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Executives

Tim Arens – Vice President and Interim CFO

Gary Maharaj – Chief Executive Officer

Analysts

Ernie Andberg – Feltl

Ross Taylor – CL King

Jeffrey Warshauer – Sidoti & Company

Charley Jones – Barrington Research

SurModics Inc. (SRDX) F2Q2012 Results Earnings Call May 8, 2012 5:00 PM ET

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the SurModics Second Quarter 2012 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, Tuesday, May 8, 2012. I would now like to turn the conference over to Mr. Tim Arens, Vice President and Interim Chief Financial Officer. Please go ahead, sir.

Tim Arens

Thank you, Lily. Good afternoon. And welcome to SurModics' fiscal 2012 second quarter earnings call. Also with me on the call is Gary Maharaj, our Chief Executive Officer.

Our press release reporting our full second quarter results was issued earlier this afternoon and is available on our website at 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 2011 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 provide an overview of our financial results and highlights for the quarter. Gary will then discuss our key achievements for the quarter and provide an update on the growth drivers and strategy, including additional detail on our newly announced share repurchase program. Following this discussion, we will open the call to take your questions.

Unless otherwise noted, second quarter financial results discuss today exclude the $200,000 second quarter loss associated with discontinued operations. Thus, the financial information that I discuss relates to our continuing operations and is in many cases on a non-GAAP basis.

As in past quarter’s, I’ll provide insights and performance comparisons, excluding financial impact related to the discontinuation of Cordis’ Cypher and Cypher Select Plus drug eluting stents.

You will recall that in prior periods, we have generated both product and royalty revenue based on tails of these Cordis products, which have incorporated our proprietary drug delivery and hydrophilic coatings technologies.

Our earnings announcement issued earlier this afternoon provide supplemental non-GAAP financial information that adjust for Cypher and certain events specific charges. We believe that these adjustments provide meaningful insight into our core operating performance and then alternate perspective of our operating results.

Our financial performance after adjusting for Cypher resulted in modest revenue growth while our core businesses generated record operating income during the quarter. Revenue for the second quarter totaled $12.2 million, an 8% decline from the $13.3 million reported in the second quarter of last year.

On a comparative basis, our second quarter revenue growth on adjusting for the $1.6 million in revenue associated with Cypher increased 4% from the year ago period.

We delivered solid bottom line results during the quarter with operating income of $3.7 million. On a non-GAAP basis operating income was $3.8 million, up 41% from the prior year.

Non-GAAP operating margin was 31%, up 800 basis points compared with the prior year period, driven by strong contributions from last year’s productivity and cost actions, and continued pull-through on our organic growth initiatives.

On a GAAP basis, our diluted earnings per share was $0.11 for the second quarter, compared to diluted earnings per share of $0.16 from the year ago period. Excluding the impact of Cypher and the $800,000 charge related to our equity investment in OctoPlus, non-GAAP diluted earnings per share in the second grew 27% and was $0.14, compared to non-GAAP diluted earnings per share of $0.11 from a year ago period driven by higher core revenue and contributions from last year’s cost actions.

I will now turn our discussion to performance by business unit. For the second quarter, Medical Device sales which include revenue from both our hydrophilic coatings and device drug delivery technologies totaled $8.7 million, down 12% from the $10 million reported in the year ago period. Adjusting for Cypher Medical Device revenue grew 5%.

Device drug delivery revenue declined $1.3 million from last year’s second quarter. This decline was largely attributable to Cypher. Second quarter results include hydrophilic coatings revenue of $8.7 million, which was flat compared with a year ago period.

During the quarter our hydrophilic royalty revenue excluding Cypher increased 4% from last year’s second quarter. During the quarter we experienced the 9% decline in our non-Cypher royalty revenue associated with the Medical Device Coronary and Cardiac Rhythm Management market segment. As a point of reference, the first quarter generated 8% growth in this market segment after adjusting for Cypher.

Based upon multiple customer interactions, we believe that this quarter’s Coronary and CRM segment performance may have been impacted by factors such as delayed customer product introductions and ongoing international pricing pressures.

On a positive note, recent feedback from coronary and CRM customers suggests a sense of improvement going forward. Additionally, we continue to see strength in other Medical Device market segments.

We saw a strong double-digit royalty revenue growth in several key Medical Device growth segments, including neuro-vascular, peripheral and transcatheter heart valve repair and replacement.

An additional revenue driver during the quarter was research and development, which increased 50%. Driving this performance was a continued increase in the number of Medical Device customers, leveraging our coating services to support their pre-clinical and commercial activities. Although, a very early indicator, today’s research and development activities can lead to tomorrow's royalty revenue.

Medical Device generated $4.1 million of operating income during the quarter, a 12% decline from the year ago period. Excluding Cypher, Medical Device operating income grew 34% from the year ago period, driven by improved product gross margins of 72%, compared with 62% in last year's second quarter, and lower operating expenses associated with last year's cost reduction efforts.

