Surmodics, Inc.
Q2 2010 Earnings Call Transcript

Published: 29 Apr 2010

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the SurModics second 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 to the questions. (Operator Instructions) This conference is being recorded today, Wednesday, April 28, 2010. I would now like to turn the conference over to Mr. Phil Ankeny, Senior Vice President and Chief Financial Officer. Please go ahead, sir.

[Phil Ankeny:]

Thank you, Marissa. Good afternoon and welcome to SurModics Fiscal 2010 second quarter conference call. Thank you very much 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 relation section of the SurModics website where the audio recording of the web cast 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 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. On today's call, I will address the company's quarterly financial results, Bruce will then highlight quarterly achievements and progress against our published fiscal 2010 company goals and finally, we will open the call to your questions. I will begin by reviewing key second quarter financial results and then provide commentary around a few highlights. For the second quarter of fiscal 2010, revenue was $18.4 million, up 6% sequentially. Diluted loss per share was $0.02 and cash flow from operations was $4.1 million. Included within our GAAP results for the second quarter were two event specific charges. Specifically, restructuring charges of $1.3 million in connection with the organizational and leadership changes we announced in March as well as a $2.1 million non-cash asset impairment charge in connection with the consolidation of the company's facilities in Birmingham, Alabama, into our new facility which we opened in January. The asset impairment charges not in connection with our new CGMP facility but rather our other facilities in Birmingham and reflects the decline in the commercial real estate market since the acquisition of Brookwood Pharmaceuticals in July 2007. However, our ultimate goal of having all our Birmingham employees under one roof should result in operating expense savings as well as enhanced productivity, communication and ultimately improved results. Excluding the restructuring and asset impairment charges for the quarter, non-GAAP results were as follows. Operating income was $2.4 million, net become was $1.7 million and diluted earnings per share was $0.10. These figures are down modestly on a sequential basis compared with our GAAP first quarter results which were as follows. Operating income was $2.8 million, net income was $1.9 million and diluted earnings per share was $0.11. Next, let's turn to revenue line items. Royalties and license fees for the second quarter were $7.8 million, down 15% sequentially. We experienced this sequential decrease in royalties and license fees primarily as a result of the continued decline in CYPHER royalties. Johnson & Johnson reported that sales of the CYPHER Sirolimus-eluting Coronary Stent were approximately $191 million in the quarter, down 24% year over year and 14% sequentially. We are pleased to report that quarter has recently launched the CYPHER SELECT Plus drug-eluting stent in Japan, the second largest market for drug-eluting stents in the world, following receipt of the reimbursement approval for that stent. CYPHER SELECT Plus has both our drug delivery polymer on the stent and our hydrophilic coating on the delivery system. So we received two royalty streams on the sale of this product. Let's take a closer look at the royalties and license fees line. While down year over year and sequentially, we actually are seeing a positive trend emerging here from the focused efforts of our sales and product development teams. In particular, we are continuing to sign a number of new customer licenses in the hydrophilic space and have been for some time. If we focus for a moment on the royalties being generated by the various customers in our hydrophilic portfolio, sales of our customers' products are a diverse mix with some increasing and others decreasing. However, the good news is that there are more customers whose products are growing than declining and perhaps more importantly, aggregate dollars from royalties in our hydrophilic portfolio grew nicely, both year over year and sequentially. And while milestones and license fees occur quite regularly in our business model, as they did again in the second quarter, in aggregate they were lower this quarter than they were in the first quarter of fiscal 2010 as well as in the second quarter of fiscal 2009. Now, let's turn our attention to product sales, which were strong in the second quarter at $5.3 million, up 16% sequentially and 10% higher compared with the year-ago period. Drilling down into these results, diagnostic product sales were a key driver, with total IVD product sales up 24% sequentially. In fact, each product category In Vitro diagnostics was up at least 20% with the exception of microarray slides which experienced some customer specific product timing issues. Finally, R&D revenue in the second quarter was also robust, as SurModics generated $5.3 million in the period, a sequential increase of 46%. R&D revenue results were propelled by strong activity with Genentech as well as many other customer-funded development programs. In fact, both Genentech and