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Executives

Philip Ankeny – Interim Chief Executive Officer, Senior Vice President, Chief Financial Officer and Senior Vice President

Analysts

Ross Taylor – CL King

Suraj Kalia – Rodman & Renshaw

Richard Rinkoff – Craig Hallum

SurModics, Inc., (SRDX) F3Q10 (Qtr End 06/30/2010) Earnings Call July 28, 2010 5:00 PM ET

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the SurModics F3Q 2010 earnings conference call. (Operator instructions.) This conference is being recorded today, Wednesday, July 28th, 2010. I would now like to turn the conference over to Phil Ankeny, Interim Chief Executive Officer, Senior Vice President and Chief Financial Officer. Please go ahead.

Philip Ankeny

Thank you, Brian. Good afternoon and welcome to SurModics F3Q 2010 conference call. We appreciate you joining us today. Our press release reporting quarterly results was issued earlier this afternoon and is available on our website at www.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 also be archived 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 2009 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 address the company’s quarterly financial results, then I will highlight quarterly achievements and finally open the call to your questions. I will begin by reviewing key Q3 financial results and then provide commentary around select highlights.

For the Q3 of fiscal 2010 revenue was $18.6 million, up 1.4% sequentially. Operating income was $2.2 million. We had a net loss of $0.9 million and diluted loss per share was $0.05. And cash flow from operations was $4.4 million.

Included within our Q3 GAAP results was a $2.6 million non-cash investment impairment charge in connection with our strategic investments, the majority of which related to our investment in an early-stage medical device company, which like many start-ups in recent times has been unable to secure sufficient financing. In addition, we had a $0.2 million non-cash asset impairment charge associated with fixed assets.

Excluding these asset and investment impairment charges, non-GAAP results for the Q3 were as follows: operating income was $2.4 million, net income was $1.8 million, and diluted earnings per share was $0.11. These figures showed improvement on a sequential basis as Q2 non-GAAP results were operating income of $2.4 million, net income of $1.7 million, and diluted earnings per share of $0.10.

Next, let’s turn to revenue line items. First, royalties and license fees for the Q3 were $9.3 million, up 20% sequentially. These results included approximately $1.25 million in license fees related to one of our medical device customers, which was one-time in nature. Encouragingly, within royalties and license fees we are continuing to see positive results from our portfolio of hydrophilic coating customers in the medical device space.

Total royalties from this profile grew nicely again this quarter, both on a year-over-year and sequential basis. These results reflect many years of work we have invested in cultivating such a strong business in medical device coatings.

We achieved favorable results in royalties and license fees this quarter despite the continued decline in CYPHER® royalties. Johnson & Johnson reported that sales of the CYPHER® Sirolimus-eluting Coronary Stent were approximately $167 million in the quarter, down 29% year-over-year and down 13% sequentially.

Now let’s turn our attention to product sales, which hit a new record in the Q3 at $5.8 million, up 9% sequentially. Particular areas of strength included in vitro diagnostic products and reagents. We continue to see broad based customer demand for our component in vitro diagnostic products, and strong sales of our reagents reflects growing usage of our coatings technologies.

In our third category of revenue, SurModics generated $3.5 million in R&D revenue in the Q3. While 34% lower sequentially this is not an unexpected result. Rather, it is a natural phenomenon in our R&D revenue line reflecting the normal ebbs and flows of activity in our various customer development programs. Importantly, looking at our portfolio of R&D programs we have not lost any significant customer programs and signed some exciting new projects during the Q3.

Turning to our revenue reporting by market, I will begin with Therapeutic. In total, Therapeutic revenue was $15.4 million, down 1% sequentially. Cardiovascular revenue for the Q3 was $11 million, up 19% sequentially. If you exclude the approximately $1.25 million license fees that were one-time in nature, Cardiovascular revenue was up 6% sequentially.

Moving on to Ophthalmology. Revenue here was $1.1 million for the quarter, down 68% sequentially. As the vast majority of revenue in Ophthalmology is R&D related, this quarter’s results reflect the ebbs and flows of activity in our R&D projects that I discussed earlier.

We continue to have Ophthalmology projects with three top-ten pharma customers including Genentech. Rounding out Therapeutic, other markets' revenue was $3.3 million, up 13% sequentially, driven principally by growth in R&D revenue from our SurModics Pharmaceuticals business in these Therapeutic areas.

