Surmodics, Inc.
Q3 2013 Earnings Call Transcript

Published: 1 Aug 2013

[Operator:]

Good day, ladies and gentlemen, thank you for standing by. Welcome to the SurModics Third Quarter 2013 Earnings Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions). This conference is being recorded today, Wednesday, July 31, 2013. I would now like to turn the conference over to Mr. Andy LaFrence, Vice President and Chief Financial Officer. Please go ahead, sir.

[Andy LaFrence:]

Thank you, Damon. Good afternoon, and welcome to SurModics’ fiscal 2013 third quarter earnings call. Before we begin, I would like to remind you that 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 Litigation Reform Act of 1995 and include 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, resulting from certain risks and uncertainties, including those described in our SEC filings. SurModics disclaims any duty to update or revise our 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 the Investor Relations 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 the full fiscal year 2013. Gary will then cover our key achievements for the quarter and discuss our growth drivers and strategies. Finally, we will open up the call to take your questions. I’ll start with the financials. The Company’s performance for the quarter met our expectations. Revenue for the third quarter totaled $14.3 million, a 2% increase from $14.0 million reported in the third quarter of last year. I would also mention that we are comparing our current year quarter to a very robust year ago quarter in which our non-GAAP revenue that is revenue excluding our J&J’s Cypher stent grew 17%. In the 2013 third quarter, we delivered an operating income of $4.2 million, a 12% decrease from the prior year. Operating margin was 30% compared with 34% in the prior year quarter. On a GAAP basis our diluted earnings from continuing operations increased 22% to $0.22 per share for the quarter compared with $0.18 per share in the year ago period. Turning to our two business units. In Medical Device, which included revenue from both our hydrophilic coatings and device drug delivery coatings, sales totaled $10.6 million. This represented an increase of 3% from $10.3 million reported in the year ago period. Revenue in the third quarter included a milestone payment received from OrbusNeich upon the European approval of its COMBO therapy stent. This recently launched product incorporates one of SurModics' biodegradable polymer platforms. Third quarter hydrophilic coating royalty revenue rose 4% to $7.3 million. Coronary sector hydrophilic coating royalty revenue was down 3% for the quarter resulting from overall coronary market weakness. However during the quarter we achieved hydrophilic coating royalty revenue growth in our key Medical Device market segments including neurovascular, peripheral, and transcatheter heart valve replacement. Our Medical Device unit generated $5.2 million of operating income in the third quarter, a 1% increase from fiscal 2012. Medical Device operating margin was impacted by higher planned drug coated balloon research and development expenditures. For our In Vitro Diagnostics Unit, third quarter revenue totaled $3.7 million, up slightly compared to a year ago. Of note, our IVD businesses generated 11 consecutive quarters of year-over-year revenue growth. Increased sales for our stabilizer and antigen lines for the quarter were offset by softness in spite a component of our Molecular Diagnostics business as well as our BioFX branded products. Product gross margin for IVD was 60%, 1.9 points higher than the year ago period. IVD operating income of $0.9 million was down from $1.1 million in the third quarter of 2012 as a result of higher operating expenses that included allocated corporate expense as well as additional marketing initiatives needed to support growth. Our diagnostic operating margin for the quarter was 25%. Going forward, we expect it would be in the mid 20s to low 30s range. Now, I’d like to discuss our third quarter 2013 revenue summary by category. Royalty and license fees which are generated primarily in our Medical Device business unit were $7.8 million, a 10% increase from $7.1 million last year. Third quarter product sales of $5.6 million decreased 3% from the year ago period. The company generated solid growth in stabilizer and antigen product sales which were offset by declines in both hydrophilic reagent sale and other diagnostic product sales. Lastly, R&D revenue in the third quarter was approximately $0.9 million, a decrease of $0.2 million from $1.1 million reported last year. Coating services support for key hydrophilic customers was lower than a year ago. SG&A expenses for the fiscal quarter of 2013 were 28% of revenues compared with 24% in the prior year quarter. SG&A in 2013 totaled $4.1 million and rose 19% from last year on a dollar basis. The $640,000 increase in SG&A expense reflects higher professional