Surmodics, Inc.
Q1 2010 Earnings Call Transcript

Published: 28 Jan 2010

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the SurModics first quarter 2010 earnings conference call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator instructions) This conference is being recorded today, Wednesday, January 27, 2010. I would now like to turn the conference over to Phil Ankeny. Please go ahead.

[Phil Ankeny:]

Good afternoon and welcome to SurModics’ fiscal 2010 first quarter conference call. Thanks for joining us today. Our press release reporting quarterly results was issued earlier this afternoon and is available on our website at www.surmodics.com. Joining me on the call today is Bruce Barclay, our President and Chief Executive Officer. Before we begin, it is my 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. I will remind you that some of the statements made during this call may be considered forward-looking. The 10-K for fiscal year 2009 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward-looking statement 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. On today’s call, I will address the company’s quarterly financial results, Bruce will then highlight quarterly achievements and finally we will open the call to your questions. I will begin by reviewing key first quarter financial results and then provide more detailed commentary around a few line items. For the first quarter of fiscal 2010, revenue was $17.4 million, diluted earnings per share was $0.11 and cash flow from operations was $8.2 million. Looking at results on a non-GAAP basis, including the $3.5 million upfront license fee from Genentech, which has been amortized over 20 years under GAAP, revenue was 21 million and diluted earnings per share was $0.24. In reviewing our financial results, I will focus my commentary on the sequential comparison of first quarter results to fourth quarter results. We believe this is a more relevant comparison for the time being. Please refer to the press release for the year-over-year comparisons. Looking at our results on more of an apples-to-apples basis, if you exclude revenue related to Abbott from the fourth quarter of fiscal 2009, non-GAAP revenue increased 17% sequentially. Next let’s turn to individual revenue line items. Royalties and license fees for the first quarter were $9.2 million, down only 3% sequentially even though this figure includes only a fraction of the $3.5 million upfront license fee from Genentech. Furthermore, if you exclude the $1.25 million Abbott settlement from fourth quarter results, royalties and license fees were up 12% sequentially. Moving on to product sales. After generating sequentially increasing product sales in each of the pass three quarters, product sales for the first quarter were $4.5 million down 18% sequentially. Our product sales have largely recovered from the difficult economic environment experienced a year ago. However, in the first quarter despite strength in several product categories, we did see some sluggishness in our diagnostic products. We do expect sales of our diagnostic products to improve in the second quarter. Turning toward our third revenue component, R&D revenue for the first quarter was $3.6 million, down 13% sequentially. As we have discussed in the past, SurModics R&D revenue was prone to fluctuate from quarter-to-quarter, as a result of ebbs and flows of activity in our various customer development programs. One factor that negatively impacted first quarter results was the completion of clinical trial materials for one of our customers. This customer was a prominent driver of R&D dollars through the fourth fiscal quarter. However, after getting them armed to launch their clinical trial, the customer generated very few R&D dollars in the first quarter. Regardless of the near-term fluctuations in R&D revenue, SurModics is continuing to add new customers to our R&D pipeline and we remain confident in our R&D prospects. Going forward in fiscal 2010, we expect to see R&D revenue increase as we have multiple large programs requiring our support including the program with Genentech. Now, let’s turn to our revenue breakout by market starting with therapeutic. Cardiovascular revenue for the first quarter was 10.7 million, up 9% sequentially. Our cardiovascular results continue to benefit from the breadth of customers we have assembled. For the quarter, cardiovascular constituted 62% of total revenue. Growth in cardiovascular is particularly gratifying against the backdrop of the continuing decline in year-over-year