Surmodics, Inc.
Q4 2013 Earnings Call Transcript

Published: 6 Nov 2013

[Operator:]

Good day, ladies and gentlemen, thank you for standing by. Welcome to the SurModics Fourth Quarter FY 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 also being recorded today, November 05, 2013. I would now like to turn the conference over to our host Andy LaFrence. Please go ahead.

[Andy LaFrence:]

Thank you, Crescent. Good afternoon and welcome to SurModics’ fiscal 2013 fourth 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 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 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 fourth quarter and fiscal year and our outlook for fiscal 2014. Gary will then cover our key achievements and discuss our growth drivers and strategies. Finally, we will open the call up to take your questions. I will start with the financials, revenue for fourth quarter totaled $14.3 million, a 2% increase from $13.8 million reported in the fourth quarter of last year. In the 2013 fourth quarter we delivered operating income of $5.6 million, a 20% increase from the prior year. Operating margin was 39% compared with 34% in the prior year quarter. The current year quarter benefited from $1 million recovery of legal fees associated with SRI litigation partially offset by $0.5 million restructuring charge. The company’s earnings performance for the fourth quarter exceeded our expectations. On a GAAP basis our diluted earnings per share from continuing operations increased 53% to $0.26 per share for the fourth quarter compared with $0.17 per share in the year ago period. On the pro forma basis diluted earnings per share from continuing operations increased 20% in the current year quarter to $0.24 per share as compared to $0.20 per share in the fourth quarter of fiscal 2012. Turning now to our two business units, in Medical Device which includes the revenue from both hydrophilic coatings and device drug delivery coatings revenue totaled $10.3 million. This represents an increase of 3% from $10 million reported in the year ago period. Fourth quarter hydrophilic coating royalty revenue increased 1% to $7.4 million. Coronary sector hydrophilic coating royalty revenue declined 1% for the quarter resulting from overall coronary market weakness. Our Medical Device unit generated $5.3 million of operating coming in fourth quarter increasing 2% from the year ago. Medical Device operating margin was impacted by higher planned drug coated balloon research and development activities. For In Vitro Diagnostics Unit, fourth quarter revenue totaled $4 million, an increase of 4% compared with the prior year quarter. Of note, our IVD business has generated 12 consecutive quarters of year-over-year revenue growth and has also achieved record product revenue this quarter. Continued strength in our stabilizer and antigen lines for the quarter was offset by softness in both [supplies] a component of our Molecular Diagnostic product line, as well as our BioFX branded products. Product gross margin for IVD was 62% in the fourth quarter, rising from 61% in the prior year quarter. IVD operating income was $1.3 million was comparable with the fourth quarter of 2012 as increased revenue offset higher allocated corporate expense. Our diagnostic operating margin for the quarter was 32% compared to 34% in the prior year quarter. Now, I’d like to discuss our fourth quarter 2013 revenue summary by category. Royalty and license fees which are generated primarily in our Medical Device business unit were $7.5 million, increasing slightly from $7.4 million last year. Fourth quarter product sales of $5.8 million increased 10% from the year ago period. The company generated solid growth in hydrophilic reagent, stabilizer and antigen product sales which were partially offset by declines in other diagnostic product sales. Lastly, R&D revenue in the fourth quarter was $1 million, a decrease of 9% from $1.1 million reported last year. Coating services revenue for select hydrophilic customers was lower than a year ago, resulting from the execution of multiple technology transfers to our customers’ manufacturing sites. As a reminder, this is a steer course of business with our licensing model. Now to expenses; SG&A expenses in the fourth quarter of fiscal 2013 were 16% of revenue compared to 27% in the prior year quarter. SG&A in the fourth quarter of 2013 totaled $2.3 million and decreased 39% from last year on a dollar basis. The $1.4 million decrease in SG&A expense reflects two things. Reduced professional fees from the July 2013 $1 million recovery of legal fees associated with the SRI litigation and $0.5 million of Dutch Tender Offer expenses incurred in the fiscal 2012 fourth quarter. And the aggregate of $0.6 million of SRI legal fee recovery related to periods prior to 2013. As a percent of