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Executives

Phil Ankeny – SVP & CFO

Gary Maharaj – President & CEO

Analysts

Ross Taylor – CL King & Associates

SurModics Inc. (SRDX) F3Q2011 Earnings Call August 3, 2011 5:00 PM ET

Operator

Good day ladies and gentlemen, welcome to the SurModics Third Quarter 2011 Earnings Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator instructions) This conference is being recorded today, Wednesday, the 3rd of August, 2011.

I would now like to turn the conference over to Phil Ankeny, Senior Vice President and Chief Financial Officer. Please go ahead.

Phil Ankeny

Thank you, Luke. Good afternoon and welcome to SurModics fiscal third quarter 2011 conference call. Thank you all for joining us today. Also with me on the call is Gary Maharaj, our Chief Executive Officer. Let me first apologize for the technical difficulties before we were able to commence our call today.

Our press release reporting quarterly results was issued earlier this afternoon and is available on our Web site 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 Web site, 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 2010 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.

I will begin with some highlights of our financials. For the third quarter of fiscal 2011, we reported revenue of $18 million, up 3% on a sequential basis. On a GAAP basis, diluted earnings per share was $0.22. On a non-GAAP basis assuming a normalized effective tax rate of 38%, diluted earnings per share was $0.13, and cash flow from operations was $3.8 million. Please refer to the supplemental tables in our earnings release for an explanation of our non-GAAP accounting.

Let me now provide an overview of our third-quarter results by revenue line. Royalties and license fees for the third quarter were $7.5 million, down 2% on a sequential basis.

Johnson & Johnson reported its sales of the Cypher sirolimus-eluting coronary stent were approximately $64 million in the quarter, a decrease of approximately 61% year-over-year. These sales results implied and earned royalty that is below the quarterly minimum royalty specified in our license agreement with Cordis. As a result, SurModics will receive a minimum royalty of $1 million for the quarter.

Compared with the second quarter our royalty for J&J drug delivery license was down 13% sequentially. In addition in mid-June, J&J announced that Cordis made the decision to cease production of its Cypher and Cypher Select Plus sirolimus-eluting coronary stents by the end of the calendar year. While we were disappointed by this decision we had already anticipated the eventual sunset of royalties from Cypher in our strategic and operating plans.

Importantly, J&J’s decision reinforces and validates our long-term strategy plan of focusing on our core hydrophilic technology and In Vitro Diagnostics businesses. Going forward, we expect our fiscal fourth quarter will include the $1 million minimum royalty. Beyond Q4, we expect royalties to be based on a percentage of Cypher sales, if any.

Product sales in the third quarter of 2011 were $5.8 million, up modestly on a sequential basis, but posting another all-time high for the company.

Lastly, R&D revenue in the third quarter was $4.6 million, up 15% sequentially, reflecting the strong performance of our Pharma business.

I will now shift gears and discuss results by business unit. Revenue in our Medical Device business was $9.6 million in the third quarter, down 4% sequentially.

The most significant drivers were the decrease in royalties from Cypher and lower reagent sales. However, in spite of this sequential decrease, the Medical Device business continues to be a consistent cash flow generator and a source of stability with ample growth potential.

As you will recall, we began disclosing operating profit by segment last quarter, which you will find as an additional table in today’s press release.

As has historically been the case, Medical Device was our most profitable business during the third quarter, generating an operating profit of $4.5 million. Given our core capabilities and the strength of our pipeline in this segment, we are confident that this business will remain a strong performer for us going forward.

Now let’s turn to our In Vitro Diagnostics business. We are pleased with the results of IVD, which has also been a source of stability for SurModics. Revenue in IVD was $3.4 million in the quarter, up 3% sequentially. IVD also contributed nicely to the company’s profitability, generating an operating profit of $1.4 million for the quarter.

We are pleased with the performance of this business and are excited about last week’s launch of our new Assay Diluent product. This represents our first new product introduction in our core product offerings in years and the feedback from customers has been encouraging.

Lastly, our Pharmaceuticals business generated revenue of $5 million in the third quarter, up 19% sequentially. This strong performance was primarily a result of an uptick in activity in our various customer R&D programs, both existing programs and new ones.

The Pharma business generated an operating loss for the quarter of $0.8 million, which is an improvement sequentially compared with an operating loss of $2.3 million in the second quarter.

Turning now to operating expenses, total R&D expenses decreased 5% sequentially, as we continue to explore opportunities to be more efficient in our operations. We held SG&A expenses relatively constant compared with the second quarter.

In the area of other income, our investment income benefited from some modest gains in our investment portfolio. On the bottom-line, third quarter diluted earnings per share was $0.22 on a GAAP basis. However, adjusting for a normalized tax rate of 38% non-GAAP EPS was $0.13 in the third quarter, up from $0.08 in the second quarter.

Our balance sheet and operating cash flow continued to be strong. Our cash and investments at the end of the third quarter totaled $63.2 million and we had zero debt.