CYPHER sales. Johnson & Johnson reported that sales for the quarter of the CYPHER Sirolimus-eluting Coronary Stent were approximately $223 million, down 18% year-over-year. While CYPHER sales were lower overall drug-eluting stent penetration rates once again increased and now stand at an estimated 77% in the United States, up from 73% in the year earlier period. This trend is important as SurModics participates in a number of other partnered products and development efforts in the drug-eluting stent area beyond CYPHER. In addition, we are pleased that earlier this month J&J received regulatory approval for CYPHER SELECT PLUS in Japan. Moving on to ophthalmology, revenue was 2.5 million for the quarter, up 35% sequentially. GAAP revenue included only $44,000 amortization of the $3.5 million upfront licensee from Genentech. On a non-GAAP basis, ophthalmology revenue was 6.2 million for the quarter. Bruce will provide more detail on our ophthalmology business in his remarks. SurModics has elected to early adopt EITF 081 which we believe provides more favorable accounting treatment for the Genentech agreement than our accounting for the Merck agreement under EITF 00-21. Rounding out therapeutic, Other Markets revenues was 1.9 million, down 35% sequentially. The majority of revenue in other markets is R&D related and lower R&D revenue contribution from the customer for whom we completed clinical trial materials in the fourth quarter was a significant factor in our sequential decrease in other markets revenues. As is the case with broader R&D revenue, other markets performance is prone to quarter-to-quarter fluctuations in our various customer development programs. Finally, I will review results from our diagnostic market. For the first quarter, diagnostic revenue was 2.3 million, down 51% sequentially. Excluding the $1.25 million Abbott settlement from fourth quarter results, however, diagnostic revenue was still down 32% sequentially. As diagnostic has become largely a product business following the expiration of the Abbott patents, results were impacted by the softness in diagnostic products that I mentioned earlier. However, we believe the softness is a near-term issue related to inventory levels and timing of purchases by our customers. We expect to see improved diagnostic product sales in the second quarter. Now, let’s return – let’s turn to a review of operating expenses. We are continuing to manage costs and expenses well. Operating expenses excluding product cost were 12.7 million in the first quarter, down 3% sequentially. Decrease in operating expenses has been somewhat offset by an increase in cost associated with the new cGMP manufacturing facility. A capital investment is largely behind us and we expect to invest approximately 3 to $4 million on facility-related equipment in the remainder of fiscal 2010. We began depreciating the facility in December which added approximately 160,000 to total depreciation in the quarter. Going forward, we would expect depreciation related to the facility to be roughly half a million dollars per quarter. Also remember, that we will consolidating Surmodics’ other two Alabama locations into this new facility and expect savings from the consolidation once completed. We anticipate that the cGMP facility will begin generating revenue in the second quarter. Looking forward, the most significant returns from the investment we have made will be realized in the form of customer agreements that generate royalties and license fees overtime. There is a significant near-term cash benefit from the facility, I’d like to highlight. And SurModics was successful in completing the facility in calendar 2009. We qualified for a tax benefit against our federal taxes. Current tax law allows us to take accelerated depreciation against the substantial component of our facility investment, effectively saving us approximately $4 million in cash tax payments in fiscal 2010. In addition, overtime we expect to benefit from state and local tax incentives. Lastly, let me turn to our balance sheet, which is in great shape. As of December 31, SurModics cash and investments increased to 51.5 million from 47.9 million at September 30 and we have zero debt. Given our optimism in the company’s potential for long-term growth, we’ll continue to leverage our strong balance sheet to invest in our business. In this regard, we strive the balance out deployment of capital for share repurchases, facilities related investments and business development. With that, I will now turn the call over to Bruce.