Looking at our In Vitro Diagnostics business unit, our IVD sales for the second quarter totaled $3.5 million, an increase of 3%, compared with $3.4 million in the second quarter of fiscal 2011.

Our IVD business unit has now generated six consecutive quarters of year-on-year revenue growth. Notably, our second quarter IVD product sales was our highest -- second highest ever.

However, our growth rate of 3% was lower this quarter, mainly due to the timing intervals of several of our key customers. When looking to gain insights relative to our IVD revenue growth and performance, it may be useful to look at two quarters to eliminate some of the timing intervals that can be associated with the customer orders. In fact, on a six month basis, our diagnostics revenue has grown over 7%, compared with the year ago period.

Our In Vitro Diagnostics performance will continue to benefit from executing on our organic growth strategy, including growing our diagnostic test kit customer base, introducing new products, and leveraging our new website and e-commerce channel to drive awareness and orders.

IVD generated $1.3 million of operating income during the quarter, an 8% increase from last year’s second quarter.

Now, let's discuss our revenue summary by category. Royalties and license fees, which are generated primarily in our Medical Device business unit were $6.3 million, down 18% from the $7.6 million reported last year. Excluding the impact of Cypher, royalty and license fees grew 4% in the second quarter of fiscal 2012.

Product sales of $5.1 million were basically flat from the year ago period. Growth in IVD product sales was offset by lower hydrophilic coating reagent sales.

Lastly, R&D revenue in the second quarter was $860,000, an increase of 53% from the $560,000 reported last year. Coating services support for certain of our hydrophilic customers drove the increase in R&D revenue.

Moving on, we generated product gross margin of 68% in the second quarter of fiscal 2012, compared with 64% last year. This 400 basis point improvement was primarily from the consolidation of our diagnostic manufacturing activities and to our Eden Prairie facility. This consolidation has allowed us to leverage our fixed operating expenses over higher production volumes.

SG&A expenses in the second quarter of fiscal 2012 were 28% of revenue, compared with 26% in the year ago period. Excluding Cypher revenue, SG&A during the second quarter of fiscal 2011 was approximately 29% of revenue. SG&A expenses declined 2% from last year, mainly as a result of our cost reduction efforts.

Research and development expenses were 29% of second quarter revenue, compared with 28% in the second quarter of fiscal 2011. Adjusted for Cypher, R&D expenses were 32% of revenue during the second quarter of fiscal 2011. R&D expenses declined 8% from the year ago period. Last year’s productivity and cost actions contributed to this quarter’s lower expense.

Taking a quick review of our balance sheet, our cash and investments totaled $102.4 million. Included in this balance is a $2.9 million release from escrow, established in connection with the sale of our pharmaceutical assets. All escrow amounts associated with that transaction have now been released.

We continue to generate solid cash flow during the quarter. Cash flow from operations was $4.2 million during the second quarter. In just a moment, Gary will provide an update on our activities pertaining to the use of cash to create shareholder value, including our share repurchase program.

Finally turning to guidance. As you saw in our press release, we’ve confirmed our revenue and earnings per share outlook for the full fiscal year 2012. As a reminder, our full year revenue outlook remains unchanged and is expected to be in the range of $47 million to $51 million.

GAAP diluted earnings per share from continuing operations also remains unchanged and is expected to be in the range of $0.45 to $0.53 per share. Our outlook is based upon our diluted share count of 17.6 million shares.

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

Gary Maharaj

Thank you, Tim. This is our first full quarter without the pharmaceutical business that was sold in November 2011. However, reported financial results today demonstrate the return to profitability.

In the last earnings call, I said that our actions during the second year, year two of my time here at SurModics would be defined by three areas. First, our ability to expand our core businesses to generate profitable growth and cash flow.

Second, our investment in internal R&D to drive organic growth and optimize long-term returns from this pipeline. And third, our strategy for use of cash on the balance sheet.

With that overview, let’s review each of these strategic priorities in more detail. First, our ability to profitably expand our core businesses critical to our long-term growth. In both our Medical Device and IVD businesses, our customers are facing increasing headwinds in the form of healthcare cost, regulatory scrutiny and lower overall industry growth.

So our ability to provide right solutions to our customers that improve results, reduce costs and mitigate regulatory risk continues to make SurModics an invaluable strategic partner.

In the Medical Device business, our growth initiatives within the core are focused on expanding our leadership in Hydrophilic Coatings with our next generation hydrophilic platform. Generation five, let’s call it Gen 5 for short. The Gen 5 coating provided the same low friction capabilities expected from earlier generations of Surmodics as coatings and it provides improved durability, which is a critical need for multiple vascular applications.

We’re conducting valuations in Gen 5 with select clients and are in a process of expanding its capabilities to multiple substrates and even more challenging applications. Importantly, our time to revenue from this Gen 5 coating will depend on our customer’s product development and regulatory approval timeline.

