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Executives

Stephen Zarrilli – President, Chief Executive Officer

Jeffrey McGroarty – Senior Vice President, Chief Financial Officer

John Shave – Vice President, Business Development and Corporate Communications

Analysts

Paul Knight – CLSA

Chris Lewis – Roth Capital Partners

Bob Labick – CJS

Jim Macdonald – First Analysis

Greg Mason – KBW

Allen Zwickler – First Manhattan

Safeguard Scientifics Inc. (SFE) Q1 2013 Earnings Call April 25, 2013 9:00 AM ET

Operator

Good day and welcome to the Safeguard Scientific First Quarter 2013 Financial Results conference call. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today’s presentation there will be an opportunity to ask questions. To ask a question, you may press star then one on a touchtone phone. To withdraw your question, please press star then two. Please note this event is being recorded.

I would now like to turn the conference over to Mr. John Shave, Vice President Business Development and Corporate Communications. Mr. Shave, the floor is yours, sir.

John Shave

Good morning and thank you for joining us for the Safeguard Scientifics First Quarter 2013 conference call and update. Joining me on today’s call are Steve Zarrilli, Safeguard’s President and CEO; and Jeff McGroarty, our newly appointed Senior Vice President and Chief Financial Officer. During today’s call, Steve will review highlights for the quarter as well as other developments, then Jeff will discuss Safeguard’s financial results and strategies. After that, we will open the lines for your questions. Jim Datin, Executive Vice President and Managing Director and head of our deal team will also be available to answer any of your questions during the Q&A.

As always, I must remind you that today’s presentation includes forward-looking statements. Reliance on forward-looking statements involves certain risks and uncertainties, including but not limited to the uncertainty of future performance of our partner companies and the risks of acquisition or disposition of interests in partner companies, capital spending by customers, and the effect of regulatory and economic conditions generally, as well as the development of the healthcare and technology markets and other uncertainties that are described in our filings. During the course of today’s call, words such as expect, anticipate, believe and intend will be used in our discussion of goals or events in the future. Management cannot be certain that financial outcomes will be as described today. We encourage you to read Safeguard’s filings with the SEC, including our Form 10-K which describe in detail the risks and uncertainties associated with managing our business. The Company does not assume any obligation to update any forward-looking statements made today.

Now here’s Safeguard’s President and CEO, Steve Zarrilli.

Stephen Zarrilli

Thanks John, and thanks all for being here today to have an update on Safeguard Scientifics and our partner companies. Results for the quarter ended March 31, 2013 were distributed earlier today. In addition, we also announced this morning that Jeff McGroarty has been named Senior Vice President and Chief Financial Officer. Jeff and I have worked closely together over the past several years to improve Safeguard’s financial strength and flexibility. In addition, Jeff has been instrumental in executing Safeguard’s strategy of building high potential growth stage companies in healthcare and technology sectors. I would like to take this time to congratulate Jeff on this well-deserved promotion.

Before I discuss specifics about Safeguard and our partner companies, I thought it prudent to take a few minutes to highlight broader trends taking place within the venture capital industry. According to data compiled by Dow Jones Venture Source, PWC, and the National Venture Capital Association, venture capital deal volume, capital raised and capital invested all declined in the first quarter compared with the same period in 2012. In addition, mergers and acquisitions and IPOs were weak. Overall, the venture capital industry posted the fewest M&A transactions in Q1 since 2009.

Over the past several years, investors have been allocating less money to capital-intensive businesses, such as clean energy technology, and more money to capital-efficient businesses in software and IT. Allocations and deal activity during the quarter bore out the focus on capital efficiency. IT and healthcare segments each accounted for 30% of total capital raised and 56% of closed deals in the period. This trend echoes Safeguard’s focus on healthcare and technology, which we’ve maintained for the past seven years. Safeguard too shifted away from companies with high CAPEX requirements and now focuses on companies with lower CAPEX requirements that are near or at commercialization. Today we target initial capital deployments between 5 and 15 million and follow-on financings between 5 and 10 million, with the total size to not exceed 25 million over the life cycle of each partner company relationship.

Today, Safeguard has a strong balance sheet and offers an invaluable platform of resources to its partner companies. This has become a key competitive differentiator when prospective companies evaluate Safeguard against other capital providers. This value-add attracts entrepreneurs to Safeguard in light of a rapidly contracting venture industry.

