Surmodics, Inc.
Q4 2010 Earnings Call Transcript

Published: 11 Nov 2010

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to the SurModics fourth quarter 2010 earnings conference call. During today’s presentation, all participants will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator instructions) I would now like to turn the conference over to our host, Phil Ankeny, Interim Chief Executive Officer, Senior Vice President and Chief Financial Officer. Please go ahead.

[Philip Ankeny:]

Thank you, Alicia. Good afternoon and welcome to SurModics fiscal fourth quarter and full year 2010 conference call. Our press release reporting quarterly and full year results was issued earlier this afternoon and is available on our website at www.surmodics.com. 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 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 highlight select financial results and key achievements for the quarter and year. I will then discuss our outlook for fiscal 2010, and finally, we will open up the call to take your questions. Let me begin with some financial highlights. For the fourth quarter of fiscal 2010, revenue was $15.5 million, 16% lower sequentially. Non-GAAP diluted loss per share was $0.05 per share. Our non-GAAP results exclude a goodwill impairment charge related to the 2007 acquisition of SurModics Pharmaceuticals of $13.8 million, asset impairment charges associated with long-lived assets of $2.6 million, and an impairment loss in connection with the company’s portfolio a strategy investment of $5.4 million. Cash flow from operations for the quarter was $5.3 million. For fiscal year 2010, non-GAAP revenue was $73.4 million compared with $86.8 million in fiscal year 2009. As a reminder, Merck’s termination of our agreement resulted in the recognition of approximately $45 million of GAAP revenue in the first quarter of fiscal year 2009. Excluding restructuring charges and goodwill, asset and investment impairment charges, as well as expensed IP R&D from 2009, non-GAAP diluted earnings per share was $0.39 for fiscal 2010 compared with $1.07 in fiscal 2009. And lastly, cash flow from operations for the year was $22 million compared with $31.3 million for fiscal 2009. Please refer to the supplemental tables in our earnings release for an explanation of our non-GAAP accounting. Now let me turn to our revenue lines. Royalties and license fees for the fourth quarter were $7.9 million, a decrease of 15% on a sequential basis. Recently, Johnson & Johnson reported the sales of the CYPHER sirolimus-eluting coronary stent were approximately $136 million in the quarter, down 19% sequentially and 36% year-over-year. However, excluding the $1.25 million in one-time license fees from our third quarter results, royalties and license fees decreased 2% sequentially in spite of the 19% decrease in CYPHER sales. Product sales were $4.6 million in the quarter, down 20% sequentially. While our product sales were weaker in the fourth quarter, we continue to generate broad-based customer demand for our component in vitro diagnostic products, polymers, and coating reagents. Lastly, R&D revenue in the fourth quarter was $3 million, down 14% sequentially, reflecting continued softness in R&D activity, which is a result of the normal ebbs and flows of activity in our various customer development programs. Importantly, we have not lost any significant customer programs from our portfolio of R&D program and we signed some exciting new projects during the fourth quarter. However, bottom line, we are disappointed with our fourth quarter and fiscal year 2010 performance. While the environment remains challenging and we have been navigating several revenue transitions, we know we are capable of doing better and we are committed to doing better. As you know, the major revenue transitions we’re working through include the cancellation of our ophthalmology program with Merck, the loss of the Abbott Diagnostics royalty stream due to patent expiration, and the continued decline in royalty revenue from J&J’s CYPHER stent. As we move forward, I can assure you of two things. One, returning our business to profitable growth is a tough priority for management and the Board. And two, we will continue to monitor the business and relentlessly execute to drive improved operating results over time. To this end, in the midst of conducting SurModics’ annual strategic planning review, it became clear to us that we needed to right-size our cost structure to bring it more in line with customer demand and expected revenue. Accordingly, in October, we announced a 13% reduction in force, which will save us between $3.0 million and $3.5 million on an annualized basis. While difficult, we believe this decision was necessary. In addition to the cost actions, we announced a new organizational structure, which reflects our three complementary but distinct business units; medical device, pharmaceuticals, and in vitro diagnostics. We believe that our customers’ needs as well as our own will be better served by this new structure by providing enhanced accountability, improved efficiency, and more effective resource deployment. Over the past few years, we have invested considerable capital as well as management’s time and attention on establishing a presence in the pharma drug delivery space. We have faced some challenges along the way, which I will address in just a moment. But as a result, we weren’t as focused on our other two businesses, medical device and IVD. However, our new structure will help to ensure we are dedicating the necessary resources and making the right investments to drive near-term performance in these businesses. In spite of our recent overall financial performance, our medical device and IVD businesses have compelling customer offerings and have long provided stability for SurModics. Additionally, both