In last quarter’s earnings call, we mentioned that since the beginning of calendar 2010 SurModics has signed nine new customer programs leveraging our SurModics pharma technologies, and these programs contributed to the Q3 performance in other markets.

Finally, I will review results from the diagnostic market. For the Q3 diagnostic revenue was $3.2 million, up 14% sequentially. As this business is principally comprised of product sales, the growth was driven by the strong performance in our various component diagnostic products that I discussed earlier.

As announced in our press release earlier this week we are pleased to introduce a new product in our StabilTM line of in vitro diagnostic reagents called StabilBlotTM Buffer. This new product reduces background and increases signal in western blot tests, an important technique for measuring proteins in research and amino diagnostic tests.

Now let’s turn to a review of operating expenses. Total operating expenses were impacted by the $2.8 million in asset and investment impairment charges I mentioned previously. Excluding the impairment charges, total operating expenses excluding product costs were $13.8 million in the quarter, up 3% sequentially. Expenses benefited modestly from the headcount reduction associated with the reorganization we announced in March. Going forward, however, this benefit will be counterbalanced by investments we are making to support our customers and our long-term growth objectives.

Customer R&D expense decreased slightly on a sequential basis, but you will notice that the margin on R&D revenue is negative this quarter, reflecting the significant sequential decrease in R&D revenue coupled with the fact that our costs are largely fixed over short intervals of time, since they’re principally comprised of personnel costs and expenses associated with our cGMP facility. Another factor contributing to the sequential increase in operating expenses was an increase in stock-based compensation, which was driven by some accounting true ups in the quarter.

Finally, let me turn to our balance sheet, which provides the company with notable strength and opportunity. SurModics cash and investments as of the end of the Q3 totaled $54.8 million, an increase of $3 million from the end of the Q2. Operating cash flow from the quarter was $4.4 million, compared with $7.9 million in the Q3 of fiscal 2009. For the first nine months of fiscal 2010 cash flow from operations was $16.7 million as the company continues to generate cash.

Next I will turn to a review of certain customers and operating highlights. The value of partnership with SurModics was enhanced in January when we opened up our new state of the art cGMP facility for manufacturing and development. The facility greatly expands our capability and flexibility to support our multiple customers and their varying needs. We are continuing to transition customer projects into the facility. In May, we received ISO certification for our facilities in Alabama, including the cGMP facility. Certification of our quality systems by an outside auditing body speaks to our ability to meet the needs of our customers.

As we disclosed in a press release earlier this month, SurModics has entered into an agreement with Clinuvel Pharmaceuticals of Melbourne, Australia, to license certain biodegradable polymer implant technologies for the treatment of sun-induced skin disorders. The agreement emerged following a multiple-year collaboration in which the companies had been developing a sustained release implant formulation for Clinuvel’s drug SCENESSE® or afamelanotide. The product is being developed as a prophylactic treatment for a range of UV- and light-related skin disorders. SurModics’ biodegradable polymer drug delivery technology enables the drug to be released in a sustained and tightly-controlled manner. The SCENESSE® implant stimulates the production of melanin in the patient’s skin to protect them from ultraviolet and light exposure.

Some investors have commented that it can be challenging to keep track of the many companies SurModics works with, given the numerous announcements we and our partners make. So at this point I will update you on some of our most promising revenue-generating opportunities which we expect to develop over time.

Our development program with Genentech is an important driver for our Ophthalmology business. We are collaborating with Genentech on the development of a sustained-release formulation of Lucentis®, Genentech’s drug for the treatment of neo-vascular age-related macular degeneration and macular edema following retinal vein occlusion. This product that we are developing with them uses our proprietary biodegradable microparticle technology. Since signing the agreement in October, the teams from SurModics and Genentech have worked well together, and the development program continues to progress.

It is also worth nothing that Genentech’s drug Lucentis® was recently approved for the treatment of macular edema following retinal vein occlusion, or RVO, in addition to the initial indication of neo-vascular age-related macular degeneration. RVO affects more than 1 million people in the United States and is the second most common cause of vision loss due to retinal vascular disease.

Additionally, we are making significant progress across our broader portfolio of customer projects in Ophthalmology. As we have mentioned before we are working with three top-ten pharma companies, including Genentech. We believe that our portfolio of customer projects in Ophthalmology will be a significant source of opportunity for years to come.