[Bruce Barclay:]

Thank you, Phil, and welcome to today’s call. During SurModics’ first quarter of fiscal 2010, we continued to make important progress in a number of key areas, including our ophthalmology, cardiovascular and SurModics pharmaceuticals businesses. Most significant accomplishment in the quarter came when we announced our agreement with Genentech in October, licensing our drug delivery technology and ophthalmology. In addition, our license partner, OrbusNeich initiated a first demand clinical trial with a new drug eluting stent employing our symbiosis biodegradable polymer. Finally, we officially opened our new cGMP facility in Alabama, which will be a vital component of our long-term growth and as a testament to our financial strength, we accomplished these results while preserving a strong balance sheet growing our cash balance and generating solid operating cash flow. As we’ve discussed previously, our Genentech agreement is a major advancement for realizing our strategic vision to develop technologies that address important clinical needs in the large and growing ophthalmology market. The prospect of developing a sustained delivery formulation that uses our proprietary biodegradable micro particles and combination with a known, approved and highly successful drug in Lucentis is a tremendous opportunity for SurModics. And if successful would be an important validation of our critically enabling technologies. Lucentis is the only treatment proven to maintain and improve vision in patients with wet age-related macular degeneration or AMD, a leading cause of blindness in people over 50. Because AMD generally affects older adults, the incident of ARMD is expected to increase significantly as the baby boom generation ages and overall life expectancy increases. Additionally, Lucentis is in late stage clinical trials in patients with DME and ARVO. Since signing the agreement, the teams from SurModics and Genentech are working well together and making good progress against our development plans. It is also important to note that the agreement with Genentech has not affected our other customer programs and relationships in ophthalmology. That’s our last update in November. We continue to support a number of ophthalmology projects with several different customers. Of the importance, three of these current customers in ophthalmology are top 10 pharma companies including Roche and Genentech as one. We believe our portfolio of customer projects in ophthalmology is healthier than it has ever been and will be a significant source of growth for years to come. Further, we believe our technologies and capabilities to deliver large molecule biologics, sets SurModics apart from the competition. That’s our announcement of the Roche-Genentech agreement in October. Some investors have asked us to compare our new agreement with Genentech to the one we signed with Merck in 2007. Let me be clear on this point. We believe the Genentech agreement is much more valuable to SurModics than the Merck agreement at the time of signing. There are several important factors supporting us to believe. First, Lucentis is already a significant product in terms of sales suggesting that potential sales of the ultimate sustained release product could be significant as well. Second, Genentech already has an established, very strong position in the market with Lucentis, a strong contrast to Merck did not have any existing FDA approved products for the treatment of AMD. Third, while we cannot disclose the royalty rate in the agreement, we can assure you that it exceeds the royalty rate we received from CYPHER. And fourth and perhaps, most importantly, Lucentis has already been approved for the treatment of AMD by the FDA. We believe this is a – this is significant as it reduces the development risk of the program, compared to one that includes a yet to be proven drug. Overall, we’ll see more upside opportunity at a lower risk. We are pursuing large and growing market opportunities with a drug treatment already approved by regulatory agencies and in partnership with a market leader like Genentech. In addition to our exciting ophthalmology projects, there are several additional prominent revenue generating opportunities in other parts of our business. While, CYPHER related revenues have been decreasing, our overall cardiovascular franchise is strengthening. In the stent market our portfolio of licensed customer product opportunities both on the market and in our pipeline is substantial. For example on the December 1, our licensed partner OrbusNeich announced that it had enrolled the first patient in its remedy clinical trial, which is a randomized clinical trial for their Combo Bio-Engineered Sirolimus-Eluting Stent. The Combo Stent combines the pro-healing technology used in OrbusNeich’s Genous Bio-engineered R stent for rapid endothelial coverage with an abluminal sirolimus drug eluting coating for control of neointimal proliferation. The low dose sirolimus elution is accomplished using the SynBiosys biodegradable polymer matrix from SurModics. We were particularly pleased by the comments from Renu Virmani, President and Medical Director of CVPath Institute, regarding the potential benefit from biodegradable polymers in these next generation stents and a positive animal data (inaudible) preclinical work with SynBiosys. This ability to generate solid preclinical data that demonstrates the value of our various polymer families have been a strategic initiative of ours for sometime as it helps to create customer interest and has a strong competitive differentiator. As Phil mentioned, we are pleased to report that earlier this month J&J announced regulatory approval of the CYPHER SELECT Plus Sirolimus-eluting Coronary Stent in Japan. In the press release J&J highlighted the enhanced delivery system for this product and in particular that’s the product has “an innovative coating technology that is significantly more lubricious than previous CYPHER Stent products.” As you know lubricious coating is licensed from SurModics. In addition to the – in addition, the product contains a second license technology that being the drug delivery polymer on the – on the stent. As such, we will receive two royalties on this new product and we will also sell two different types of associated reagents. This approval is significant as Japan is the second largest market in the world for drug-eluting stents. Product will be launched following reimbursement approval. We are also taking important steps to diversify our exposure beyond stents within the cardiovascular space. In particular, our work with drug-eluting balloons continues to progress and