businesses made important progress on a number of fronts during fiscal 2010. By way of background, our medical device business is comprised of our hydrophilic or lubricious coating technologies, as well as our various drug delivery coating technologies. This business has been at the core throughout most of SurModics’ 30-plus year history and remains an area of consistent growth – consistent strength for the company. We have been particularly encouraged by the strong results we have generated in royalties from our portfolio of hydrophilic coatings in the medical device space. Yet again in the fourth quarter, royalties from this portfolio grew both on a year-over-year and sequential basis. While decreasing CYPHER sales continue to depress our results for total royalties, we believe we are nearing an inflection point where royalties from the broader portfolio will more than offset the decrease in royalties from CYPHER. Broad-based demand for our coating technologies has fueled substantial licensing activity in the medical device space. In the past five years, SurModics has signed nearly 150 license agreements, and more than 90% of them have been in medical device. Our portfolio of license customer product opportunities, both on the market and in our pipeline, includes more than 100 product classes already on the market contributing to royalty revenue; the previously announced licenses with Evalve, which was acquired by Abbott; and Invatec, which was acquired by Medtronic; as well as a drug delivery license with OrbusNeich on their combo bioengineered sirolimus eluting stent, for which they recently completed enrollment in an important clinical trial. The potential near-term opportunity in our medical device segment is notable. As we have the ability to penetrate adjacent high-growth markets and leverage exciting new medical device product categories, including percutaneous heart valves, dent grafts, pro-healing stents, drug-coated balloons, and many other minimally invasive products in the coronary, peripheral and neurovascular markets. Importantly, the development timelines and customer attrition rates are more favorable in our medical device business. Our in vitro diagnostics business also represents the source of stability and growth potential. Again, for background purposes, the IVD business consists of component products for diagnostic test kits and biomedical research applications. Our product offerings include microarray slide technologies, protein stabilization reagents, substrates, and antigens. Similar to the medical device segment, the storyline for the IVD business over the past year has been clouded by issues related to a discrete revenue stream. In this case, the expiration of the Abbott patents. Revenue relating to these patents continued through fiscal 2009, but in fiscal year 2010, we earned no royalties from the Abbott patents. Today, our in vitro diagnostic business drives virtually all of its revenue from sales of our component IVD products. Going forward, our comps for IVD will be more reflective of the underlying customer demand for our component IVD products. Now we will turn to our third business, pharmaceuticals, which incorporates a broad range of drug delivery technologies for injectable therapeutics, including microparticles, nanoparticles, and implants. This business maintains substantial long-term revenue potential and had some exciting developments during the year. Our pharma business includes the research, development and collaboration efforts we have announced with the following customers. Genentech, on a sustained release formulation of their blockbuster drug Lucentis. Clinuvel, on their SCENESSE implant, addressing ultra-violet related skin disorders. This product is currently in Phase III clinical trials outside the United States and Phase II in the United States. NuPathe, on a sustained release formulation of their drug NP201 for the treatment of Parkinson’s disease. Edge Therapeutics, on improving the delivery of medicines to the brain. And Eyetech, with whom we are jointly developing a sustained release formulation of Macugen. However, despite our strong portfolio of customer R&D programs, financial results for the pharma business have been disappointing. Driven largely by weaker macroeconomic conditions and increased cost, particularly relating to our cGMP facility. I’ll address this last point in just a minute. As you recall, we made a big commitment to the pharma business with our acquisition of Brookwood Pharmaceuticals in August of 2007 and further extended our position in the market in April 2008 when we announced the purchase of a building in Birmingham, Alabama, as part of our plan to construct a new cGMP manufacturing and development facility. We believe the decision to invest in the facility was a sound one. Developing leading drug delivery technologies and supporting customers from early development through clinical trials and all the way to commercial supply is an integral element of our pharma strategy. The cGMP facility allows us to provide that support. Further, it helps the company reduce risk for customer programs, which has the added benefit to SurModics of increasing the probability of ultimately generating royalties, the most profitable phase of our business model. In essence, the facility makes us a more valuable partner. In fact, constructing the CGM facility was a critical need for the joint development program with Merck as well as other customer programs at that time. Candidly, the environment has changed dramatically since then. Notably, we have felt the effects of the global economic recession. The impact on our pharma business has been particularly pronounced and prolonged. Overall, the industry experienced widespread contraction in R&D spending, as development funding was reduced or eliminated and timelines on many