Beyond Ophthalmology, SurModics has several additional prominent revenue-generating opportunities in other parts of our business, including Cardiovascular. Although CYPHER® revenues continue to contract, the company’s overall Cardiovascular franchise remains an important source of opportunity. Our portfolio of licensed customer product opportunities both on the market and in our pipeline is substantial. We have previously announced licenses with Evelle (sp), which has a novel device for the minimally invasive repair of mitral valves in the heart, and which is now part of Abbot, as well as Invotec, which is now part of Medtronic.

Further, our license partner OrbusNeich continues to enroll patients in a clinical trial for their combo bio-engineered sirolimus-eluting stent. As a reminder, this stent combines OrbusNeich pro-healing technology used in their Genous® stent with a sirolimus drug-eluting coating for control of proliferation. The low dose sirolimus solution is accomplished using SurModics biosys biodegradable drug delivery system.

Our market-leading and highly regarded coating technologies and talented team have enabled SurModics to attract a board range of medical device customers who are developing exciting new products, including minimally invasive heart valves, stent graphs for peripheral applications, pro-healing stents, and drug-eluting balloons to name a few.

The final growth driver I will highlight today is SurModics Pharmaceuticals. We have converted four sustained drug delivery programs into licenses, including the Clinuvel agreement we recently announced. This success demonstrates our ability to license our proprietary drug delivery technologies to pharma and biotech customers.

Notably, Clinuvel’s SCENESSE® implant is currently in phase three clinical trials outside the United States, and phase two trials in the United States. This program represents the latest stage opportunity in the SurModics Pharmaceuticals pipeline. In terms of market size, independent estimates place SCENESSE®’s potential market for all UV-related disorders being investigated by Clinuvel in excess of 7 million patients worldwide.

An additional SurModics Pharmaceuticals customer in the CNS base, NuPathe has filed a registration statemtn for an initial public offering. We have been collaborating with NuPathe on the development and commercialization of a sustained-release formulation of NuPathe’s MP201 for the treatment of Parkinson ’s disease, a significant unmet clinical need and a large and growing market.

In another exciting area of drug delivery, SurModics recently executed a continuation of a feasibility collaboration with EGEN, focused on long-tem controlled release of siRNA complexes. In work presented earlier this year at the Boston TIDES 2010 meting, the companies disclosed more than 100 days of sustained release of siRNA nanocomplexes in vitro. Importantly the released siRNA nanocomplexes remained active as measured in a gene expression model. We are unaware of any groups showing activity in release for this duration.

Our product pipeline contains of a portfolio of opportunities providing potential for growth and diversification for years to come. Overall, SurModics has more than 100 licensed products generating royalties, and nearly 200 customers’ projects in our pipeline not yet on the market. As of June 30th we had a total of 111 licensed customers, several with multiple licenses, up from 105 a year ago. SurModics customers had 104 licensed product classes on the market generating royalty revenue, compared with 105 a year ago. The total number of licensed products not yet launched was 110, compared with 105 in the prior year period.

Major non-licensed opportunities stood at 72, compared with 87 a year ago. While this last figure is down year-over-year we believe the quality of projects has improved. In total, the company has 182 potential commercial products in development with customers behind each one of them, which we believe highlights the magnitude of opportunity in our pipeline.

Finally, we are making good progress on our fiscal 2010 non-financial goals. As in previous years, these objectives are designed to offer insight into how we manage our business and to provide a view of the company’s future opportunities. However, we don’t control the timing of most aspects related to our customer objectives. This year we articulated a goal of signing 18 new licenses with our customers. In the Q3 we signed five new licenses, bringing our year-to-date total to 16.

Second, among these 18 new licenses we expect to sign two new licenses relating to SurModics Pharmaceuticals drug delivery technology in addition to the agreement we already announced in early fiscal 2010 with Genentech. As I mentioned previously, the Clinuvel license satisfies one of these two SurModics Pharmaceuticals licenses.

Third, we expect that our customers will launch ten new product classes incorporating SurModics license technology. Launches are significant because they mark the point in our business model where the flow of royalties to SurModics begins. In the Q3 our customers launched two new products, bringing our year-to-date total to seven.

Fourth, we expected one of our customers to initiate a new human clinical trial for a product using SurModics drug delivery technology. This was achieved in the Q1 by our partner OrbusNeich, when they initiated a human clinical trial for their combo drug-eluting stent, which uses our symbiosis biodegradable polymer drug delivery system.

