Surmodics, Inc.
Q2 2013 Earnings Call Transcript

Published: 8 May 2013

[Operator:]

Good afternoon ladies and gentlemen, thank you for standing by. Welcome to the SurModics second quarter 2013 earnings conference call. During today's presentation all participants will be in a listen-only mode. (Operator Instructions). This conference is being recorded today Tuesday May 7th 2013. And at this time, I would now like to turn the conference over to Gary Maharaj, President and CEO. Please go ahead, Sir.

[Gary Maharaj:]

First allow me to introduce Andy LaFrence, our Vice President of Finance and Chief Financial Officer. Andy joins SurModics on February 12 and he has a strong background on public accounting having spent 26 years at KPMG; including a decade leading to twin cities life science practice at KPMG. Most recently Andy was the CFO of CNS therapeutics which was acquired by Conidian in October of 2012. Some of you have already Andy and several investor road shows within the last two months. Andy has in a very short time become an integral member of our leadership team and a trusted partner for me. Welcome Andy.

[Andy LaFrence:]

Gary, thank you for your warm introduction and good afternoon and welcome to SurModics fiscal 2013 second quarter earnings call; before I begin I would like to remind you during the course of this call, we will make forward looking statements. These forward looking statements are covered under the Safe Harbor Provisions of the Private Securities Levitation Reform Act of 1995 and includes statements regarding SurModics future financial and operating results or other statements that are not historical facts. Please be advised that actual results could differ materially from those stated or implied by our forward looking statements due to certain risks and uncertainties including those described in our SEC filings. SurModics disclaims any duty to update or advise or forward looking statements as a result of new information, future events, developments or otherwise. Finally, this conference call is being webcast and is accessible through investor relation section of the SurModics website where the audio recording of the webcast will also be archived for future reference. A press release disclosing our quarterly results was issued earlier this afternoon and is available on our website at www. SurModics.com. On today's call, I will provide an overview of our financial results; highlights for the quarter and our outlook for fiscal 2013. Gary will then cover our key achievements for the quarter and discuss our growth drivers and strategy. Finally, we will open the call to take your questions. I will start with the financials; we are pleased with the company's performance. Revenue for the second quarter totaled 13.7 million, a 12% increase from 12.2 million reported in the second quarter of last year. We've delivered quarterly operating income of 4.1 million also a 12% increase from the prior year. Operating margin was 30% which is comparable with last year; on a GAAP basis, or diluted earnings from continuing operations totaled $0.23 per share for the second quarter versus $0.11 per share in the year ago period. The fiscal 2013 quarter increase included discreet income tax benefits of $0.03 per share. The prior year second quarter was negatively impacted by a $0.05 per share under than temporary impairment charge. On a non-GAAP basis, diluted earnings from continuing operations totaled $0.20 per share for the second quarter compared to $0.16 per share in the prior year period. Turning now to our two business units; in medical device which includes revenue from both of our hydrophilic coatings and device drug delivery coatings, sales total 9.7 million, this represented an increase of 11% from 8.8 million reported in the year ago period. Second quarter hydrophilic coatings royalty revenue increased 10% to 9.6 million. During the quarter, we achieved double digit hydrophilic coating royalty revenue growth in our key medical device market segments including neurovascular and transcatheter heart valve replacement. Our medical device unit generated $4.8 million of operating income in the second quarter, a 16% increase from the fiscal 2012. As you noted in our first quarter 2013 conference call, research and development expenses in the first half have been lower than anticipated as a result of the timing of R&D activities. We expect consolidate R&D expenses that is encompassing both business units to increase for the full fiscal year 2013 by at least 8%. For our in vitro diagnostic unit second quarter revenue totaled 4.0 million, a 15% increase from a year ago. Of note, our IVD business has generated 10 consecutive quarters of year-over-year revenue growth. Sales for the quarter benefited from strong demand and stabilization and BioFX products as well as slides, a component of our molecular diagnostic business. Product gross margin for IVD was 64%, 230 basis points lower than a year ago. Gross margin was impacted by increased allocation of indirect cost. IVD operating income of 1.3 million was flat with the second quarter of 2012. The gross margin gain did not offset the higher