Surmodics, Inc.
Q3 2008 Earnings Call Transcript

Published: 28 Jul 2008

[Operator:]

Welcome to the SurModics third quarter 2008 Earnings Call. (Operator Instructions). I would now like to turn the conference over to Phil Ankeny, Senior Vice President and Chief Financial Officer. Go ahead, sir.

[Phil Ankeny:]

Thank you very much, Mitch. Good afternoon. Welcome to SurModics fiscal 2008 third quarter conference call. Thanks for joining us today. Our fiscal 2008 third quarter results' press release was issued earlier this afternoon and is also available on our company website at www.surmodics.com. Joining me on the call today is Bruce Barclay, President and Chief Executive Officer. Before we begin, it is our duty to inform you that this conference call is being webcast and is accessible through the "Investor Relations" section of the SurModics website, where the audio recording of the webcast will also be archived for future reference. We expect the total call to last approximately one hour. I will remind you that some of the statements made during this call may be considered forward looking. The 10-K for fiscal year 2007 identifies certain factors that could cause the company's actual results to differ materially from those projected in any forward-looking statements made during this call. The company does not undertake any duty to update any forward-looking statements as a result of new information or future events or developments. Please be advised that during the call, non-GAAP financial measures will be used to provide important information pertinent to our ongoing business performance. These measures are reconciled to the GAAP measures and are available in today's earnings press release. At this point, I will provide you with a brief overview of the topics that will be addressed during today's call. First, I will cover the quarterly financial results, Bruce will then highlight recent achievements, discuss pipeline opportunities and update you on the status of our fiscal 2008 corporate goals. And, lastly, we will open up the call to your questions. Now, I will begin by providing an overview of the third quarter financial results and follow that with specifics on discrete line items. Next, I will discuss significant revenue drivers and breakdown revenue by component and business segment. Finally, I will cover expenses, review our balance sheet and cash flow and provide an update on our share repurchase program. Third quarter revenue was $24.3 million, a 37% increase from $17.8 million in the year-earlier period. This total includes $4.7 million in revenue from Brookwood Pharmaceuticals and $1.1 million from BioFX Laboratories, both of which we acquired in the fourth quarter of fiscal 2007. Excluding the revenue from Brookwood and BioFX, our Legacy business generated revenue of $18.5 million, a 4% increase from the year-ago quarter. We will continue to breakout the revenue contributions from these recently acquired companies for the remainder of fiscal 2008. Moving down the income statement, the company reported operating income of $7.2 million, a decrease of 4%, from $7.5 million in the prior year period. Net income was $4.8 million for the quarter, a 14% decrease from $5.6 million in the same period last year. Diluted earnings per share were $0.26, compared with $0.31 in the third quarter of fiscal 2007. Consistent with recent quarters, earnings growth did not keep pace with revenue growth, primarily as a result of the changing mix of revenue sources, and because of the accounting treatment relating to our Merck agreement. Recall that we have to recognize all of the development expenses as they are incurred even though revenue is amortized over time. As we seek to maximize transparency in presenting our financial and operating results, SurModics will continue to provide supplemental non-GAAP disclosure related to the Merck agreement accounting treatment. We believe that this supplemental non-GAAP disclosure complements our GAAP reporting and allows the investment community to better understand current performance by showing what our results would have looked like had we fully recognized as revenue all of the items related to our collaboration with Merck, compared with amortizing the amounts as we do under the EITF 00-21 accounting guidelines. Please refer to the supplemental tables in our press release to follow along with the upcoming comments. To provide more of a cash basis view of the accounting for Merck, we back out the revenue recognized from license fees and cumulative R&D work, both of which are non-cash items in the quarter. We then add in the amounts that were billed during the quarter. A very significant item occurred during the quarter. As Bruce will discuss in greater detail, Merck initiated the Phase IIb clinical trial for I-vation TA under the agreement we had signed in June 2007. This important event triggered a $9 million milestone payment from Merck. With the addition of these significant amounts during the quarter, total non-GAAP revenue for the third quarter was $34 million. Following this level of revenue through the P&L and taxing the resultant pre-tax income at our effective tax rate of 39% results in non-GAAP diluted earnings per share of $0.59. Additionally, at the bottom of the supplemental table you can see that our deferred revenue balance related to Merck grew to $34.6 million at June 30, 2008. With this growing deferred revenue balance, we are building a stream of recurring GAAP revenue and earnings for the future. Shifting gears a bit, I will now discuss the CYPHER Sirolimus-eluting Coronary Stent from Cordis Corporation, a Johnson & Johnson company. As a reminder, CYPHER has been on the market in the United States for over five years, producing the longest term clinical data of any drug-eluting stent, and has generated very strong revenue and cash flow for SurModics during this period. Johnson & Johnson reported worldwide sales of CYPHER of approximately $394 million, down 11% year-over-year. Despite the decrease in sales, J&J estimates that the CYPHER Stent has retained 36% market share in the United States and 34% market share outside the US during the third quarter. Continued softness in the drug-eluting stent market has been driven by lower penetration rates and reduced prices compared with year-ago levels, although J&J reported that penetration rates in the US have grown from roughly 60% and have stabilized at approximately 66%. While we expect that the recent approval of Abbott's Xience and Boston Scientific's PROMUS drug-eluting stents will increase competition in subsequent quarters, many analysts believe that next generation stents such as these will potentially serve to expand the size and improve the prospects for the US drug-eluting stent market. While greater competition will likely affect results for CYPHER going forward, it is important for investors to know that our license agreement covering the drug delivery polymer provides minimum royalties to us valued in the millions of dollars as long as this agreement remains in place. In other words, even if competition drives CYPHER to an extremely low market share, SurModics will continue to receive minimum royalties of millions of dollars per year, suggesting that this revenue stream has sustained viability despite market and product-specific headwinds. While total SurModics revenue associated with CYPHER decreased 21% compared with the prior year period, we have long anticipated an eventual downturn. The diversification