programs were pushed back. Perhaps more importantly, numerous pharma companies began to make difficult portfolio rebalancing decisions in the phase of impending patent clips on blockbuster drugs. This resulted in the discontinuation of previously well funded programs as was the case for our agreement with Merck. Beyond Merck, we had other late-stage customers, for whom the cGMP facility was an important asset. But several of those programs have fallen victim to similar circumstances. Although the facility has enhanced our capabilities and we are actively leveraging it for several customer programs, at this stage, it presents a significant earnings challenge. Since we opened the facility in January of this year, the cost to operate it is running at significantly higher levels than the revenue we have been able to generate. This near-term imbalance is reflected in our outlook. We estimate the pharma business will impact overall corporate operating profitability in fiscal 2011 by more than $10 million, with the cGMP facility comprising roughly $8 million of that shortfall. That said, viewing the facility and the broader pharma business through a longer term lens would highlight a compelling model from a growth and profitability perspective. In fact, the valuation creation opportunity inherent in our relationship with Genentech alone is very significant. But let me be clear. The management team and the Board recognized that this situation is untenable over the long-term. We can’t afford to invest in pharma at this level indefinitely. The challenge lies in balancing our interest in the near and long-term. While we continue to take a hard look at this business, we have already begun taking proactive measures. The initial step we took was the recent reduction in force. But we cannot cost-cut our way to profitability, as much of our expenses are fixed. This reality has led us to undertake other measures to improve the economics of the facility. For example, we have approached certain customers with our manufacturing services for injectable drug products that leverage our facility and core capabilities. In fact, we have recently secured a manufacturing collaboration for a liposome product, which is in late stage clinical trials. Liposomes are a promising delivery technology with proven market potential, most notably, in oncology. And they represent an excellent fit with our capabilities. This brings us to a total of three collaborations in the liposome space, two at late clinical stage Going forward, we will aggressively look for similar revenue-generating opportunities that leverage our facility and core capabilities. While SurModics is taking the strategic actions necessary to expand our revenue streams and minimize expenses, we anticipate that 2011 results will remain challenged. For fiscal year 2011, SurModics expects to generate revenue in the range of $55 million to $63 million, and non-GAAP diluted EPS ranging from a loss of $0.15 per share to positive earnings of $0.05 per share. The underlying assumptions supporting our revenue forecast include a decrease in medical device revenue, driven by lower royalties from CYPHER, offset partially by higher royalties from our portfolio of hydrophilic coatings; modest revenue growth in our in-vitro diagnostics business; and a decrease in revenue from our pharmaceuticals business reflecting continued softness in R&D revenue. From a profitability perspective, we expect the medical device and IVD businesses to be profitable in fiscal 2011. And as I mentioned earlier, the pharma business is expected to negatively impact 2011 operating profitability by more than $10 million. Non-GAAP diluted EPS would exclude any one-time charges such as restructuring charges, asset impairment charges, acquisition-related charges and the like. On a GAAP basis, we will have certain one-time charges in fiscal 2011, which we would exclude from non-GAAP results. As we disclosed in connection with our recent reduction in force and changes in our organization structure, we expect to record restructuring charges in the range of $1.3 million to $1.7 million in the first quarter of fiscal 2011. In addition, we are likely to incur certain milestone payment obligations related to our acquisition of SurModics Pharmaceuticals. Assuming we do, we expect to record an additional goodwill impairment charge of approximately $5.7 million in the first quarter of fiscal 2011. The negative impact of these charges to GAAP diluted EPS for fiscal 2011 is estimated to be approximately $0.38 per share. Accordingly, GAAP diluted EPS is currently expected to be in a range of a loss of $0.53 per share to a loss of $0.33 per share, all on a GAAP basis. Although our fiscal 2011 projections are modest, we will be highly focused on driving improved near-term results in our medical device and IVD businesses. Further, we have a great sense of urgency and are taking action to address the issues within our pharma business. We intend to remain strategically nimble and execute relentlessly to drive improved operating results and remain confident in SurModics’ long-term potential. SurModics balance sheet and operating cash flow continued to be strong. Our cash and investments balance at the end of the fourth quarter totaled $56.8 million, an increase of approximately $9 million from the end of fiscal 2009. Before concluding, I want to update you on the company’s search for a permanent CEO. This is an extremely high priority for our Board and excellent progress is being made. They have been pleased with a number of strong candidates, conducting a thorough, thoughtful and complete process takes a lot of time and energy, and the Board is satisfied with the progress. The Board is moving to make a decision in due course. Operator, that concludes our prepared remarks. We would now like to open the call to questions.