operating expenses that stem from increased allocation of corporate expenses as well as additional hiring needed to support growth. It is worth noting that our diagnostics operating margins for the quarter was 32%, going forward we expected it will be in the high 20s to low 30s range. Now, I would like to discuss our second quarter 2013 revenue by category. Royalty and license fees, which are generated primarily by our medical device business unit, were 7 million, an 11% increase from 6.3 million last year. Second quarter product sales of 5.8 million increased 14% from the year ago period; the company generated solid growth in both hydrophilic reagent sales and diagnostic product sales. Lastly, R&D revenue in the second quarter was approximately 1.0 million and increase of 15% from 0.9 million reported in last year. Coating services support for key hydrophilic customers was primarily driver of the increase. Turning to the expenses, SG&A expense in both the second quarters of fiscal 2013 and the year earlier were 28% of revenue. SG&A in 2013 totaled 3.8 million and increase of 13% from last year on $1 dollar basis. The $453,000 increase in SG&A expense is result of increased staffing in compensation expense. As percent of total revenue second quarter R&D expenses were 28% versus 39% in the year ago period. R&D expense of 3.8 million for the quarter increased 7% from last year resulting from investment in clinical experiment and drug coated balloon development initiatives. As I noted earlier, we anticipate increased acceleration of R&D expenditures in the second half of fiscal 2013. To clarify we expect our third quarter R&D investment to support future growth initiatives will increase to the point where year to date and full year R&D will grow by at least 8%. Income tax expense from continuing operations was 21.2% of pre-tax income in the second quarter compared to 39% in the prior period. We realized discrete income tax benefits of a $0.01 per share from the retroactively reinstated R&D tax credit as well as a benefit of $0.02 per share related to the capital loss carrybacks from the investment strategic asset capital loss. We anticipate our continuing operations of effective tax rate to be approximately 33% in the third and fourth quarters of fiscal 2013. During 2013 fiscal second quarter the company realized net of tax income from discontinued operations of 0.7 million primarily as a result of settlement of a job incentive obligations with the City of Birmingham, Alabama. Let’s turn to the six months results. The company has also performed well in our six months results. revenue for the first half totaled 27.5 million a 14% increase from 24.1 million reported in the prior year period we delivered operating income of 9 million in the first half of 2013 a 30% increase from the prior year total of 6.9 million operating margin in the 2013 six month period was 33% a 400 basis point improvement over the same period last year on a GAAP basis our diluted earnings from continuing operations totaled $0.52 per share for the current year period compared with $0.23 per share in the year ago period. The fiscal 2013 increase included discrete income tax benefits of $0.03 per share. Changes in net strategic investment gains and losses between the periods account for an additional $0.13 per share change in EPS. on a non-GAAP basis diluted earnings per share from continuing operations increased 46% to $0.41 per share for the current year’s six month period compared to $0.28 per share in the prior year period looking at our balance sheet it continues to be strong our cash and investments totaled 63.2 million at March 31, 2013. We continue to generate solid cash flow during the quarter. Cash from operations was 6.8 million during the first six months of fiscal 2013. We also received 2.3 million from the sale of strategic investments in the first six months of 2013 and we repurchased approximately 100,000 shares for 2.7 million in the second quarter. Approximately 7.6 million remains outstanding under our share repurchase program. This repurchase program reflects our commitment to enhancing shareholder value. We also noted in our press release disclosure of a correction on an error from the September 30, 2010 financial statement to reduce by $1.2 million and other than temporary impairment charge under strategic investment. The impact of this adjustment was not deemed to be material to the results of operations, total assets or stockholders’ equity for the previously reported periods. Finally I want to comment on our expectations for fiscal year 2013. For the full year we are reaffirming our revenue outlook in the range of 55 million to 58 million. This is an increase from 51.9 million for fiscal 2012. We are also reaffirming our EPS outlook from continuing operations of $0.86 to $0.99 per share. our fiscal 2012 EPS totaled $0.58 per share, it is important to note that our earnings per share outlook excludes any potential share count reduction that could occur as a result of share repurchase we may make. At this point I would like to turn the call back to Gary for his perspective on our operations. Gary.