The Safeguard team continues to screen for opportunities where we can add value and drive growth with the goal of achieving risk-adjusted cash-on-cash returns at a minimum of two times cost over a three to five-year period. The team funnels more than a thousand leads through a process that we believe should result in the closure on average of four to eight deals in any given 12-month period.

This year, Safeguard is celebrating its 60th anniversary. Over the past 60 years, Safeguard has evolved into a respected provider of capital and operational support to growth stage businesses in healthcare and technology. Today, our team remains focused on Safeguard’s core business as the main driver to increase the company’s capital under management to a range of 550 to 700 million by the end of 2015 from about 370 million as of the end of the year 2012. Not much time has passed since our year-end call, which took place in early March; nonetheless, Safeguard and our partner companies have been aggressively executing our strategies to grow, operate effectively and efficiently, and to create value. Our guidance on aggregate revenue for the year remains unchanged. We expect aggregate partner revenue in the range of 250 to 270 million, an increase of 27 to 37% respectively from 2012.

As I mentioned during our last call, we are intently focused on Safeguard’s core business. Our strategic focus has three key facets: we intend to be more proactive in driving growth of existing partner companies, we intend to deploy capital at a more consistent pace and to increase our roster of partner companies to 25 by the end of 2013, and we are working to realize solid risk-adjusted returns from additional opportunistic exits from partner companies on a more consistent basis. Our target in 2013 is to realize two exit transactions by year-end 2013.

We made measurable progress toward these goals during the first quarter. Safeguard deployed capital into two new companies, bringing our partner company roster to 20. These companies are Pneuron, a provider of data analytics and system integration software, and Sotera Wireless, a developer of a mobile medical device that measures, displays and transmits patient vital signs to clinicians. Let me take a few moments to review the details of these transactions.

Massachusetts-based Pneuron is our tenth technology partner company. Pneuron’s cloud-ready patent pending software platform offers businesses new ways to analyze their competitiveness, operational effectiveness, and risk management. Fortune 5000 enterprises can reduce the time and cost of application development by up to 50%.

Most business-intelligent initiatives require consolidating all data into a single repository before building business applications. Pneuron is different. Instead of organizing a massive data development project, CEO Simon Moss and his team deploy small lightweight components next to client data, leading to faster development of applications and highly reusable components. In addition, clients can move applications into the cloud one component at a time.

The financial services industry spends approximately $10 billion per year on cloud enablement, information management software, and BI analytics collaboration software based on Forrester Research estimates. While analysts agree that Pneuron does not fit neatly into any category, the company is positioned to be a disruptive player across the financial services industry.

Pneuron is initially focused on some of the most pressing and complex areas of financial services, including global regulations, risk, conversion management, and revenue generation; however, the company is already gaining traction in insurance and healthcare with emerging partnerships. We believe Pneuron is well positioned to address the billions of annual spend on cloud enablement, information management software, analytics and collaboration. Pneuron’s go-to-market strategy includes partnerships with PWC and other system integrators and independent software vendors.

Safeguard deployed $5 million of a 6 million Series B financing into Pneuron. We have a 28% primary ownership position and managing director Phil Moyer represents Safeguard on Pneuron’s board of directors.

Sotera Wireless – headquarters in San Diego, Sotera Wireless is a medical device company that has developed a new wireless patient monitoring platform called VisiMobile, which launched commercially during the third quarter of 2012. The patient-worn device weigh just 125 grams and measures, displays and transmits six core vital signs to clinicians with ICU-grade precision. The wireless connection ensures that patients receive timely care. The Sotera device and platform allows healthcare institutions to realize savings from improved staff efficiency and avoid expensive adverse events if patients are not monitored.

Sotera has received FDA clearance for wireless vital sign monitoring. An application is pending for FDA clearance for additional non-invasive, continuous blood pressure monitoring which would enhance the Sotera offering. The regulatory decision is expected around mid-2013. In addition, Sotera recently announced its partnership with Intermountain Healthcare on a pilot program to use VisiMobile in the post-surgical care units of two large hospitals in Utah.