total revenue, fourth quarter R&D expenses were 28% compared to 25% in the year ago period. R&D expenses of $3.9 million for the quarter increased 13% from last year, resulting from planned investment to support our drug coated balloon development initiatives. In the fourth quarter of fiscal 2013 as previously disclosed, we recorded $0.5 million restructuring charge related to work force reduction. The annual savings from this action are estimated to be $1 million and will be redeployed into fiscal 2014 research and development initiatives. Income tax expense from continuing operations was 33.3% of pre-tax income in the fourth quarter compared with 40.7% in the prior year period. The decrease in the tax rate in the current year quarter primarily resulted from federal R&D tax credits which were reinstated in January 2013, a benefit from a manufacturing tax deduction in fiscal 2013 and non-deductible Dutch Tender Offer expenses in 2012. Let’s now turn to the fiscal year results. The company has performed well. Revenues for the fiscal year totalled $56.1 million an 8% increase from $51.9 million in the prior year. We delivered operating income of $18.8 million in fiscal 2013, a 15% increase from the prior year total of $16.3 million. Operating margin in fiscal 2013 is 34%, a 3 percentage point improvement over the same period last year. The fiscal 2013 improvement in operating margin reflected the positive impact of the SRI legal costs indemnification and the fiscal 2012, non-recurring Dutch Auction tender offering class offset partially by increased R&D investment and the fiscal 2013 fourth quarter restructuring charge. On a GAAP basis, our diluted earnings from continuing operations totaled $0.99 per share for fiscal 2013 compared with $0.58 per share in the previous quarter. On a non-GAAP basis, pro forma diluted earnings per share from continuing operations increased 29% to $0.85 per share for fiscal year 2013 compared with $0.66 per share in 2012. The increase in earnings per share is impressive and Gary and I would like thank all SurModics employees for this outstanding accomplishment. As further described in a table on our press release, we have identified non-recurring items, which have impacted the fiscal 2013 results including net strategic asset gains, discrete tax items, restructuring charges recovery of prior year legal fees and a one-time royalty catch-up payment. Looking at our balance sheet it continues to be strong. Our cash and investments totaled $58.1 million and we had no outstanding debt at September 30, 2013. We continued to generate solid cash flow during the year, cash flow from operations was $17.8 million during the fiscal year 2013 we also received $2.3 million from the sale of strategic investments and invested $1.9 million in property, plant equipment in fiscal 2013. Reflecting our commitment to enhance shareholder value under the $20 million repurchase authorization announced in July 2013 we’ve bought back 391,000 common shares totaling $8.5 million in the fourth quarter of fiscal 2013. For fiscal 2013, we repurchased 796,000 commons shares for an aggregate price of $18.8 million including open repurchases at September 30, 2013. We have $11.5 million outstanding under the existing share repurchase authorization for future purchases as of September 30, 2013. Next I want to comment on our expectations for fiscal 2014, the company estimates revenue for fiscal 2014 to be in the range of $58 million to $62 million reflecting 3% to 10% year-over-year revenue growth. We anticipate GAAP diluted earnings to be in the range of $0.80 to $0.92 per share. On a GAAP basis the fiscal 2004 earnings per share guidance includes an increase of approximately 20% in research and development investment over fiscal 2013 levels primarily related to drug coated balloon activities. The fiscal 2014 earnings per share outlook reflect 14.4 million diluted shares outstanding in the 31% to 33% income tax rate. The earnings per share and income tax rate guidance excludes the impact of any strategic investment gains and losses. Cash flow from operating activity is expected to range between $17.6 and $18.6 million for fiscal 2014. We project capital expenditures for fiscal 2014 to range between $2.2 and $2.5 million. While dependent on market conditions and business development initiatives we expect to continue to repurchase common shares under the $11.5 million remaining under our existing repurchase authorization. Finally, I am pleased to announce that we have entered into a $20 million line of credit agreement with Wells Fargo. This three year agreement takes advantage of current favorable lending conditions and provides SurModics capital and flexibility for general corporate purposes. At this time, I would like to turn the call to Gary for his perspective on our operations, Gary.