strategy we pursued to counter this eventual decline is bearing fruit, as evidenced by the continued strong growth experienced by our remaining businesses, with non-CYPHER-related revenue increasing 62% from the year-ago quarter. Even if you exclude revenue from Brookwood and BioFX, the rest of our business grew 15% year-over-year. Our sustained ability to generate strong revenue, despite declining contributions from CYPHER sales highlights the benefits associated with growing and successfully managing a broad and diverse portfolio of technologies. Diversification has been one of our key strategic initiatives and these results reinforce how successful we have been in this regard. In fact, in the third quarter, total revenue from J&J, which includes other products besides CYPHER, constituted less than 20% of total revenue. This figure is down from 33% at the end of fiscal 2007 and 47% in fiscal 2006. In the past two years, our non-CYPHER revenue has grown at 39% compound annual growth rate. Moving on, I will discuss SurModics' mix of revenue in the third quarter, which breaks down as follows; 56% generated from royalties and license fees, 18% from product sales, and 26% from research and development revenue. In contrast, in the year earlier period, royalties and license fees accounted for 75%, product sales were 17% and R&D revenue was 8%. As we have discussed in prior conference calls, the acquisitions of Brookwood Pharmaceuticals and BioFX Laboratories have shifted our near-term revenue mix towards higher contributions from product sales and R&D revenue, which has had an adverse impact on our operating margin. However, we believe this near term effect is more than offset by the benefits of a stronger, more diversified business and fully expect Brookwood's robust pipeline to generate royalties and license fees. Next, let's discuss revenue components for the quarter. Royalties and license fees were $13.6 million during the quarter, up 1% from the year-ago quarter, even though CYPHER sales were down substantially, as gains in non-CYPHER-related royalties and license fees more than offset the significant decline in CYPHER-related royalties and license fees. Product sales were $4.4 million, an increase of 51% year-over-year from $2.9 million in the prior year period. Turning to our final revenue component, we generated $6.2 million in research and development revenue in the third quarter, a significant increase from $1.4 million in the year-ago quarter. The increase reflects the addition of Brookwood to our business, as well as increased R&D activity with Legacy SurModics customers. Importantly, this level of R&D revenue was achieved despite the bulk of the roughly $1.9 million billed for our employees' efforts in support of Merck being recorded as deferred revenue. As our supplemental non-GAAP table illustrates, R&D revenue would have been $7.9 million, or 27% higher, if we did not amortize the amounts in accordance with EITF 00-21. Next, I will review results across business segment lines. The Drug Delivery segment generated revenue of $10.7 million in the quarter, an 85% increase year-over-year and down 11% sequentially. The increase from the year earlier period reflects strong revenue from ophthalmology and other drug delivery customers, which offset the impact of the 11% year-over-year decrease in CYPHER sales. In addition, Brookwood contributed approximately $4.7 million to drug Delivery Segment revenue. Moving on to the Hydrophilic and Other operating segment, we generated revenue of $7.9 million during the period, up 14% year-over-year and down 5% sequentially. The year-over-year increase was driven by growth across the board, in royalties, reagents, and R&D revenue. Our continued growth in this segment illustrates the substantial customer traction that exists for SurModics technologies, including the US launch of the Endeavor Drug-eluting Stent by Medtronic. And, lastly, revenue for the In Vitro segment was a record $5.7 million, up 12% year-over-year, and up 4% sequentially. Growth in product sales, including BioFX, offset a decrease in royalties. Next, I will turn to review of operating expenses. SurModics continues to invest heavily in R&D, as we expand our technology, leadership and support our culture of innovation, as well as providing support for our multiple customer projects. In the third quarter we dedicated 43% of revenue to R&D. Overall, R&D expense constituted 69% of total operating expenses, excluding product costs. We are also continuing to grow our technical team, adding capabilities to better support our customers, today, and in the future. With the addition of Brookwood and BioFX, combined with the organic hires we continue to make in our Legacy organization, total R&D expense was $10.5 million, up 70% from last year. SG&A expense increased 70% compared with last year as well, with much of the gain associated with the addition of Brookwood and BioFX, as well as expansion of our organization to support our growing business. Also included in this quarter's expense was amortization of intangibles from Brookwood and BioFX totaling approximately $300,000. Expenses also include an accrual for bonuses that may be paid for fiscal 2008 performance under our bonus plan. Non-cash stock-based compensation was approximately $1.8 million for the quarter, down sequentially from $3.4 million in the second quarter and down from $2.2 million in the year ago quarter. Finally, patent-related legal fees were a bit higher this quarter, as we continue to invest in establishing and protecting our intellectual property portfolio, which is the cornerstone of our technology licensing business model. Now let's turn to the balance sheet. As of June 30, SurModics had a cash and investment balance totaling $70 million. Cash flow from operations was $13.7 million during the quarter, compared with $7.1 million in the year-ago quarter. For the first nine months of fiscal 2008, cash flow from operations was $22.6 million, compared with $23.6 million in the first nine months of fiscal 2007. Please note that these cash and cash flow figures do not include the $9 million milestone payment from Merck, as the milestone was achieved in June, but was not due to be paid until July. We have now received the $9 million cash in the month of July. We continue to be active in the deployment of capital with a goal of enhancing shareholder value. Since announcing our new share repurchase program in November 2007, and once our trading window opened in early 2008, we have purchased approximately 263,000 shares of SurModics stock for $11.2 million at an average price of $42.74 per share. Our share repurchase program reflects our strong confidence in our near and long-term prospects and our belief that SurModics stock is under-valued. We also have been making investments in our facilities to provide cGMP manufacturing capabilities in support of our customers. In addition, SurModics remains active in business development. For example, we announced last week that our Brookwood Pharmaceuticals subsidiary has licensed a lipid nanoparticle technology from PharmaSol GmbH of Berlin, Germany. This license further broadens the drug delivery technology offerings of SurModics and Brookwood, and complements our existing portfolio. And we continually review additional business development opportunities that can support our growth strategy, enhance our market positioning, and add shareholder value. With that, I will now turn the call over to Bruce.