The global market for patient marketing devices is estimated at 3.3 billion and is expected to grow by more than 10% annually. Sotera has already opened a Singapore regional office and has plans to expand to the U.K., Canada, and Australia later in 2013. Sotera’s initial domestic market is 5,800 hospitals or 500,000 beds. Sotera is currently targeting the 7% of U.S. hospitals that are considered early technology adopters. By 2018, Sotera intends to have a 20% share of U.S. hospitals.

Jim Datin, head of Safeguard deal team, has joined Sotera Wireless’ board of directors. Safeguard deployed 1.3 million of capital into Sotera Wireless in February of 2013 plus paid 1.2 million for additional shares acquired from a previous investor, and as a result we hold an 8% primary ownership position.

Nearly every Safeguard partner company recorded meaningful progress during the quarter, but I’ll stop now and turn the call over to Jeff for an update on Safeguard’s financial strategies and performance. Jeff?

Jeffrey McGroarty

Thanks Steve. Let’s lead off with a review of key financial metrics for the quarter ended March 31, 2013. At period end, we had 185.6 million in cash, cash equivalents and marketable securities. This amount does not include 6.4 million of cash held in escrow. The total carrying value of outstanding debt was 49.2 million, resulting in net cash of 136.4 million.

During the quarter, primary uses of cash were 7.5 million in funding and acquisition of ownership interests in new partner companies, Pneuron and Sotera Wireless; follow-on deployments in two partner companies totaling 4.8 million; 2.1 million deployed into a Pen Mezzanine loan participation, and cash used in operations of 6.9 million. Our priorities for uses of cash remain unchanged: capital deployment into new partner companies, follow-on funding of current partner companies and Pen Mezzanine loan participations, our corporate expenses, and expansion of our platform.

We increased our roster of partner companies to include Pneuron and Sotera Wireless. As of March 31, 2013, the total cost of our 20 partner companies was 225.2 million. At that same date, our carrying value or net book value of those partner companies on our balance sheet was 148.5 million. Safeguard’s financial strength, flexibility and liquidity are evident from the company’s balance sheet at March 31.

With that, I’ll now turn the call back over to Steve to lead us through the Q&A segment of the call.

Stephen Zarrilli

Thanks Jeff. Now Operator, let’s open the phones for any questions.

Question and Answer Session

Operator

Yes sir. [Operator instructions]

The first question we have comes from Paul Knight with CLSA. Please go ahead.

Paul Knight – CLSA

Good morning. I was wondering if you’d just do a quick update on the top two, three high-traction companies.

Stephen Zarrilli

Sure. If you recall from some of the other material that we’ve shared in the past, we talk about companies that are in our what we call expansion stage, and those companies tend to be the ones that are growing probably at a rate that is not only consistent but at a rate which is producing profits. So just to remind everyone, those companies today are AHS, a revenue cycle management company for physician groups; Beyond.com, Bridgevine, and MediaMath. So they are the four that fall into that expansion stage category – again, greater than $20 million in revenue—I’m sorry, high traction stage, more than $20 million in revenue and producing profits.

Right behind them is what we call the expansion stage, which is that 5 to $20 million category, and in there you’d have companies like Crescendo, NovaSom, Putney and Spongecell all demonstrating revenue growth and a march towards profitability in their respective business models. And then from there, you go down the ladder to initial revenue stage companies, and we do expect that there will be movement amongst these categories as the year goes by, especially with some companies in the initial revenue categories moving into expansion and potentially even leapfrogging into high traction.

Paul Knight – CLSA

Steve, with the S&P up 10% this year and the biotech index up 25-plus, what’s your view, what’s your sense from bankers on what the IPO liquidity window looks like right now? Is it a lot better now than the autumn, or where are we, do you think, in the options available?

Stephen Zarrilli

I kind of look at the world through two different lenses. The first is what I’ll consider to be the M&A marketplace, and the second, which would be the IPO environment from a liquidity perspective. So as we’re putting money to work, we’re always trying to keep an eye on so what’s the external macroeconomic environment, not only today but what we do see it potentially morphing into in the near term, if you will, two to three years out.