non-Genentech-paid R&D were up sequentially over the first quarter. We experienced a noticeable uptick in new customer R&D drug delivery programs, this quarter which we attribute to SurModics’ improved sales efforts as well as the power of our new facility in helping convince customers of our unparalleled ability to support them from early development through clinical trials and into commercial production. Also, more broadly, the healthier economic environment encouraged select customers to resume or ramp up their R&D programs in the second quarter. We expect to generate strong paid R&D in the third and fourth quarters of fiscal 2010 as well. Turning to our results, our revenue reporting by market, I will begin with therapeutic. In total, therapeutic revenue was $15.5 million, up 3% sequentially, reaching its highest level in four quarters. Cardiovascular revenue for the second quarter was $9.3 million, down 14% sequentially. The principal cause of this decrease was the lower royalties and license fees as I discussed earlier. In the second quarter, cardiovascular constituted 50% of SurModics total revenue. Moving on to ophthalmology, revenue was $3.4 million for the quarter, up 36% sequentially. GAAP revenue included only $44,000, of the $3.5 million upfront license fee from Genentech as it is being amortized over 20 years. As a reminder, in the first quarter, SurModics earlier adopted EITF 081 which is now called ASU 2009-13 topic 605, the accounting treatment. As a result, the company will not defer any of the R&D revenue associated with the Genentech agreement. We consider this a positive development as it more closely aligns our financial reporting with the underlying economics. Further, it allows SurModics to provide investors with a clearer picture of the company's current condition and financial performance. Rounding out therapeutic, other markets revenue was $2.9 million, up 54% sequentially, driven principally by strong growth in R&D revenue and product sales from our SurModics pharmaceutical business in Alabama. Finally, I will review results from the diagnostic market. For the second quarter, diagnostic revenue was $2.8 million, up 23% sequentially. As this business is principally comprised of product sales, the growth was driven by the strong performance in our various component diagnostic products as I mentioned earlier. Now, let's turn to a review of operating expenses. As mentioned previously, SurModics operating expenses on a GAAP basis were impacted by the organizational and leadership changes announced in March. The company recorded restructuring charges of 1.3 million related to employee severance and facilities exit charges. On an annualized basis, SurModics expects to save approximately $500,000 to $1 million from the changes we instituted to our organizational structure. The company also recorded a $2.1 million asset impairment charge in connection with the consolidation of our facilities in Birmingham. As we have said often in the past, we will be consolidating SurModics’ other two Alabama locations into our new cGMP manufacturing and development facility and expect improved efficiencies, productivity and expects expense savings from the consolidation once completed. We have another bit of good news relative to our facilities, I'd like to report about. We recently signed an agreement with BBVA Compass Bank, a leading bank in the south and the third largest bank in Alabama, who were leased over 50,000 square feet of our office space in the new facility in Alabama. This transaction will reduce our operating expenses once the multi-year lease goes into effect later this fiscal year. Our ongoing operating expenses benefited from the modest headcount reduction announced in March. Although in the second quarter, these savings were realized for less than one month. Going forward, however, this benefit will be counterbalanced by investments we are making to support our customers and our long-term growth objectives. Overall, total operating expenses excluding product costs and the restructuring and asset impairment charges were $13.5 million in the second quarter, up 6% sequentially. As we acknowledged in our first quarter earnings call, the principal driver of this increase was a full quarter of depreciation and other expenses related to our new cGMP manufacturing and development facility. In addition, higher expenses on customer development projects contributed to the increase but, of course, we delivered higher R&D revenue as well. Finally, let me turn to our balance sheet, which continues to be a source of strength and opportunity. SurModics cash and investments at the end of the second quarter totaled $51.8 million. Operating cash flow for the quarter was $4.1 million, compared with negative $0.6 million in the second quarter of fiscal 2009. For the first six months of fiscal 2010, operating cash flow was $12.4 million, as the company continues to demonstrate its ability to generate cash. During the second quarter, the company purchased approximately 103,000 shares of its common stock for $2 million. As we mentioned last quarter, the capital investments associated with the remodel of our new facility in Alabama are largely behind us. Accordingly, we expect our capital expenditures for the remainder of the fiscal year to be more routine in nature. With that, I will now turn the call over to Bruce.