[Bruce Barclay:]

Thank you, Phil, and thanks everyone for joining us today. My comments will highlight quarterly achievements, review our key opportunities, and bring you up-to-date on the product pipeline. I will also provide an update on the progress made against SurModics fiscal 2008 corporate goals. SurModics' broad and diverse business continued to generate good results in the third quarter. We again delivered strong overall results and double-digit revenue growth in each of our three operating segments for the third consecutive quarter. Our results are all the more gratifying, despite the continuing decline in CYPHER Stent sales. While our GAAP earnings have not kept pace with revenue growth, it is important to remember that the continued growth of R&D work and our collaboration with Merck is actually dilutive to GAAP earnings, because of the accounting treatment for that agreement. This was especially true in the third quarter as we build more R&D than we ever have with Merck since our collaboration with them began. In fact, as Phil discussed, for the first nine months in fiscal 2008, our pro forma EPS, adjusted only for Merck, was $1.31, which is $0.46, or 54% higher than reported GAAP EPS. We also achieved a very significant milestone just last month. Earlier we announced the initiation by Merck of a Phase IIb clinical trial to evaluate the safety and efficacy of SurModics I-vation TA product in patients with diabetic macular edema. We are pleased with the progress towards commercialization and congratulate Merck for its success to-date. As mentioned earlier, the initiation of this Phase IIb trial triggered a milestone to $9 million during the quarter, which was paid in our fourth fiscal quarter. I also want to take a moment and recognize the tremendous efforts by our employees at SurModics and at Merck as they complete the significant amount of work necessary for initiating this clinical trial. The progress we are achieving is very exciting. And we are proud to have reached this important goal together. On June 26, 2008, we celebrated the one-year anniversary of the signing of our Research Collaboration Agreement with Merck. As such, I think it's instructive to look back and recognize how much progress has been made in developing our Ophthalmic Technology and highlight how this mutually beneficial relationship continues to tie our companies more closely together. SurModics technical teams continue to be kept extremely busy supporting Merck's various development programs. During our first full year, since signing our agreement, we have generated over $38 million in cash from Merck, including license fees, milestone payments, as well as R&D fees. As a point of comparison, the most we ever generated from CYPHER in a single year was $31 million, and no one can question the unqualified success that product has experienced and its positive impact on SurModics. This fact is also further evidence of the strength of our unique business model, allowing us to generate such a significant amount of cash, even though no product has been launched commercially by our partner. Beyond our development programs with Merck, our scientists and engineers are also busy on other ophthalmology development projects for both back-of-the-eye and front-of-the-eye diseases with numerous customers. These projects leverage our drug delivery platforms and polymer matrix technologies for sustained delivery of customers' proprietary drugs to the eye. We continue to be successful in advancing customers to the next steps in their respective programs through work at SurModics headquarters in Minnesota, at our ophthalmology business in California, and at Brookwood in Alabama. SurModics continues to have several paid development programs in process for both small and large molecules, and again for both posterior and anterior segment applications across several of our technology platforms. The customer demand for our research and development services reinforces the opportunity we see in sustained drug delivery applications in ophthalmology. Next, I'll update you on our Brookwood Pharmaceuticals business, which provides proprietary site-specific and systemic drug delivery solutions. The company is developing improved pharmaceutical products. Brookwood generated $4.7 million in revenue this quarter, highlighting the continued strong customer interest in its technology. Revenue has been driven by customer supported R&D, product manufacturing for clinical trials, and polymer sales. However, as customer projects move along in the development cycle, there remains a significant upside potential from royalties and license fees, which we expect to begin to flow within the next two to three years. Brookwood is well positioned to continue this impressive growth. During the third quarter Brookwood signed a new development agreement with a top 50-pharma company for a product in the oncology space. Not only does this bring a new and significant customer into the fold, it also satisfies one of our fiscal 2008 goals related to Brookwood. Also encouraging are developments relating to Brookwood's relationship with Ambrilia Biopharma. As a bit of background, Ambrilia is a licensed customer of Brookwood that recently announced positive results from its FDA-based Phase III study for its proprietary formulation of Octreotide C2L to treat acromegaly, chronic disease affecting approximately 40,000 patients worldwide. This recent announcement represents the first time that a therapy based on Brookwood's technology has successfully completed a Phase III clinical trial. Ambrilia's plans are to submit an application to the FDA by the end of calendar 2008 with the goal of approval and commercialization by the end of calendar 2009. If this timetable tracks to plan, royalties could begin to flow to Brookwood as early as fiscal 2010. Given that the market size for acromegaly treatment is approximately $1 billion, we view this as a compelling opportunity. As we announced in April, SurModics is supporting Brookwood's growth through the purchase of a new facility in Birmingham, Alabama. The facility is designed