[Operator:]

Thank you, sir. (Operator instructions) And our first question comes from the line of Ross Taylor with CL King. Please go ahead.

[Ross Taylor:]

Hi. I have a couple questions I guess primarily related to the cGMP facility. But how much of that $8 million loss associated with the facility is depreciation and amortization expense? And how long would you be willing to absorb these types of losses from the pharma group or how quickly do you think some of those efforts you referenced might be able to actually improve profitability there, substantially reduce the loss, I guess, I should say?

[Philip Ankeny:]

Ross, first of your question was the depreciation, which is – of the $8 million in operating expenses for the cGMP facility, depreciation is about a third. And so that would be the non-cash portion. In terms of the length of time that we’d be willing to sustain the kinds of operating losses that we are seeing right now, I’m not sure I can answer that. That’s a decision that the Board would look into as to exactly what alternatives we consider as we go forward. From a management team standpoint, we are very focused on driving the revenue line and maximizing the profitability. We do have other opportunities that are on the table and aren’t across the goal line yet, but certainly ones that have the potential to move the needle in the right direction. So we’ll continue to work through this and revisit all of the assumptions and progress as we go forward here.

[Ross Taylor:]

Okay. And maybe just two or three other questions. Can you comment at all about your expectations for R&D revenue over the next several quarters? And do you expect to maintain your R&D spending at similar levels where they were in Q4 over the balance of the next fiscal year?

[Philip Ankeny:]

We’re not giving guidance at the line item level, but rough order of magnitude where we are today, we do see the potential for some growth from there, but not significant. So it will depend on how things unfold with the various customer programs. In terms of resources to support it, we made some very hard decisions in the reduction in force, and we’ve balanced the ability to support the customer programs that we have as well as how much flex we can have to take on new programs and also looking hard at the positions that are not directly necessary for generating that R&D revenue.

[Ross Taylor:]

Okay. And last question, do you have a rough estimate of what the capital spending might be in fiscal ’11?

[Philip Ankeny:]

Order of magnitude, it’s about $5 million is our expectation.

[Ross Taylor:]

Okay. All right. That’s all I have at the moment. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Suraj Kalia with Rodman & Renshaw. Please go ahead.

[Suraj Kalia:]

Good afternoon, gentleman. So, a lot of questions. Let me see if I can just try to hone in a few that’s just burning here. I find the timing of the asset impairment quite interesting. I mean, last quarter you all took about a $2.6 million impairment if I remember correctly. Some early stage company wasn’t able to raise funds. Now there is a whole bunch of asset impairment. I guess, on a fundamental level, you will have to look at the longevity, the probability of success, the cash flows that an asset can produce at least based on my recollection of how asset values are recognized, and now you are writing it off. I don’t know the specifics. What has changed suddenly in a quarter that you all are taking so much of write-offs? I’m not sure I understand.

