Safeguard Scientifics' CEO Discusses Q3 2013 Results - Earnings Call Transcript

Oct. 24, 2013 1:08 PM ETSafeguard Scientifics, Inc. (SFE)
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Safeguard Scientifics, Inc. (NYSE:SFE) Q3 2013 Earnings Conference Call October 24, 2013 9:00 AM ET

Executives

Steve Zarrilli - President & Chief Executive Officer

Jeff McGroarty - Senior Vice President & Chief Financial Officer

John Shave - Vice President, Business Development & Corporate Communications

Analysts

Troy Ward - KBW

Arnie Ursaner - CJS Securities

Jim MacDonald - First Analysis

Paul Knight - Janney Capital Markets

Ed Woo - Ascendiant Capital

Operator

Good morning and welcome to the Safeguard Scientifics, third quarter 2013 financial results conference call. All participants will be in listen-only mode. (Operator Instructions). Please note, this event is being recorded.

I would now like to turn the conference over to John Shave, Vice President, Business Development and Corporate Communications. Please go ahead.

John Shave

Good morning and thank you for joining us for our third quarter 2013 conference call and update. Joining me on today’s call are Steve Zarrilli, Safeguard’s President and Chief Executive Officer; and Jeff McGroarty, Safeguard’s Senior Vice President and Chief Financial Officer.

During today’s call Steve will review highlights of the quarter, as well as other developments at Safeguard and our partner companies. Jeff will then discuss Safeguard’s financial results and strategies. Then we will open the lines to take your questions.

As always, I must remind you that today’s presentation includes forward-looking statements. Relying on some forward-looking statements involve certain risks and uncertainties, including but not limited to the uncertainty of future performance of our partner companies, the risks associated with our acquisition or disposition of interest in partner companies, risks associated with our decisions about the deployment of capital and the effect of regulatory and economic conditions generally, as well as the development of the healthcare and technology markets and other uncertainties that are described in our SEC filings.

During the course of today’s call words such as except, anticipate, believe and intend will be used in our discussion of goals or events in the future. Management cannot be certain that final outcomes will be as described today.

We encourage you to read Safeguard’s 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 CEO, Steve Zarrilli.

Steve Zarrilli

Thank you and John and thank you all for joining us today for the updated on Safeguard Scientifics and our partner companies. For some of you it will be somewhat of a redundancy since you were at our Investor Day, but we do want to provide an update where possible on our partner company activity.

Safeguard and our partner companies achieved real progress and measurable growth during the third quarter and remain on track to achieve and/or exceed operating, financial and strategic milestones. Focusing consistent execution are vital to the success of our business and we remain encouraged by our parent company’s progress in the aggregate and the gradual improvement of the M&A environment

As a result, subsequent to the quarter we increased 2013 aggregate partner company revenue guidance to a range of $285 million to $295 million, up from our initial revenue guidance of $250 million to $270 million. This range represents a 44% to 49% increase as compared to the $197 million in 2012.

We maintained a disciplined focus on our core business as the key driver for shareholder value. We strived for a greater consistency and the amount of capital deployed and capital realized and we’ll continue to target aggregate cash-on-cash returns at a minimum of two times cost.

We believe that this combination will push our capital under management to a range of $550 million to $700 million by the end of 2015. The continued growth and success of our partner companies will help us to achieve this capital under the management target.

As of today we have not achieved one of our goals for 2013, related to an exit or two regarding our partner companies. The team is still working diligently to potentially achieve this goal before year-end.

As a reminder, we categorize our partner companies by revenue stage. It is important to note that a company does not need to move all the way from the left to the right in order to be an attractive acquisition target. We have had partner companies acquired who were initial revenue companies, as well as expansion stage companies.

The evolution of our partner companies through these stages can make them attractive targets for strategic acquirers, so lets quickly review the stages. Development stage is for pre-revenue businesses that maybe proving their technology through prototype development or beta product versions. Safeguard has one development stage company NuPathe, which is also our only publicly traded partner company today. As of September 30, this stage represented 9% of our total capital deployed in our current partner companies.

Initial revenue stage represents 10 of our 22 partner companies. Businesses in this stage are building corporate infrastructure and management teams; they are beginning to penetrate target markets and have revenues of $5 million or less. As or September 30, we had 35% of our deployed capital in this stage.

Expansion stage currently has six partner companies with the characteristics of commercial grade solutions, growing market penetration, complete infrastructure and management teams and revenue in the range of $5 million to $20 million. As of September 30, we had 28% of the deployed capital in this stage.

And finally high traction stage represents companies with revenues of more than $20 million, in which we are experiencing rapid growth and significant commercial success. This stage includes five of our partner companies; most recently added was GoodStart Genetics. So of September 30 we had 28% of our deployed capital in this category.