to support growing interest from existing and prospective customers in the expansion of Brookwood's infrastructure to support larger scale R&D and manufacturing services. Additionally, the facility will be the manufacturing site for the late-stage clinical trial and commercial product for the I-vation TA drug delivery systems, currently in development with Merck. Reaction to the announcement that we are building out the infrastructure to enhance our capacity has been very favorably received by both existing customers, as well as prospective customers. Another emerging bright spot is our progress in diversifying and participating in next generation technologies in the drug-eluting stent space. While SurModics' current stent-related revenue continues to be impacted by market headwinds and competitive dynamics, the DES market remains an important revenue generator for SurModics. We are pursuing multiple opportunities to participate in its future development. Developments relating to our collaboration with Xtent, serves as a great example of how we are diversifying our business within the existing $4 billion drug-eluting stent market. If you recall, in May of 2006, Xtent partnered with SurModics to provide hydrophilic coating on its DES delivery system, which is capable of delivering multiple custom-length stents to treat lesions in numerous vessels with a single catheter. Analysts expect Xtent to receive a CE mark in European approval for its drug-eluting stent system later this year. Next, I'd like to turn your attention to our customer project pipeline as of June 30. We had a total of 101 licensed customers, several with multiple licenses, compared with 89 such customers in the prior year period. SurModics had 102 licensed product classes on the market-generating royalty revenue as of June 30, compared with 98 a year ago. The total number of licensed products not yet launched was 105, up from 93 in the prior year period. Major non-licensed opportunities stood at 98, compared with 74 a year ago. In total, the company had 203 potential commercial products in development. All of these numbers include customers and projects at Brookwood as well. This quarter marks the first time we have exceeded 200 pipeline projects, as well as 300 total projects and products. As these numbers and our paid R&D for the quarter suggests, the magnitude of the R&D work we are doing on behalf of customers is a testament to the significant value of our pipeline and the potential for future licensees and royalties. Let me finish up by reviewing our progress against selected fiscal 2008 goals. I'm pleased to report that we are continuing to execute our strategy and realize more of our goals as we move into our final quarter of fiscal 2008. Let's begin with the corporate goals. Our first objective was to launch 10 new product classes by our customers in fiscal 2008. In the third quarter, customers launched four new product classes in the market. This brings our year-to-date total launches to 10, achieving our 2008 goal. We also articulated a goal of signing 18 new licenses with customers in fiscal 2008. SurModics had another terrific quarter on this front, signing six new license agreements with customers, and bringing our fiscal year-to-date total to 19, already exceeding our license goal for 2008. The final goal we laid out in the corporate strategy was to exceed $10 million in cash for paid R&D. For the first nine months of fiscal 2008, we generated total cash R&D of $23.5 million, further surpassing the goal we had already achieved last quarter. Next, we laid out three fiscal 2008 goals for Brookwood Pharmaceuticals. We have now achieved one of these goals, signing a development agreement with a top-50 pharma company. The second goal was to sign at least one license relating to Brookwood technology, and the third for Brookwood is to generate $17.5 million in revenue. The third quarter came in at $4.7 million, bringing our year-to-date total to $14.1 million. We believe we can achieve the other two goals during the fourth quarter. Our goal for In Vitro technologies was to exceed $4 million in revenue from BioFX products. In the first three quarters of fiscal 2008, BioFX has generated $3.3 million in revenue, and so we remain on pace to meet this goal as well. Referencing our earlier comments, we achieved two significant goals in ophthalmology during the quarter, namely the initiation of the next phase clinical trial for I-vation TA and completion of the development milestone under the Merck License and Research Collaboration Agreement. Finally, relative to our third goal in ophthalmology, signing a second license agreement, we continue to believe we can achieve it this quarter. Another goal I want to comment on was our fiscal 2008 cardiovascular objective to have a customer conduct a first-in-man procedure with a next-generation drug-eluting device using our technology. We achieved this goal when the SynBiosys biodegradable drug delivery polymer system was incorporated in a first-in-human trial evaluating a small vessel stent developed by CardioMind. Medtronic's launch with the Endeavor DES in US satisfied another of our fiscal 2008 cardiovascular objectives. Our final goal in cardiovascular was to commence a first-in-human trial with our FINALE prohealing technology. Paragon, our partner in this area, continues to inform us that they are on track to commence this trial by September 30. We are pleased with the progress we are making against SurModics ambitious fiscal 2008 goals. Through the first nine months of the year, we've accomplished 8 of our 15 goals, and believe we can achieve most, if not all, remaining objectives by the end of our fiscal year, September 30. In conclusion, SurModics continues to leverage its well diversified technology portfolio and innovation leadership to penetrate and exploit multiple high value market opportunities. Both SurModics and our investors are focused on results, and we remain committed to delivering those results that matter most. Mitch, that concludes our prepared remarks. We'd now like to open up the call to any questions.