Operating cash flow for the third quarter was $3.8 million. As a result of better-than-expected nine-month results and our expectations for the remainder of the year, we believe it is appropriate to update our full-year fiscal 2011 guidance. We are raising the low-end of our full-year expected revenue from $63 million to $65 million, and now expect our full-year revenue to be between $65 million and $68 million.

Non-GAAP diluted earnings per share is now expected to be in the range of $0.28 to $0.38 per share, up from our previous range of $0.13 to $0.26 per share.

Including event-specific charges such as restructuring charges and goodwill impairment charges, GAAP diluted EPS is now expected to be in the range of $0.03 to $0.13 compared to our previous range of a loss of $0.21 to a loss of $0.08 per share.

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

Gary Maharaj

Thank you, Phil. The past few months have been busy and quite productive for our company. As I outlined in our last call, we are focused on three main areas in 2011. First, achieve our financial plan for the fiscal year; second, complete the strategic alternatives review process for the Pharmaceuticals business; and third, develop a strategic plan to guide the company. I’m pleased to see that we are making great progress in each of these priorities.

Start with our financial plan, as Phil just discussed, our third quarter results put us in a good position to achieve our fiscal 2011 full-year targets. And we raised our full-year earnings guidance yet again. This has not happened then, it is a result of renewed focus and a passion to achieve results in each of our business units.

Second priority for the company is to reach a conclusion in the review of strategic alternatives for Pharmaceutical business. As we have said all along, we are committed to producing the best possible outcome for all of our stakeholders. We received significant interest from a number of parties and the process remains on track with our expectation. We expect to conclude this process by the end of calendar year 2011. I want to emphasize that this is a very active and high-priority process for us.

Finally, I want to take the remainder of the time to update you of the strategic planning process for the company. As you may recall, our strategy is based on the principle that sustained profitable growth requires a well-defined and strong core as a foundation of the business.

As a result, our approach is two-fold. First, we’ll define the core business for Medical Device and IVD business units, and then focus on strengthening the core to drive profitable growth over the near-term. Second, we will carefully assess the opportunities to expand from within this core to deliver further sustained profitable growth over the medium-term and long-term.

We began our strategic planning process by applying this approach to the Medical Device business. As you recall from the last quarter, we have defined the core for Medical Device as follows: Hydrophilic coatings of minimally invasive medical devices.

During the third quarter, we applied a similar approach to the IVD business and that define the core of this business as follows: Immunoassay reagents that improve the performance of diagnostic tests. These definitions are carefully chosen as they highlight our core strength and competitive advantages in each business. Importantly, these definitions also speak to the current cash flow engine of each business and our lowest risk opportunities for near-term profitable growth.

Since I’ve already discussed our Medical Device core business in previous calls, let me spend a little more time on the IVD business. Our immunoassay reagents that improve the performance of diagnostic test kits are based on four product platforms

First, dry the protein stabilization, StabilGuard and StabilCoat products. These formulations stabilize and retain the activity of a protein dried to a surface material.

Second, liquid protein stabilization. Our StabilZyme (inaudible) of products. These formulations stabilize and retain the activity of protein in a liquid medium.

Third, Colorimetric Substrates, our BioFX Colorimetric Substrates line. These formulations change color, signal the positive or negative reaction in a diagnostic test. In essence, these substrates indicate the presence or absence of the disease.

And fourth, the biomolecule attachment to surfaces, our CodeLink Microarray Slides line. These products immobilize specific biological entities to assist this material. Microarray Slides are typically used for DNA and protein analysis.

Our all IVD products offer some compelling customer benefits. Not only do they extend shelf life and reduce material costs, they can offer the clinical benefit of helping detect a disease even at low concentrations of the disease in a patient sample, which offers the potential of detecting disease earlier.

Looking at both our IVD and Medical Devices businesses, I’m pleased to the progress that we made during the quarter. Having defined the Cordis businesses in a crisp and clay manner, we are actually now actively implementing our strategic plan.

We’ve increased our focus in each business and are seeing positive early results. I have personally met with many of our key customers to understand the needs and how SurModics increase our competitiveness and our ability to partner with them. And I’m pleased to say that we continue to be well positioned as a valued partner to our customer base.

During the quarter we signed five-year licenses of Medical Devices customers including some in high growth strategic areas for SurModics.

So go to next strategy step, as you may recall, the second step is to carefully assess the opportunities require to expand the core and further deliver profitable growth over the medium-term and long-term.

As a technology base business, R&D is at the heart of value creation for SurModics. Accordingly, we continue to assess and reset the priorities in our R&D portfolio to ensure we optimize our investments and long-term returns. Our R&D portfolio now consists of three elements

Ideas, experiments and projects.

In order for an idea to evolve into a project for full funding internally, we put it through the crucible effects augmentation with a critical market technical, economic and intellectual property questions are answered. We commit to project funding only if these early answers are satisfactory. In the last three months, we’ve been busy completing the overhaul of our R&D portfolio in both the Medical Device and IVD businesses along these general lines.

