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SurModics, Inc. (NASDAQ:SRDX)

Q1 2013 Earnings Call

January 30, 2013, 05:00 pm ET

Executives

Tim Arens - VP, Finance & Interim CFO

Gary Maharaj - President & CEO

Analysts

Jeffrey Warshauer - Sidoti & Company

Ross Taylor - CL King

Operator

Ladies and gentlemen, thank you for standing by and welcome to the SurModics First 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 January 30, 2012.

And I would now like to turn the conference over to Tim Arens, Vice President and Interim Chief Financial Officer. Please go ahead sir.

Tim Arens

Thank you, Makela. Good afternoon and welcome to SurModics’ fiscal 2013 first quarter earnings call. Also with me on the call is Gary Maharaj, our Chief Executive Officer. A press release disclosing our quarterly results was issued earlier this afternoon and is available on our website at 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 be also achieved 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 2012 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 provide an overview of our financial results, highlights for the quarter and an update on our outlook for fiscal 2013. Gary will then discuss our key achievements for the quarter and provide an update on our growth drivers and strategies including additional detail on our $10 million share repurchase authorization. Following this discussion we will open the call to take your questions.

I will begin our discussion with an overview of our financial highlights related to the quarter. As a reminder, we are no longer adjusting our results to reflect the impact of the discontinuation of Cordis' Cypher and Cypher Select Plus drug-eluting stents. Therefore, all of my comments pertain to our GAAP results unless otherwise noted.

Our business delivered strong revenue and operating income growth of 16% and 51% respectively compared to the first quarter of fiscal 2012 as both business units delivered solid revenue growth during the quarter. We achieved record hydrophilic coating revenue and record In Vitro Diagnostics product revenue during the quarter. We generated $4.9 million of operating income for the quarter which translates to 35% operating margin.

Our balance sheet remains healthy with $64 million in cash and investments at quarter end which reflects strong operating cash flow contributions of $5.4 million as well as proceeds of $1.3 million from the sale of one of our strategic investments. Our first quarter’s effective tax rate of 31% is significantly lower than the 38% tax rate used to guide our initial earnings per share outlook for fiscal 2013. This lower tax rate affects our updated earnings per share outlook which I will provide greater detail around later in my comments.

Before I fully discuss our results from continuing operations for the first quarter, let me address two specific items that will lend some clarity to our results. These items include a one-time catch up royalty payment and a gain on the sale of one of our strategic investments. In October, we received a one-time catch up royalty payment of $570,000 from one of our hydrophilic coatings customers. This payment represents royalties that the customer owed for non-vascular product sales that occurred in previous years.

In addition, our first quarter earnings per share saw an approximate $0.08 benefit resulting from the acquisition of Vessix Vascular by Boston Scientific. SurModics received $1.3 million from the sale resulting in the gain of nearly $1.2 million. There was no tax expense associated with this gain. In addition, SurModics could earn an additional $4.3 million depending on the achievement of future milestones.

Moving on to our fiscal 2013 first quarter results. Our financial performance resulted in solid revenue growth and the business generated strong operating income growth. Revenue for the first quarter totaled $13.9 million, increasing 16% from the $11.9 million reported in the first quarter of last year. We delivered first quarter operating income of $4.9 million, an increase of 51% from the prior year.

Our operating margin was 35%, up 800 basis points compared with the prior year period, driven primarily by the strong quarterly revenue performance. On a GAAP basis, our diluted earnings per share from continuing operations was $0.29 for the first quarter compared with diluted earnings per share of $0.12 from the year ago period.

Turning now our attention to our medical device unit, the results that I will discuss today include the one-time catch up royalty payments of $570,000 recognized in the first quarter. First quarter medical device sales which include revenue from both our hydrophilic coatings and device drug delivery coatings totaled $10.5 million, an increase of 19% from the $8.9 million reported in the year ago period. During the quarter, hydrophilic coating revenue increased 27% from last year to $10.1 million.

During the first quarter, we saw double-digit hydrophilic coating royalty revenue growth in our key medical device market segments, including neurovascular, peripheral vascular and transcatheter heart valve replacement. Medical device generated $5.8 million of operating income during the quarter, representing a 49% increase from the year ago period.

Looking at our In Vitro Diagnostics business unit, sales for the first quarter totaled $3.3 million, an increase of 9% compared with a year ago period. Our IVD business unit has generated nine consecutive quarters of year-on-year revenue growth.

Our first quarter product gross margin of 59% was 700 basis points lower than a year ago period impacting our product gross margin was a greater percentage of our diagnostics sales coming from lower margin products. We expect that our IVD product gross margins will return to historical levels approaching the mid 60% range in future periods.