The M&A market, we’re cautiously optimistic about. We believe that some of the companies that we’ve been talking to or that our partner companies have been talking to which may prove to be a potential strategic acquirer, if you will of these companies, that segment of the market we believe is strong, that there’s some real interest there. Now, those strategic acquirers, I think are going to be just as stringent as we are when we put capital to work, and they’re going to look for the proper opportunities to do that. But that’s our preferred method of exit; that’s where we spend a lot of time focused on understanding the dynamics of that marketplace as it relates to the various segments that we participate in.

We’re not necessarily seeing substantial signs of a robust IPO market. Very few of our companies are probably of the size right now that they could even legitimately pursue that as an opportunity, so really what we do is spend a lot of our time on the M&A market and we believe—we’re cautiously optimistic that 2013 is going to be a strong year for that activity.

Paul Knight – CLSA

Thank you, Steve.

Operator

Next we have Matt Dolan of Roth Capital Partners.

Chris Lewis – Roth Capital Partners

Hey guys, this is Chris on for Matt. Thanks for taking the questions. First on the goal of 25 partner companies by the end of this year – thanks for that update – if you do assume the two exits that you’ve talked about, that would imply about seven new partner companies for the remainder of the year. So could you just walk us through what gives you confidence that that number is achievable and how should we expect those deployments in the new partner companies to trend throughout the remainder of this year?

Stephen Zarrilli

So keep in mind we’ve still got eight months on the clock, if you will, so if I just did some simple math and looked at each quarter and hoped that I could get two done in each quarter, and maybe one of those quarters having three, that gets you to the seven; and obviously we’re spending some time with our partner companies also to get to those exits.

You know, just in the first quarter we looked at more than 250 opportunities. Today, we have 15 that are very high on our list that we’re doing deep diligence on to try to understand, one, are they companies that meet our criteria with regard to growth; and two, can we get in at the valuation that’s going to allow us to meet those financial return expectations that we have. So though some areas of the market have been less robust in having capital deployed, as we mentioned earlier in the call, and if you did some research online you’ll find that there are a number of statistics that show that there’s been this lull in the marketplace, the good news is we’re not seeing in our pipeline. But what we’re really trying to make sure of is that we’re being very diligent in how we’re going about evaluating these companies.

One of the things that you probably are getting a sense of is that the average dollar amounts that we’re deploying into these companies is generally more in the line of 5 to 15 million versus some number that’s greater than that. Now, we do that with an eye towards not only putting that initial capital to work, and then sometimes we’ll even tranche that against milestones to further de-risk the opportunity, but we are sitting there recognizing that we’re willing to put additional capital to work at some point in the future.

Another piece of color with regard to the pipeline – of those 15 that we have a focus on today, the healthcare companies that we’re focused on generally are in that 10 to $15 million range of capital required. If they are a little higher than that, it usually means that we’re going in with a couple of other capital providers to slice up the pie. And keep in mind, we’re still focused on getting 20% or greater of ownership.

In the technology pipeline that we’re looking at, actually those companies are generally in that 3 to $6 million range, so you can already see there’s a dichotomy between that which we’re seeing in the healthcare sectors that we focus on that which we’re seeing in the technology.

So we’ve got a number of different attributes that we’re working through; but again, if I go back to the simple math, two a quarter for each of the three quarters through the end of the year will get us another six. You add maybe one additional one in one of those quarters, you’re up to seven. You take the two exits that we’re hoping for, you’re down to 25. That’s the simple math. That’s what the team is focused on.

But I want to make sure that everyone understands – we’re not going to just push capital out for the sake of pushing capital out. It’s not right for our shareholders and it’s not right to have time and energy spent by this time to pursue bad deals. If you recall, our incentive compensation is highly tied to performance metrics that are directly aligned to the objectives of the shareholder, meaning much of our equity incentives don’t vest until we’ve produced rational, reasonable, consistent cash-on-cash returns, and the only way that I know how to do that is to make sure that what you ultimately initially put capital to work in can have a legitimate shot of producing the returns in that environment.

The other point I want to make is there is a number of different scenarios that we’ve worked through over the course of the last couple of months that may require some additional time to get through diligence, but we’re negotiating those valuations. We want to be rational at the valuation that we’re going to put capital to work in, and sometimes those discussions with that management team or those other investors takes a little bit more time than you might originally anticipate. So I would conclude on this particular point – we’re still very bullish. We still have the same goals and objectives set for the year. I’m not pulling back from them, and we’ll continue to keep you updated as to how we’re making progress against those.

