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Safeguard Scientifics Inc. (NYSE:SFE)

Q1 2012 Earnings Call

April 26, 2012 09:00 AM ET

Executives

John Shave – VP, Corporate Communications

Peter Boni – President and CEO

Steve Zarrilli – SVP and CFO

Analysts

Greg Mason – Stifel Nicolaus

Matt Dallman – Roth Capital Partners

Paul Knight – CLSA

Nick Halen – Sidoti & Co.

Operator

Good morning ladies and gentlemen and welcome to the Safeguard Scientifics First Quarter 2012 Results conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will follow at that time. (Operator Instructions). As a reminder, this conference call is being recorded.

I would like to introduce your host for today's conference, Mr. John Shave, Vice President of Business Development and Corporate Communications. Sir, you may begin.

John Shave

Good morning and thank you for joining us for Safeguard Scientifics’ first quarter 2012 Conference Call and Update. Joining me on today’s call are Peter Boni, Safeguard’s President and Chief Executive Officer and Steve Zarrilli, Senior Vice President and Chief Financial Officer. During today’s call Peter will review first quarter 2012 highlights as well as other developments, then Steve will discuss Safeguard’s financial results and strategies. After that, we will open the lines for your questions.

Before we begin, 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 life sciences and technology markets and other uncertainties that are described in our SEC filings.

During the course of today’s call, words such as accept, 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 our 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 is Safeguard’s President and Chief Executive Officer, Peter Boni.

Peter Boni

Thanks John and thank you all for joining us today for an update on Safeguard Scientific's and our partner companies. Results for the first quarter ending March 31st were distributed earlier today. Now as a whole we are especially encouraged by the steady growth and development of our 16 partner companies during the quarter. In the face of some macroeconomic headwinds and wobbly capital markets Safeguard's performance validates our strategic focus on growth stage, life science and technology businesses.

Today's prepared remarks will be brief since not much time has passed since our 2011 year end update that was late in February. Nevertheless there is solid progress to discuss. During the quarter we had two new technology partner companies and deployed follow on financing for a few of our current partner companies. Four of Safeguard's 16 partner companies have achieved sustained, positive EBITDA status. Moreover our platform expansion initiative is gaining traction. Safeguard's partnership with Penn Mezzanine is generating interest income and planning is under for a continued evolution of that vehicle as a long term activity for us.

In short our team is executing a focused and disciplined strategy that enhances Safeguard's brand as the preferred catalyst to build great companies, alternatively boosting the company's financial strength and flexibility and driving value for our shareholders.

Safeguard's continued progress underscores that substance that trumps even the macroeconomic environment where global capital markets are volatile and domestic economy remains fragile and politically charged. Now year-to-date M&A and IPO activity remains curiously subdued despite current low interest rates in corporations large cash balances, as surveyed by investment bank Think Equity concluded that the technology IPO window may be reopening. Recent pricing may signal an upturn in demand for tech offerings. Through March 13 tech IPOs raised and aggregate $1.8 billion with 22 deals in the wings targeting an additional $7 billion in capital and the passing of the Jobs act may only add to this upturn. Now we'll keep an eye on all of these macro-economic trends and then the potential trickledown effect for our partner companies.

In the meantime Safeguard's disciplined and focused are unwavering, were augmenting companies for expansion and growth and ultimately an exit transaction remains our path to continued financial strength and flexibility as well as improved shareholder value.

Now for those of you who are new to the Safeguard story I'll review the hallmarks of our strategy which are built on three pillars, focus, discipline and execution. Focus is the first pillar of Safeguard's strategic foundation. We deploy capital to high potential businesses in specific segments of life sciences and technology industries that exploit five strategic growth driving themes, maturity, migration, convergence, compliance and cost containment.

In Life Sciences we target opportunities in the areas of lower relative technological and regulatory risk not in new therapeutics but rather in molecular and point of care diagnostics, medical devices, specialty pharmaceuticals and some selected healthcare services.

In technology we pursue transaction enabling applications with a recurring revenue business model. In internet new media financial technology, Healthcare IT and other selected business services. Safeguard's discipline compliments our focus. We will not deploy capital or pursue exits simple for activities sake. Now if an opportunity clears our strategic growth and return hurdles, we respond appropriately. Our deal team evaluates more than 1000 proposals each year. We typically deploy up to $25 million in growth capital per company and then time our exits from ownership positions in these companies to achieve an aggregate targeted risk adjusted return on capital of two to five times over three to five years.