Operating income of approximately $750,000 declined 17% compared with the year ago period driven by two factors. These factors include the impact of our product sales mix and gross margin and higher operating expenses. It is worth noting that our diagnostics operating margin for the quarter came in at 23%. Going forward, we expect that our IVD operating margin will be in the mid 20s to low 30s range.

Now let’s discuss our first quarter 2013 revenue summary by category. Royalty and license fees which had generated primarily in our medical device business unit were $7.5 million, an increase of 14% from the $6.6 million reported last year. First quarter product sales of $5.4 million increased 16% 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 first quarter was approximately $1 million, an increase of 46% from the $670,000 reported last year. Once again, coating services support for certain of our hydrophilic customers was the primary driver of the increase in R&D revenue.

SG&A expenses in the first quarter of fiscal 2013 were 26% of revenue compared with 29% in the year ago period. SG&A expenses were at $3.7 million, and increased 5% from last year. Research and development expenses in the first quarter of 2013 were 24% of revenue compared with 31% in the year ago period. R&D expenses were at $3.4 million and declined 8% from last year, mainly as a result of timing associated with certain of our R&D activities. For the full year, we continue to expect R&D expense to grow on the 5% to 8% range.

Taking a quick review of our balance sheet; our cash and investments totaled $64 million. This balance reflects the $1.3 million received from the sale of our Vessix investment. We have recently sold our shares in another strategic investment and generated proceeds of $1 million which will be reflected in our second quarter financial statements. We continue to generate solid cash flow during the quarter; cash flow from operations was $5.4 million during the first quarter.

Finally, I want to update 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. As you saw in today's earnings release we have increased our outlook for earnings per share from continuing operations. Diluted earnings per share is now expected to be in the range of $0.86 to $0.99 per share, above our initial range of $0.75 to $0.87 per share. It is important to note that our updated earnings per share outlook excludes any potential share count reduction that could occur as a result of any share repurchase that may occur during the year.

I would like to provide some additional color around and revised earnings per share outlook for fiscal 2013. Our revised earnings per share reflects the impact of the $1.3 million gain from the sale of two of our strategic investments. Our updated outlook reflects an effective tax rate of 33% for the full fiscal year, mainly as a result of the favorable tax impact associated with R&D tax credits, our manufacturing tax deduction and from our investment gains. Our outlook assumes 14,863,000 shares outstanding. This concludes my comments.

At this point, I would like to turn the call over to our Chief Executive Officer, Gary Maharaj. Gary?

Gary Maharaj

Thank you, Tim. Tim did a terrific job of speaking about the drivers behind our financial results for the quarter. So I will not spend much time reiterating these financial highlights.

While we are pleased with our overall results, I'm personally proud of our team of 1,000 employees who continue to demonstrate their dedication to our mission. I also want to thank our many named and unnamed customers who continue to recognize SurModics as their partner that deeply cares about their success.

As they could talk I knew that it would be a witness to our extraordinary efforts to help them achieve via challenging device and diagnostic product objectives. These extraordinary results translate into meaningful revenue growth of both our core medical device and in vitro diagnostic businesses in a difficult economic environment.

Our cash flow from operations and overall profitability are healthy. We are making significant progress and executing against our strategic objectives such as development of new product like our Gen 5 hydrophilic coatings platform which we believe will strengthen our leadership in hydrophilic coatings and drive SurModics future growth and earnings potential.

Finally, we continue to evaluate the best amount in which to use our cash and are committed to returning excess cash to shareholders. During the last earnings call, I expressed my excitement about fiscal year 2013, and continuing to build upon the positive momentum behind our strategy in this third year of the transformation of SurModics. This year, we plan to balance the continued focus on driving our core businesses while starting the process of methodically expanding our call. It is worth repeating the tight definitions of what we consider our core businesses.

In medical devices our core is lubricious also known as hydrophilic coatings on catheter-based delivery systems in endovascular tube. This spans a gamut of devices used from vascular access device delivery, device intervention and all the way to vascular closure.

We have built them the leading market position and our next generation technologies such as Gen 5 platform will further strengthened the licensing opportunities in this very important area. We intend to set the pace on direction of innovation and explore the full potential and full penetration of this business was in the coronary, peripheral, neural and structural heart market segments which include strength catheter valves.

In vitro diagnostics, our core is chemical reagents amino acid based diagnostic caskets. We are well known for our differentiated room temperature stable drive and liquid protein stabilizers and our colorimetric substrates.