We do believe that our Gen 5 coatings sets a new standard and demonstrates our commitment to improving hydrophilic coatings technology as well as our product leadership in this important market. We are pleased with our progress in this area both in our on-time commercialization of these proprietary reagents and the number of active collaboration with established clients that we are conducting.

Expediting the optimization and commercialization of Gen 5 coatings on our client’s unique devices remains the key elements in securing future royalties from these events platform. While hydrophilic coating business continues to seek new products come to market.

This past quarter, Medtronic’s and Endeavor Resolute Drug-Eluting Stent which uses our hydrophilic coating for the stent delivery system received at the approval. We remain excited about more products in these categories where we are being selected as the coating technology of choice being commercialized in both the U.S. and Europe.

In our IVD business, we continue to execute in our plan for organic growth in this core business. We’ve now achieved six consecutive quarters of year-on-year revenue growth. During the last quarter, we gained five new diagnostic kit customers who incorporate these products as components in their kits.

Also this past quarter, we launched our new website with new e-commerce capabilities, which allows our customers to shop for IVD product in far more convenient manner that have been previously available. The enhanced website is also an important tool for improving the awareness of our products and our brand.

Feedback to date has been excellent and we’re already seeing strong customer response to the site.

Let’s now talk about the second area of focus, R&D, which is key to long-term value creation and growth for SurModics. As I said before, our R&D pipeline consists of three portfolios, ideas, experiments and projects.

IVD business unit will continue to move a healthy pipeline of ideas into experiments and projects culminating a new product introductions. This past quarter, we launched our StabilBlot, family of blotting reagents. StabilBlot represents SurModic’s newest offering of our stable brand of quality, market proven new diagnostic reagents that enhance sensitivity and minimizes the background in blotting application.

These are important market needs as we strive to improve the performance of our customer’s diagnostic test kits. We also plan to launch additional IVD products in the back half of this fiscal year, and we look forward to sharing more details on these launches in the future.

We remain on plan to launch at least two new products each year and our R&D team remains on plan for the rest of this year in launching those products we discussed. In Medical Device R&D, we have had two keys areas of focus, first as described earlier we are working to optimize our Gen 5 coatings, multiple substrates and devices.

Our second big area focus has been our drug-coated balloon project. As you may recall, drug-coated balloons may offer bad alternatives with current therapies in areas of vasculature where placing a stent is not ideal. Examples of this are interventions in the peripheral vessel such as a superficial femoral artery and the coronary vessel to treat infantry stenosis. The worldwide market potential for drug-coated balloon is predicted to be over $1 billion annually.

During the past three months, we have experimented with the coating formulation on multiple balloon catheter designs, both coronary and peripheral, and difference substrates as we work with multiple potential partners. We have also begun work on process optimization at an even very early stage in order to understand the effects of this coating on balloons of different sizes and lengths.

Our work has been tasted with informative in-vivo preclinical experiments. We recognize that our hemo study in high standard of consistent control of the drug on the surface of the device will require deep understanding from multiple and iterative experiments. We are very excited about our accomplishments over this past quarter and aggressively supporting this project to advance as quickly as possible.

Finally, let’s talk about our third strategic priority. That is how to best deploy our capital in each value for our shareholder. We are pleased to know that after careful and deliberate consideration, our board has authorized the largest share repurchase of up to $50 million. This represents a major step in our commitment to both create value and return cash to our shareholders.

Our objective here was to strike the right balance between our priority of continuing to fund our organic growth through investments in our R&D pipeline, while maintaining the financial flexibility to be both opportunistic and to manage risk, while returning cash to our shareholders.

Given where our business stands today, we felt that a strong balance sheet of $102 million and consistent cash flows will allow us to establish the share repurchase program, while continuing to make the necessary investments to grow our business. In conjunction with our board, we will continue to carefully evaluate appropriate balance of these three uses of cash, cash deployment to create value, cash returns to shareholders to redistribute value, and cash reserves to be both opportunistic and to manage risk.

In summary, we continue to be excited about our opportunities going forward in the three critical areas that we have defined. Growth from our core product, our R&D opportunities that are catalyst for future growth and finally, the strategic yet disciplined use of cash to create, return and protect value for our shareholders. We feel good about the strategic plan and what we have in place. And we are very confident, we’ll be able to achieve long-term sustainable double-digit growth.

Operator, this concludes our prepared remark. We would now like to open the call to questions. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from the line of Ross Taylor with C.L. King. Please go ahead. Pardon me. I don’t know what happened. Current question comes from the line of Ernie Andberg. Please go ahead, sir.

Ernie Andberg – Feltl

Good afternoon, Gary, Tim.

Gary Maharaj

Hi, Ernie.

Tim Arens

Hi, Ernie.