For all non-legacy capital deployments since January of 2006 had been realized or written off, Safeguard has thus far realized gross aggregate cash on cash returns of two times. Exit opportunities may arise at any time and in different forms including privately negotiated sales of Stockner assets, public offerings now indicates that the publicly traded partner company's exits can involve the sale of stock on the open market. Execution is how focus and discipline are tested and it's also how Safeguard has distinguished itself.

Focus, discipline and execution have served Safeguard and its shareholders well by any measure, the company is fundamentally stronger today and better positioned for continued growth in value creation, this year and we believe beyond.

Now let's review some recent developments to illustrate how we are expanding Safeguard's business model. Safeguard's partnership with Penn Mezzanine formed last year represents our first initiative to augment our capabilities as a growth capital provider and participate in the management of external sources of capital. This platform expansion initiative is producing current interest in loan fee income and we expect it to produce management fee income as well as profit participation as this initiative growth and then matures.

Managed by a team of experienced mezzanine lenders this platform enables Safeguard to provide flexible financing strategies to our current and prospective partner companies as well as other potential lower middle market borrowers to build value in their businesses and ultimately realize that value through a well-timed exit.

Penn Mezzanine closed its first fund at 2011 after raising more than $64 million. That was including $30 million of capital from Safeguard. As of March 31st this year Penn Mezzanine has deployed an aggregate of 26.4 million in seven companies, yielding 12.8%.

Safeguard has deployed $3.9 million in Penn Mezzanine in August 2011 and has a 36% ownership position. In addition as of March 31st, Safeguard has deployed $12.2 million in connection with Penn Mezzanine's lending activities of which $9.8 million remains outstanding at this date.

Now in the interest of time I will stop and turn the call over to our Chief Financial Officer, Steve Zarrilli for an update on our financial strategies and our performance. Go ahead Steve.

Steve Zarrilli

Thanks Peter. Good morning. At March 31st Safeguard's interest in its 16 partner companies represented an aggregate of 174.5 million in capital deployed. As of the same date, our cash, cash equivalents and marketable securities totaled $234.4 million.

Net cash equaled $188.5 million after subtracting the total carrying value of debt outstanding of $45.9 million. Over the past five years, the Safeguard team has delivered meaningful and measurable results for shareholders. Despite unprecedented volatility in capital markets we remain focused on building value in partner companies realizing that value and then communicating our progress concisely, consistently and credibly.

Disciplined focus on enhancing Safeguard's financial strength and flexibility also has positioned the company for continued success. We repaid and restructured corporate debt, continued to control our holding company expenses and have developed alternative sources of capital and income.

Today Safeguard is stronger, leaner and better positioned to execute our game plans than in any other time over the past 10 years. This team's focus on value creation is keen and we remain optimistic about perspective opportunities.

Further our interests are closely aligned with Safeguard shareholders by virtue of our long term compensation incentives. Our management team remains focused on building and realizing value for shareholders.

So let's move on to our key financial metrics for the quarter. At period end we had $234.4 million in cash, cash equivalents and marketable securities. This amount does not include an aggregate $16.4 million of restricted cash and cash held in escrow. The total carrying value of outstanding debt was $45.9 million, resulting in net cash of $188.5 million.

During the quarter primary uses of cash were cash operating expenses of $6.7 million or $0.32 per share versus $0.35 per share in the same period of 2011. During the first quarter of 2012 Safeguard deployed $12.2 million into new partner companies Lumesis and Spongecell, $2.5 million into Penn Mezzanine loan participations and follow on deployments of $37 million in Good Start Genetics and $800,000 in Alverix.

In 2012 we project uses of cash between $100 and $150 million in the areas of capital deployment into new partner companies, follow on funding for current partner companies and Penn Mezzanine participations, corporate expenses and the expansion of our platform.

During the first quarter we received $300,000 in cash interest and fees related to our Penn Mezzanine participation. We expect to receive an aggregate of between $1.4 million and $1.6 million in interest and fees in 2012 from such participations. This cash return directly offsets our cash expenses. We also received $2.4 million in the first quarter from the repayment of the loan participation with respect to Penn Mezzanine.

Safeguard's partner companies remain well positioned for continued revenue traction and value creation. For 2012 Safeguard projects aggregate partner company revenue in a range of $160 million to $16 million. Results for Safeguard partner companies are reported on a lone quarter lag basis. For Q1 aggregate revenue of our partnered companies grew 26% in line with our guidance. Our partnered companies continue to executive aggressively, are using their cash to grow and in some cases generating cash and making strategic and opportunistic acquisitions.

We work with the management teams of each partner company to evaluate levels of existing and required capital, strength of personnel resources and unique opportunities for growth. Our focus on these ongoing processors allows Safeguard to assist partnered company management teams in unique ways to drive value creation and maturity.