Finally, we expected to qualify and bring our new cGMP facility online during the fiscal year, to make it available to current and future customers. As we mentioned earlier in the year, construction is complete, the facility is open, and we successfully migrated our first revenue-generating customer programs into the facility during the Q2. We will give you our final report card of our results relative to these fiscal 2010 goals in our year-end earnings call.

Before concluding, I want to acknowledge the resignation of Bruce Barclay as President and Chief Executive Officer last month. During his six-and-a-half-year tenure, Bruce provided sound leadership and helped grow and diversify SurModics as well as expand its technology portfolio. We wish Bruce the very best.

The Board has engaged an executive search firm and will be thoughtful and deliberate in the selection process for a permanent CEO. While the search for a permanent CEO is ongoing, SurModics will be focused on executing against our operating and long-range strategic goals, and we are confident that our portfolio of compelling customer development programs combined with our strong base of technology and talented employees positions the company favorably for long-term success.

Operator, that concludes our prepared remarks. We’d now like to open the call to questions.

Question-and-Answer Session

Operator

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

Ross Taylor – CL King

Hi, I just have two or three questions. Most of these relate to the financials. But can you remind us why the R&D revenues that you get don’t match up real well with the R&D expenses related to your customers? And I guess what I’d look at is in the June quarter last year your R&D revenues were much higher than your R&D expenses related to customer programs, whereas in this quarter it was the reverse – the R&D revenue was less than the R&D revenue related to customer programs.

Philip Ankeny

Yeah, let me attempt to help you on that, Ross. It’s a complicated exercise because the way we mange the R&D organization is really as a consolidated entity. And so we don’t manage to a customer R&D expenses and an "other" R&D expense the way it shows up in the P&L. Our organization is quite flexible, where scientists and engineers an others are able to work on both customer programs as well as internal projects, and it really depends on their level of activity in any particular quarter, how individuals spend their time and how it might, how their time might get allocated. And then at the end of each quarter there’s an accounting exercise where an algorithm is applied to the total costs in R&D and allocation of overhead between the two lines of customer-funded R&D as well as the other R&D line.

So some of it is just an accounting algorithm but the biggest factor is really all about where the costs reside. And if you look at the combination of the two lines year-over-year you’ll notice that there’s an increase there of the sum of the two lines, mostly as a result of the facility coming online and being allocated. So that overhead of the facility is being allocated into these R&D lines whereas previously it has been in SG&A before the facility was on stream. So that explains a little bit of the numbers themselves, but you know, in general I wouldn’t read too much into the actual expenses relative to the revenue, the R&D revenue, because the costs are largely fixed.

Ross Taylor – CL King

Okay, that helps a lot. And I know you don’t want to forecast much or at all, but would you expect the R&D revenue’s going to head back up here in the September quarter? Or can you make any comments about that?

Philip Ankeny

You know, it’s always very challenging to know exactly how much work our customers are going to need from us in any given period, and they’re largely in control of those timelines and what they ask us to do. Based on what we see our customers doing now we think there’s strong potential that that could increase sequentially, but again, it really depends on how the programs unfold.

Ross Taylor – CL King

Okay. And the license fee of $1.25 million that yo mentioned, can you say whether that was related to a new agreement or whether it was related to accomplishing development milestones for an existing partner?

Philip Ankeny

Yeah, it was on an existing agreement.

Ross Taylor – CL King

Okay. And can you talk or do you have any color as to what category that might be in or what market?

Philip Ankeny

It’s a Cardiovascular customer.

Ross Taylor – CL King

Okay. And final questions, did you give out any numbers in terms of how the hydrophilic royalties performed in the quarter? I might have missed that.

Philip Ankeny

The only commentary I did include was that it did grow again, both year-over-year and sequentially.

Ross Taylor – CL King

Okay, that’s all my questions. Thank you.

Philip Ankeny

Okay. Thank you, Ross.

Operator

Thank you. Our next question comes from the line of Suraj Kalia with Rodman & Renshaw. Please go ahead.

Suraj Kalia – Rodman & Renshaw

Hey, Phil.

Philip Ankeny

Hello, Suraj.

Suraj Kalia – Rodman & Renshaw

Phil, forgive me if I missed it – the impairment loss in investments, did you mention what investments those were?

Philip Ankeny

No, we did not. We’re not at liberty to disclose which investment that was.