[Bruce Barclay:]

Thanks, Phil. Let me welcome everyone to today's call as well. SurModics delivered strong sequential growth in Opthalmology, Diagnostics and other markets in the second quarter. And total Therapeutic revenue was at its highest level in four quarters, reflecting our enhanced sales efforts and improved economic conditions. These positive results are helping SurModics bridge the gap over several difficult revenue transitions. These transitions include the cancellation of our Opthalmology with Merck, the loss of the Abbott Diagnostics royalty stream due to patent expiration and the continued decline in our revenue from CYPHER. Despite these well-known challenges, we are delivering growth in the rest of our business. In fact, if you exclude revenue associated with CYPHER, Merck, and Abbott Diagnostics from our results, SurModics total revenue is up 6% year-over-year and up 14% sequentially. This is especially encouraging considering the absence of any major milestones or lump sum payments in the second quarter. Another encouraging highlight from the quarter was the strong growth of our R&D revenue, which also reached its highest level in four quarters as the number and quality of our customer projects continued to expand and advance. While our program with Genentech drove a large portion of the sequential increase in R&D revenue, I am pleased that this growth in R&D was broad based, as the sum of the rest of our customer programs, that is all programs excluding Genentech, also grew sequentially over Q1. As you know on January 21st, we officially opened our new state-of-the-art cGMP facility for manufacturing and development in Birmingham. It was a very exciting day for our employees and the community alike and a significant milestone for the company. Reflecting our strategy, we believe the new facility significantly enhances the growth prospects of the company and especially our SurModics pharmaceuticals business, as it broadens our scope of possibilities for customer engagement and makes us a more valuable partner. It is truly a world-class facility and underscores our unique capability and flexibilities to support our multiple customers and their oftentimes varying needs. The feedback we have received has reinforced our belief that this facility fundamentally improves how customers view SurModics as a development and manufacturing partner. We are continuing to transition existing customer projects into the facility and are pleased to report that we did generate revenue from customer paid work in the new facility during the quarter. For example, numerous Genentech activities occurred in the facility during the quarter. I believe SurModics' ability to support its partners will also be enhanced by the organizational changes announced on March 4, which completed the task of converting the company into a singular organization. Our new structure is expected to allow us to better meet customer needs and leverage our customer relationships across our entire technology and product portfolio. In addition to consolidating SurModic's sales and marketing, research and product development efforts, these changes should enhance accountability on the management of customer relationships and revenue targets as well as improve resource allocation. Now, let me take a few minutes to update you on some of our most promising revenue generating opportunities. As initially discussed in early October, our Genentech agreement continues to be an important step forward for our Opthalmology opportunity. Among other things, it offers SurModics the prospect of developing a sustained-release formulation using our proprietary biodegradable micro particles, in combination with a known, approved and highly successful drug in Lucentis. Since signing the agreement, the teams from SurModics and Genentech have worked well together and a development program continues to progress. Also as we announced in March, SurModics entered into an agreement with ForSight Labs to license certain non-core Opthalmology technology to them. The technology licensed in this agreement does not include our I-vation drug delivery platform. We identified these technology assets as being outside our core strategic areas of focus, and are delighted to have reached an agreement with ForSight Labs. So that this technology can be further developed and potentially commercialized. The license agreement provides us with an upfront license fee, milestone payments and royalties upon commercialization. Additionally, as we had planned, we are making significant progress across our broader portfolio of customer projects in Ophthalmology. Importantly, we are continuing to work with three top 10 pharma companies including Roche and Genentech as one. We believe that our portfolio of customer projects in Ophthalmology is healthier now than it has ever been in the past. And will be a significant source of growth for years to come. Beyond Ophthalmology, SurModics has several additional prominent revenue generating opportunities in other parts of our business including cardiovascular. Although, CYPHER revenues continued to contract the company's overall cardiovascular franchise remains a source of opportunity. In the stent market our portfolio of licensed customer product opportunities, both on the market and in our pipeline is substantial. We're all taking important steps in diversifying our exposure beyond stents within the cardiovascular space. Our previously announced licenses with Evalve, now Abbott and Invatech, now Medtronic are but two examples. And our work with drug leading balloons continues to progress and remains an area of strong interest within the industry. The final growth driver I will highlight today is SurModics Pharmaceuticals. This business has been developing nicely, as we've converted three sustained drug delivery programs into licenses. This demonstrates the important progress we're making with our business model, as well as our success and licensing our proprietary drug delivery technologies to pharma and biotech customers. Since January 1, of this year we've begun nine new paid drug delivery programs leveraging our SurModics pharma technologies for customers. In particular, I'm pleased to announce that we recently signed a new paid R&D agreement with another top 10 pharma company for the development of a novel large molecule drug delivery product for clinical use outside of Ophthalmology. With this new agreement, we now have paid development programs with 8 top 10 pharma and top 10 med-tech companies. The final point about the success of our SurModics pharma business is revenue growth, as both R&D revenue and other markets revenue are up sequentially. I continue to view our product pipeline as a portfolio of opportunities that will enable future growth and diversification for years to come. We now have more than 100 licensed products generating royalties and nearly 190 customer projects in our pipeline not yet on the market. As of March 31, we had a total of 110 licensed customers, several with multiple licenses up from 103 a year ago. SurModics customers had 102 licensed product classes on the market generating royalty revenue, unchanged from a year ago. The total number of licensed products not yet on the market was 111 compared with 106 in the prior year period. Major non-licensed opportunities stands at 75 compared with 92 a year ago. While, this last figure was down year-over-year, we believe the quality of projects has actually improved. In total, the company has 186 potential commercial products in development with customers behind each one of them, which we believe highlights the magnitude of the opportunity in our pipeline. Finally, we are continuing to make good progress on our fiscal 2010 goals. Several of our goals are designed to measure full year's activity and we're on midway through the year. These goals are aspirational in nature only, as often we don't control the timing of all aspects related to our customer projects. As in previous years, these objectives are designed to offer insight into how we manage our business and to provide a view of the company's future opportunities. This year we articulated a goal of signing 18 new licenses with our customers. In the second quarter, we signed five new licenses bringing our year-to-date total to 11. Second, among these 18 new licenses, we expect to sign two new licenses relating to SurModics Pharmaceuticals drug delivery technology. In addition to the agreement already announced in early fiscal 2010 with Genentech. Third, we expect that our customers will launch 10 new product classes incorporating SurModics licensed technology. As you know, launches are significant because they mark the point in our business model when the flow of royalties begins. In the second quarter, our customers launched four new products bringing our year-to-date total to five. Fourth, we expect it one of our customers to initiate a new human clinical trial for a product using SurModics drug delivery technology. In the first quarter our partner Orbus Neich initiated the human clinical trial called remedy, using our SynBiosys biodegradable polymer, thereby 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. As we've already mentioned, construction is complete, the facility is open and we are successfully migrating our first revenue generating customer programs in that facility during the second quarter. As we've done in the years past, we will keep you updated on our progress against all of your fiscal 2010 goals throughout the year. In closing, SurModics portfolio of opportunity is significant and I believe the benefits we are able to provide to our customers will help us deliver sustainable long-term shareholder value for our owners. Marissa, that concludes our prepared remarks. We'd like to open up the call any questions.