remains a very active area of interest for us. Also, I am pleased to report that Invatec, an existing royalty generating customer of SurModics will be acquired by Medtronic as announced on Monday of this week. In addition, SurModics Pharmaceuticals continues to be an important growth driver for our future. This business has reached an encouraging infliction point by converting three sustained drug delivery partnership programs into licensees in the past few months. As we’ve said previously, and consistent with our strategy, converting this business to our licensing business model and changing the mix of revenue to more royalties and license fees is critical to our long-term success and we’re making good advances. The license agreement we’ve signed have attractive financial terms and represents solid growth opportunities for the company. Further, they demonstrate the important progress for making with our business model as well as our success in licensing our proprietary drug delivery technologies to pharma and biotech customers. One of these agreements is with as of now undisclosed partners for the development of an oncology product. Another agreement which we announced November 2, is with NuPathe and relates to the development and commercialization of a sustained release formulation of their drug NP201 for the treatment of Parkinson’s disease, a significant unmet clinical need in a large and growing market. Analysts estimate that the global market for Parkinson’s disease is approximately 2 to $3 billion per year and growing. The use of our proprietary drug delivery implant technology is an ideal match in this clinical area, as dose levels must be carefully controlled to achieve optimal clinical outcomes. Overtime, we expect to see the progress we’re making with these license customers and others going forward to change our mix of revenue to include more royalties and license fees, which will be the strategic payoff from our acquisition of this business. And as you saw from our press release on January 21, we had the official grand opening of our new world-class cGMP manufacturing facility in Birmingham with the Governor of Alabama in attendance to help commemorate the event. It was a great day for everyone and especially for our employees. The agreement with NuPathe as well as the oncology program anticipates use of this facility to support multiple clinical and commercial products. These opportunities in our previously announced agreement with Genentech serve as good examples of how the cGMP facility broadens our scope of customer engagement and makes us a more valuable partner. We’re excited that in the current quarter we’ll begin to generate revenue from customer paid work in the 16,000 square feet of clean room production space. The facility is truly state-of-art. Each of the four clean room suites has independent air handling systems, enabling SurModics to accommodate multiple drug compounds in the same facility at the same time. We have outfitted the facility with the appropriate support utilities and equipment to meet the needs of our drug delivery customers, including antiseptic manufacturing processes, which are typically required to handle therapeutic proteins and other large molecules. It’s truly an impressive facility and as already attracted and we believe will continue to attract new customers. We believe the facility offers significant benefit to our customers including reduced risk for the development programs and potentially shortening their time to market. Finally, we continue to advance our broad pipeline, which we view as a portfolio of opportunities that will enable future growth and diversification for years to come. We have more than 100 license products generating royalties and nearly 190 customer projects in our pipeline not yet on the market. As of December 31, we had a total of 107 licensed customers, several with multiple licenses, up from a 104 a year ago. SurModics customers had a 104 licensed product classes on the market, generating royalty revenue up from 99 a year ago. The total number of licensed products not yet launched was 108, up from 107. Major non-license opportunities stood at 80, compared with 87 a year ago. In total, the company has 188 potential commercial products in development. In our November conference call, I provided you with SurModics fiscal 2010 objectives. As in previous years, these goals are designed to offer insight into how we manage our business, as well as where selected growth opportunities exist. Some of these goals are aspirational in nature as we often don’t control the timings related to our customer dependent objectives. In our first quarter of fiscal 2010, we made significant progress against these goals. Our first goal is to sign 18 new license agreements with SurModics customers. In Q1, we signed six new licenses, including our major license agreement with Roche and Genentech in ophthalmology. Second, among these 18 new licenses we expect to sign two new licenses relating to SurModics Pharmaceuticals, drug delivery technology. And that’s in addition to the agreement already signed with Genentech. We are on track to sign one SurModics Pharma license agreement in the near term and at least two in total by the end of fiscal 2010. Third, we expect our customers will launch 10 new product classes incorporating SurModics license technology. As you know, launches are significant because they mark the point in our business model when the flow of royalties begins for us. In the first quarter, one of our customers launched a new product class. Fourth, we expected one of our customers to initiate a human clinical trial for a product using SurModics drug delivery technology. As I mentioned before, in the first quarter, our partner OrbusNeich initiated a human clinical trial using our SynBiosys biodegradable polymer, therefore achieving this goal. Finally, we expected to qualify and bring our new cGMP facility online, during the fiscal year to make it available to current and future customers for years to come. As mentioned earlier, construction is complete. The facility is officially open and we are on schedule to have our first revenue generating customer in the clean rooms by March 31. As we’ve done in the past, we’ll keep you updated on progress against these goals throughout the year. In closing, our portfolio of opportunities is significant and we believe that source for future growth for years to come. We have many exciting opportunities in front of us. We remain confident in our position as we look to the future. Operator, that concludes our prepared remarks, we would now like to open up the call for any questions. Operator?

