Safeguard Scientifics, Inc.
Q2 2012 Earnings Call Transcript

Published: 26 Jul 2012

[Operator:]

Good morning, and welcome to Safeguard Scientific’s Q2 2012 Results Conference Call. Please note this event is being recorded. (Operator instructions.) I would now like to turn the conference over to John Shave, Vice President of Business Development and Corporate Communications. Please go ahead.

[John Shave:]

Good morning, and thank you for joining us for Safeguard Scientific’s 2012 Conference Call and Update. Joining me on today’s call are Peter Boni, Safeguard’s President and Chief Executive Officer; Steve Zarrilli, Senior Vice President and Chief Financial Officer; and Jim Datin, Executive Vice President and Head of the Safeguard Deal Team. During today’s call Peter will review Q2 2012 highlights as well as other developments, then Steve will discuss Safeguard’s financial results and strategies. After that we will open the line for your questions. Before we begin I must remind you that today’s presentation includes forward-looking statements. Reliance on forward-looking statements involves certain risks and uncertainties including but not limited to the uncertainty of future performance of our partner companies and the risks of acquisition or disposition of interests in partner companies, capital spending by customers and the effect of regulatory and economic conditions generally as well as the development of the life sciences and technology markets and other uncertainties that are described in our SEC filings. During the course of today’s call words such as “expect,” “anticipate,” “believe” and “intend” will be used in our discussion of goals or events in the future. Management cannot be certain that final outcomes will be as described today. We encourage you to read Safeguard’s filings with the SEC including our Form 10(k) which describe in detail the risks and uncertainties associated with managing our business. The company does not assume any obligation to update any forward-looking statements made today. Now here is Safeguard’s President and CEO, Peter Boni.

[Peter Boni:]

Thanks, John, and thank you all for joining us today for updates on Safeguard Scientifics and our partner companies. Results for Q2 ending June 30 were distributed earlier today. Our 16 partner companies continue to grow strategically and operationally, and we are therefore increasing our 2012 aggregate partner company revenue guidance to the range of $170 million to $175 million. That’s up from our previous guidance range of $160 million to $165 million. This is evidence that we are continuing to build genuine value in our businesses. Safeguard’s platform expansion initiative with the partnership with Penn Mezzanine is producing interest and fee income. We believe this now small but growing Mezzanine lending activity is a natural expansion of Safeguard’s strategic strengths and can be an important long-term activity for us. Safeguard’s deal pipeline is also full of exciting opportunities in our target markets in the life sciences and technologies sectors. With a challenging exit environment we remain cautious and disciplined in pursuing new capital deployments. Additionally, with fewer venture firms actively investing deal syndicates are supporting more selectively. We also continue to monitor the impact of Obamacare on our healthcare IT deployment strategy and thesis. Furthermore, we’ve set a high bar on our return expectations and we remain firm on our valuations we will pay for new opportunities. We’re encouraged by Safeguard’s performance in the short term and optimistic about our long term despite the ongoing volatility and uncertainty in the economy and capital markets as well as in the political landscape. Our optimism stems from this team’s execution of a focused and disciplined strategy. During the team’s tenure we’ve focused Safeguard’s strategy, broadened our business model, boosted the company’s financial strength and flexibility and we’ve driven value for shareholders. Today we’re prepared for the vagaries of capital markets, politics, and the economy. Safeguard continues to push forward as the preferred catalyst to build great companies, grooming companies of substance for growth and ultimately an exit transaction remains our path to ongoing financial strength and flexibility, as well as improved shareholder value. There are always listeners on the call who are new to Safeguard’s story, and as a result I’ll review the hallmarks of our strategy which is built on three pillars

[Steve Zarrilli:]