[Philip Ankeny:]

The impairment charges that we have are all different and unique and different from the ones that we had in the third quarter as well. In terms of the investment, impairment charge was related to a different company and our portfolio in Q3. In Q4, it was another one that has been having some challenges raising the amount of money that they want at the valuation that they want. The other impairment charges, so the goodwill impairment is really one that has been triggered largely by the decline in our stock price, which forces we go through a goodwill impairment test at least annually. And any time our market cap starts to approach the book value of our equity, then we’ll go through a much more rigorous goodwill impairment exercise and started to look at the actual operating units. And so the pharmaceutical business, we looked at the value of the goodwill there relative to the stock market value, and that’s where we determined the impairment was. So really there – all of the impairments are unique and isolated events. And it was our judgment that it was during the fourth quarter when these impairments arose. And so those are the charges we booked.

[Suraj Kalia:]

Okay. Just given the last, let’s say, three years or four years or – when the time when Bruce was here, there was a huge focus on pharma. And correct me if I’m wrong, on this call, it seems like there is a gradual shift in tone back towards medical device line. Now, one, am I reading it wrong? I know you mentioned about ophthalmology and all the programs you have, the NuPathe and others, but it almost comes across you all are suggesting, look, we are going back to our roots. That’s the one thing. And the follow-up to that is, Phil, how would you reconcile with everything we are seeing in device line in terms of a stricter regulatory landscape and increasing price pressure? Can you help us reconcile all these different elements vis-à-vis your guidance for fiscal ’11, and you all reverting back to your original device routes?

[Philip Ankeny:]

Sure. There is a lot there, so let me attempt to put it all in perspective. I think we – we did say that we may have taken our eye of a ball on medical device and IVD a little bit as we were focused on pharma for the past X amount of time. And we – in our strategic planning exercises we do, we’ve reminded ourselves that these are fantastic businesses and they deserve a lot more investment than perhaps we’ve been steering in their direction in the last few years. And so your characterization of returning to our roots there a little bit is probably fair, at least as it relates to balance of investment. The pharma business, we still see a lot of strong promise there, but we do have the earnings-related challenges that we are working through. Your question about the medical device business, on the landscape of tougher regulatory environment and healthcare reform and the like, the place where we live is our hydrophilic coatings business is really all about minimally invasive medical devices. And that is absolutely the trend in medical device product development where you have things like percutaneous valves that open up entirely new ways of getting valves into very sick patients. And the excitement at TCT this year where you had some new data that was unveiled surrounding percutaneous valves and the implications for treating very, very sick patients who couldn’t survive open heart surgery. And so the ability to have products that open up new possibilities for physicians and their patients is great. And by the way, those kinds of technologies need hydrophilic coating and oftentimes need drug delivery. And so we think our technologies are very well positioned and we’ve got a lot of products that have already been licensed by SurModics, and they are working their way through and have nice growth potential. So we see strong opportunity there and a lot of interest in some of our technologies for things like drug-coated balloons and other areas of drug delivery that still have great promise. So despite a tougher regulatory environment with FDA and other regulatory bodies as well as the cost environment, on balance, we are seeing a lot of companies continue to innovate and come up with therapies that happen to leverage our technologies quite nicely.

[Suraj Kalia:]

Last question, Phil. Believe me, I do understand this is a hard teleconference for you. But having said, Phil, and not necessarily a reflection of you, I don’t understand the rationale for changing the business structure. If I remember correctly, maybe two or three or more times the business – the different businesses have been reorganized. And I guess the question I have, Phil, is let’s say the Board comes in tomorrow and they say, let’s make Scott Ward [ph] our SurModics’ CEO. I don’t know, I’m just throwing it out there. So he would want to come in and develop a strategic direction for the company. He would want to put us on stand. And now that the business re-org has been done in the absence of a permanent CEO, can you help me understand what is the thought process of the Board in doing all these changes while looking for the head of the organization?