[Gary Maharaj:]

Thanks Andy. I am pleased with our accomplishments in fiscal 2013. Let me tell you why, one year ago I characterized fiscal 2013 as a year which will test SurModics’ ability to balance, by trying to achieve to go very different strategic goal simultaneously in order to enhance shareholder value. By this I meant the ability to balance the continued focus on core growth and profitability while laying the foundation for future core expansion. I am pleased that we are able to accomplish this in 2013. This was the challenging endeavor for our team even at the start of the year. It became even more challenging as the year progressed for a couple of reasons. First in Medical Devices, the customers in our coronary segment representing a large part of our royalty revenue experience sluggish growth during fiscal 2013. Second, there were slower than expected timelines to launch certain products in all customers pipeline. This resulted in a lower than expected reported royalties for these applications during fiscal 2013, because of the big launch delays. Our results in fiscal Q3 and Q4 reflect these challenges. Despite this our team maintained a high and continued to focus on core revenue. As a result our revenue growth is better than the respective Medical Device and In Vitro Diagnostics segments of our customers. We substantially improved our operating incomes and earnings per share with high quality earnings, not just one time event and generated significant cash flow in the process. Concurrently, we honored our commitments to shareholders and successfully repurchased $18.8 million of our outstanding share. Another component of balance in fiscal 2013 was laying the foundation for future core expansion. I'm happy to say that we have accomplished a lot here especially during the past three quarters. In Q2, we launched SurModics Serene, the next generation platform for hydrophilic coating, which breaks the tradeoff between diversity on particulate. In Q3, our Diagnostics business launched SurModics StabilZyme Protein-Free, the world's first protein-free stabilizer that has high retained activity. We also matched our structure to our strategy. In Q2, we hired Andy as our new CFO to both complements and add capacity to an overly leading this management team. This allowed Tim Arens to focus full time on leading our corporate development strategy. In Q4 with Andy fully on boarded we further rewind our organizational structure to better accomplish the management’s intensity required to successfully execute strategy. Now our general managers of Medical Devices and In Vitro Diagnostic, Charlie Olson and Joe Stich respectively have a single minded focus on the markets and the customers we serve with the business development and marketing team. Andy is working with operations team to continue to improve operational efficiency. Bryan Phillips our General Counsel and the Head of Human Resources is also charged with continuous improvement of our deeper practices to reinspire and engage our talented employees. Finally, I have direct responsibility now for both the quality and the research and development team. In particular, my job in the technology company of SurModics’ size and investments in R&D is to ensure that the strategic alignment of our R&D pipeline opportunities that matches our long-term value creating goal. Now, I want to share with you the substantial progress we've made on our drug coated balloon initiatives. We have completed our internal pre-clinical evaluation of this technology platform with excellent results. As you recall, drug coated balloons may offer better alternatives in current therapies in areas of the vascular tube what we think a stent is not ideal. The worldwide market potential for drug coated balloons has been 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 approval in the U.S. On our last call, I mentioned that the intent of our DCB program is to understand the capability of our drug coating platform to achieve five critical objectives compared with other markets’ devices on the market in Europe or in [physical] clinical trials in the US. Of these objectives are once [again]; better control of the manufacturing process so that the uniformly consistent loading of the drug on the balloon is achieved and also from balloon to balloon. Second, better control of the paclitaxel drug on the balloon 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 on the arterial walls that reduces smooth muscle cell proliferation and hence restenosis. And finally, an absence of safety issues both the local treated tissue and the distant tissues. Our preclinical evaluation including detailed independent histopathological analysis has demonstrated consistently positive results in each of these objectives that I have just described. In fact the data lead us to believe that our platform has a potential of being a third generation drug coated balloon that substantially improves the efficiency of drug transfer compared with other drug coated balloon devices in the preclinical model. In addition and very significantly, we believe our technology is capable of studying a new standard and consistency and uniformity of the drug expectation, the [morphology] and processing of the drug which may have significant advantages to manufacture those in an actual device. It’s important to note that further preclinical testing is also underway and there continues to be risk associated with any early stage endeavour of this nature and the very high goals we have set internally for this project. In addition, depending on the regulatory pathway for approval more preclinical studies maybe required. I will say this however this is a noteworthy accomplishment for our SurModics team as we seek to establish ourselves, to re-establish ourselves as the innovator in device drug delivery. So after laying the foundation for future growth in 2013 how do we plan to build on that in the new fiscal year? In 2014 we will continue to drive core revenue growth even in light of tougher market conditions. In medical devices increasing the adoption of the Serene platform is critical. We continue to see a strong pipeline of feasibilities for new device applications with targeted customers. The majority of our feasibilities going forward will leverage the SurModics Serene platform. I expect to see revenue contribution from these licenses later in the fiscal year depending of course on regulatory timeline and our customers’ final commercialization and launch schedule. In In Vitro Diagnostics we continue our core focus on stabilizers and substrates including driving adoption of the new products that we have launched recently. We also plan to introduce several new IVD products in 2014. An important note is that our revenue guidance includes growth from core activity, but not from core expansion project such as the drug coated balloon. On corporate development front we continue to be extremely proactive in the screened multiple opportunities. However we will be both disciplined and patient to ensure that any M&A we undertake will be of both a strategic fit and a financially viable value creator. Now let’s talk specifically about our drug coated balloon program in 2014. From what we have seen, we intend to increase our investment in this platform. In fact if we continue to demonstrate the positive results that we have seen to-date, we may actually choose to accelerate this investment. Our EPS guidance for fiscal 2014 includes the range of potential investment projections for the drug coated balloon project that we foresee in this year. An important distinction in our go forward investments on drug coated balloons is actually moving from the area of coating platform to an actual drug coated balloon device. We believe that by providing a whole product with this purely technology solution, our eventual partner or partners will be able to move more quickly advanced to human trials and other requirements of a long regulatory process. This time savings will be of significant value to a strategic partner. To that end in fiscal 2014, we’ve already been very busy. We have already specified identified and are currently characterizing a peripheral balloon platform that is being used in our preclinical testing. These costs are captured in our investment estimates for the project in fiscal 2014. Now we recognize that this investment reduces our potential EPS in fiscal 2014 and furthermore it occurs in the year of tougher revenue growth conditions for the market. However we believe that incremental investment has the potential to yield outsize returns for our shareholder and are therefore worthwhile even including the incremental risk. Our team has worked really hard to maintain on our expense structure to remain true to our objective delivering operating income in the 30% range even with this incremental investment. I'm very proud of that that we have demonstrated this. This we believe adequately [bounce] the downside risk to our shareholders. I'm excited about far SurModics has come these last two years. I am confident in the future. 2014 will be both challenging and exciting for our talented team of employees. And they continue to positively transform our company. Despite industry headwinds, we remain committed to our mission of providing enabling technologies that improve the detection and the treatment of disease. And with our Board we are demonstrating that with our commitment to R&D investments to further expand our profitable core and create long-term shareholder value. Operator, this concludes our prepared remarks. We would now like to open the call to questions. Thank you.