Ernie Andberg – Feltl

You talked about the operating margins and they look very good and as best as I can separate out the effects safer over the years and all the extraordinary items are probably as high as they’ve been in these two businesses. Are they sustainable to operate this 30% plus area over the balance of the year and next year or was there something unusual in the quarter?

Gary Maharaj

We believe we are sustainable, Ernie, but last seem to go into the details.

Tim Arens

Ernie, this is Tim. I would say that the way we would ask you and others to think about the operating margins going forward would be, they should be within a couple of hundred basis points of what we’ve delivered here in this second quarter.

Ernie Andberg – Feltl

Okay. Fair enough. The other and I suspected that it could be potential issue in the overall revenue progress in the quarter was you describe that is buying patterns, stocking patterns of your major customers. You described first half, first quarter versus second quarter, any absolute idea of the potential drag in the quarter of stocking patterns, Tim?

Tim Arens

So Ernie, this is something that we monitor and we pay a particular attention to. I can tell you that some of the timing issues only pertain to several key large customers. We do speak with our customers as you can imagine on the consistent ongoing basis. Our view is based upon the customer feedback that we’ve received. We’re not concerned about the revenue growth performance this quarter.

Ernie Andberg – Feltl

You described a potential impact on the quarter. Are you care to be more specific or are you just going to leave it in general terms, Tim?

Tim Arens

Yeah. I'd leave it in more general terms, Ernie. In fact, my comments really pertain to Q2, our fiscal Q2. In terms of the customer feedback that we received and how I’m articulating how to think about this going forward, it pertains more to Q3.

Ernie Andberg – Feltl

All right. Thank you very much.

Operator

Thank you. Our next question comes from the line of Ross Taylor with CL King. Please go ahead, sir.

Ross Taylor – CL King

Just wanted to start maybe with the repurchase program you all announced. A, any sense on how quickly you might be able to act again buying back shares or any sort of parameter you said in that regard at this point?

Gary Maharaj

It is a large amount of authorization and this timing depends on a number of factors, price market conditions, and such. So that's as much clarity as we can give. I think we are pleased to have gotten the authorization and in terms of implementation, the timing as we said in the press release, it will depend on those conditions.

Ross Taylor – CL King

Okay. And I might also ask, I mean given that your stock not real liquid at this point, does that restrict you in any way or maybe make you want to be more opportunistic in trying to buy block from some of your larger shareholders?

Tim Arens

Ross, this is Tim. And clearly, it is a large repurchase amount that's been authorized. You make a great point about the liquidity and the volume. We will look to be as effective and as efficient as we can in repurchasing shares, but you make a very good point.

Ross Taylor – CL King

And second and then final question is related to your new Gen 5 coating, is sort of the feedback and maybe timing at which some of your customers may be able to move forward with this product, I mean does it seem to be on track with some of your original expectations when you first began discussing this several months ago?

Gary Maharaj

Yeah. So I think we said in the previous calls that we're going to begin the commercialization in this calendar year and given the product development or regulatory [pathways] of our customers we are excited for those who actually evaluating it in specific devices. Each of the devices have a different timeline.

I expect in fiscal 2013 we will see some revenues come online for that. I'd say probably a little bit later in 2013, and that's purely because of the timing, not because of the acceptance of the product but the timing of the introduction.

Ross Taylor – CL King

Okay. All right. Good. And actually just one last question with the drug-eluting balloon you also mentioned looking at that in coronary indications and how much more of a difficult process is that from a development standpoint, I guess the question there how likely we can see something develop for that market in addition to peripheral?

Gary Maharaj

From the end view point the clinicals required for demonstrating superiority in coronary will be, that's probably be the long pole in the tent at the end of this. The reason we were doing it on coronary [balloons] is we wanted to understand the impact of small balloons, small length, small sizes, as well as the peripheral balloons which certainly sized differently many respect. So it was not necessary that we are heading down for coronary indications. That would be for some future customer if I was to decide that, but really we wanted to spend the range to test the adaptability of our techniques.

Ross Taylor – CL King

Okay. That's good color. Thank you.

Operator

Our next question comes from the line of Jeffrey Warshauer from Sidoti & Company. Please go ahead, sir.

Jeffrey Warshauer – Sidoti & Company

Good afternoon. Thanks for taking my questions. I just wanted to go back to the operating margins for a moment. So we are looking at 30% this quarter nice sequential improvement, even on top of seeing some of the restructuring changes last quarter. Do you think additional leverage could be had as revenue starts to pick up again?

Gary Maharaj

Jeff, that's exactly how I would encourage people to think about it. Clearly, as we continue to drive revenue growth, we should see some benefit with the middle of the income statement leading to higher operating margins.

Jeffrey Warshauer – Sidoti & Company

And I know had in the past stern staff reductions, have you guys been adding to staffs or what's your status there?