[Philip Ankeny:]

It’s a great question. And that was something that definitely was deliberated because it’s not customary for companies to make significant changes when a permanent CEO is not in place. But I offer my tribute to the Board here for having the conviction to recognize that we needed to make change. And candidly, it’s my belief that the structure we have gone to is not radical. It’s very logical in terms of how our businesses align. And it’s the best way we see to be able to drive the appropriate results going forward. And so the Board was very supportive of making these changes even in the absence of a new CEO coming in and might have different thoughts. But it was our collective judgment that the challenges the company has been working through warranted swift action and change that we believe can put the company on a better path, both operational as well as strategically. And so I appreciate the support of the Board and I guess I’d reiterate that the Board and the management team are very aligned here in what we are doing.

[Suraj Kalia:]

Thanks for taking my questions, Phil.

[Philip Ankeny:]

Yes. Thank you, Suraj.

[Operator:]

Thank you. Our next question comes from the line of Dorsey Gardner with Kelso Management. Please go ahead.

[Dorsey Gardner:]

Just a couple of comments, Phil. Thanks for giving us some guidance on the expenses of the Birmingham plant. I think that helped resolve sort of live with the risk of getting that up and sort of going. And when you compare the amount of money you have in it and the amount you are investing and you’re shooting for contracts that can be hundreds of millions of dollars, I think we can all, for ourselves, sort of judge whether or not we’re willing to take the risk or whether it was efficient. But I think that’s very helpful to the shareholders. The question I have is, what’s happened to Genentech? Most people agree that Lucentis is the product of choice for an accurate degeneration. And it just hasn’t sort of come through as expected. Obviously you can’t speak for them, and I’m sure they have their own ideas. But is there anything out there that you’ve heard about or read about or any reason why that slowdown?

[Philip Ankeny:]

The Genentech program remains in place. As I said during the prepared remarks, we haven’t lost any key customers and that applies to ophthalmology as well. So we continue to have three top-ten pharma companies in the portfolio, and that includes Genentech. Clearly, we are disappointed with the level of R&D revenue and that it was down sequentially and so that applies to both Genentech as well as other customers. But really it’s just the normal ebbs and flows. And I think your point was a good one as well about just the need for sustained release drug delivery. Clearly, Lucentis and Genentech have a strong belief in the potential for a sustained release product offering, which is why they have invested in the program to the degree they have. And we continue to hear that from all of our customers as well as prospective customers at industry trade shows that drug delivery is really what’s needed here to improve the therapy for patients. So we still see that as being very much a strategic need and a viable offering for SurModics. As in any development though, it just takes time.

[Dorsey Gardner:]

Yes. And the other, I guess, observation or question is the number in your traditional business, the royalty business, the drug device business, the number of agreements that you’ve signed has hardly been disappointing. I mean, I think you’ve exceeded your own milestones, your bogies [ph]. And the only question I have is, are the royalties less on average? Obviously, if you take CYPHER as the one that stores all the numbers, but are you signing deals today that will deal the royalties in the future that will be better than the average royalty four or five years ago? Bruce would talk about getting higher royalties on each yield. And so, is the pipeline filled with better deals or not as good deals or –? Can you comment on that?

[Philip Ankeny:]

Sure. I’d say it depends on the technology we are talking about. When the deals are drug delivery, they tend to be much better than where we sit on average today. When they are in hydrophilic, they are going to be – as you look compared to history, they are either as good or better. I don’t think they are degrading. And really the benefit here is just the growing of the portfolio where you have – we have a portfolio where on average there are more products in the portfolio that are growing and contributing to royalty growth than declining. I mean, you always going to have some products that aren’t doing as well as the customers hope in the marketplace. But we have a lot more that are growing than declining. And then you have the layering effect of having more and more products that do get on the market and start paying us royalties. And so that’s what contributes to the layering effect of the growth characteristic of this portfolio. And so – and as I was talking to the response to an earlier question, the wave of products coming to market and getting funded for minimally invasive approaches just continues. And it makes perfect, perfect sense. And so the opportunity to continue to serve these customers with a technology where clearly we are the gold standard, that’s a great place to be in. So we’re committed to continuing to drive our innovation and work with customers to help them with their innovative products get the market as quickly as possible.