service cost primarily associated with the SRI litigation as well as staffing additions and compensation expense. As a percentage of total revenue third quarter R&D expenses were 28% versus 25% in the year ago period. R&D expenses of $4.0 million for the quarter increased 14% from last year resulting from investments in pre-clinical experiments associated with our drug coated balloon development initiatives. As we’ve noted in our second quarter 2013 earnings call, we anticipate accelerating our R&D expenditures in the second half of fiscal 2013. To support future growth plans we expect our fourth quarter R&D investment to increase by at least 20% over the year earlier quarter. Income tax expense from continuing operations was 26.1% of pre-tax income in the third quarter compared with 35.6% in the prior year period. We realized discrete income tax benefits of a penny per share from the finalization of our prior year tax liabilities with the filing of our 2012 income tax returns and the release of reserves for uncertain tax positions in jurisdictions in which statutory filing dates expired in the third quarter of 2013. We anticipate our continuing operations effective tax rate to be approximately 33% in the fourth quarter of 2013. During the fiscal 2013 third quarter, the company realized a discontinued operations loss of 47,000 net of tax from the positive settlement of job incentive obligations with the State of Alabama, offset by a loss from the finalization of prior year tax liabilities with the filing of the 2012 income tax returns. Let’s now turn to the nine month results. The company has performed well. Revenue for the first nine months totaled $41.8 million, a 10% increase from $38.1 million reported in the prior year period. We delivered operating income of $13.2 million in the first nine months of 2013, a 13% increase from the prior year total of $11.7 million. Operating margin in the 2013 nine month period was 32%, a one point improvement over the same period last year. On a GAAP basis, our diluted earnings from continuing operations totaled $0.73 per share for the current year period compared with $0.41 per share from the year-ago period. On July 30, 2013, we reached an agreement for the indemnification of historical and future litigation costs related to the SRI litigation. We incurred reimbursable and non-reimbursable SRI litigation cost of approximately $0.03 per share and $0.02 per share in the first nine months of 2013 and 2012 respectively, and expect to record a $0.04 per share benefit in the fourth quarter of 2013 from the reimbursement of historical costs, which were recorded as SG&A from continuing operations. The fiscal 2013 EPS increase included discrete income tax benefits of $0.05 per share. Changes in net strategic investment gains and losses between the periods accounted for an additional $0.12 per share change in EPS. On a non-GAAP basis, diluted earnings per share from continuing operations increased 37% to $0.63 per share for the current nine month period compared with $0.46 per share in the prior year period, very nice growth. Looking at our balance sheet, it continues to be strong. Our cash and investments totaled $60.1 million at June 30, 2013. We continue to generate solid cash flow during the quarter. Cash flow from operations was $11.9 million during the nine months of fiscal 2013. We also received $2.3 million from the sale of strategic investments in the first nine months of 2013, and we repurchased approximately 405,000 common shares for $10.3 million in the first nine months of fiscal 2013 completing our previously announced share repurchase program. We are pleased to report that the board of directors has approved an additional share repurchase program of $20 million. Finally, I want to comment on our expectations for fiscal 2013. For the full year, we are narrowing our revenue range outlook to a range of $55.5 million to $57 million compared to the previous range of $55 million to $58 million. This is an increase from $51.9 million for fiscal 2012. We are also narrowing our EPS outlook from continuing operations to a range of $0.95 to $0.99 per share compared to the previous range of $0.86 to $0.99 per share. The updated earnings per share outlook includes a $0.04 per share 2013 fourth quarter benefit and continuing operations from the finalization of an indemnification agreement signed in July 2013 for reimbursement of historical litigation costs incurred by SurModics in the SRI litigation. As I said earlier, our earnings per share outlook also reflects an incremental research and development increase of at least 20% in the fourth quarter compared to the same quarter of 2012. Our fiscal 2012 EPS totaled $0.58. It’s important to note that our earnings per share outlook excludes any potential share count reduction that could occur as a result of share repurchases. . At this point, I would like to turn the call to Gary for his perspective on our operations.