[Operator:]

Thank you, sir. (Operator Instructions) And our first question comes from Steve Ogilvie with ThinkEquity. Go ahead please.

[Steve Ogilvie:]

Hey, guys. Just a few accounting things to get out of the way first, could you clarify on the $9 million payment, you said it's not in operating cash flow in 3Q. But the deferred revenue category in 3Q seems to have jumped up. Am I reading that wrong or is that $9 million in the deferred revenue?

[Phil Ankeny:]

You're reading that correctly. It is in the deferred revenue, but it's also in accounts receivable and so essentially those two offset one another. The actual cash has been received in July and so it'll show up in the operating cash flow line, on the bottom line, if you will, there in Q4.

[Steve Ogilvie:]

Okay, great. That answered my next question about accounts receivable. And then in terms of employee compensation, last fiscal year in your fourth quarter there is a bit of an issue with the accounting and how people were compensated for achieving your goal. Is the accrual you mentioned going to prevent that from happening this year? And I guess another way to look at it is, are the employees being compensated on a non-GAAP metric or on a GAAP metric?

[Phil Ankeny:]

The compensation plans and the incentive compensation are geared to non-GAAP metrics. And the accruals that we've got so far are essentially assuming that we are on plan to achieve the target compensation, as it were. If you recall, how we laid out the plan in our CD&A and the proxy. There is a range of outcomes that the plan specified on a low end and a high end, which would be higher or lower than target. And if the achievements were higher, the amounts would be somewhat higher than what's currently been accrued. It will all depend on the ultimate outcome and achievement for the full fiscal year.

[Steve Ogilvie:]

Okay.

[Phil Ankeny:]

But as opposed to a year ago, where there had been no accrual throughout the year, here we at least, we do have accrual both under the bonus as well as performance share payment plan.

[Steve Ogilvie:]

Okay, great. And you don't care to give any range of what the minimum payment on CYPHER is?

[Bruce Barclay:]

No, we're not in a position to do that, Steve.

[Steve Ogilvie:]

Okay. And if I gave out ranges, I don't suppose you'd. Okay. Then I guess just the final thing it is more of a big picture question. With Xience and Promus coming this quarter, it's a pretty big quarter, something that everyone's been looking for a long time, to see the impact that it has on you. Internally, I'm just curious kind of where you're headed and what your thoughts are. If there's anything you're doing or do you just kind of ride this out and hope that your diversification plays out as you've spoken to?

[Bruce Barclay:]

No, I really can't probably add any more than what we said in the prepared remarks. While we would not have known the exact timing of customer entry into the U.S. market, we've been planning for at least since Phil and I got here five years ago for eventual competition in the U.S. DES market. And that's the way we've been running the business for the last five years. So, I think for us to now say we've got a plan, because there's our new market entrants I think would be grossly overstating the way we run the business. We've been expecting competition in this area and we've been diversifying the business and doing a variety of other things for at least five years now. So, the short answer is, we have a plan, we've been executing against it, and we continue to execute against it going forward.

[Steve Ogilvie:]

Great, and if I could just slip in one last thing.

[Bruce Barclay:]

Sure.

[Steve Ogilvie:]

What gives you the confidence that you'll be able to sign the next ophthalmology deal by September? I mean, is it customer that said they'll do it, or is it the progress of the clinical work, or maybe give us a little more insight into that.

[Bruce Barclay:]

Yes, really we can't provide any detail other than, again, what we've talked about in the remarks. There is a tremendous amount of interest in what we're doing and it's a very significant opportunity which a number of companies have recognized. And I would say that there's never a guarantee of these things because, as you know, negotiation is not a unilateral process, it's a mutual process. But we've seen enough to believe that we're on track.

[Steve Ogilvie:]

Okay, great. Thanks, guys.

[Bruce Barclay:]

Thank you.

