanced business profile for the group. For the last 12 months ended June 2016, Merck generated revenues of EUR14.1 billion. 70.3% of Merck's capital is family owned with the rest being listed. Rating Methodology and Scorecard Factors 5

6 Ratings Exhibit 2 Category MERCK KGAA Outlook Issuer Rating Senior Unsecured MTN -Dom Curr Jr Subordinate -Dom Curr Other Short Term -Dom Curr Moody's Rating Stable Baa1 (P)Baa1 Baa3 (P)P-2 MERCK FINANCIAL SERVICES GMBH Outlook Bkd Senior Unsecured -Dom Curr Bkd Other Short Term -Dom Curr Stable Baa1 (P)P-2 EMD FINANCE LLC Outlook Bkd Senior Unsecured Stable Baa1 Source: Moody's Investors Service 6

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8 Contacts Knut Slatten Vice President 8 CLIENT SERVICES Yasmina Serghini Associate Managing Director Americas Asia Pacific Japan EMEA