[Gary Maharaj:]

Thank you, Andy. The transformation of SurModics continues as we have planned. Fiscal 2013 is about the balance of focusing on the core, while creating the foundation for co-expansion. Our activities, results and recent accomplishments reflect this balance. In our core Medical Device business, we seized the expected headwinds in the coronary segment. Many of our customers in this segment experienced declines in coronary procedures along with continuing price and competitive pressures in certain geographic markets. SurModics’ performance is partially offset by gains in other growth oriented segments such as peripheral vascular, structural heart including transcatheter valves and neurovascular diseases, as Andy said. I’m encouraged by our progress and positioning in these growth areas. Our IVD business growth was mainly challenged by the timing of customer orders has resulted in very strong 15% increase in revenue in the second quarter 2012. Despite difficult external market forces, we are diligently focusing on what we can control and are making excellent progress on our internal strategic projects. In terms of co-expansion, the European regulatory approval and commercial launch of OrbusNeich’s COMBO drug-eluting stent represents a return to the device drug delivery component of our business. We have licensed to OrbusNeich the biodegradable drug delivery polymer matrix when the adluminal or vessel contacting wall of the COMBO stent. This is a small but pivotal start for us in co-expansion beyond the hydrophilic coatings. In diagnostics, this past Monday, we announced an innovative new product at American Association of Clinical Chemistry, the AACC Meeting in Houston, Texas. We introduced the world’s first high performance Protein-Free Stabilizer for ELISA based immunoassays, the SurModics’ StabilZyme Protein-Free Stabilizer. Diagnostic assays have become increasingly sensitive in recent years and protein stabilizers most commonly used to stabilize biomolecule activity may actually contribute to interference and cross-reactivity. Our new StabilZyme Protein-Free Stabilizer delivers excellent retained activity a key performance factor, while eliminating the risk of interference and cross-reactivity. This launch reflects continuing investment in the development and commercialization of highly differentiated core products. The adoption of the new-to-the-world chemistry such as StabilZyme Protein-Free Stabilizer will take place over the next four to six quarters. This adoption is paced by the need to intercept new diagnostic tests as they are being developed and demonstrate the capabilities of this technology on critical assays. Rebuilding our presence as a product innovator in a highly competitive diagnostics market will take time and this marks yet another small but important move in the right direction. Some of our increased expenses in IVD resulted from our intense market research efforts to clearly target our product development initiatives in the molecular diagnostic space. We are very early now with screening process by experiments in this area and intend to begin new early experiments in fiscal 2014. We continue to make progress with the feasibility assessments of our next generation low particulate hydrophilic platform SurModics Serene. This important work by our R&D team creates opportunity to demonstrate the benefits on actual devices currently underdevelopment by our customers. As you are aware, we have been investing heavily in the development of a drug-coated balloon. Drug-coated balloons, as I've mentioned in previous calls, may offer better alternatives than current therapies in the areas of the vasculature, where placing a stent is not ideal. Examples of this are interventions in peripheral vessel such as the superficial femoral artery and then coronary vessel to treat small vessels bifurcations and in-stent restenosis. The worldwide market for DCB is predicted to be over $1 billion annually. Several first generation products are already in the market outside of the U.S. and several products currently have an IDE in the U.S. We intent to follow DCB platform is to understand the capability of our technology in achieving five clinical objectives and compared with other devices currently on the market are in pivotal clinical trials in the U.S. Our objectives are better control of the manufacturing process so that the uniformly consistent loading of the drug on the balloon is achieved from balloon to balloon. Better control of the paclitaxel drug on the balloon itself so that less drug is lost in transit to the target lesion. Third, consistent and sufficient uptake of paclitaxel into the walls of the artery. Fourth, demonstration of a biological effect off the drug that has been up taken in the arterial walls showing that there is reduced smooth muscle cell proliferation and potentially restenosis. And finally, an absence of safety issues in both the local and the distant tissues. Towards these goals, we continue to make excellent progress and are pleased with our interim results. As we continue to build our database of results with ongoing pre-clinical study, we believe that our platform has capabilities that may indeed be superior to any of the competitive products we have tested to-date. We will continue to invest significantly in this platform during the next three quarters in order to generate further data that will inform us of what value and the capabilities of our unique technology, stay tuned. Finally, even as we are developing our technology our strategy to deploy cash in our balance sheet in order to create future profitable growth. We continue to balance this for the need to return excess cash to our shareholders. Our $20 million repurchase authorization reflects this strategy. In addition our corporate development continues to screen multiple opportunities that are aligned with our goal to expand from the core and that have the potential to enhance shareholder value. I want to emphasize that our talented team of employees continues to execute on our strategy of transforming SurModics while continuing to grow in our core markets. Despite the current industry headwinds we remain committed to our mission of providing enabling technologies that improve the detection and treatment of disease. We are confident in our ability to make progress on all our stated strategic goals and remain committed to our investments in R&D and exploration of corporate development opportunities to further expand our profitable core. Operator, this concludes our prepared remarks. We would now like to open the call to questions.