Gary Maharaj

Yeah. We have been adding especially operations and coating services areas. I have been very careful and as the management team of what we add, when we add it, because we want to add when we know there is ongoing need for capacity not just spikes in capacity. And so, we've been backloading that a little bit which certainly temporary fast, but we continue to add full ample positions.

Jeffrey Warshauer – Sidoti & Company

Great. And just one last one. I know in your press release this quarter you made mention to three customers launching new products, using your coatings, in the past you had discussed signing new licensing, new licenses. So just to try to get an idea of consistency going forward, because I know there is timing in terms of those generating revenue licensing comes first and then your customers will obviously launch products and then you start generating revenue. I mean, is this -- do you think you will be continuing to offer this type of information and would you be willing to retroactively offer all product launches?

Tim Arens

Jeff, this is Tim. And we thought long and hard about what's really valuable and insightful information to provide to our shareholders. We find that providing the information relative to the number of licenses signed each quarter isn't always that predictive in terms of future revenue or at least near term, sometimes because you have a license doesn't mean that the product or products are actually commercialized.

In other cases, they can take years to see something commercialized and we continue to sign licenses. I would say that the quantity of licenses that we signed certainly are arrivals what we have done in the past, but our intention here going forward is really to focus more on the new products that are launched by customers.

Jeffrey Warshauer – Sidoti & Company

Right. And so I mean in an effort to improve transparency, would it be possible for you to go back and tell us how many products were launched over the previous year or six quarter something like that?

Tim Arens

I think we do this every quarter Jeff. In fact, if you look at the last several earnings release, you will see the numbers. I don't have them at the fingertips, but they are out there and so we are going to continue to highlight that going forward, but for the last six quarters you'll for sure see that.

Jeffrey Warshauer – Sidoti & Company

Okay. Great. I'll (inaudible). Thanks.

Operator

Thank you. Our next question comes from the line of Charley Jones with Barrington Research. Please go ahead, sir.

Charley Jones – Barrington Research

Gary and Tim, thanks for taking my questions. Congratulations.

Tim Arens

Hi, Charley.

Charley Jones – Barrington Research

Yeah. Nice execution. It's a nice change year. Anyway I was hoping you could update us on a few things. Tim real quick one for you I think, could you discuss what tax rate you have implied in your guidance for EPS?

Tim Arens

We are using a 38% tax rate, Charley.

Charley Jones – Barrington Research

Okay. All right. Great. I was of course real happy to see that authorization be a little bit higher than maybe we are thinking it could be, but I was hoping you could discuss a little bit, I know you guys talked doing a very analytical review of it. What the put and takes were for more or less?

And I guess I would particularly like to focus on what you guys thought about when you chose not do more, whether or not the issues were more around liquidity or having a conservative balance sheet or future acquisitions? Thanks.

Gary Maharaj

Understood, Charley. The way I look at it is a very sound first half. The two words characterize when we consider this as we wanted to be both balanced and flexible and disciplined obviously.

And so the balance section was balancing the return with risks and opportunities in the business and focus less on risk, but I had more focus and opportunities in terms of making sure we had returned a reasonable amount, as you characterized too little of a return to our shareholders, we didn't want to send that signal.

On the other hand we didn't want to go overboard and reduce the balance of that, primarily for flexibility in future cash generation and uses of cash, which can include future returns. And so where we ended up is it was a sound first step right down the middle of the fairway, not too much, not too little.

Arguably still obviously, but then it provided us really flexibility for future uses of cash and I don't want to – I say risks and opportunities I mean that's small risk but really large opportunities. Part of those opportunities are still also future returns of even more cash to shareholders.

Charley Jones – Barrington Research

Yeah. That's certainly what we are hoping this year and I guess – I guess mostly because risk and opportunity where really synonymous in the past. So yeah I guess one more question on this line and I apologize for asking this question, but I'm sure others are wondering.

You obviously have a number of members on your Board who are investors and I'm just curious whether or not you did look at a dutch here and what you thought about and whether or not there are any restrictions in black purchases by from any of your Board members or for the shares of any of your Board members?

Gary Maharaj

I know the board considered certainly the size of authorization and multiple mechanisms which we will certainly communicate to the future date, but that will certainly all mechanisms were considered and given the appropriate weighting.

I don't believe I can comment with much education on the individual and certainly the Board members who control certain blocks of our purchases at this point. There are some SEC regulations that will need to be filed if and so those things go into action. But there will be transparency at that point for sure.

Charley Jones – Barrington Research

Great. I'll follow-up offline. A couple of more, I was hoping you could discuss the opportunity of your new IVD program? Is there an existing market and if there is how big is that and how big can it be? What can operating margins can we expect from this product line obviously you're probably not going to get into detail but higher or lower than Company or IVD business segment?

Tim Arens

So Charlie great question. This is Tim again. And so the way that I kind of characterized StabilCoat family is it's more – it's a product that's very important. It's important for those folks who are doing membrane based applications. I would say with all our products that have been recently released or introduced, it does take time or real traction with revenue. It can take up to 6 quarters for customers to evaluate and incorporate into their diagnostic test kits and received approval and then actually commercialize and sell.