[Operator:]

Yes, thank you. We’ll now begin the question-and-answer session. (Operator instructions) Our first question comes from the line of Ross Taylor with CL King. Please go ahead.

[Ross Taylor:]

Hi, I just have two financial questions. It looks like the royalty and license fee revenue you have picked up sequentially from the September quarter, with adjustment at 1.25 million payments you got in September and I just wondered if you can detail at all what might have caused that sequential increase? And the other question I had is with the new facility in Alabama opening up I wondered what that does to your depreciation expense in the current quarter going forward?

[Bruce Barclay:]

Sure. Let me take those, Ross. First of all, the royalties and license fees line was a strong result for the quarter and there was some sequential improvement in CYPHER as you know based on J&J’s results there. They are down 18% year-over-year, but sequentially, they were up a little bit. So that certainly was a factor, but there was some good strength across the portfolio in royalties, cardiovascular and others. So that was a good portfolio contribution really for the quarter. In terms of depreciation, what we added in this quarter was about $160,000. That was from one month’s worth of depreciation, because we brought the facility online in December. And going forward, we would expect that quarterly run rate on that facility to be about half a million.

[Ross Taylor:]

Okay. And last question, have you disclosed at all which technologies you’ve licensed to Invatec?

[Bruce Barclay:]

No, we have not. We are not...

[Ross Taylor:]

Okay. That’s all my questions. Thanks very much.

[Bruce Barclay:]

Thank you.

[Phil Ankeny:]

Okay, thanks Ross.

[Operator:]

Thank you. Our next question comes from the line of Brian Jeep with Sidoti & Company. Please go ahead.

[Brian Jeep:]

Good afternoon gentlemen.

[Bruce Barclay:]

Good afternoon.

[Phil Ankeny:]

Hi, Brian.

[Brian Jeep:]

I have a question about customer R&D projects. It looks like – I think the margin there fell off pretty substantially. I mean, is that because it was just lower revenue or is there something else going on there that we should be looking at and then I guess what should we be thinking about for a run rate on that if you can?

[Phil Ankeny:]

So the margin definitely was compressed this quarter, mostly because of the decline in R&D revenue. So it’s really an allocation between the customer-funded R&D side of R&D expense to the other R&D expense, which is really more about the internal programs and the like. And so, there is overhead that gets allocated between those two and so effectively it’s an absorption issue, because the R&D revenue was sequentially down from the fourth quarter.

[Brian Jeep:]

Okay. Sorry, go ahead.

[Phil Ankeny:]

So if you remember last quarter we were about 29 30% and in this quarter we are considerably under that and it’s really a function of that. And so, the fourth quarter numbers are probably a little better ballpark of where we expect to be, but again it depends on the level of R&D revenue at the different parts of the company.

[Bruce Barclay:]

Okay. I was just going to comment on going forward as we alluded to a little bit in the prepared remarks, I think for the rest of fiscal 2010, we do see a definite increase in our paid R&D number, some of what we experienced in Q1, I still mention was one particular customer. I would say there are other timing issues with a couple of other customers as well, but we see those timing issues starting to dissipate in terms of paid R&D for us in the – for the rest of the year. And we also see some new business coming in as well, which we don’t have yet, but we expect to close on soon. So we think that this is timing and we’ll see that improve for the rest of the year.

[Brian Jeep:]

Okay. And I think you haven’t given out too many specifics on the Genentech deal, I mean if you could just give us a sense of whether it’s possible or even likely that you will achieve a milestone before the end of fiscal 2010?

[Bruce Barclay:]

Now, we really can’t talk about the side or the timing of the milestones relative to the program other than just what we announced at the initiation of the release, which was the total milestone, packages approximately $200 million.

[Brian Jeep:]

All Right. Okay. And you – I know you were trying to get the Genentech agreement, you had the Merck agreement before that. Looking at these I am wondering, is it a coincidence that you signed two big ones in the last say 2.5, 3 years or should we expect the possibility that there is going to be another big one coming in the next year too?

[Phil Ankeny:]

We got a number of programs in place now, not only in ophthalmology, but also in other areas of drug delivery that are not licensed at this point. And as we said in the past, we don’t control precisely the timing of the licensing of those technologies, because of the value that we expect from that A) it’s an enabling technology and B) our programs are in very large markets with many cases very large companies, we have a high expectation of what the value of those deals should be. So there are not things they get entered into unless there is some data from the programs that would support and that was certainly our experience with Genentech and we felt like worth the way, because of the magnitude of the program and the importance of the customer. So, the timing of those I can’t comment on, I will tell you that, as I’ve said we got other large Pharma. We are doing programs which aren’t licensed yet. And if those programs continue as we hope that they will and there is certainly no guarantee, they have to license at some point down the road.

[Brian Jeep:]

Okay. All right. Thank you. I’ll get back in the queue.

[Bruce Barclay:]

Thanks for the call.

[Operator:]

Thank you. Our next question comes from the line of Daniel Owczarski with Avondale Partners. Please go ahead.

[Daniel Owczarski:]

Yes. Hi, Bruce. Hi, Phil.

[Bruce Barclay:]

Hi, Dan.

[Phil Ankeny:]

Hi.

[Daniel Owczarski:]

Just to return to the R&D number, can you quantify what that impact was sequentially when that customer went to the clinical trial, how sizeable was it?

[Phil Ankeny:]

I don’t know the number on top of my head. I don’t know; it’s one of several programs that we have.