Now with that I'll turn it back over to Peter to lead us through the Q&A session of the call.

Peter Boni

Thanks Steve. Chuck. Let's open the phone lines for any questions there might be.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from Greg Mason with Stifel Nicolaus. Go ahead. Your line is open.

Greg Mason – Stifel Nicolaus

Peter, could you talk about Avid a little bit. You received your first payout as an earn-out from the sale of Avid to Eli Lilly. What are the kind of milestones or how is it measured to get potential future payouts and what should we think about potential future payouts from Avid.

Peter Boni

I'm going to ask Steve to comment on that.

Steve Zarrilli

So we as you noted just received our first milestone payment in April as we disclosed. The clock is now ticking on a three year period for commercialization activities by Lilly and throughout that period as they hit certain milestones as defined in the original agreement we will potentially have the opportunity for enhanced earnings from that transaction in the form of earn out payments.

As we get more clarity we will begin to share with the street what we think those numbers might look like but we're going to be having to pull information from Lilly on somewhat of a regular basis as they begin this process. So more to come. We don’t have much visibility at this moment in time. We're only about two weeks away from when FDA approval was provided. To quantify that drag we could get up to $54 million based upon the primarily the revenue and commercial milestones over the next couple of years.

Greg Mason – Stifel Nicolaus

Okay, great. And then could you talk about how the PixelOptics roll out is going? I know you start with a few states in the southeast. What does demand look like? What challenges are you facing? How is the prospects for Pixel looking with this rollout?

Peter Boni

Greg, Steve sits on the Pixel board so once again I'm going to ask him to make commentary.

Steve Zarrilli

So Greg, we are somewhere between 6 and 12 months behind schedule as it relates to the roll out. Now having said that we are in the market. We are producing glasses and we are selling them to consumers and principally in the southeast, as you know, we've recently brought on a new CEO, by the name of Brett Craig and Brett has a lot of experience including being part of the management team that took transitions optical from about $100 million in revenue to $1 billion in revenue. So Brett has kind of reset the table, has been doing some things operationally to enhance the supply chain processes, principally related to one of our largest suppliers, Panasonic. Those efforts have actually begun to bear fruit in that we're going to see lower cost, higher gross margins but it also delayed some of our activity in a more aggressive roll out of Pixel through the Eyecare Professional Network that we've established.

We have over 2,000 Eyecare Professional Organizations targeted. We have rolled out kiosks if you will that have the ability to demonstrate the technology as well as having the complete section of frames to well over 500 of these ECPs. We are working through a very targeted program with 60 of them to ensure not only that sales are occurring but that any kinks in the process in getting lenders to the optician to the lab for grinding and position and back to the consumer that they worked out in a way that will ultimately provide the acceleration path that we're planning for as we get into the second half of the year.

So a little bit of two steps forward, one step back, but management is managing through it very efficiently. We did provide some additional capital in the form of a (inaudible). We will probably provide some additional capital as we get into the summer. All of the existing investors are very much engaged and we expect that to continue as we pursue this rollout.

Greg Mason – Stifel Nicolaus

What are you seeing on the demand side from the consumer? Is there any balk at the price or what's the consumer demand look like behind the supply chain?

Steve Zarrilli

Yes, the marketing has stirred consumer demand. So there is a lot of pent up demand if you will. There are people who are literally looking for this product to arrive to their market. We haven't seen any real pushback on price. Our revenue assumptions are actually fairly conservative in that we are looking for a certain number of pairs of glasses to be sold by each ECP and early indications suggest that that's actually going to ahead of original projection.

So demand is there. It's just a matter of making sure that when we get the product into the hands of the consumer that they're actually getting the product that they have come to expect and we're wanting to make sure that those quality measures are really nailed very substantially. There were a few hiccups in the beginning that we've been able to correct very quickly but you really do want to minimize those types of things, especially with a high profile consumer product like Pixel Optics is producing.

Peter Boni

Anecdotally Greg this comes with a $1,200 suggested retail price. There is no evident of balk on that and actually one eye care professional told us that he thought that he was getting $1,400 as opposed to $1,200 and had no balk at that. So he's been selling his for above the suggested retail price.

Operator

Thank you. Our next question comes from Matt Dallman with Roth Capital Partners.

Matt Dallman – Roth Capital Partners

First question on deployment. I know you said the funnel is as full as it's ever been but it looks like deployments are about a third of the way through the year here, are below that type of run rate in terms of your guidance of $100 to $150 and I did hear you say that you won't deploy capital for the sake of activity. So should we anticipate deployments to be closer to the low end or should we look for a big wave of deployments here going into the summer months, maybe can you just help frame that number to what we've seen so far.