Since future cash flow streams are based on the accuracy of our decisions in that portfolio, we are being very careful to invest appropriate diligence before scaling up any experiments into full-fledged projects. Each of these elements have in balance now for appropriate level of risk, return and timing.

Our project portfolio is currently focused on the Cordis business. In Medical Devices, we intend to build our leadership in hydrophilic coatings for minimally invasive system. In order to do this, we have invested substantially in developing the next generation of PhotoLink coatings that perform dramatically better, while maintaining the process efficiencies inherent to PhotoLink chemistry.

Our R&D scientists have recently had exciting breakthroughs in the development of this next-generation platform. So much so that we believe we can introduce this new technology platform to customers in fiscal 2012.

In our IVD business last week, we launched the SurModics Assay Diluent product at American Association for Clinical Chemistry in Atlanta, Georgia. This represents an exciting return for SurModics in developing and launching new products at IVD markets. We have several new pipeline projects underway, and it is our aim to launch these within the next year.

Let’s turn to the experiments portfolio. In that portfolio, we are investigating the application of current core technology platforms to adjacent markets. And, in fact, we have started several exciting new experiments in this portfolio. One example of an ongoing experiment, that is a high priority and which I can’t mention is a pre-clinical characterization of a new drug delivery platform for drug coated balloon products.

While still in its early stages, our R&D scientists have achieved some promising results, suggest the potential to dramatically improve the performance curve over existing drug coated balloons designed for the treatment of coronary and peripheral artery disease.

In summary, we have high expectations where we can take this business and feel confident we can execute in our strategic plan to get us there. We remain on track with our previous stated goals and are committed to taking the necessary steps to transform SurModics into a focused and efficient business capable of generating significant shareholder value through profitable growth.

Operator, at this point, please open the line for questions. Thank you.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Ross Taylor. Please go ahead.

Ross Taylor – CL King & Associates

Hi, I just have two or three questions; first one relates to the minimum royalty with the Cypher, and I just want to know why it’s going away after your fiscal Q4. Do you get anything, you want exchange for that, your goodwill on some other projects or something like that with J&J?

Gary Maharaj

Yes, Ross, this is Gary. What Cypher, they have informed us recently that they are going to wave the exclusivity provision within that license. And by waving exclusivity provision, it also as a result of waving of the minimum royalty requirement.

Ross Taylor – CL King & Associates

Okay, that makes sense. And second question is just to help me out with modeling a little bit, but the Pharma business I had been assuming was running at an annual operating loss rate of a little bit north of $10 million, and it sure looks like it come well down from that. Would you comment at all about kind of what you think the annual operating loss of that business might be on an annual basis now?

Phil Ankeny

Yes, we’ve been working hard with the team in Birmingham to look at opportunities for cost control and they’ve been very successful in identifying areas, particularly, as it relates to the cGMP facility for getting some efficiencies there. The real driver this quarter of the better operating profit was more on the revenue front, and they’ve had an exceptionally strong quarter in the business, they’ve really been clicking on also under this quarter, exactly how that pans out going forward depends on the pace of the customer programs and those are, as you know, Ross, challenging to predict with precision on a quarterly basis. So, I’d say based on the uptick in activity and some improvements on the cost side, yes, we think there is definitely an opportunity for that business to be less dilutive to the operating profit line than what we envision at the beginning of the year, however, it gets probably premature to predict an exact number there.

Ross Taylor – CL King & Associates

Okay, fair enough. And last question, the new PhotoLink Hydrophilic technology that you might be able to launch in fiscal year ’12, do you think you can get better pricing for that potentially? And would that be technology that really just used on your new products or put your existing products to be upgraded to that relatively simply?

Gary Maharaj

I’m convinced will be offering a better value because that the performance curve, our scientists have been able to break some of the trade-offs and still achieve a very low friction values. We thought we’re unachievable prior to this while maintaining the clean and easy process of PhotoLink. So, we’re not under point of the business model of that yet, but this will be a substantial value enhancement to the customers that choose this next generation.

Phil Ankeny

Yes, the other piece I’d offer there, Ross is what we’ve seen performance-wise clearly could for certain applications be market share movers for those who embrace the technology really and get into market in advance of competition, so we think it definitely can set a new bar here, and for those who are able to grasp the bull by the horns and get it across the regulatory goal line quickly and into their product line, could have nice impact for our customers, who see that vision for the right applications.

Ross Taylor – CL King & Associates

Okay. All right, that’s all, very helpful. Thank you.

Phil Ankeny

All right. Thanks, Ross.

Operator

Management, there are no further questions in the queue. Please proceed.

Gary Maharaj

I would like to thank everyone for listening in today, and we look forward to speaking with you again when we announce our fourth quarter and full year results this fall. Thank you.

Operator

Ladies and gentlemen, this concludes SurModics third quarter 2011 earnings conference call. You may now disconnect. Thank you for your participation.

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