[Daniel Owczarski:]

Okay. And then moving that specific one, moving to the clinical trial, it sounds like it’s not cardiovascular-related or ophthalmology or can you talk a little bit more about what’s starting there?

[Phil Ankeny:]

Yeah, that is neither of those programs, not if those clinical areas is and I think Phil alluded to, it’s in the other markets area, which is a bucket of programs that we have that cover between 8 to 10 to 12 different clinical areas depending upon the quarter in which we are doing work. So it’s a lot of different clinical areas. It’s mostly made up of paid R&D and of the programs of various sizes and various progress along the development pathway.

[Daniel Owczarski:]

Okay. Because – and I was wondering if that – if we could – is that a possibility of manufacturing in Birmingham supporting that clinical trial is that something along that pathway?

[Bruce Barclay:]

Yeah, absolutely. I mean I think it’s our hope and I would say expectation with some programs, contractual commitments in some cases that as we begin to work with the customers on GMP animal studies and then move into Phase I and Phase II clinical trials, we’ll do that work naturally because there is a close connection between the scale-up required for those – for that testing with the R&D work that’s done by our scientific teams. And, well, there is a lot of science with the manufacturer of these products. There is also a fair amount of art with it as well. I think being able to have the close connection between the benchtop work and then the animal and early clinical scale-up is really important. That’s critical to the success of our cGMP facility. And our customers believe that connection is important as well. And then, the question becomes, once you’ve done the GMP animal Phase I, Phase II, will you be an option for Phase III and commercial? It’s not a given, but once you reach that point and there is continued good data coming out of the clinic, we think it’s more likely than not, customers want to stay with us for the large scale Phase III and then the commercial. FDA requirements, I think are significant that you can keep all that done in one side. We think there is a significant advantage for us. We are also seeing trends in the industry that suggest that pharmaceutical companies are increasingly comfortable with forming out the manufacture of these clinical and commercial product manufacturing requirements. And again, I think we are counting on that going forward with our facility. So, long answer to your question, I apologize, but there is definitely a connection between the early work that we are doing for clinical studies and then the Phase III and large commercial manufacturing components.

[Phil Ankeny:]

I think we have been – articulate this in the past and Bruce spoke to it well. But, the phrase we hear from customers all the time is risk and how been able to have the program go through its various stages and particularly, if you get to Phase III clinical trial material production a customer typically does not want to ever consider moving that from that location to a different location because it adds risk to the FDA approval and to ultimately getting a successful product that meets all of the GMP requirements et cetera and that just then backs up into the earlier stages where if you cannot transfer even at any stage, you are just minimizing risk and reducing risk from each stages you progress. And so, that’s a big reason behind why we felt that this investment in this new facility was so strategic and so compelling.

[Daniel Owczarski:]

It’s helpful color. Thank you.

[Bruce Barclay:]

Thanks for the call.

[Operator:]

Thank you. Our next question comes from the line of Ernie Andberg with Feltl & Company. Please go ahead.

[Ernie Andberg:]

Good afternoon.

[Bruce Barclay:]

Hi, Ernie.

[Ernie Andberg:]

Hey, Phil, you suggested that the diagnostic area softness was a timing issue and you expect revenues to improve actually Abbott royalty. Can they – do you think they go back to where you were in the fourth quarter actually Abbott royalty or are we between where we are now. And I recognize, I’m asking you for a forecast, but how do we think about your comments?

[Phil Ankeny:]

I would – it’s probably a lot safer to give you the directional line that we do see improvement there more precise within a range I feel a whole lot less comfortable. So – but we do have strong confidence and the ability to growth that line. But, the rate of growth when we get back to numbers you’ve seen in the past probably wouldn’t be prudent to peg that down.

[Bruce Barclay:]

I think that’s right. I think I would say, it’s a – it’s more of a timing issue whether those return sales come in Q2 or beyond. We think Q2 will be better; we certainly haven’t lost customers because of the reduced sales in diagnostics in Q1. It’s more about will they return exactly to the same level in Q2. We are hopeful, but I can’t guarantee that. There is no one event, no customer – significant customer loss that happened, it’s purely timing. And given the fact that reagents we sell are baked into scientific tests, many times FDA approved products there is good comfort there that they will need to buy those products eventually from us.

[Ernie Andberg:]

Okay. Second question, just on line items, SG&A bounced up sequentially by about 10% and was probably higher than most of the quarters last year Phil, how do we think about that line moving forward?

[Phil Ankeny:]

As we’ve looked at the need to continue to support the business and customers, we’ve seen a bias upward in that through the balance of the year.