Suraj Kalia – Rodman & Renshaw

And Phil, the reason the impairment happened, is it the normal, conventional way impairment is recognized or was there some other mitigating factor that caused you all to recognize it now?

Philip Ankeny

No. It’s a normal accounting exercise of looking at the value of our holdings.

Suraj Kalia – Rodman & Renshaw

Okay, fair enough. And final question, Phil, Ophthalmology, if I can remember correctly you said revenues were $1.1 million, down 68% and you said it was in the normal R&D cycle. Given the number of customers if I remember there were close to ten at least that I remember Bruce had mentioned. Was there a change in the number of customers? Is it a change in the breadth of the products? What’s really changed this quarter?

Philip Ankeny

You know, really the only change is just the phase of programs that we’re in and it was not concentrated in any particular customer either. We’ve had multiple customers whose activity was considerably less in the quarter than it was in the Q2. So it’s just normal ebbs and flows and these things always happen.

Suraj Kalia – Rodman & Renshaw

Okay. Thanks again, Phil.

Philip Ankeny

Yep. Thank you, Suraj.

Operator

(Operator instructions). Our next question comes from the line of Richard Rinkoff with Craig Hallum. Please go ahead with your question.

Richard Rinkoff – Craig Hallum

Thank you. Phil, you guys seem to be stuck on the revenue line and you seem to be stuck at a very low EPS per quarter, like $0.10, $0.11 per quarter. How long are we going to stay there and should we just assume that 2011 is going to be whatever you just reported multiplied by four and then add a little bit more? How do we get material growth here?

Philip Ankeny

Yeah, that’s a fair question. We don’t provide guidance. I’d remind you and others that we’ve been fighting the continued decline in CYPHER® which has definitely continued, but because of the minimum royalties that are baked into that agreement it won’t hit zero. And the hydrophilic portfolio continues to grow which we think is a wonderful trend. So the royalties and license fees were actually, even if you back out the one-time items were a healthy number this quarter. And really the weakness was just in the R&D revenue. So a lot of it is just timing of the activities we’re doing and admittedly R&D was a weak number this quarter. And so you know, we align our expenses the best we can but we need to be able to support the customers as their programs kick into higher gear, and so we don’t eliminate expenses quarter-to-quarter when activity lets up a little bit.

Richard Rinkoff – Craig Hallum

You said in the prepared comments R&D was down 34% sequentially and it was not unexpected. At what point was it not unexpected, and if you knew at the beginning of the quarter why didn’t you suggest that? And why can’t you give guidance for this quarter since you seem to know the direction of these things?

Philip Ankeny

Well, I guess the characterization is unexpected. It was not a guidance concept; it was more a phenomenon concept, more that the fact that it went down is not an unexpected thing because over time it, our revenue, R&D revenue does fluctuate considerably on a quarter-to-quarter basis. So that was more what we intended to say with that word “unexpected.”

Richard Rinkoff – Craig Hallum

Mm-hmm. And when you get a quarter with very low R&D revenue can you ever recover that? Or is there a maximum capacity R&D revenue you could ever book?

Philip Ankeny

There’s a capacity to it because there’s really, it’s function of how many people we have that might be able to work on behalf of a customer program.

Richard Rinkoff – Craig Hallum

And what might that number be?

Philip Ankeny

You know, I mean we’ve had R&D revenue quarters in the past that have been quite a bit larger, so our capacity is definitely higher than where we are now unquestionably. I mean we’ve had quarters that have been almost double where we are today.

Richard Rinkoff – Craig Hallum

Would that represent maximum capacity then? $6 million, $7 million?

Philip Ankeny

I don’t know that that’s maximum but it’s you know, it’s in that neighborhood definitely.

Richard Rinkoff – Craig Hallum

And the line fizzed down a little bit at the beginning of the call. Did you say that one-time license fee was $1.25 million or did I hear it wrong?

Philip Ankeny

Correct.

Richard Rinkoff – Craig Hallum

$1.25 million. Okay, thank you.

Philip Ankeny

Alright. Thanks, Rick.

Operator

At this time I am showing no further questions. Please go ahead with any closing remarks.

Philip Ankeny

Thank you, Brian. I want to thank everybody again today for participating in this quarter’s conference call, and I’ll look forward to speaking with you on our Q4 and full-year conference call later this fall.

Operator

Ladies and gentlemen, this concludes the SurModics F3Q 2010 earnings conference call. You may now disconnect.

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