[Operator:]

(Operator Instructions) Our first question comes from the line of Richard Rinkoff with Craig-Hallum. Please go ahead.

[Richard Rinkoff:]

That would be Craig-Hallum. Good afternoon. Your R&D revenue went up very nicely, as you mentioned in the call. Should we expect a similar type of increase to hit those strong Q3 and Q4 numbers that you talked about?

[Phil Ankeny:]

We did say we expect strong R&D revenue as we go forward in the balance of the fiscal year. I wouldn't anticipate the kind of sequential increase you've seen, but we do believe there is potential to see higher revenue in the out quarters. Again, I probably wouldn't count on significant increases, but we definitely do see big opportunity and it really depends on how much work we're asked to do on behalf of the customers in the time periods. But the pipeline is as strong as we've seen in awhile.

[Richard Rinkoff:]

You talked to us before about the profitability of R&D revenue. If you look at the income statement, your R&D revenue is $5.3 million but R&D expense for customers was $4.8 million, a very different picture from previous time periods. Has the margin changed or what are we missing to reconcile that?

[Bruce Barclay:]

The principle difference driving that, Rick, is really the addition of the facility into R&D. If you think about the way the accounting worked before we brought the facility on stream, all of the expenses associated with the facility were really in SG&A. Once we brought it online, the depreciation, the utilities and maintenance and all of the activities and expenses associated with the facility, now get allocated mostly to R&D because that's the activity that the expenses support. And so a lot of it is really just a shift in where it's been captured. And then the other piece that amplifies the expenses is the fact that we're capturing a full year, excuse me, a full quarter of depreciation in Q2, where as in Q1 it was on the one-third of a quarter.

[Phil Ankeny:]

I guess I'd also add, Rick, that from the operating side, there's a fair amount of inefficiency in that new facility right now as well, which is not surprising given the fact that we are transitioning, we are bringing it up to speed. There is still rooms being qualified that type of thing. So as we get it fully up qualified, running which should happen in the very near future here, we would expect to see the efficiencies and improvement occur. But the transition is going very nicely. People are working a lot of hours down in Birmingham to bring it online and I'm confident that investment will be a good one for us long-term.