[Operator:]

Thank you. We'll now begin the question-and-answer session. (Operator Instructions). Our first question comes from the line of Ross Taylor with CL King. Please go ahead.

[Ross Taylor:]

Hi. First question just relates to your revenue guidance for 2014. That the range of 3% to 10% growth is that, that range is it, kind of is the variance driven by industry growth or is it related to your new product launches or your partnership or you’re just trying to determine what might drive the low-end versus the high-end of that revenue guidance?

[Andy LaFrence:]

Hey good afternoon, Ross. It’s Andy LaFrence here. It’s primarily driven by industry considerations and things are now within our control obviously some of the new product launches we have this year, as well as focusing on some of our [type of] clean business which we feel like we have some good opportunities. And so there is a wide range, but we think the majority of that guidance is coming from the industry.

[Gary Maharaj:]

Yeah. And one thing I will add is, customers continue to look for stability and decline of some of the coronary procedures. And so as we look at our range, we have to say though we haven’t necessary seen that stability yet and so we have to accommodate that as well.

[Ross Taylor:]

Okay. That’s helpful. And I was wondering if you want to get this granular with the 2014 outlook, but for SG&A we adjust the Q4 SG&A amount for some of those unusual items. Is that a good run rate to use for next year or how should we think about that?

[Andy LaFrence:]

Yeah. If you adjust SG&A for the SRI indemnification and back that up, SG&A less, to be in the 4% to 5% growth rate.

[Ross Taylor:]

Okay. And then my last two questions just relate to the drug coated balloon project. What types of additional preclinical work might you have to do before it’s ready for first in man trial and how quickly before you decide that?

[Gary Maharaj:]

It’s a fairly branched tree depending on the regulatory pathway. And certainly we have completed our internal preclinical assessment on our balloon platform. It comes on to have the strategic partner once it’s on their balloon platform and then you have to go through a battery of test to demonstrate that we have been able to transfer the coatings technology to another balloon platform, which actually we believe it’s one of the strength of our technologies, it’s fairly well portable. So in that case, we will have some more preclinical. It’s indeed for, certainly for US regulatory ID approval, usually they require as you know for GLP animal study which is a fairly long and detailed animal study that is beyond just in general study conducted with me under independent orders and stuff like that. So that's another type of preclinical level required.