Margins will probably be not unlike which you see with other diagnostic products that we sell, which is a high 60's and I would say that in a relative to traction and update were real pleased with the initial customer interest. We have with all of our price that we release three product family that we released here over the last several quarters.

We have over 100 customers and potential customers evaluating these products for inclusion into their diagnostic test kits. So we are real pleased with the traction that we are getting so far in the early stage. We look forward to that translating into conversion into actual product sales and using kits in the future.

Charley Jones – Barrington Research

Maybe you can help me a little bit better understand the potential opportunity from these products and year – year going out with and I guess really they could put it in perspective of your current business. Is this the mid-single, high single low double-digit grower or could you or do you have some new products here that, if they hit could be multiples?

Gary Maharaj

Yeah. So we have characterized this in the past, Charley as being a basic strategy and we look at it as being something that would be additive to the overall organic growth for the existing products. So we see growth from our existing base and layering on top of that. Growth that will be coming from new products and we layer on top of that growth coming from new channels like our e-commerce channel that we highlighted today as well, which is recently introduced.

I hope that gives you a little bit of perspective in terms of how we think about these. For us it's not just the ability to bring a new product and have that be leveraged to drive growth. One of the key things that we think about as we bring new product to market as it give us an opportunity to engage existing customers.

I think I might have mentioned this before but in a diagnostic test kit, there can be upwards of six different chemical components that could be used. SurModics provides our customers with many of these chemical components.

Not every customer is using all of the chemical components that we have available to them. So at often times opens up the discussion on what is new at SurModics and gives us an opportunity to engage the customer around what their needs are and how we might satisfy those needs. Whether it is with the new product or with the existing product.

So it's a biggest strategy for us and just going out and launching new products and generating revenue after the new products and also demonstrate commitment to this phase.

Charley Jones – Barrington Research

Yeah. No absolutely. I guess I'd love to hear – if you do you have a general take on maybe as a final follow-up, which of these businesses you see better return on invested capital if there is a difference, but before you go there. My last question is around your coatings platform. And I was hoping you could understand – help us understand a little bit about it. It's relative profitability to your current product line and I guess you could – I was hoping you could put it helpless – put your entire medical operating margins in the perspective here. You can't have been on a roller coaster and obviously things have changed as a result of Cypher being gone but just hoping if you could give us some goals here, Gary. You talked when you first came out at a high 40's operating margin and obviously you're not there today, but maybe you can help us understand the potential of that business? Thanks a lot.

Gary Maharaj

Yeah. Our generation five coating what will be in the same margin bracketing. If we were offering substantial advantages with this platform to our customers than I think many of them are beginning to recognize that. The adoption time as you know, depends on the product launches.

You might –were we having though and first of all we like the ROIC -- return on invested capital of both of these businesses. The issue is on a incremental basis, which one will give us the earlier cash flow. So in many respects I see them as very complimentary, IVD certainly is an adoption time for products in the marketplace.

Medical Devices, I have always said has had a longer throttle response in terms of a cash flows we can get. What it comes down to for me, Charley it is. So we are focusing on the strength in the core.

We do have to start slowly and methodologically expanding the core, I mean the Medical Device business is a unique by materials company-based on surface modification and so hydrophilic coatings is – it's really good for us right now, investing heavily in that.

But certainly things like drug coated balloon, I see as a first child of many and that's critical for investment going forward. Similarly, the IVD is a unique reagent Company in the diagnostic space and while we're exercising base hits, part of the reason we're doing that is we haven't been up the back for some time and so R&D team is really exercising the capabilities in the next couple of years in terms of the doubles and the home runs we want to hit, so those are clearly on tap.

As far as the operating margin, it's going to come down to a balance between our investment in R&D and other organic growth strategies, but really R&D is the big one and to balance that, which has the longer term value creation, especially in the Medical Device business with the short-term margin and that is something we as management looking at.

What are margin can we get out of the current businesses and which part of that we can see for investment in long term businesses? My goals are still the same, but they will certainly average out over the long term.

Charley Jones – Barrington Research

And I'd just like to repeat, thank you both for your hard work and getting this Company back on track here.

Tim Arens

We would appreciate it, Charley.

Gary Maharaj

Thank you, Charley.

Operator

Our next question is a follow-up question in the line of Ernie Andberg. Please go ahead.

Ernie Andberg – Feltl

Gary, I think it was you who might have said that it would take up to six quarters to get customers up and running on your IVD products. I think we are roughly one or two quarters into that process, does that suggest you could start to see an improvement in the revenue stream on the growth side equation next fiscal year or is that how you are looking at that business?

Gary Maharaj

Yeah. So that is how we like to look at it. Because the adoption curve really is, as they validated and that – gets themselves incorporating and even start getting those kits out. We certainly are looking for better results from the new products in 2013.