Chris Lewis – Roth Capital Partners

Okay, thanks for the detail there. And then turning over to the exit side, would you expect those two exits to come from the high traction type companies, or can we expect an earlier stage company take-out?

Stephen Zarrilli

Generally speaking, Chris, the high traction stage companies are the ones that are probably most highly targeted at this point in time. Do you potentially have a bluebird opportunity where something that’s a little younger in its evolution being targeted for a take-out? Absolutely. And also keep in mind – when I talk about two exits, I’m talking about two exits that produce profits, not exits that would just return capital.

Operator

The next question we have comes from Bob Labick of CJS.

Bob Labick – CJS

Good morning. First I just wanted to extend my congratulations to Jeff on the well-deserved promotion.

Jeffrey McGroarty

Thank you, Bob.

Bob Labick – CJS

Absolutely. And then my question – obviously you’ve covered the exits and the deployments so far. Can you just give us an update on the co-participation fund? I know it’s a goal and it’s not a short thing or anything, but how has the progress gone on that? Where does that stand, and is it still a priority for this or next year?

Stephen Zarrilli

Well Bob, first, good morning and thanks for being here; but to immediately address your point with regard to the co-participation fund, it is still part of our strategy outline, but I want to make sure that everyone is clear that it is not required in order for us to get to some of our longer term goals that we’ve spelled out in the past.

Having said that, we continue to evaluate the opportunity to be successful with that co-participation fund activity. If you recall in a prior conversation that we may have had on a quarterly call, I think we’ve noted that we’ve been principally focused on trying to find pools of capital that we may be able to access in Europe, and that continues to be the focal point. We think that that potentially in the long term provides the right venue for us to spend our time and energy.

Having said that, Europe is not performing as strongly as those economies would like, and we’re getting a sense through our discussions with potential targets that liquidity is right now something that is very key and that alternative classes, like the one that we’re trying to offer, is not necessarily top of mind as they are trying to wrestle with other macroeconomic developments that they are faced with.

So we continue to prudently spend time, not spending exorbitant costs, if you will, to pursue these initiatives until we feel that there is a better framework and a better market and environment to engage in deeper dialogue. Jim and Brian Sisko were just over in Europe in the last 10 days to continue those conversations, and quite honestly what we’re hearing is the concept resonates with those that we talk with but they are not ready to pull the trigger at this point in time.

Bob Labick – CJS

Okay, terrific. Thank you.

Operator

The next question we have comes from Jim Macdonald with First Analysis. Please go ahead.

Jim Macdonald – First Analysis

Yeah, good morning guys. Most of my questions have been answered. I just wanted to confirm, though – you are reconfirming your goal of having two exits this year?

Stephen Zarrilli

I have not pulled back from that goal at all, Jim.

Jim Macdonald – First Analysis

Okay. And you put more money in Pixel, and it looks like they are planning a European launch first. Maybe you could talk a little bit more about the progress at PixelOptics and how much money you’re willing to put into that deal.

Stephen Zarrilli

So we are being very prudent in how we put any additional capital to work in Pixel. We are desiring to have alongside us for commercialization purposes other capital sources, and management and the board have been working to see if those other capital sources are available for longer term commercialization. Conversely, we also look at opportunities to see whether or not there is a strategic player in the marketplace that might find real value in owning this asset in whole or in part, so for us right now it’s a dual stage strategy.

We know that by the end of 2013, one of those two has to play out and we’ve been spending a lot of time with management and the other investors to make sure that the right level of resource is applied to those two paths, that capital is being used efficiently and effectively, and the reason why you’re seeing Europe for us right now in a modest roll-out is we have very specific ECPs that have been working with a number of—we’ve been working with them in order to address some real near-term opportunity to demonstrate that the supply chain works for the product in the marketplace, and it allows us to ensure that the technology for the generation 2 product is operating as originally planned.

Jim Macdonald – First Analysis

Great, thanks.

Operator

Next we have Greg Mason of KBW.

Greg Mason – KBW

Great, good morning gentlemen. Could you talk about the $6.9 million of cash used to fund operations? Are you still on your target for, I believe it was 15 to 16 million of annual cash usage for operations, and is that number kind of seasonally high or what should we be thinking about this quarter and the annual operating cash burn number?