[Richard Rinkoff:]

Should we still think about a 30% margin over the long-term?

[Phil Ankeny:]

That's certainly in the target range, absolutely.

[Richard Rinkoff:]

Okay. And on product sales, I know they're all over the place and you don't have a great history of predicting them. But could you try and predict them again for the next two quarters?

[Phil Ankeny:]

Well, we do see good opportunity in the products area. I think most of them have stabilized somewhat from some of the year-end issues we experienced. The other factor I believe is embedded in your question is speaks to the margin, because our gross margins on products this quarter were down sequentially and certainly down from where we've been a little bit historically. Most of that is mixed and a little bit of it is just allocation of facility expenses in the like. So if you wanted to think about margins going forward. I'd probably keep them closer to where they are now.

[Richard Rinkoff:]

Okay. And just to note, your SG&A went down $0.5 million from the previous quarter to this quarter? That reflects the company being transferred to the expense in R&D line, is that right?

[Phil Ankeny:]

Yeah. That's the bulk of it. And then some of the additional decline is a stock-based compensation was also lower than it was in Q1.

[Richard Rinkoff:]

Thank you.

[Phil Ankeny:]

Thanks for the call. Thank you, Rick.

[Operator:]

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

[Ernie Andberg:]

Rick, hit the some significant questions on margin there. But how do we judge where the bottom of the royalty and license line is, Bruce? It hit probably the lowest level in several years. How does that get or when do you think it stabilizes and then turns around?

[Bruce Barclay:]

Yeah. That's a good question. It was part of the reason, why we included some of the language in our press release and also our prepared remarks from the script relative to some of the trends we're seeing. If you look at taking out the well-known headwind that we've been facing on CYPHER and Abbott, I would say we're actually seeing trending in the other direction. We're seeing some nice pickup in our hydrophilic business. And we tried to demonstrate that through signing licenses, which are up substantially over the last several years and most of those are hydrophilic based. The other variable in that is license fees and milestones which if you go back over the last whatever it's been 20 to 25 quarters that I have been here, we generate license fees milestones in almost every quarter. The magnitude will differ, but our business model is one it's very much dependent upon. And that we can expect royalty, sorry, milestones and license fees given the number of contracts that we have. The number of contracts that have provisions and then for future milestones and the number of new contracts we sign on a new basis. Especially, as we generate more contracts in the drug delivery space for SurModics Pharmaceuticals. So if you take away the headwinds, you take away the things that are not recurring. We expect to see that line to start to trend up over time.

[Phil Ankeny:]

And one other comment I would add, Ernie, is that if you are looking at that line in aggregate. Obviously, the biggest contributors to the trend line that has been going down in your view is CYPHER and Asher. And obviously Abbott is behind us. But CYPHER just let me remind you and others what we have disclosed in the past and that is that our agreement with J&J actually has minimum royalties built into it. So that as long as CYPHER is being sold somewhere in the world, we are likely to get the minimum royalties each quarter, that's a true statement. And those minimum royalties are actually in the millions of dollars per year. So there is a floor, as long as that product is being sold at some point here.

[Ernie Andberg:]

That begs the question or opens the question, what's the floor? In millions of dollars?

[Phil Ankeny:]

It's multiple millions of dollars. Unfortunately we are not at liberty to disclose that.

[Ernie Andberg:]

Fair enough. Phil, you said that you expect capital expenditures to be more routine in nature over the balance of the year, relative to the first and second quarter, which second quarter came down. Where do you think that goes?

[Phil Ankeny:]

We -- when I say routine, we think about maintenance levels of CapEx in our business as being somewhere in the call it, the $5 million a year range. And so we are probably close to within that. There is a few projects that may need some capital investment to support customers and the like, as we go forward the rest of the year. But it's certainly less than $5 million for the balance of the fiscal year.

[Ernie Andberg:]

Okay. Thank you very much.

[Phil Ankeny:]

Yeah. Thanks for the questions, Ernie.

[Bruce Barclay:]

Thanks for the call.

[Operator:]

Thank you. At this time, we have no further questions. Please continue.

[Phil Ankeny:]

Great. Thanks, Marissa. Let me thank you again for participating in this quarter's conference call. We look forward to speaking with everyone again for our third quarter results in July. Thank you.

[Operator:]

Thank you. Ladies and gentlemen, that does conclude our conference for today. If you would like to listen to a replay of today's conference, please dial 303-590-3030 or 1-800-406-7325, using the access code 4283019. Thank you for your participation. You may now disconnect.