Thank you, Peter. Good morning. I’m going to first start with Penn Mezzanine. As you remember, Safeguard’s partnership with Penn Mez was formed in 2011. It represents our first initiative to augment our capabilities as a growth capital provider and to participate in the management of external sources of capital. This platform expansion initiative is producing current interest and loan fee income, and we expect it to produce management fee income as well as profit participation as the initiative grows and matures. Penn Mez is managed by a team of experienced mezzanine lenders. This platform enables us to provide a flexible financing alternative to our current and prospective partner companies as well as other potential lower middle-market borrowers. Penn Mez closed its first fund in 2011 after raising more than $64 million including $30 million of capital from Safeguard. Planning is currently underway for a second fund. As of June 30, Penn Mez has outstanding an aggregate of $20.9 million in seven companies. Safeguard recognized an impairment charge in Q2 of about $700,000 related to its Penn Mez loan participation activities. As of June 30, 2012, Safeguard had outstanding an aggregate of $13.7 million in Penn Mezzanine and Penn Mezzanine capital deployment participations. Safeguard maintains a 36% ownership position in Penn Mezzanine. Shifting gears I wanted to outline a few key big picture trends in Safeguard’s financial performance. Over the past five years the Safeguard team has delivered meaningful and measurable results for shareholders. Despite unprecedented volatility in capital markets we remain focused on building value in partner companies, realizing that value and then communicating our progress concisely, consistently, and credibly. We also remain focused on ensuring that we are managing operating costs and developing ongoing capital augmentation strategies in connection with our platform expansion strategies. Our goal is to continue to leverage our current infrastructure against other pools of assets of which we can manage or co-manage. We continue to actively work towards these long-term strategies. Our interests are closely aligned with Safeguard’s shareholders by virtue of our long-term compensation incentives. Our management team remains focused on building and realizing value for shareholders. Now let’s move on to some key financial metrics for the quarter ended June 30. At period end we had $241.4 million in cash, cash equivalents, and marketable securities. This amount does not include an aggregate of $16.4 million of restricted cash and cash held in escrow. Our total carry value of outstanding debt was $46 million, resulting in net cash of $195.3 million. During the quarter primary uses of cash were cash operating expenses of $2.9 million, or $0.14 per share versus $0.15 per share in the same period of 2011. During Q2 2012 Safeguard deployed an additional $2.1 million in PixelOptics. Based upon new capital deployments year-to-date and our expected pace of deployments during the second half of 2012, we believe our projected uses of cash will be near the low end of our $100 million to $150 million projected range. Uses of cash remain unchanged and they are as follows

[Peter Boni:]

Okay, thanks Steve. Valerie, let’s open the phones for any questions that the audience might have.

[Operator:]

We will now begin the question-and-answer session. (Operator instructions.) The first question comes from Jim Macdonald of First Analysis.

[Jim Macdonald:]

Good morning, guys. On your platform expansion comments, can you give me more specifics about possibly timing for a second Penn Mezzanine fund and any new funds? And is it possible those new funds could be more equity related?

[Peter Boni:]

Jim, let me ask Steve to make a comment.

[Steve Zarrilli:]

So let me take the second question first and then I’ll answer the first question second. With regard to what we might look for in future opportunities outside of Penn Mezzanine, we probably will most likely pursue platforms that are more equity oriented than debt oriented. With regard to Penn Mezzanine, they continue to look for the proper ways in which to deploy their capital and I would suspect that their planning activities will ultimately lead to the launch of some specific activities on a second fund within the next twelve to eighteen months.

[Jim Macdonald:]

And in terms of timing of a possible equity related fund, would that be this year or next year?

[Steve Zarrilli:]

We have actually been discussing opportunities with a number of parties, all at various stages of their own fundraising activities and processes. Part of the diligence is to try to understand their track record as well as their legitimate capability of actually raising the particular fund that they may be focused on, so it’s very difficult for us to be predictive with regards to a timeline as to when those opportunities may actually end up coming to fruition.

[Jim Macdonald:]

And moving over to the Penn Mezzanine results and then I’ll get back in queue, the impairment charge – does that relate to a write down of an investment or what does that relate to?

[Steve Zarrilli:]

It related to one of the loans that they have and where they believe that there’s been a change in the short- and near-term prospects for that company, and we properly evaluated that particular situation and thought it prudent to provide for a partial reserve against the loan balance recognizing that the loan currently is in a non-pay, non-accrual situation. But we expect that within the next three to six months that that situation may change and allow us to potentially get back into a current pay situation with that loan.

[Jim Macdonald:]

Thanks for that. So for your P&L, did the Avid and the Portico things run through the P&L? They’re sort of hard to see – I guess they’re offset by these impairment charges? Is that how it worked?

[Steve Zarrilli:]

They do run through the P&L, and in the P&L you have to take into account not only the income related to these milestone or escrow payment receipts, you have any impairment charges that we took during the quarter and then our pro rata share of the losses or income of our partner companies.

[Jim Macdonald:]

So the only two impairment charges were Penn Mezzanine and Pixel, so that implies I guess that the partner losses increased in the quarter.

[Steve Zarrilli:]

You have Penn Mezzanine and Pixel as impairments and you have the pickup of losses. And Jim, I don’t know… Oh, that’s right, somebody just mentioned to me we also have Tengion running through that which is also going to distort the numbers that you see there.

[Jim Macdonald:]

And the Tengion, was that impaired last quarter or this quarter?