[Operator:]

Okay. Thank you. And our next question comes from Richard Rinkoff with Craig-Hallum. Go ahead, please.

[Richard Rinkoff:]

Thank you. You guys have a bunch of new products that have come out in the market through your customers. But when I look at all the revenue lines, the royalty license line, the product line and the R&D line, they are pretty much trending down this quarter versus last quarter. Are they stuck? Is this quarter a fluke? Or how should we view that going forward?

[Phil Ankeny:]

I wouldn't characterize them as stuck. I would just remind you and everybody else that there is some seasonal patterns, if you want to call it that, that relate to some seasonality, s well as some agreements that we have with customers that do have tiering structures to how the royalties are comprised. And so there are some of those that had a negative impact in the current quarter, and so that certainly characterizes part of it. And so I wouldn't say by any stretch of the imagination that there is anything that is troubling us.

[Richard Rinkoff:]

Should I infer then that, seasonally, next quarter is going to be better?

[Phil Ankeny:]

We don't talk about forward-looking quarters.

[Richard Rinkoff:]

Seasonally, it has historically been better.

[Phil Ankeny:]

Can't comment, Rick.

[Richard Rinkoff:]

That's looking backwards. Product gross margin 60%, last quarter lower. I mean, they've been all over the place. What should we assume going forward and why do they move around so much?

[Phil Ankeny:]

It's really a functional mix. And we have a very broad and a much broader product portfolio than we had a couple of years ago, and so it's really just a function of which products are contributing the most. So, it's really nothing other than that. I think the current quarter is certainly repeatable in terms of margins.

[Richard Rinkoff:]

Okay. And last question, at least for the moment. Should we assume that the expense lines this quarter R&D, SG&A are kind of indicative of what they will be going forward, or is there going to be some significant changes?

[Phil Ankeny:]

And again, here, we don't give precise guidance on this. What I would say directionally is that the current neighborhoods are reasonable. There is continued growth in terms of adds to the business to support the growing customer needs. But a more important factor in at least the sequential expenses you'll see will depend on our ultimate achievement of the 2008 goals and what our actual level of bonus and incentive compensation ends up being that we record for the quarter.

[Bruce Barclay:]

The other thing I would add is that a number of adds, especially headcount across, we look at whether those folks are directly revenue generating or not. So, it's a little bit difficult to take the expense line out of context. If we believe that there is sustained R&D work, for example, we will add people that we think could support that R&D work. And so, hopefully, you would see an increase on the top line as well.

[Richard Rinkoff:]

Thank you.

[Bruce Barclay:]

Thanks.

[Operator:]

Thank you. And our next question comes from Ross Taylor with CL King. Go ahead, please.

[Ross Taylor:]

Hi. I had a couple of questions. First one is the hydrophilic revenue line item, growth there of 14% or 15% for the quarter is below the trend in the last five quarters, where it was up better than 20% each quarter. Is there anything that's changed there that you can tell us about that is driving that lower rate of growth?

[Phil Ankeny:]

There is a lot going on in that one. That's certainly our broadest portfolio, particularly on the royalty line. But I would also remind you that there's contribution from all three line items in that segment as there are in every segment. And so the reagent sales as well as the R&D work that's in that segment that has been probably more than anything a contributor to the slightly different year-over-year comparison as opposed to more recent quarters.

[Ross Taylor:]

I see. And to the extent maybe reagent and R&D work had something to do with the high rate of growth past couple of quarters, would that mean maybe we'd see a pick up in the royalty contribution to that line going forward?

[Phil Ankeny:]

Again, I'd save that until next quarter in terms of forward-looking statements.

[Ross Taylor:]

Okay, all right. And also, if I'm looking at these numbers right, for the Merck GAAP revenue that you record for R&D, I mean, it looks like this quarter it was about $180,000, and I think if my numbers are right it was about 667 last quarter and why would the GAAP revenues be going down sequentially even though the cash you're getting from them seems to be holding flat on a sequential basis?

[Phil Ankeny:]

That's a good thing for you to pick up on. There's one other element of how we account for the Merck activity is what we call pass-through revenue, where we are incurring expenses on behalf of Merck and it's included in revenue, but it's essentially also included in expense and that is included in GAAP. And there was some activity in that category last quarter that contributed to what was being shown as amortized in the second column last quarter.

[Ross Taylor:]

Okay, all right. I think I follow that. And also going back to the CYPHER agreement and the minimum, I know you can't talk about the amounts, but can you talk about how many years out that agreement holds or extends?

[Bruce Barclay:]

Sure, I can. It extends for as long as the agreement is in place. So, as long as Cordis/J&J continue to need a license under the patents covering the technology on their product, the agreement needs to remain in place. So, as long as it's there, we'll get those minimum royalty payments.

[Ross Taylor:]

Okay. So, as long as they're selling CYPHER, it sounds like you would get those minimums.

[Bruce Barclay:]

That is least for that, and then they might continue it on beyond that as well, as a defensive measure, for example. And I don't know that, but there are reasons where companies all the time maintain license agreements in place beyond the commercialization of a product. But at least as long as they continue to commercialize products with that polymer on there.