[Dorsey Gardner:]

Well, I mean, my last comment would be – don't you know if you feel the outlook is good, you’re generating cash, don’t be shy about buying the stock. Anyway, I think you do it as well as we include on a difficult conference call, and my compliments.

[Philip Ankeny:]

Thank you, Dorsey.

[Operator:]

Thank you. (Operator instructions) And our next question comes from the line of Richard Rinkoff with Craig-Hallum. Please go ahead.

[Richard Rinkoff:]

Thanks. Phil, do you expect all of the three revenue lines to be down in 2011?

[Philip Ankeny:]

Most likely, yes.

[Richard Rinkoff:]

So that means that despite all that you are working on, all the products that you have for, say, yourself and all of the royalties that are already in the market, all of those categories you’re dropping?

[Philip Ankeny:]

In the range we’ve got, yes, that’s a possible scenario.

[Richard Rinkoff:]

Should we assume that there were no milestone payments from Genentech or anyone else of any size?

[Philip Ankeny:]

Within our guidance, we do not have any significant milestone payment assumed. So any that do come would be – would represent upside. But at this point, since those are never a certainty, we don’t want to include those in any of our forecasts.

[Richard Rinkoff:]

Cash from operations for the year was $22 million is an estimate for 2011?

[Philip Ankeny:]

We don’t have one right now.

[Richard Rinkoff:]

Would it be positive?

[Philip Ankeny:]

Positive operating cash flow?

[Richard Rinkoff:]

Yes.

[Philip Ankeny:]

Yes.

[Richard Rinkoff:]

Okay. And I noticed on your R&D line that the R&D expense was more than the revenue. Is there an explanation for that?

[Philip Ankeny:]

That’s really –

[Richard Rinkoff:]

Customer R&D, I mean.

[Philip Ankeny:]

It’s principally – we've been there in some prior quarters as well. The main reason there is really just the facility costs that are allocated to that customer R&D line and when the R&D revenue is softer, the margin gets upside down.

[Richard Rinkoff:]

Okay. Thanks.

[Philip Ankeny:]

Thanks, Rick.

[Operator:]

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

[Daniel Owczarski:]

Yes, thanks. Hi, Phil.

[Philip Ankeny:]

Hi, Dan.

[Daniel Owczarski:]

With your outlook, and you talked a little bit directionally about the different buckets of revenues going forward, I was hoping that you could give us any more insight as to your thinking around the CYPHER royalties, whether you still see continued deterioration or maybe it starts flattening out or give us any kind of a ballpark of what you are looking for there. And then also, just reminding us – when do these patents start running out related to the CYPHER and what’s the latest with J&J coating other stents with your technology?

[Philip Ankeny:]

We never know with precision what’s going to happen with CYPHER. Looking at past history, it’s been in a secular decline for some time now probably in the range of 25% to 35% year-over-year declines for two or three years. So we are assuming some continued erosion of that royalty stream. Eventually, we will hit minimal royalties in the agreement. And so it really depends on where we get to. We’re getting closer, but we’re not there. So that’s the commentary on that. The patents for the Bravo polymer that’s on CYPHER run out into the late teens. And so we have considerable life left in those. And as J&J makes transitions to other technologies like Neebo [ph] as long as CYPHER has been sold somewhere in the world, minimum royalties are due under the agreement. And then with respect to other products in the future, I’m not at liberty to talk about where the pipeline programs are.

[Daniel Owczarski:]

And then just to go back to the R&D revenues, how much visibility do you really have in that line item? How long is a typical contract there? And I realized that there is different stages and the phases can lengthen, but can customers just stop and pull out if they think a project isn’t going anywhere? I mean, is that – I'm just trying to get an idea of how much visibility you really have in that line?