[Steve Zarrilli:]

Now remember, Tengion’s marked at fair value and as the stock value of Tengion moves we take that change through our P&L as well.

[Jim Macdonald:]

Thanks, I’ll get back in queue.

[Operator:]

The next question comes from Paul Knight of CLSA.

[Paul Knight:]

Hi, I was wondering how the commercialization of Good Start Genetics is developing?

[Peter Boni:]

Hi Paul. Since Jim Datin is in the room and Jim has a good command of Good Start I’ll ask Jim to answer that. Jim, you okay with that?

[Jim Datin:]

Sure. Paul, this is Jim. Good Start recently launched their product in Q2. They are gaining widespread customer acceptance. There will be a national launch this quarter. They now appear to have their test menu that should be nearing full status or completion by end of Q3 and they seem to be gaining a lot of steam, good traction. The orders are picking up, the ASP is increasing, and a surprisingly good size, the majority of the cases have been approved by insurance. So look for further updates on this but we’re pleased that they’re on plan year-to-date.

[Paul Knight:]

And then a broader question I guess for either of you would be the hoped for change in diagnostics discovery tools with genetic sequencing rapidly advancing. Obviously Good Start is a beneficiary of that. What do you see in deal flow? Is genetics changing the type of deal flow you’re seeing?

[Peter Boni:]

Jim, go ahead.

[Jim Datin:]

Paul, the sequencing market continues to be hot. We’ve seen a lot of deals there since we’ve got a lot of traction and expertise and know the space well. We’re looking at several opportunities in that field today. We believe that based on reimbursement trends and the technology shifts toward this marketplace it’s clearly where the future is going to be. So it’s another component of our diagnostics strategy in addition to molecular point of care. Genetics and the sequencing fields are going to continue to expand and we expect to expand our portfolio there as well.

[Paul Knight:]

And the Peter, you had started out or the press release started by talking about deal flow or less competition. Are you seeing better pricing, higher quality deals or what are the components of that that make you excited?

[Peter Boni:]

Why don’t we do this in two pieces, Paul? I’ll answer that question and then I’ll ask Jim to do some supplemental commentary, okay? Regarding the pace of capital deployment, we have a challenging exit environment and we continue to be cautious and disciplined in our pursuit of new capital deployments as a result. And there’s a consolidation going on within the venture community and actually there are fewer firms that are actively investing, and as a result deal syndicates are forming a little bit more selectively. We’re part of that selective forming process. We’re looking at the impact of any political change, Obamacare as an example, and that’s providing some additional filter on our healthcare and IT deployment strategy in our thesis. Anecdotally we had three deals that were in the terms sheet stage. One we opted out on at the funding stage, another company backed out at the funding stage deciding not to raise funds, and the third was actually acquired by a strategic who paid a higher multiple than we were willing to pay. Furthermore we’ve set a high bar on our return expectations and we remain firm on any valuation that we are looking at that we will pay for new opportunities.

[Paul Knight:]

And then last, PixelOptics, is that going as expected or where are we with rollout there?

[Peter Boni:]

Steve, you’re on the Board at PixelOptics so I’ll ask you to make some commentary.

[Steve Zarrilli:]

So we’re behind plan with regard to market launch. We’re probably 18 months behind plan at this point in time. Management is effectively working through a number of challenges that they’ve been dealing with with regard to supply chain and some other elements of the go to market strategy. Brett Craig has now been onboard for more than six months. He’s actually in the process of calibrating his management team. We are continuing to support Pixel from a capital perspective because we do believe in the long-term prospects for Pixel but it is behind schedule based upon our original investment thesis. We did take an impairment as we mentioned with regard to Pixel because of some of those reasons in order to properly reflect what we think the value of the business is currently today, but that does not suggest that that will not change in the future. Pixel is a work in progress and we continue to feel bullish but recognize the practical matters that have to be addressed in order for it to be in the market in 2013.

[Operator:]

The next question comes from Greg Mason of Stifel Nicolaus.

[Greg Mason:]

Great, thanks. And Steve, just to follow up on that last comment on Pixel

[Steve Zarrilli:]

We’re going to continue to put capital under the current structure of a bridge right now through March of next year, and you can expect that it will be somewhere in the $2 million to $5 million range between now and then. We are also exploring ways in which we can potentially introduce other forms of capital to complement the existing shareholder base with Pixel and we typically are focused on potential strategic partners that can help in augmenting the capital need for Pixel beyond the end of 2012. But I do want to again reiterate we are very positive about Pixel’s future. There are some things that we have to work through. Management is working through specific milestones and we’re working to ensure that our capital deployment kind of works in lockstep with the achievement of those milestones. So said differently, we’re wanting to make sure that the capital that’s being deployed is being used very specifically in connection with these milestones that we think will be effective in getting them to the market in 2013. Once they get to the market we believe that there will be some other funding alternatives that they can legitimately seek and we’re trying to help them in assessing what those additional alternatives could look like, and in the same vein protecting the current investment that we have within the company. And we still remain as a significant shareholder and expect to going forward.