[Ross Taylor:]

Okay, all right. And last question. Investment income in the quarter was down to about, almost half the level where it had been. What would have driven that, since your cash balance is up still about the same place it's been?

[Phil Ankeny:]

There are really two things going on there. One is just lower interest rates and then the other piece is gains in the portfolio. We had some gains in there in the second quarter and we had de minimis gains this quarter. So really it's the two of those.

[Ross Taylor:]

Okay. All right, that's all I have. Thanks very much.

[Bruce Barclay:]

Thank you.

[Operator:]

Okay, thank you. And our next question comes from Daniel Owczarski with Avondale Partners. Go ahead, please.

[Daniel Owczarski:]

Yes, thanks. Hi, Bruce. Hi, Phil.

[Phil Ankeny:]

Hi, Dan.

[Bruce Barclay:]

Hi Dan.

[Daniel Owczarski:]

Can you help us a little bit with this Merck, with what happens now as far as the build R&D payments? Do those go away, slow down now that the Phase IIb trial has started?

[Phil Ankeny:]

As we've talked in the past, Dan, the relationship with Merck is very collaborative. I would say, we don't entirely control what we work on. And at the same time, they don't entirely control the work that we need to do on a given project, once it's been identified. So, it's extremely collaborative. I would say there will be a shift of work given that we have manufactured this first group of product. But they will need future products for this same clinical trial since it's a large clinical trial, and will continue to generate products around that and do the things necessary to make sure that the sites are stocked as they come up, so the I-vation TA work is not by any means going away. And then, as we talked in the past and as you know that they've expanded their license in January of this year, but they do have rights to other compound classes, and that work is also going on here. So, I can't be specific about what that looks like going forward. I can tell you is that, as I mentioned in my prepared remarks, we are extremely busy here there's lot of activity, great communication and a great relationship with our partners at Merck. And we expect that to continue for a long time into the future.

[Daniel Owczarski:]

Okay. And then just to follow-up on that Phase IIb trial. Have they said publicly how many sites, how many patients, whether they're doing different doses and have they started enrollment there?

[Phil Ankeny:]

They have started enrollment. That was the announcement that occurred in late June. They have filed a brief document with the FDA which has been made public relative to some of the specifics around the trial, and I can refer that to you at clinicaltrials.gov, if you'd like to see it in detail. I won't repeat it all here. But it does talk about the trial, the expected start date, and the estimated completion date for the primary phase of the trial, and different doses, for example. So, there is some information that's been made public. Obviously, we can't comment beyond what's been made public, since it is their trial and essentially their product now going forward.

[Daniel Owczarski:]

Okay. And then just lastly on Brookwood, you announced this development agreement with a top-50 pharmaceutical company. How does that differ from all the work that they're doing right now? Is it strictly the size of the customer, or is it different development agreement than what they've done in the past?

[Phil Ankeny:]

It's an additional customer; it's like a new customer. And we put the range around the top-50, because that, to us, would mean it's a significant customer as well. So, it's significant in respect that it's new and it's an area that we have interest in, and we think the technology will work well in that particular space.

[Daniel Owczarski:]

But the agreement looks like, say, the couple dozen other ones that they have to pay for R&D projects?

[Phil Ankeny:]

Essentially, yes. It is a paid R&D agreement, that's right.

[Daniel Owczarski:]

Thank you.

[Phil Ankeny:]

Not yet licensed, of course. This is still just a development agreement, but it certainly has that potential.

[Daniel Owczarski:]

Thank you.

[Phil Ankeny:]

Okay, thank you.

[Operator:]

Thank you. (Operator Instructions). And our next question comes from Charley Jones with Barrington Research. Go ahead, please.

[Charley Jones:]

Good afternoon. Are there any ongoing stent programs using FINALE outside of Paragon?

[Bruce Barclay:]

We have few projects with customers using FINALE, and I don't believe there are any in the stent space other than Paragon.

[Charley Jones:]

Okay. And does the Merck contract have a change of control clause? And specifically, will the contact cancel if either you or Merck is acquired?

[Bruce Barclay:]

I don't recall, Charley. That contact has been made public. It was also redacted in some respect. I don't know why it got redacted relative to that provision, if any. I just simply don't remember right now.

[Charley Jones:]

I'm just trying to figure out if you had another ophthalmology contract, would there be change of control language in there? Would it basically allow the program to continue in the event either of you were acquired? There's a fairly large ophthalmology player out there that's had a bid for it recently.

[Bruce Barclay:]

Yeah. I don't recall what our contract says in that respect.

[Charley Jones:]

Okay. Is there a reason why you guys decided to go with a 12-month elution time rather than a two-year elution time for TA, and is there anything inhibiting that from a two-year and 18-month trial being done with other drugs?

[Bruce Barclay:]

It's really the decision of the project teams that are working on this project, between Merck and SurModics. And I don't know the specifics beyond that. But that was a decision considering, I would imagine, a variety of factors that they were aware of. Can we deliver drugs off of this platform longer than 12 months? Absolutely.

[Charley Jones:]

Is the safety as good at 18 months as it is at 12?