Peter Boni

Now we're at the term sheet stage of the number of things we've guidance and we've reaffirmed that guidance and we believe we'll achieve within that range but it's hard to be predictive but we are giving you a good range.

Steve Zarrilli

Yes, and there's two thirds of the time left on the clock here Matt. I wouldn’t get too predictive at this point in time as to suggesting that we're at the lower end of that range. We are being disciplined though. The valuation marketplace is kind of squirrelly right now and you know from having kind of followed us now for a bit of time, we actually win bigger when we can actually manage the dollar amount that, or the valuation that we go in at. So we're being extraordinarily disciplined in having very substantial conversations around valuation and valuation expectations. We're also trying to make sure that for a couple of the ones that we have in our queue, that we've got the right partners joining us in those opportunities, especially for some of the life science opportunities, having the right partner is extraordinarily beneficial to us because it gives us the confidence to move forward that if in the event a hiccup occurs, we've got some others that can stand tall with us and actually that played out with Pixel in a very nice way. So those types of things are sometimes not necessarily as fluid as you would expect but it takes some time just to work through some of the nuances in order to get to the end result which is a deployment into a new opportunity.

Matt Dallman – Roth Capital Partners

In terms of just the aggregate growth rate for the year, I think it's kind of a maybe slightly upper teens number that's implied and I think you said that you grew 26% on an aggregate basis. So are you remaining conservative on the guidance front in terms of aggregate revenue or what would maybe cause a slowdown throughout the year looking at those numbers?

Peter Boni

Again one quarter into the game we're making sure that we manage the clock here. So stepping away from that basketball analogy for a moment, I think as we get further into Q2 we'll have a better perspective as to what the end of the year looks like for many of these companies and when it's appropriate we will make whatever adjustments to our guidance as we think is necessary.

Matt Dallman – Roth Capital Partners

Okay, and then last one is on Penn Mezz and maybe more generally, other alternative views on capital. It sounds like that's going at least as well as you had hoped. Why not accelerate that program or comparable programs to help offset your core operating spend?

Peter Boni

We're executing our strategy Matt which includes platform expansion and when we have something to announce we'll announce it.

Steve Zarrilli

Just to tag on to that I think, one of the things that we're trying to do with our platform expansion is not be redundant. So to go long and deep say in Mezzanine which I'm not necessarily sure you are suggesting, that would probably begin to create some concentrations that may not ultimately provide the long term returns that our shareholders are looking for. What Peter and I are also focused on along with the rest of the management team are finding opportunities either in these co managed opportunities where not only is our good solid revenue flow for Safeguard much like Penn Mezz but we're moving into other areas of the market that we think are synergistic to what our core business is focused on. So it could be other areas of technology or in the other areas of healthcare services. Geography might come into play. We recognize we've got to touch a lot of rocks in this process in order to see what opportunities truly exist. We're looking for credible teams with proven results that we can be highly confident that they're going to be able to execute in a way that we're executing. So we're spending a lot of time and energy pursuing and evaluating opportunities but as we get closer to getting a couple of that we think are real we will begin to share with the street what we think those could be like.

Peter Boni

I'll reemphasize that Matt. We are executing in the platform expansion area. We just don’t have anything to announce but there is plenty of activity in the sidelines there.

Operator

Thank you. Our next question comes from Paul Knight, CLSA.

Paul Knight – CLSA

Starting with the revenue guidance of 160 to 165 in FY'12, was the pro forma in 2011 131 or is my math off?

Peter Boni

I'm going to ask Steve to take some commentary.'

Steve Zarrilli

Last year was $140 million. Keep in mind Paul we're on a one quarter lag basis as well with these companies.

Paul Knight – CLSA

Okay. So you're saying Q1 or Q4 was up 26%?

Steve Zarrilli

Year-over-year Q1 was up 25% in aggregate. And quarterly basis that actually represents the Q4 activity for these partner companies. So hopefully we haven't confused you. We speak about it just like Peter says, as Q1, because we have historically inconsistently accounted for these, we're represented these on a quarter lag basis.

Paul Knight – CLSA

And then Alverix and Good Start Genetics both have begun commercial launch early this year. Could you comment on each of those two diagnostics firms?

Steve Zarrilli

Well Good Start Genetics did receive $3.7 million of follow on capital from us to really move to commercialization. They have moved to commercialization according to plan and that they are up and running. Alverix is now at the initial revenue stage through some OEM activity with (inaudible) for a flu related handheld device, not only here but also abroad and once again they continue to produce, producing revenue in the initial revenue stages. That for us is a $1 million to $5 million range.