Our reagents have a gold standard choice of customers who need uncompromising performance in these assays. So these businesses clearly have a long runway for continued growth and we intend to maximize this opportunity. We recognize and are ready for the inherent challenge in balancing the focus required for core growth with the exploration required for core expansion.

However, our expansion strategy to go beyond hydrophilic coatings and diagnostic reagents for immune assays is important and timely. Core expansion strategies require some clear insights and careful examinations of both opportunities and the risks.

In addition, the organizational capability to support expansion can quickly become the limiting or worse the detrimental factor to long-term results.

We are interested in building an enduring and resilient organization. And I believe that the time required and the challenges intrinsic in core migration are usually more than originally planned. As such, we share sense of urgency just here to start now so that we are well positioned to generate additional future cash flows from co-expansion. To reiterate areas of focus for the company for this year.

First, we're commercializing our Gen 5 hydrophilic coating platform. Second, we intend to complete the preclinical assessment of our drug coated balloon technology. Third, we're conducting meaningful experiments on core technology that improves the performance of implantable medical devices and amino acid based diagnostics. And fourth, we're assessing the opportunity for core expansion into molecular diagnostics with our existing IVD technology.

Let’s talk about medical devices first. Our Gen 5 hydrophilic coating continues to make progress in early commercialization and the validation on multiple device surfaces or substrates as we call them. A small, though pivotal milestone occurred in our Q1. The first medical device that incorporated our Gen 5 coating was cleared by the FDA.

This was pivotal because it represents our first customer being cleared for US commercialization. While regulatory review time is very widely based on the device application, we expect to see other customers receive regulatory clearance or approval in calendar 2013.

Our core expansion activities in medical devices are centered in our drug coated balloon project. We continue to fund preclinical studies to determine optimum processing and do symmetry requirements for this important platform. This preclinical work will accelerate in 2013 fiscal year in order to fund full gamut of tests to demonstrate the validity of our technology and its suitability for human application.

As a result, our R&D spending will increase to reflect this acceleration in this next three quarters. In our IVD business diagnostics, we have need real progress in R&D in response to some challenging custom formulations of core products specific to the technology needs of several key amino acid customers.

From a core expansion viewpoint, we have already seeded multiple experiments that we believe have the potential to dramatically improve the performance of molecular diagnostic test. Note, these experiments will need to be thoroughly vetted internally before they become bonafide projects.

In order to purposely balance the risks of core growth and the core expansion, we have also made some positive changes in our senior leadership team. After an extensive search process, we are pleased that Andy LaFrence has decided to join our team as our Vice President of Finance and Chief Financial Officer.

Andy’s appointment will be effective February 12, 2013. His extensive financial and accounting experience will add to our existing capability in these areas and his leadership will provide stewardship of all financial functions and management contributions to our team as we grow.

Tim Arens who has done a stellar job guiding us as interim CFO for the past six quarters will assume a critical responsibility as the Vice President of Strategy and Corporate Development to strengthen our position in critical and high growth markets. To mandate in Tim’s role is a disciplined use of our balance sheet cash to create growth, earnings and future cash flow streams. Tim’s tenure and track record of experience previously in corporate development, financial planning and analysis, general management of the diagnostics business and as interim CFO has prepared him well in his knowledge of our markets of business economics, strategy and technology in order to serve SurModics in this new role.

Congratulations to Tim on his new role and a welcome to Andy as he joins our team. Finally, as part of our ongoing commitment to returning excess cash all the time to our shareholders, I am pleased to announce an authorization by our board of directors to repurchase up to $10 million of SurModics stock.

This repurchase authorization is an addition $0.3 million that it remains under prior share repurchase programs. Importantly, this announcement highlights increasing financial strength of the company especially as we continue to generate substantial cash flow and exemplifies all commitment continually evaluating how to deploy cash to create value for our shareholders.

So to summarize, our team is excited about this year. We are off to healthy start and remain confident in our ability to make progress in our stated strategic, operational and financial goals in fiscal year 2013.

Operator, this concludes our prepared remarks. And now I would like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Jeffrey Warshauer from Sidoti & Company.

Jeffrey Warshauer - Sidoti & Company

If you could just clarify for me the size of the one-time royalty in the quarter, and if you think that the effective tax rate you are using going forward, that we should continue to use in years beyond fiscal ’13.

Tim Arens

So clarifying the one time royalty catch up payment the amount was $570,000. In terms of how to think about our effective tax rate going forward; Jeff I think we will keep our effective tax rate common to this fiscal year. We will provide a little bit more insight around what we think that will look like as we get into providing outlook for guidance for fiscal 2014.