[Greg Mason:]

Great. And then a question on the Penn Mez, the slightly lower guidance - $1.0 million to $1.5 million down from $1.5 million

[Steve Zarrilli:]

It’s actually both. There’s some impact from the non-accrual scenario that’s impacting that projected amount of income and there’s also a recognition that they’ve deployed a lesser amount of capital in 2012 than originally anticipated so we wanted to at this mid-year point adjust our forecast of what we thought we were going to earn in income. Interestingly enough, the mezzanine market has become quite competitive principally due to the fact that commercial lenders are actually becoming more involved in providing credit alternatives to even the lower middle market enterprises. So what we’re trying to do is find credits that still fall within the thesis that we put forward. We have some targeted returns that we have as a part of the long-term plan here and we’re trying to remain consistent with those theses and game plans. I would suspect that we will continue to find ways to deploy capital but it probably will be for the next six months or so at a pace that’s a bit slower than what we originally anticipated.

[Greg Mason:]

Okay. And then the Alverix sales that began in March, I know it’s just a short timeframe here but how have they been relative to your expectations out of the gate?

[Peter Boni:]

Jim, why don’t you take that question?

[Jim Datin:]

Sure, I’d be happy to. So Alverix has partnered with Becton Dickinson on the flu product; they’re launching that in Japan. Clearly a lot will depend on the flu season that’s upcoming but Becton Dickinson has enormous interest in this and has expanded their sales force and resources to be able to properly launch it, not only ex-US but in the US as well. There’s also a lot of interest from other partners out there as well who would like to work with Alverix in this area and we expect further announcements to be made of other collaborations with Alverix.

[Greg Mason:]

Okay, great. And then I just want to make sure I noticed this correctly

[Peter Boni:]

Yes, Greg, that’s correct. The expansion phase companies are all $5 million to $20 million in size and the high traction companies are $20 million on up. So Beyond has been growing and growing appreciably and they have made the transition from stage three to stage four this past quarter.

[Greg Mason:]

Okay, great. And then one last question

[Peter Boni:]

Jim, would you take that?

[Jim Datin:]

Sure. James Hollingsworth, the former CEO is an advisor to the company. The company is nearing commercialization and it’s hopeful that the product will be approved by the FDA next year and that they’ll be in position to launch soon. I worked with Armando at GlexoWellcome. He ran the Imitrex franchise there; he was very successful in building up a $1 billion business there, and also at Auxilium as Peter mentioned that he commercialized and launched a new product. So he has a lot of expertise in this area and the company had evolved to a stage where Armando’s talents were well suited to take it to the future.

[Greg Mason:]

Great, thank you guys.

[Peter Boni:]

Jim, since you have the floor already, we partially answered Paul Knight’s question regarding capital deployment and the pace and you were ready to do something supplemental when we moved on to Greg. So let me just back up and just ask you to talk about the pipeline and so forth.

[Jim Datin:]

Sure. Well, our pipeline continues to be strong as Peter noted and on average here we’ll see over 1000 different business opportunities. Many of it is timing and cycle related – last year we completed eight transactions. We have a strong pipeline and believe that there will be other opportunities closing in the near future. We certainly spend a lot of time building value in our current companies but we’re in late stages, terms sheet stages with several different opportunities both in technology and healthcare and are planning to get several of these completed in the near future.

[Peter Boni:]

Okay, thank you.

[Operator:]

Your next question comes from Matt Dolan of ROTH Capital Partners.

[Matt Dolan:]

Hey guys, good morning. First question is on the guidance

[Peter Boni:]

Steve, go ahead.

[Steve Zarrilli:]

That increase is just evidence of the fact that these companies are getting stronger and achieving or in some cases potentially exceeding their original expectations.

[Peter Boni:]

A good deal of the revenue right now is being produced by our technology businesses, and you’d have to say that the technology businesses in particular are seeing some robust growth although the ones that are in life sciences that are generating that revenue are seeing that growth as well.

[Matt Dolan:]

Okay, so we can make some guesses as to who it is. On the deployment side of things I guess two questions

[Peter Boni:]

Jim, why don’t you make a comment first and then Steve, if you have something supplemental go ahead.