[Gary Maharaj:]

Thank you, Andy. SurModics' strategy to focus on growth in our core business units is showing consistent results, I'm pleased with our 12% revenue growth and 30% operating margin in the second quarter for two reasons. First we're transforming SurModics into a consistently profitable and growth oriented company in the midst of a challenging economic environment. Second we continue to improve what is in our control, that is, our internal teams executing against our strategic objectives. SurModics' dedicated employees deserve a credit for these results. We are aware just as you are of recent industry earnings reports which have raised our awareness of more headwinds in certain market segments; however our EPS and revenue guidance remains unchanged. Fiscal 2013 continues to be transformative for SurModics. This year is about balance, the balance of continuing to focus on core growth even as we lay the foundation for core expansion. Our focus on the core goal for the medical devices unit is to drive adoption of SurModics Serene low particulate coatings into the next wave of devices currently under development by our customers. SurModics Serene as you may recall represents our next generation of hydrophilic lubricious coatings. It is the first hydrophilic coating that breaks the tradeoff between lubricity and durability. Finally our customers can have the benefits of low friction and low particulates. Let me clarify the process of adoption of SurModics Serene low particulate coating so you have a clear understanding of the efforts and the timing involved. First of course we have to improve the awareness of our current and potential customers so there's now a dramatically better solution for their lubricious coating needs. As we do that they can incorporate SurModics Serene into the product lifecycle of their next generation devices. Second, our application engineering teams must work with these customers to assess the capability of SurModics Serene on each individual device platform. This occurs during development and within the constraints of the customers' usually aggressive timelines. It requires (inaudible) testing and sometime preclinical evaluation to generate sufficient data to satisfy both customer specifications and regulatory requirements. Please note that at SurModics this is also part of our R&D expenditure. Third, our licensing team then jumps in to negotiate the signed license agreements for the SurModics Serenes on the particular devices involved. Fourth our coatings services team supports the customer through their clinical trials, regulatory filing and the US approval process. Finally our tech support engineers transfer the technology to our customers' manufacturing location globally or we continue to coat their devices through our in house coating services. I've been emphasizing this adoption process because it demonstrates a couple of things. First SurModics is not merely a supplier but a solution provider with a very high service component as a company. Secondly the rate of adoption of SurModics Serene depends on the throughput of several serial processes including regulatory clearances for customer's products prior to our ability to generate worldwide royalties. I am happy to report that today we're currently performing the vast majority of our feasibility programs with the Serene platform. Several SurModics Serene customers are currently in their initial stages of the regulatory review process and we anticipate this number will grow as we continue to help customers advance these through the regulatory channels in coronary, peripheral, neuro and structural heart market segments. Now turning to the in-vitro diagnostics, our focus on the core goal there is to drive new customer acquisition and current customer utilization by improving our commercial operations. Our IVD team is focusing on three main initiatives to accomplish this goal

[Operator:]

(Operator Instructions) And our first question is from the line of Ross Taylor with CL King & Associates, please go ahead.

[Ross Taylor:]

My first question relates to the IVD business. I just wanted to clarify; did I hear you say your objective for the operating profit margin for that business over the long term was in high 30% to low 40% range? And if I heard that correctly, what does it take to get you to that kind of level?

[Gary Maharaj:]

Let me clarify, it was the high 20s the low 30s.

[Ross Taylor:]

Okay. So, that's the objective for the IVD business. Okay.

[Gary Maharaj:]

That’s correct.

[Ross Taylor:]

Okay. And then you mentioned you hired some additional people in that division to help support future growth. What functions or departments is that occurring in?

[Gary Maharaj:]

We have invested in some marketing health. we also have the general manager, Joe Stich who is fully allocated to the driving of the activities in that division as well. So it really relates to marketing activities, new product targeting and product launches.

[Ross Taylor:]

Okay. And the final questions relate to your R&D, and Gary, maybe you alluded to this in some of your remarks. But I just wondered what specific areas are driving the ramp-up in R&D over the back half of the year. Is it all related to the drug-eluding balloon? And I guess, is there any incremental acceleration we might see in R&D revenues as well?