Jeffrey McGroarty

Hey Greg, good question. Our first quarter is always higher than our other quarters. A large component of that 6.9, over half of it relates to the payment of our 2012 management incentive plan, so that is typical. We did not change our expectations for the remainder of the year. You could expect to see a more normal pace being in the low 3’s, so getting us somewhere in the 16 million range by the end of the year.

Greg Mason – KBW

Okay, great. And there was an article, I believe, in the Wall Street Journal yesterday or a couple days about Glaxo starting a big venture capital push. Does that change your opportunity set at all with another kind of big pharma player coming in to the venture capital market?

James Datin

Greg, it’s Jim. Good morning. So Glaxo today has a venture capital fund, SR1. We partner with them on deals; in fact, we’re a co-investor with them. Some of the transactions and valuations in the healthcare have become depressed because of the points that Steve made earlier about the capital and liquidity drying up. We view that as a positive. We had a meeting with the Glaxo team in the last month here and we see them as a co-investor, so from our perspective it’s a positive effort.

Greg Mason – KBW

Okay, great. And then did you have any companies that moved to different stages this quarter?

Jeffrey McGroarty

No, we did not have any that moved in the quarter, Greg, but we do have—as Steve had alluded to earlier, we would expect that over the next year we would see two out of the four expansion stage companies move into the high traction stage, and probably out of the seven or so initial revenue stage companies, we’ll see some movement out of that stage into expansion stage or possibly even high traction stage for one or two of those companies.

Greg Mason – KBW

Okay, great. And then one last one – the $4.8 million in follow-on capital deployment, I know three of that was Pixel. Could you tell us what other companies you made follow-on investments this quarter?

Jeffrey McGroarty

The remainder was in our company, Lumesis for about 1.8.

Greg Mason – KBW

Can you just talk about what the use of that capital is, and was that part of the original plan that you had for your investment in that company?

Jeffrey McGroarty

Yes. Part of our initial plan when we initially invested in Lumesis, we put 2.2 million in about a year and a half ago, which is a relatively small amount; but as we have done with a number of these smaller technology, early stage companies, we’ve deployed lower amounts of initial capital with plans to have follow-on funding within 18 to 24 months, that makes it more of a significant exposure for us to that company. So this was always part of the plan, and it’s for them to continue to fund their growth.

Greg Mason – KBW

Great, thank you guys.

Operator

Next we have Allen Zwickler of First Manhattan. Please go ahead.

Allen Zwickler – First Manhattan

Good morning. Is there a way that you could explain to me and some of the others how you measure investing in a new company, not a follow-on but a new company versus repurchasing your shares, which you’ve announced that you would do and have not done to date?

Stephen Zarrilli

So as we’ve said in the past and we’ll reiterate this morning, currently we believe that we can provide our shareholders with a greater return by putting capital to work in the core operating business model of the company than purchasing back shares of stock at this point in time. Until we find that that equation would suggest something different, that will be how we continue to operate.

Allen Zwickler – First Manhattan

Let me try one more time.

Stephen Zarrilli

Sure.

Allen Zwickler – First Manhattan

The best investment you could make is in yourself – wouldn’t you agree? – rather than buying something that may or may not work out in the long run. And you have many, many investments currently in your portfolio, so what you’re implying with that statement is that you are saying that you have a better shot at investing in something which may or may not work out, than investing in yourself. Could you respond to that? I’m not trying to be provocative; I’m just trying to understand the logic because it doesn’t make sense to me.

Stephen Zarrilli

So I’m going to reiterate – our focus is on the core. We believe that the core, when we’re properly deploying capital into the opportunities that we’re seeing in the market, should provide the appropriate return that our shareholders are anticipating, and thus that’s the proper use of our cash at this point in time.

Operator

It appears that we have no further questions at this time. We’ll go ahead and conclude our question and answer session. I would now like to turn the conference back over to management for any closing remarks. Gentlemen?

Stephen Zarrilli

I just wanted to thank everyone here for joining us today, and we’ll keep you apprised of our progress as we move forward. Thank you.

Operator

And we thank you, sir, and to the rest of management for your time. The conference call has now concluded. We thank you all for attending today’s presentation. At this time, you may disconnect your lines. Thank you and take care everyone.

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