Jeffrey Warshauer - Sidoti & Company

Okay, thank you. And regarding Gen 5 will you see any margin gain for that or is that equivalent to the current coatings.

Tim Arens

Jeff, probably the best way to be thinking about this is the royalty rates that we would be looking to receive on our Gen 5 hydrophilic coating will be no less than what we are generating today on Gen 4, providing us with the potential for some possible upside. Every customer is a bit different, so not looking to stay in the signal here in terms of how one should be thinking about the royalty rates on Gen 5, but I want to give you kind of more of a range on how to think a it.

Gary Maharaj

Yeah, one thing to consider is Gen 5 is a platform, the product specific applications range from very simple to very complex and that impacts how we relate to those customers on our licensing agreements.

Operator

(Operator Instructions) And our next question comes from the line of Ross Taylor from CL King.

Ross Taylor - CL King

I just disconnected myself at the start of the Q&A and I'm going to ask another question about the tax rate I heard part of your answer, but can you just review the factors that are impacting the rate this year if you take out the investment gain is it primarily just the R&D tax credit and is there any catch up for 2012 that's included in your new rates or your adjusted rate for fiscal year ’13.

Gary Maharaj

Thank you for the question Ross. So yes if you were to take a look at excluding the gain on the investment, you will see that the effective tax rate for the full year will be somewhere around 35%. When you include the investment gain which is in tax, you are looking at a full year tax gain of 33%. The driver beyond the investment gains are really two; there is the R&D tax credits as you mentioned as well as a manufacturing deduction that we are able to qualify for this year, and as far as any catch up R&D tax credit this is a go-forward tax credit for us.

Ross Taylor - CL King

That helps and just two or three other questions, obviously you mentioned you expect the operating margin to go up there and other than the impact of improving gross profit margin, is there anything on the SG&A or operating expense side that you expect for change to push that margin up?

Gary Maharaj

I won't provide any real clarity or color or guidance in terms of operating expense spend for the business unit. What I will tell you is that it's embedded along with an improving sales mix, or improving in terms of greater portion of our mix coming from higher margin products. But I will just make a general comment with regard to operating expenses with the business unit and the business in general. We are investing in our diagnostic business and so one would expect that as a result of those investments, operating expenses will grow year-on-year and so we will have some effect on the operating margin but I won't provide much detail on that.

Ross Taylor - CL King

Okay, alright. And with regards to validating some of your technology for the potential use in molecular diagnostic, how long might that take in order to be successful. When could you kind of go to market with products in that area?

Gary Maharaj

This year is the year in our pipeline of five years experiments on projects. This is the year we really jet out a lot of (inaudible) experiments, and vet them out as to which would become projects. Now there is a different timeline depending on the complexity of the experiments we're trying to validate to ourselves, but speaking this on a macro basis, I would like, these experiments, the ones that survive lets put it that way scale up to projects for our fiscal 2014. Not to say it couldn’t be earlier but that’s how we all plan to fund these projects and projects also have a timeline before they become commercial. I am not looking for commercialization of some of these this year let’s put it that way.

Ross Taylor - CL King

Okay, alright that’s helpful. My final question just had to do with your thoughts on use of cash and acquisition. You are going down the road very far, do you have much of your pipeline in terms of potential acquisition candidate at this point and you also are going to have a pretty large cash balance even if you factored out your new share repurchase authorization how big is your appetite for acquisition?

Gary Maharaj

That’s something that we pulling (inaudible) strategically and that’s one of the critical components of Tim’s job, as you know Tim knows the company inside and out and he knows our strategy into fit. So over next couple of quarters that’s what we intend with our Board of Directors to flush out really the strategy and the fit we are looking for proactively in our M&A strategy. Certainly there is always reactive things that come to us, but I think our intention is to really be proactive, find out what we need for the future cash flows then what’s the fit we are looking for and then go into action. So at this point we are not prepared to get much more than that.

Operator

Thank you. And at this time I am showing no further questions in the queue. I would like to turn the conference back over to management for closing comments.

Gary Maharaj

Thank you. I want to thank everyone again for participating in this quarter’s conference call and we look forward to providing further updates on next quarter’s call. Thank you.

Operator

Ladies and gentlemen this does conclude our conference for today. If you would like to listen to a replay of today’s conference, you may do so by dialing 1-800-406-7325 or 303-590-3030 and entering the access code of 459-3304 “#”. We thank you for your participation. And at this time you may now disconnect.

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