[Jim Datin:]

Matt, our capital deployment thesis remains the same. We’re not looking to augment it by doing any larger deals. We have deals in the pipeline today that represent the innovation size, the small end to the upper end – the $10 million to $20 million size – so it’s a balanced portfolio. We’ve been very proactive in certain segments, particularly healthcare IT and we believe that several of these can be culminated soon as we work through the terms sheet negotiations.

[Matt Dolan:]

Okay, and then the first part of the question was if you’d had any deals that you didn’t do because of this lack of access issue?

[Jim Datin:]

No, no. We have several companies out there now that are performing, doing well, garnering strategic interest but that was not an issue in holding back on our deployment.

[Peter Boni:]

We always ask ourselves, Matt, what’s our exit strategy before deploying capital. That’s one of our criteria but specifically we did not do a deal because of the exit-ability of it.

[Matt Dolan:]

I see, so you’re not, maybe to clarify your earlier comment wasn’t surrounding the fact that you haven’t had as many exits as maybe you had a year ago. It has to do with, as you said, the exit-ability of the target investment. Is that what you’re saying?

[Peter Boni:]

Exactly, Matt, thank you.

[Matt Dolan:]

Okay. And then the last one just to finish on Pixel, is this purely a supply issue? And Steve, maybe you can just go through what the demand size of the equation is? I know you mentioned there’s some interested customers out there in the eye care world. Just talk about the demand side of the equation because I think that’s what has most people excited about that opportunity.

[Steve Zarrilli:]

Yeah, and that’s what keeps us excited. The demand still is there. The gen one product that they are selling, though modestly selling so I don’t want to misrepresent the amount of revenue that they’re generating right now, has actually achieved a lot of great feedback both from the eye care professionals as well as the customers. The challenge that the company is working through is that they one, had a supply chain configuration that wasn’t going to lead to the right level of profitability on a long-term basis that made the financial model unwieldy – and they’re in the process of fixing that. They had a number of matters that ultimately are getting resolved with regard to the impact to the lenses when they were going through the manufacturing process themselves. They’ll talk about things called voids and hazing that occur in the lenses and they’re in the process of correcting that. So part of the challenge that they had with the first generation of the product was they were able to get these eyeglasses into the consumer’s hands but then about half of those pairs would come back, have to be corrected and then placed back into the consumer’s hands. And we just knew that we couldn’t continue to operate that way. And then finally they’re working through, because the generation two product which they’re planning to launch in 2013 is going to introduce a couple of key features that they think will actually be better for the consumer

[Matt Dolan:]

Okay, that’s helpful. And then just to tack one on

[Peter Boni:]

Revenue guidance, Matt?

[Matt Dolan:]

No, for the quarter itself. I think you’ve given that in the past, what the growth rate was or what the revenue number might have been for the quarter.

[Peter Boni:]

We did not yet provide that but we can provide that supplementally.

[Matt Dolan:]

Thank you.

[Operator:]

The next question is a follow-up from Jim Macdonald of First Analysis.

[Jim Macdonald:]

Hi guys, just a couple small things. So on NuPathe, do you expect to participate in their funding that you talked about?

[Peter Boni:]

Jim?

[Jim Datin:]

So Armando has just joined the team. He’s going to be coming back into Safeguard after they’ve formalized the commercialization strategy and we’ve had an opportunity to look at it. Clearly the company will need to raise capital and we’ll evaluate that based on the revised plan the second half of this year.

[Jim Macdonald:]

Okay. And just a technical question

[Peter Boni:]

Go ahead, Steve.

[Steve Zarrilli:]

So as you know, cash actually modestly increased on a gross basis quarter-over-quarter and it’s just the movement of monies from a long-term to a short-term classification of the relatively conservative investments that we’re maintaining this cash in.

[Jim Macdonald:]

So the cash went to a long-term investment – that’s what jumped the long-term?

[Peter Boni:]

Yeah, sometimes when we look at our deployment page, Jim, and we’re able to look at the uses of cash over a certain period of time, we will occasionally move the investments around, if you will, so that we can maximize even in the most conservative model that we use and see if we can actually improve upon the returns that we’re getting while still maintaining that conservative posture.

[Jim Macdonald:]

Okay, that helps. Thanks.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over the management for any closing remarks.

[Peter Boni:]

Okay, thanks very much, Valerie, and thank you all for your continued interest in Safeguard. I’ll remind you that we’re ready to schedule in the first half of October an Investor and Analyst Day in New York City and we’ll be getting back to you with more information on that as the time goes on. So thanks again for your interest and we’ll continue to keep you posted on our efforts to build value.

[Operator:]

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.