[Gary Maharaj:]

You know there is a couple dynamics, the big one really is the preclinical data package generation for the drug-coated balloons. As you know there is a substantial amount of data and statistics they require to demonstrate the viability of the approach, things such as dosing studies, a fair amount of data on process development. As mentioned earlier in Serene as well that, recall that SurModics is application development team for our customers is also viewed as R&D expenditure. Sometimes we get paid to do R&D as R&D revenues there. But a lot of time for the adoption of Serene, that’s part of our R&D revenue as well. The third component really is the experiments that we want to conduct. We have a choice of do we cut back a little bit on the experiment portfolio to drive on the drug-coated balloon. Our feeling right now is we need to continue to do both because the experiments represent cash flows, ways out and I prefer not to cut those seminal data generation to just I will look for the short terms gains on current projects. So that’s our philosophy going forward, and we really want to get back to being that R&D based company even as we see headwinds in the industry.

[Ross Taylor:]

Okay. And my final question and I apologize if I misheard some of the remarks here as well, but it sounded like you mentioned you were refining the drug-eluting balloon platform a little bit. And if I heard that correctly, what's driving that decision? Does that represent a lot more time involved in getting this program up to speed or you are further along?

[Gary Maharaj:]

I think one of the things we have recognized, certainly in drug-coated balloon, the need for really high-quality process control and if this is going to have the SurModics brand on it, one of the things we would like to offer to our customers is that, it doesn’t just work in the lab. We actually have a very refined process for making these. another key thing is that we believe our platform is transposable to just about any balloon catheter platform to be a very unique capability that we can offer and so we’re actually generating a lot of statistics so that when we’re ready and certainly that the preclinical animal testing, we can demonstrate a very high valued technology platform to our potential customers.

[Operator:]

Thank you. Our next question is from the line of Ben Haynor with Feltl and Company. Please go ahead.

[Ben Haynor:]

So, you mentioned that several of your customers have the Serene coating before regulators. Would that be several products as well, or is it more than several products?

[Andrew LaFrence:]

We currently have a number of products in front various regulatory agencies worldwide. So, it’s not one or two, it’s several and we would anticipate to start seeing some additional approvals here in the next quarter or two.

[Ben Haynor:]

Okay. Great. And then, any chance you can discuss what segments of the market those might be targeting?

[Andrew LaFrence:]

No. We really don’t disclose that, I mean our current product has been approved out there, it’s both peripheral and coronary. So, we would anticipate that, it’s going to continue to be a very broad based applications that will be approved and that will be amongst our all of our different market segments.

[Ben Haynor:]

Okay. Great. And then, is there any more color that you can provide on the preclinical assessment of the drug-coated balloon? You know, how are the pigs coming back these days?

[Andrew LaFrence:]

The one thing I think before we were communicating that we’ll be able to fully complete the preclinical animal testing in this calendar year. Depending on the pathway, some of these studies are three versus six months studies, it could drift in our Q2 of fiscal ’14. And so, that’s what have to office but what’s exciting though is that the data we’re getting and stability of our platform is something we want to keep hammering on. So, as I said earlier to Ross, you know in the industry there is a lot of optionality of people acquiring drug coated balloons for future competition. We want to have the best and we want to have what I would a third generation technology that’s very robust from the get go. So that will take a little more data collection to demonstrate that fact.

[Ben Haynor:]

So, you're saying you're not too worried about CV Ingenuity?

[Andrew LaFrence:]

No. I actually, to be honest I like to see the whole category do well because I think we’re always trying to solve this problem, we’ll have a dramatic impact, the more, the better, to help patients.

[Operator:]

(Operator Instructions). And I’m showing no further questions at time. I’d like to turn the conference back over to Mr. Maharaj for any closing remarks.

[Gary Maharaj:]

Thank you. Let me reiterate that SurModics reported strong revenue and EPS growth into 2013 second quarter. Going forward we are focused on core growth and simultaneous expanding the core. I want to thank everyone today for participating into this quarter’s conference call and we look forward to providing further updates on our third quarter call. Thank you everyone.

[Operator:]

Thank you, sir. Ladies and gentlemen this does conclude the SurModics second quarter 2013 earnings conference call. Thank you very much for your participation. You may now disconnect.