Ernie Andberg – Feltl

And enough of your 100 people who are evaluating are far enough along – and you're concerted in that, observation Gary?

Gary Maharaj

Well, I'll let Tim handle that a little bit. It depends on the validation is one step to really getting the kits and then the marketability of that kits as well. So we have a few more necking downs to do, off the process, but enough of them are validating to be able to get to the finish line, and that's how it calculated.

Ernie Andberg – Feltl

That's right.

Tim Arens

It's a really good question Ernie, and what I'll tell you is that we're already seeing customers order these new products and I can tell you it's a small mix of our overall revenue from our diagnostics business. I'll tell you that these are based and basically the way I define a base it is, we're talking several 100,000 to $0.5 million of revenue per basic per product and that's how we think about it.

Now there's a lot of factors that can go into revenue generation too, as you have – your customers continuing to bring new products markets, so they might be in one diagnostic kit Ernie but as years go by it might be in 5 to 10 but the same customer they might love the product and continue the usage and those others you could actually see them even greater revenue opportunity.

We're always hopeful for serendipity, just because we might think it's a basic – it doesn't mean that that precludes it from being a home run. And being able to generate over a million or several million dollars of revenue. To just continue to bring new products to market and fill the bag.

Ernie Andberg – Feltl

Okay. Thank you. Let's go down the same line of thinking on drug-eluting balloons, and I don't what you care to disclose but do you have any customers actually in, clinical trial, late stage clinical trials in balloons in PAD in the US?

Tim Arens

No. This is really this is all pre-clinical work, it certainly moved off the bench stop but seasonally into pre-clinical trials, certainly not in humans, so I the timeframe this is you know for US market type timeframes it's seven plus years out – what our customers can do with it.

However, we don't bring products like this to market typically. And so it would be in collaboration with customers we continue to have conversations as we have over the past years and it's a multiple parties – who will be monitoring our progress and certainly been working with their specific devises so it's a fair result.

Ernie Andberg – Feltl

That's helpful. Thank you.

Tim Arens

Ernie, don't lose sight either that SurModics has been generating revenue in a lot of different ways from our drug-eluting balloon project, if – I think you're well familiar with our licensing model, if we're to project from that same construct and view we generate development revenue, you can generate milestones, license fees and ultimately you can get to royalty revenue. But we're real optimistic about the program and we only mentioned that several quarters ago and we've made some really great progress here in the interims.

Ernie Andberg – Feltl

Yeah. Thank you very much.

Operator

Our next question is a follow-up question from the line of Mr. Jeffrey Warshauer with Sidoti & Company. Please go ahead.

Jeffrey Warshauer – Sidoti & Company

Hey. Thanks again. Just real quickly I want to follow-up on the write-down of OctoPlus, you know not having strain on your operating business for a moment, and I remember, if I remember correctly, there were some other equity investments, like you had, we're just wondering what happened there and the status and carrying value of your direct investments?

Tim Arens

Thank you. Great questions, Jeff. What I'll tell you is we have about $2 million on the balance sheet, other strategic investments, OctoPlus was written and traded down I think the Amsterdam Exchange, we evaluate all of our strategic investments every quarter, we've gotten no concerns or any concerns relative to impairment on the other strategic investments. And OctoPlus was written down here – really as a result of the trading price on the Amsterdam stock exchange over the last several quarters. I think we're carrying OctoPus at about $900,000 on the balance sheet after this $800,000 write-down.

Jeffrey Warshauer – Sidoti & Company

So OctoPlus makes up $900,000 -- a good portion of…

Tim Arens

Excluding OctoPlus the other strategic investments are $2 million including it's closer to $3 million.

Jeffrey Warshauer – Sidoti & Company

Okay. That's it. Thanks again.

Tim Arens

Thanks.

Gary Maharaj

You're welcome.

Operator

Our last question is follow-up question from the line of Mr. Charley Jones with Barrington Research. Please go ahead.

Charley Jones – Barrington Research

Yeah. Thanks for the follow-up, just a couple of questions on the drug-eluting balloon program, I'd like to clarify two things, are you just working on the coating, are you looking to be able to buy some sort of drug, like a Paclitaxel from somebody else, wholesale and do both. Are you contemplating actually having a balloon at all here?

Gary Maharaj

No. We – our current thinking is sticking to the core, we will really good at coating the devices, at this point I wouldn't characterize this as a device company and because as you can imagine, bringing a product to the market requires a lot of device experience, not that we don't have it but it's not core.

And also a lot of clinical research expertise in designing and monitoring trials which clearly would not – that's not our core. So our focus is really being able to get the technology of getting them best drug coating release and control characteristics on a balloon and showing that to our potential partners that are able to then exploit it this on their devices.

Charley Jones – Barrington Research

A couple of follow-up questions on this, are you have – does your coating work with several drugs or have honed on a drug or two.

