Surmodics: Convergence of Devices and Drugs

In late August, I wrote about three stocks that I thought might do well in a decelerating economic environment: Advisory Board (ABCO), Astec Industries (ASTE) and Surmodics (SRDX). I ended up adding all of them to my watchlist. While I had hoped SRDX might dip as low as 44, it retreated only to 45, and I ended up recently establishing a “starter” position. As an aside, I had hoped to pick up ASTE as low as 43-45, which I did after its recent earnings report. I ended up having a conversation with the CFO of ABCO and really liked what I heard. I am waiting for them to report and will make a decision, though the price has increased a bit.

As far as SRDX (52.85, $950mm market cap), which has moved up over the past several weeks back towards its six-year high of 53 and change, my further investigation led me to have more confidence in the longer-term prospects. In my prior article, I had mentioned that I would be happy to send an informational report to anyone who requested, and I received several requests, some of which were from investors who had followed the company for quite some time. I am grateful to those who shared with me their perspectives.

I would characterize SRDX as a misunderstood company, and perhaps management is to blame to some degree. Even I was guilty before a closer investigation of thinking of the company as a “one-hit wonder”. As you can see in the chart below, the stock was a former rocket, riding on the promise of coated stents. Their delivery technology enabled Johnson & Johnson (JNJ) to coat the first next-generation stents on the market (Cypher) with sirolimus. The problem has been that the company hasn’t had any major hits after Cypher. Of course, the market there has gotten risky for the company as well due to safety concerns that some fear could result in the removal from the market. So, many investors look at SRDX and see a big risk and a lack of sales or earnings growth in recent years (3-yr annualized sales growth of 12% and EPS growth of 10%) and probably fail to see what is going on behind the scenes. I say behind the scenes, because the company is rather quiet about discussing future opportunities. When I attributed some of the misunderstanding to management’s failure to hype, I certainly don’t mean to criticize. There is large inside ownership (17%), and they don’t sell, so there isn’t too much need to pump and simultaneously divulge sensitive information.

The cat did come out of the bag a bit in late June, which resulted in a huge spike: A very large deal with Merck that would allow the company to use SRDX technology (I-vation) to combat eye diseases such as glaucoma. The deal was large ($20mm up-front, royalties and $288mm potential milestones) and non-exclusive. This transaction could potentially transform the company, but it appears that not too many folks have picked up on this since the initial run-up. The stock is covered by just 5 analysts, so perhaps the lack of awareness isn’t too surprising. The company acquired 35mm in stock in the first half of the year, following up on its announcement in September, 2006. Nice job! Average cost: under 35.

As far as what they do and what some of the other things are or might be, the company is organized into three divisions. The one with the stent revenue, Drug Delivery, was formerly the largest and in decline (32% of sales, down 33% in Q3 of the September fiscal year), while Surface Modification (39%) grew 25% and In Vitro (29%) grew 28%. That works out to a 2% decline in overall sales, fairly consistent with the rest of the fiscal year. Sales in Q4, which will be announced in November, are actually expected to rise 11% and accelerate further in the coming fiscal year. While this theoretically is “in the stock”, many investors like to see positive growth, which SRDX has been lacking. EPS too are projected to rise 22% next year.

The Drug Delivery segment counts the following leading companies as customers: JNJ, Abbot Labs (ABT), Medtronic (MDT), Boston Scientific (BSX) and its subsidiary Rubicon Medical, St. Jude Medical (STJ), and FoxHollow Technologies (recently acquired by EV3 (EVVV)). Additionally, they include CardioMind, X-Cell Medical and Novocell. Novocell, a stem-cell based company in San Diego, has a P1/2 clinical development effort for an insulin delivery system to treat Diabetes. Becton-Dickinson (BDX), the huge diabetes-focused company, is a partner as well. The technology allows companies to control the rate of drug delivery and to deliver multiple compounds, ranging from small molecules to large proteins. You can learn more about I-vation by visiting their white paper, but, suffice it to say, they are going after large, poorly treated diseases. (Cardiovascular, Ophthalmology, Orthopedics, Diabetes, Oncology, CNS and Pain). The Surface Modification segment caters to catheter-based treatments employing their Harmony Advanced Lubricity Coatings. This segment also deals with organ replacement (Cardiovascular, Ophthalmology, Orthopedics and Diabetes). The In Vitro segment uses technology for GE (Genomic slides), Corning (GLW) and for ABT, and the segment has recurring revenue through the use of reagents. (In Vitro Diagnostics, Cell Culture and Genomics). You can view a recent investor presentation to learn more.

So, I imagine a lot of people look and see a stock trading at 33X 2008 estimates with their largest segment in decline and at risk of regulatory intervention. Big mistake, because they miss a lot. The company has a very strong balance sheet - $94mm in cash with $20mm more coming from MRK and no debt. Plus, they have made two large acquisitions this year (Brookwood for Drug Delivery and BioFX for In Vitro), paying $51mm in cash to expand technology and customer reach. While many companies with cash cows might let a lot drop to the bottom-line, not SRDX. They spent 29% on R&D last year and are on track to spend about 33% this year. That is called making a major investment in the future!

The company has lots of shots on goal. The convergence of drug delivery and drugs is an important patent extension strategy for Big Pharma. Perhaps more importantly, it is good for the patient. Delivering the drug locally can save a ton of time. The MRK deal is a huge validation of their technology for back-of-the-eye treatment. If successful in treating AMD, the patient would avoid multiple injections in the eye of Lucentis or Macugen. The Novocell device, if successful, would reduce the hassle and increase compliance in treating diabetes. The Drug Eluting Stent market is tremendous, and the company has a significant number of partners in that area. Orthopedics will increasingly use integrated drugs for quicker healing and decreased infection. Look for the company to make its first named partner announcement soon, perhaps next month. In oncology, the ability to deliver toxic drugs locally and to avoid systemic delivery will reduce the side effects and perhaps improve efficacy as well. The company has a large patent portfolio, world-class partners, strong financial capability and many diverse opportunities. Technically, the stock has built a nice base since announcing the MRK deal and should pull out of the consolidation, perhaps as soon as after the year-end conference call next month. In fact, a few more points higher, and the stock will make an all-time high and catch a lot of attention after a 6+ year consolidation. The company will celebrate its 10^th year being publicly-traded next year. Thus far, investors have been handsomely rewarded. I sure wish that I had become better aware of the company prior to the MRK deal’s announcement, but, giving thought to the next 10 years, I am happy to have discovered it now. It’s much more than a one-trick pony in an over-hyped field, and I expect that the acceleration in sales and earnings due to the growth in non-Cypher is going to encourage other investors to get to know the story better. Count me in!

Disclosure: Long SRDX and ASTE