[Ernie Andberg:]

All right. That’s a fair thing.

[Phil Ankeny:]

That’s strong, but bias upward.

[Ernie Andberg:]

Thank you. That’s all.

[Phil Ankeny:]

Thank you for the call.

[Operator:]

Thank you. Our next question comes from the line of Rick Rinkoff with Craig-Hallum. Please go ahead.

[Rick Rinkoff:]

Well, that was close enough. You’re going to start a clinical trial soon would you anticipate a milestone payment?

[Bruce Barclay:]

I am sorry. Rick, I missed the first part of your question. I was laughing.

[Rick Rinkoff:]

When you start a clinical trial in the near future as you suggested do you expect a milestone payment?

[Bruce Barclay:]

Typically that’s the case.

[Rick Rinkoff:]

Would this be a number that we would be excited about or is kind of in the six figures?

[Bruce Barclay:]

I would have to figure out which numbers excite you.

[Rick Rinkoff:]

Any number would excite me.

[Bruce Barclay:]

Yeah, people like to look through $3.5 million sometime and that really excites me. So...

[Rick Rinkoff:]

But you amortize that over twenty years. So this one you wouldn’t. So would – should we expect a sizable payment or should we expect something along the lines of the $43,000?

[Bruce Barclay:]

Well, I can assure we cash both checks within five minutes after it reached the door. So for me it doesn’t matter how they are accounted for as much. I can’t comment on the size Rick. I can just tell you that starting clinical trials and progressing through development process are commonly significant events in the course of a program and we think as they create value for our customers we always share in that. So that’s a common philosophy for us.

[Rick Rinkoff:]

And you also said you are going to launch some new products where you have royalties will you expect any of those to be significant?

[Bruce Barclay:]

I think potentially yes, we’ve talked about that CYPHER SELECT product in Japan it’s done well in Europe relative to the competition and we think in part because of the improved deliverability we’ve talked not on this call, we’ve talked in the past about our participation with the Evalve, which is now a part of Abbott Diagnostics and they reported at the JP Morgan Healthcare Conference that they would expect filing in 2010 and approval in the US in 2011. It’s already on the market outside the US in some select markets. There are many examples like that most of which we don’t have permission to discuss publicly. But we continue to believe that – as it was this quarter with more than half of our revenue coming from royalties and license fees that’s an important line for us.

[Rick Rinkoff:]

Your capital spending for the year is already not quite 4 million you suggested another amount similar to that would be spent on the building what do you target capital spending for the full year to be?

[Bruce Barclay:]

Yeah, I think the good news on the building in Alabama, the facility spend is done. And now we’re talking about the cost and timing of the equipment outfitting some of which we’ve done in core, some of which we will be transferring equipment from other facilities and we will be closing those down overtime. What we said for additional equipment at the new facility kind of 3 to 4 million max for the reminder of the year typically CapEx for the year for us, beyond that is 2 to $4 million I am looking to fill...

[Rick Rinkoff:]

Right.

[Bruce Barclay:]

Nodding his head, so I think that’s kind of the outside number – sum of those two.

[Rick Rinkoff:]

So once this facility is up and running should we assume that the run rate capital spending should be 2 to 4 million a year?

[Bruce Barclay:]

Yeah, I think it's 2 to 5 probably depends on the year.

[Rick Rinkoff:]

2 to 5 million and historically you’ve delivered north of 30 million of operating cash flow a year, so free cash flow could be 25 to 28 million assuming the 30 on the top.

[Bruce Barclay:]

Assuming the 30 on the top?

[Rick Rinkoff:]

Yeah, okay. And for the new building if you were to look out a few years what percent of the revenue that SurModics brings in do you think it would be flowing through that facility?

[Bruce Barclay:]

To say, that’s a tough one to – it to gauge, ultimately that the piece is the royalties that it can generate on the programs that are done there. And then depending on the level of manufacturing work that we are doing the – the manufacturing revenue can also be significant drivers. So I think it really depends on the timing of when things are hitting the market and how much of that’s coming through royalties, how much of its R&D revenue and how much is really the manufacturing piece.

[Rick Rinkoff:]

Okay. And where’s that Genentech revenue going to be attributed to Alabama or Eden Prairie or California, Ophthalmology?

[Bruce Barclay:]

It’s in ophthalmology.

[Rick Rinkoff:]

And Ophthalmology is in Alabama?

[Bruce Barclay:]

Well it’s everywhere, its picking up programs there enough of them, they are actually doing work all three sites – doing work on all three sites.