Paul Knight – CLSA

Which year?

Steve Zarrilli

This year.

Paul Knight – CLSA

At Alverix?

Steve Zarrilli

At both Alverix and Good Start Genetics are in the initial revenue stages today. As they produce revenue in the annualized rate of over $5 million they moved to what we would call the expansion stage. Today they are both in the initial revenue stages.

Paul Knight – CLSA

Okay. And then on Penn Mezzanine, how do you recognize the yield on these investments? What's the accounting treatment on the returns you mentioned in the press release?

Steve Zarrilli

On the current basis it's an accrual of the interest to be earned for that period of time. The accrual of interest could lag actual cash receipts but we're accounting for it on an accrual basis of accounting.

Paul Knight – CLSA

And last on Putney, could you talk a bit about the business development there?

Peter Boni

Putney is doing actually extremely well not only with their current handful of generic drugs that are selling to the veterinary community but they have, I'm not quite, two dozen in varying stages through the dog and cat version of the FDA. Their CEO has been extremely bullish that these products will get through the FDA process and give her a very strong revenue stream relative to new products as we answer the New Year and beyond. And just to further augment, three primary products currently being sold in the marketplace with a potential three to four that could be launched over the next 12 months.

Paul Knight – CLSA

And then deal flow on the healthcare care side. How is it looking, how do you like valuations right now?

Peter Boni

Our deal flow has actually been exceptionally strong and actually in both areas of technology as well as life sciences. Jim Dayton and his team have been looking at a variety of things and as I mentioned we were in the varying stages of term sheet and a number of opportunities.

Operator

Thank you. Our next question comes from Nick Halen with Sidoti & Co.

Nick Halen – Sidoti & Co.

I just had one quick follow up question for you. A lot of what I had was actually asked. Just in terms of the anticipated demand for tech IPOs going forward, is that going to affect how you guys deploy capital? Are you guys going to adjust your strategy at all or is it going to be pretty similar to what we've seen in the past?

Peter Boni

I think it will be similar to what we have seen in the past. Our teams are really in completion with one another for the company treasury chest and we will deploy capital in the best opportunities that we see and both groups, tech and life sciences focused have brought forward a number of very interesting looking opportunities. Just a word on our strategy and why we think it's paying dividends for us. We are in a multiple stage in addition to multiple domain. Tech and life sciences tend to be counter cyclical. If that’s the driver of our economic engine why be positioned in any one area if we can have some balance. Also as multiple stage, that's somewhat cyclical as well. We do some selective things in developmental stage companies and initial revenue stage companies and expansion stage companies and high traction companies. We can enter and we can exit at any stage. Now given that that's somewhat cyclical today we see that some later stage technology firms are getting the enthusiasm with LinkedIn, Facebook and Zingo Mania (ph) and that's impacted some of the expected valuations there. If we were a single domain or single stage, we'd have the risk of buying high and selling low but we have the luxury of being able to buy low with the opportunity to sell high and that's in the essence of our strategy.

Operator

(Operator Instructions). And we do have a follow up question from Greg Mason with Stifel Nicolaus.

Greg Mason – Stifel Nicolaus

Steve, I believe you gave guidance of $17 million in cash operating expenses for 2012 yet this quarter looked pretty high at $6.7 million. So that’s kind of a $27 million run rate. Is there just some lumpy items this quarter? What do we think about that $17 million 2012 operating cash number?

Peter Boni

Remember Q1 always has the payment of bonuses that relate to the prior year.

Greg Mason – Stifel Nicolaus

So no expected change in that $17 million target?

Peter Boni

None.

Greg Mason – Stifel Nicolaus

Okay, and then on medium math, how quickly will the joint venture with public group impact medium map and is there going to be any need for additional capital to expand there in Europe?

Peter Boni

The medium map is really executing on a variety of cylinders. They have evaluated whether an additional capital would be of use of them but they are actually on a positive cash flow business run rate right now. So we don’t have any guidance to give on that. Greg, just a comment on Q1. Q1 expense was actually down year-over-year and also in Q1 you've got all the audit stuff for yearend that is in there as well.

Operator

Thank you. At this time I'm showing no further questions. I'd like to turn the call over to Mr. Peter Boni for closing remarks.

Peter Boni

Thanks very much ladies and gentlemen for your interest in Safeguard and as the year progresses we'll continue to give you updates and guidance. Thanks again for your interest.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a great day.

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