[Ross Taylor:]

Okay. And it sounds like based on your prepared comments that you maybe are going to use somebody else’ balloon or technology to create a single product that you then might license to customers, did I interpret that correctly?

[Gary Maharaj:]

Yes. And we have that part of our incremental spending is what we’re hearing from some of the key strategic and what are SurModics and its long-term transformation is being able to not just provide a technology solution, but a whole product solution and some of our partners are looking for whole product solution, so that they can then use the strength of their clinical regulatory and sales channel to license that product.

[Ross Taylor:]

And is it fair to assume that a lot of your recent preclinical work has really just been performed on that one single balloon platform and....

[Gary Maharaj:]

We have been certainly evaluating it and we have very high confident in the balloon platform we have selected, yes.

[Ross Taylor:]

Okay. And last question apologize I keep going, but what kind of interest or conversations have you sensed from your partners so far. I mean is this a project that you considerably could license to somebody during FY14?

[Gary Maharaj:]

We certainly don’t comment on any ongoing discussions, but certainly last week we were all at the [Transcat] therapeutics meeting. And as you can imagine there was an entire day on just drug coated balloons on Thursday going late into the evening. There continues to be very strong interest in this market, this technology and certainly in our particular application and the data that we have. So the question is for us is at what time do we chose to or what’s the best interest to shareholders to monetize that value.

[Ross Taylor:]

Okay. Alright, that’s all very helpful. Thanks very much.

[Gary Maharaj:]

Thanks, Ross.

[Operator:]

(Operator Instructions) Our next question comes 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.

[Ben Haynor:]

Just a couple of quick ones from me on the R&D expense increase related to the drug coated balloon. Do you anticipate that being spread relatively evenly throughout the year or are there more activities that need to be done sooner rather than later or is it back half loaded?

[Gary Maharaj:]

Yeah. Andy is going to kick me under the table if I don’t close the quarterly guidance. The project does have some lumpiness in it and it depends on whether we do certain things simultaneously. So Andy what’s your thought?

[Andy LaFrence:]

I mean the guidance were, we gave that if you look at the percentage of sales we’ll probably be between 30% and 31% from quarter-to-quarter and so there maybe some lumpiness just like 2013 we saw some delays in the first quarter and then we get some cash up in the back-end, but the guidance that we think is sound for the entire year. So and I think that was granular as we’ll get from a quarterly basis spend.

[Ben Haynor:]

Well, then what would you expect for January then?

[Andy LaFrence:]

(Inaudible)

[Ben Haynor:]

You already gave quarterly, I think that maybe monthly would be better.

[Andy LaFrence:]

There a lot, I can say there is a lot of work to be done and there will be a lot of act throughout the year.

[Ben Haynor:]

Okay. And then just last real quick one from me on the three new product launches during the quarter maybe I missed this, were do those using Serene?

[Gary Maharaj:]

We haven’t commented on that in terms of new product launches, they are not using Serene. We can’t tell you that during the quarter there were a number of products that were approved by the FDA that use our Serene technology. And that is certainly all those have launched at this point.

[Andy LaFrence:]

And Ben I think the good way to say is the majority feasibilities are using Serene and somebody’s feasibilities could be 12 months or more. So if some customer started in the pre-Serene era, they can’t change because of the regulatory filings, they will continue with that. So it’s not a bad for us to see what’s coming through the shoot will be the majority of the Serene as well.

[Ben Haynor:]

Okay. That's helpful. That's all I have gentlemen. Thank you very much.

[Gary Maharaj:]

Thank you.

[Andy LaFrence:]

Thank you, Ben.

[Operator:]

I would now like to turn the conference back over for closing remarks.

[Gary Maharaj:]

Thank you. Let me reiterate that SurModics reported strong revenue and EPS growth in fiscal 2013. Fiscal 2014 represents an exciting opportunity for SurModics to continue our profitable growth even during a challenging market and while we increase our investment and opportunity for co-expansion. I want to thank everyone again for participating in this quarter's conference call. Thank you.

[Operator:]

Ladies and gentlemen, this does conclude the SurModics fourth quarter FY 2013 earnings conference call. We like to thank you for your participation. You may now disconnect.