[Rick Rinkoff:]

Okay. But to expect the 40 or $50 million you must expect a sizeable return on that in the future?

[Bruce Barclay:]

Absolutely, I think in a couple of different ways we’ve talked about in the past, its growth of revenue from manufacturing, but also being able to reduce the risk on programs that have our license technology. So that we can support the – hopefully growth of the royalties and license speed milestone payment mix that we’ve come to enjoy overtime. So it’s not just revenue line, but also the mix of the – on the revenue line will be supported by that facility.

[Rick Rinkoff:]

Okay. Last question.

[Bruce Barclay:]

Sure.

[Rick Rinkoff:]

We find out now after the fact that a clinical trial was completed in the September quarter and that’s why the December numbers were low on the R&D line. Is there anything that you want to tell us that might have been at one-time item in the quarter just ended that we are going to find out about three months from now?

[Bruce Barclay:]

I am not aware if anything at the moment, Rick.

[Rick Rinkoff:]

Okay, thank you.

[Bruce Barclay:]

Thanks for the call.

[Phil Ankeny:]

Operator, I think we’ve got time for one more question, if you can queue up one more please.

[Operator:]

Yes, we do. And we have a question from the line of Dorsey Gardner with Kelso Management. Please go ahead.

[Dorsey Gardner:]

Hi, I guess firstly, we if you had all four lines so that in Birmingham what would – what do you anticipate the manufacturing revenue would be?

[Bruce Barclay:]

There is lot of variables to that question Dorsey. It depends upon the margin of the products of course and the hours we put into the program themselves, because often times there will be less than eight hours a day and sometimes are more than eight hours a day. It’s significant. It’s tens and tens of millions of dollars potentially. These are all – so it was built for drug release products. And so, they are typically the higher margin, higher volume-type products. And oftentimes if they are large molecules, which typically, we are increasingly seeing and we are hearing from pharmaceutical customers there, increasingly shifting the mix of their own clinical pipelines for larger molecules, that actually commands a premium for us as well, because they are more difficult and we are – we have a much significant – significantly advanced competitive advantage in that space as well. So I don’t have that answer on top of my head and then just to say that we would all be happy.

[Dorsey Gardner:]

Okay. How long do you think it will take to fill up the clients?

[Bruce Barclay:]

Yeah, we have a number of programs today that are in clean rooms, not in that plan, so what we’ve got going on now is new programs that we’re starting out in the plant, like the Genentech program as an example of that. And then, we’ve got other programs that we are transferring over from existing clean room space that is really sub-optimal for continued growth of those programs as we expect that will occur. And then, we’ve got a number of new programs that we are talking about as well with customers that today are paid customers. And so, if you look at the data that we have in front of us, we think that we can be very busy in that plan in a very short period of time, but some of that is within our control and our customers control in terms of how we transfer out of the existing clean room space at for other two facilities down there. Our goal is to get out of all those facilities as quickly as we can, but reasonably so, such that we don’t impact the development of the customers programs.

[Dorsey Gardner:]

Right. Some customer’s sort of more time [ph] than others that, is there – some are involved in deciding how you fill up the plant with which customers or some be much more profitably than others?

[Bruce Barclay:]

Yeah, there is a difference in profitability. There is a difference in size of the programs, which we would prioritize or the difference in whether we are scaling up products that contain our own technology versus technology that may be as more strategic in nature, but not necessarily our own technology, but sometimes different drugs had be brought in at different times because of just FDA requirement that dictate how we stage those programs, but we are not at that point at all. I mean, we are at the point now where we’ve got customers that are starting out. Even in this quarter as we’ve said, customers will transfer overtime and then a number of customers that were in active negotiations with right now to bring in some programs that we think are going to be pretty exciting. So as we go forward, we’ll update you as best we can on that, but we continue to believe that this is an investment that is going to be worth making.

[Dorsey Gardner:]

Okay. Thanks for answering my questions.

[Bruce Barclay:]

Yeah. Thank you for the call.

[Bruce Barclay:]

In queue, I don’t show any further question at this time. Please continue.

[Phil Ankeny:]

Great. Thanks very much, operator. Thanks again to everybody for participating in our conference call today. As a reminder, our annual meeting of shareholders will be held here in Minneapolis on Monday, February 8. This year’s meeting will be at a new location, the Century Room on the 21st floor of the Wells Fargo Center still downtown. We hope you’ll be able to join us. And if not, listen in on the webcast. We look forward to speaking with all of you then. For those of you who can’t join us at the annual meeting, we look forward to talking to you in April, when we announce our second quarter results. Thank you again.

[Operator:]

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.