[Bruce Barclay:]

We don't have data that far out in patients beyond the TA product. But certainly with respect to the TA product, yes, the safety has been good all along.

[Charley Jones:]

And last question here. Thanks for your answers. At the Analyst Day, you guys discussed the ability to deliver biologics such as proteins, and being able to deliver them for about a nine-month period. Can you give us an update on the length of time you've been able to deliver biologics for an application such as in ophthalmology?

[Bruce Barclay:]

Yeah, we've published data out six months. We haven't published any data beyond that. But, again, I'd say there's a high level of confidence that we could deliver large molecules such as proteins beyond six months.

[Charley Jones:]

I think you gave us nine months at the Analysts Day. I guess I'm wondering, have you been able to put that in the animals and you've seen that go longer than nine months at this point, or is that the extent of it?

[Bruce Barclay:]

I don't recall the nine months, Charley. Maybe you're looking at something I'm not.

[Charley Jones:]

Okay. But I could be remembering incorrectly. Okay, that's it.

[Bruce Barclay:]

Yes, we can double-check. Thank you, Charley for the call.

[Charley Jones:]

Thanks a lot.

[Operator:]

Thank you ladies and gentlemen. And our next question is from Chris Sassouni with Eagle Asset Management. Go ahead, please.

[Chris Sassouni:]

Good afternoon. Could you elaborate at all or give us a notion as to the schedule of events that are going to take place now that Brookwood has signed this oncology product agreement with this top-50 pharmaceutical company? Essentially having signed it, have they or will they receive an upfront payment to start the project? What does the project plan look like and how does the flow of revenues occur without getting into specifics of quantities, and just in terms of timing and so forth?

[Bruce Barclay:]

You know, I really can't give any more detail than what we already have. It's a top-50 company, it's in the oncology space. We can't really talk about the particulars of the agreement, although I would tell you in general with development contracts there, it would be atypical for us to have upfront in those things. The commercialization term, the license terms is someplace where you'd more likely see milestones and royalties and minimums, and things like that. So, it's a fairly new contract and that it happened in the quarter. Again, we believe that the technology that we offer to this customer will work well with our given indication and we're anxious to get as far down the development path as we can. But really beyond that probably can't say too much.

[Chris Sassouni:]

Is this a drug that will first have to be put through preclinical studies, or can they borrow from any study that they might have already done prior to using your drug delivery technology? Or is this basically where you start from scratch, you have a drug, you use your Brookwood technology, and you basically start as if it was a brand-new drug going through preclinical and then clinicals?

[Bruce Barclay:]

I can't comment on the active agent, Chris. I would tell you that the benefits of using lactide/glycolide polymers that Brookwood offers are that they are very familiar with the FDA and are part of some commercial products. So, at least that component of it, the component that we offer, is well-known and characterized and again familiar to the authorities that approve those things. The drug itself I can't comment on. I apologize. Maybe as the program continues we'll be allowed to talk more, but at this point I can't.

[Chris Sassouni:]

Okay. Thank you.

[Bruce Barclay:]

Yes. Thank you for the call.

[Operator:]

Okay, thank you. And we have a follow-up question from Steve Ogilvie. Go ahead, please.

[Steve Ogilvie:]

Thanks, just a couple of quick things. Before you talk about that you were working with five of the six big pharma companies in ophthalmology. I'm wondering if you could update that figure? And then just quick updates on cell culture, if anything is happening there? And orthopedics, if there's any progress in that area? Thanks.

[Bruce Barclay:]

Sure. Let's see. In terms of the number of companies we're working on in ophthalmology, I don't have the exact number in front of me, but I believe it hasn't substantially changed from what we've reported before. Again, it's multiple platforms, large and small molecules, technologies at both Brookwood and also here at Minnesota. Relative to the Corning product, really no change, we continue to sell products to them, working with Donaldson, selling products to Corning. They continue to sell the product commercially, they continue to be very excited about what they're doing and what they're selling. I would say the sales ramp continues to be slow, although it's picking up. But it continues to be maybe slower than what we expected when we first entered into the contract. So, no real substantive change from what I believe we reported in the April call. Orthopedics, I would say same answer, really. No substantive change from what we reported in the prior call. We have some customer activity today, and it does remain an area of interest for us. However, we have not had the amount of customer-paid projects that we had hoped to have when we first began to investigate this area a couple of years ago. So, this area plus other areas outside of our, you would say more core businesses in cardiovascular and ophthalmology still are of interest to us, these emerging technology areas, but other than that nothing new to report in orthopedics specifically.

[Steve Ogilvie:]

Okay, thanks, guys.

[Bruce Barclay:]

Thank you.

[Operator:]

And, ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to management for any closing statements.

[Bruce Barclay:]

Thanks, Mitch. We want to thank everybody again for participating in this quarter's conference call. We look forward to speaking with you again this fall when we announce our fourth quarter and fiscal year end results. Thank you.

[Operator:]

Ladies and gentlemen, this now concludes the SurModics third quarter 2008 earnings conference call. You may now disconnect and thank you for using ACT Conferencing.