[Operator:]

Thank you, sir. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions). Our first question is from the line of Ross Taylor with CL King. Please go ahead.

[Ross Taylor:]

Hi, just a couple of questions. First maybe I’ll start with the drug coated balloon project, but if I’m not mistaken you kind of the next step forward was to do your final animal study and are you kind of add that point yet and how long may it be before you’re ready for first-in-man trial?

[Gary Maharaj:]

Yeah, as you know this is all pre-clinical work and there are many different ways that this can go. We intend to finish our pre-clinical assessment by the end of the calendar year. Now that may not include required regulatory pre-clinical test that we may find out we have to do, but internally for our sites on what we have as a technology by the end of this calendar year that pre-clinical work will be completed. The road to further clinical work is something that we are discussing internally and certainly we would be getting it to human patients we’ll be working and talking with potential partners about that.

[Ross Taylor:]

Okay. And let’s say the $0.04 benefit in Q4 that’s included in the guidance, is that something new within the guidance or have you expected that previously?

[Andy LaFrence:]

Yeah Ross this is Andy LaFrence. That is new to the guidance but I would comment that the guidance initially we don’t anticipate such a heavy spend on the SRI litigation which was about $0.03 per share. So that is pretty much a wash about maybe a penny pickup in terms of what we incurred during the year on the SRI litigation.

[Ross Taylor:]

Okay, yeah I guess that was kind of a follow-up question I had is it seems like those things are more or less offsetting?

[Andy LaFrence:]

That’s correct.

[Ross Taylor:]

Okay. And the milestone from OrbusNeich just kind of backing into it, it must have been roughly $0.5 million in the quarter.

[Andy LaFrence:]

Ross, we don’t comment on individual customer’s revenues. The device drug delivery segment was in the arrogate close to 6% of Medical Device revenue for the quarter. So that’s about as far as we will go.

[Ross Taylor:]

Okay. And final question just kind of given like it sounds like R&D spend could continue to ramp in your next fiscal year. Can you give us any rough guide post as to how to think your R&D, what R&D might look like for our models next year?

[Gary Maharaj:]

A lot of it depends on the pathway we choose beyond pre-clinical work with the drug coated balloon. I said earlier that it’s almost premature to talk about human trials until we actually well informed about the validity of what we have as a technology but indeed I would expect our R&D as a percentage of sales to remain within a few percentage points of where it’s at.