[Philip Ankeny:]

We have backlog for many of our customer programs. Sometimes it really depends on the nature of the collaboration. There are many of our agreements where we can be contracted for six to 12 or more months of work. And others might be a little more finite in the one to six-month range. And so it depends on how those go. Your point is spot on that yes, customers can pull out with reasonable notice in most cases, and that does happen when strategic priorities change or their funding changes or if the technology isn’t panning out the way we expected it to. I mean, those things do happen. But it is a portfolio, and so we use some portfolio judgment in formulating the guidance that we came up with.

[Daniel Owczarski:]

Okay. And then just last question, in your press release, it talks about the company going through revenue transitions and you could have done better and you plan to do better. And you talked a little bit on the call about the facility down in Birmingham and just the macro environment. But could you give us any ideas or instances where you executed poorly or where you placed your bets wrong or where you miscalculated even just expanding upon your comment that maybe you took your eye off the ball on the base business? Just any kind of other specifics around that would be helpful.

[Philip Ankeny:]

We’ve – take diagnostics as an example. We have great products there and have been investing in the last 6 to 12 months in some new product offerings there that candidly have priced us and our customers in terms of just how strong our technologies are. And so some of the things that maybe we could have been done, been doing earlier but started going down that path in the last year and it’s probably reinvigorated the level of excitement that, hey, here’s some really strong product offerings and we can create even stronger extensions to these products if we just do some more investment. So a lot of it is just kind of time over target. And so I guess that would be an example. And we just – there is – we have been working on things in drug delivery for so long and there is just a lot of really good innovation that our people have in across our various technologies, hydrophilic drug deliver as well. And so, being able to allow them to focus on innovation where it matters with our customers is we think the right thing to be doing.

[Daniel Owczarski:]

Thanks, Phil.

[Operator:]

Thank you. And our final question comes from the line of Ernie Andberg with Feltl & Company. Please go ahead.

[Ernie Andberg:]

Hello, Phil.

[Philip Ankeny:]

Hi, Ernie.

[Ernie Andberg:]

It’s been a long call here, but just some mechanical kinds of questions. You’ve said you’re not going to forecast individual line items, but your gross profit was down on product sales presumably because of the low level of sales. Should we expect a similar kind of performance if sales continue to stay down?

[Philip Ankeny:]

There were some unique elements going on in the fourth quarter here with some obsolete inventory and the like. So I’d say a margin that we would think about for the product sales line would be probably in the low 50s.

[Ernie Andberg:]

Okay. You said the $1.3 million to $1.7 million of write-offs should lead to $3.0 million to $3.5 million of expense savings over the course of the year. To give us some idea, where were the layoffs concentrated and how much of that savings do you expect to generally realize, Phil, over the balance of the year?

[Philip Ankeny:]

So the reductions were really across the Board, but probably concentrated in R&D. And there are a little bit – and just be given where our population is, which is largely R&D as opposed to SG&A employees. So if you looked at it that way, more dollars would be coming out of R&D than SG&A. In terms of impact in 2011, it won’t be a full year. It’s because of the – how it’s based in and whatnot. So it’s probably conservatively three quarters-ish impact in the fiscal year.

[Ernie Andberg:]

Fair enough. You gave a couple of figures for the cost of the SurModics Pharmaceuticals. Phil, you mentioned $10 million total impact and $8 million in the facility. Did I hear that correctly?

[Philip Ankeny:]

That’s correct.

[Ernie Andberg:]

Where is the other $2 million? Is that overhead in the SG&A line or –?

[Philip Ankeny:]

It would be people and – it's mostly people and other overhead. But mostly people.

[Ernie Andberg:]

Okay. Fair enough. Thanks much.

[Philip Ankeny:]

Okay. Thank you, Ernie.

[Operator:]

Thank you. At this time, I would like to turn the conference back to Mr. Ankeny for any closing remarks.

[Philip Ankeny:]

Thank you very much, Alicia. I want to thank you again for participating in this quarter’s conference call. And I look forward to speaking with you all on the first quarter 2011 earnings call in January. Bye-bye.

[Operator:]

Ladies and gentlemen, this concludes the SurModics fourth quarter earnings conference call. Thank you for your participation. You may now disconnect.