Gary Maharaj

Well, we certainly have honed in but I probably can't comment on much more than that, but we certainly have honed in on basically the optimal combinations of the drug and the excipient.

Charley Jones – Barrington Research

Are you typically seeing that the company is out there that are designing balloons are using almost a three balloon strategy, my understanding is that blood – white – wipes, 90% of the drug or whatever it was several years ago, that everybody talks about, off the balloon in 10 seconds or whatever, so – is there, do you actually use – are any of them using, a proximal balloon to prevent blood flow and then to have better contact with the drug and then or is it's just a single balloon here?

Gary Maharaj

That there is any number of basically, that those are on the markets, but certainly are quite a few start ups that are trying unique and novel ways to achieve or to prevent as much drug loss. Our methodology really has to do with being able to keep in on the surface until you need to release to the vessel or, but yeah, brighter minds than mine are trying that but our – our approach really uses what we know about coatings and drugs and that competency that we have. And so we're not pursuing a unique mechanical means or if that's what you mean.

Charley Jones – Barrington Research

Okay. Just a couple of other things here. Can you tell me at all, how long you can actually blood flowing over a balloon when you keep, I don't know, whatever number you want to say, x percent of drug. And is there a level of drug that – is there a time limit that you here and what do you think other's capabilities are here?

Gary Maharaj

Yeah. And my quick answer to that is that you need to keep enough drug in the balloon to get to the target lesion and not lose too much. But really what – as you know, Charley, what you want to do is to have the maximum effect of having that drug deep on to that flow, for high tissue penetrance, without having a large loathing to the systemic circulation.

I think that anybody who is in this industry that's the general aim there. And our mantra is the right amount of drug, at the right place for the right time. That's our mantra on control in our little setting or how we're approaching it. I'm sure the people approaching it with similar or different angles but that's really the core of what we want to achieve with this coating on a balloon.

Charley Jones – Barrington Research

I promise I'm getting close to the end, clear a couple of points though. On the coronary are you – why not the coronary, it seems very obvious to most of us, regardless of the barotrauma to the vessel, and then secondly how quickly can you be in Europe and I do have one last question?

Gary Maharaj

Yeah. And so those things will be left up to our device partners and our device customers to develop and so if we're able to demonstrate that our coating works on coronary peripheral neuro-balloons or whatever it maybe, then you know, they best know the market approach strategies to this.

We're just we're providing a great technology platform for potential partners to actually then deploy how they see the strategic review set, so and then I'm out of depth also that, Charley, in terms of the deployment in Europe and stuff. Certainly Europe is the first step on the regulatory pathway and then the US. But that will be up to, again potential partners who decide the right time.

Charley Jones – Barrington Research

I guess the final think I want you to maybe think about that if you can't answer to that is and kind of get back to us as, if you could help us understand a little bit of your licensing strategy here. Whether or not, to me it makes more sense to have a – non-exclusive license here, but I'm curious what your thoughts are there, curious of the opportunities for several indications, such coronaries and curious how many different do you think you can have and then finally.

I guess the last piece is, there's others out there obviously doing this I mean this is – you guys have been talking about it for a year or two, but we've been talking about it for three or five, or whatever, so and probably longer. So I’m curious what – how confident you are in your technical capabilities to do something that others don't here?

Gary Maharaj

Yeah. And so – we're very confident in our capabilities of manipulating drugs on surfaces. And the balloon is certainly one of those three criteria. As far as the licensing model, I would we're too are staying tuned, where we will – we believe we have something of value and we intend to work with the appropriate parties on that.

Charley Jones – Barrington Research

I guess just to push back a tiny bit on that, this is such a huge market opportunity if you get with the right leader does it make sense to be exclusive or given the fickleness of interventional cardiologists with balloons in general to date, does it make sense to have in your opinion a broader strategy, in first glance?

Gary Maharaj

Broad is always comforting but then it depends on the deals that you can strike and so that's we'll certainly I consider as we go forward in this strategy.

Charley Jones – Barrington Research

Thanks for all the conversation.

Gary Maharaj

Great. Thanks, Charley.

Operator

And now I'd like to turn the conference back to Mr. Maharaj for closing remarks, please go ahead sir.

Gary Maharaj

Thank you. You know we continue to build the momentum in the second quarter of 2012 with solid performances in our business. And we remain steadfast in our commitment to return SurModics to profitable, being focused revenue growth in these businesses. At the same time we are compelled to continue our investment in R&D and new products introductions and we are pleased to be able to used the strength of our balance sheet to return to cash to our shareholders in the form of a share repurchase. I want to thank everyone today for participating in this quarter's conference call, and we look forward to providing further updates on next quarter's calls. Thank you, everybody.

Operator

Ladies and gentlemen, this concludes the SurModics second quarter 2012 earnings conference call. AT&T would like to thank you for your participation. You may now disconnect.

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