[Andy LaFrence:]

High 20s.

[Gary Maharaj:]

Yeah.

[Ross Taylor:]

Alright that’s helpful. That’s all my question. Thank you.

[Andy LaFrence:]

Thanks, Ross.

[Operator:]

(Operator Instructions). Our next question is from the line of Ben Haynor with Feltl and Company. Please go ahead.

[Ben Haynor:]

Good afternoon gentlemen.

[Gary Maharaj:]

Hi, Ben.

[Andy LaFrence:]

Good afternoon.

[Ben Haynor:]

Any reports from the AACC show that you can potentially share?

[Gary Maharaj:]

Any reports.

[Ben Haynor:]

Well any color there that how couples of fees and all that stuff.

[Gary Maharaj:]

Yeah sure. We made a big splash at our booth for sure that were marketing campaign. Certainly customers this is not a unarticulated need from some of our key customers for sensitivity assays that I’m really proud of our R&D and marketing team. A year and a half ago I did not think this was even technically feasible to go completely protein free many people have tried as you know these are stabilizers as Bovine Serum Albumin which works well in many assays but actually can contribute to noise and others. And trying other forms of protein are still doesn’t get a sensitivity. So we are excited about it I know some of our key customers are excited about it. But in similarity to the Medical Device business in a regulated diagnostic space, it has to meet to intercept the development of new kits and then the validation in those new kits before going through the FDA. So it’s a shorter time cycle typically but it’s also that type of business. So but we are very excited about it because it was again thought not to be technically feasible.

[Ben Haynor:]

Yeah, great, that’s exciting. So it’s safe to say that the sales are protein free stabilizer was the big hit of the show your booth?

[Andy LaFrence:]

We think it was making the splash I would tell you both Gary and I were down there yesterday the first day and it was a very robust traffic.

[Gary Maharaj:]

To put into perspective how large industry I mean it was all the hit for ourselves I mean the show is probably three football fields in size.

[Andy LaFrence:]

That’s right.

[Gary Maharaj:]

So I’m not sure how far the report went across to hit the ball. Irrespective.

[Ben Haynor:]

Okay, great. And then just a one quick one on the Coronary sector how does it, how did things track I guess throughout the quarter and then what have you seen so far in July has it, did it weakened throughout the quarter as it kind of stabilized what are you seeing there do you offer any comments?

[Andy LaFrence:]

Yeah Ben we’ve typically don’t give guidance in terms of individual segments. I think as we look at the Coronary segment it’s one that we’ve expand articulate to say a strategy have dragging the way with that but focusing on the highest segment markets and it’s one that as we’ve read in the market place it continues to be I think some procedure on pricing pressures overall out there and even some customers probably will experience some FX pressure as well but we still think we are very well positioned in terms of the our growth markets and our diversity case and process we have in place is moving along quite nicely.

[Gary Maharaj:]

Yeah and even some customers may grow in the Coronary segment it’s a I shouldn’t say a zero some market share gain but it’s a market share treating in some instances within the segment.

[Ben Haynor:]

Okay, great. That’s helpful and I think Ross set on all my other questions. So I’ll jump back in queue.

[Gary Maharaj:]

Thank you.

[Andy LaFrence:]

Thank you.

[Operator:]

At this time, I show there are no further questions. I would like to turn it back to management for any closing remarks.

[Gary Maharaj:]

Thank you. Let me reiterate that SurModics reported strong revenue and EPS growth in the first nine months of 2013. We are pleased that we expect to end the fiscal year with sharply higher earnings on up a single-digit revenue gains. Going forward we are focusing core growth and simultaneously expanding from the core. I want to thank everyone again today for participating in this quarter’s conference call. And we look forward to providing further updates on our fiscal year end call. Thank you everybody.

[Operator:]

Ladies and gentlemen, this concludes the SurModics third quarter 2013 earnings conference call. Thank you for your participation. You may now disconnect.