With that, let me take a few minutes to highlight a few of our companies. Crescendo Bioscience, is a molecular diagnostics company dedicated to developing and commercializing blood test for rheumatoid arthritis and other diseases, so physicians can make more informed treatment decisions. Safeguard has deployed $11 million of capital in Crescendo since December 2012 and has a 13% primary ownership position.

During the third quarter, Crescendo continued to grow revenue, increase lab test volume and expand penetration of its target market. Testing volume in 2013 has more that doubled to an annual rate of 90,000 and the company is projecting $30 million of revenue in 2013.

Next up Putney, a rapidly growing specialty pharmaceutical company developing high quality, cost effective, generic medicines for pets. Putney now has four FDA approved veterinary generic products with a pipeline of more than 20 products in various stages of development and CVM review.

Putney expects to be a high traction company before year-end 2013, and by year-end 2018 Putney projects revenue of more than $190 million and EBITDA in excess of $40 million. Safeguard deployed $10 million in Putney in September 2011 and has a 28% primary ownership position.

A couple of interesting additional facts: 91% of drugs approved for dogs and cats do not have an equivalent generic, whereas 84% of volume and prescriptions in the U.S. are filled with the generic and today in the U.S. there are more dogs and cats than there are children. We see that Putney has a significant opportunity in front of them.

GoodStart Genetics is the newest member of our high traction stage group, expecting to generate more than $30 million in net revenue in 2013, achieve profitability, and be operating cash flow at breakeven. GoodStart Genetics is an innovative, molecular diagnostic company that has developed more accurate and comprehensive pre-pregnancy genetic test.

During the third quarter GoodStart Genetics laboratory test volume increased to an annual run rate of more than 250,000. Earlier the company received approval to conduct genetic screening in New York, making the company the first laboratory to offer extensively validated next generation DNA sequence based carrier screening in New York, where nearly 25% of all reproductive health carrier screening is performed each year. Safeguard has deployed $12 million of capital in GoodStart Genetics in September 2010 and has a 30% primary ownership position.

The last company I’d like to highlight is MediaMath. MediaMath is the high traction partner company that is attracting the most speculation about a potential elasticity to its few successful IPOs in the Digital Media space.

As you know, MediaMath is pioneer in digital marketing technology. From a network of 12 locations worldwide, MediaMath serves more than 3,500 clients and many of the top ad agencies. International operations are now responsible for approximately 35% of MediaMath’s annual revenue. Safeguard has deployed $18.5 million of capital in MediaMath since July 2009 and has a 23% primary ownership position.

Of note, the September IPO of Rocket Fuel, which now trades on the NASDAQ under the ticker symbol FUEL, was viewed as an important indicator of the growing value of sophisticated technologies to improve the performance of digital advertising. Rocket Fuel raised $116 million of new equity capital through the offering and now has a market valuation of approximately $2 billion on trailing 12-month revenue of approximately $160 million. At market close yesterday, shares of Rocket Fuel closed at $61.08, up from its IPO price of $29 per share.

With that I’m going to turn it over to Jeff, so that he can provide you with some information on our financial performance and ongoing goals.

Jeff McGroarty

Thanks Steve. I’ll lead off with a review of key financial metrics for the quarter and nine months ended September 30.

At period end we had $166.1 million in cash, cash equivalent and marketable securities. The total carrying value of outstanding debt was $49.7 million, resulting in net cash of $116.4 million. During the quarter, primary uses of cash were capital deployments of $12.5 million in new partner companies Clutch and Quantia. Follow on capital deployments of $2.3 million in three current parent companies and cash used in operations of $4.8 million.

For the nine months, primary uses of cash were capital deployment of $20.5 million in our four new partner companies, Clutch, Pneuron, Quantia and Sotera Wireless. Follow on deployments of $15.1 million in seven current partner companies. Cash used in operations of $16.3 million and deployments in Penn Mezzanine loan participations of $2.3 million.

Our priorities for uses of cash remained unchanged. Capital deployment into new partner companies, follow on funding for current partner companies, corporate expenses and expansion of our platform.

At September 30 our roster of partner companies totaled 22, and the carrying value of those 22 partner companies was $137 million. The cost of our interest in these companies totaled $249 million. Safeguard’s financial strength, flexibility and liquidity are evident from the company’s balance sheet at September 30, 2013.

Now it’s time for Steve to lead us through the question-and-answer segment of the call.

Steve Zarrilli

Thanks Jeff. Operator, if you wouldn’t mind, lets open the phones for any questions.

Question-and-Answer Session

Operator

Certainly. (Operator Instructions). Our first question comes from Troy Ward from KBW.

Troy Ward - KBW


Thanks. Jeff, real quick, on the other income loss of $14 million, I assume the $1.3 million impairment of Pixel was in there. But can you speak to what else is in that number?

Jeff McGroarty

You are looking at the third quarter Troy?

Troy Ward - KBW

Yes.

Jeff McGroarty

In the other income loss, net interest and equity income line of the financial statements.

Troy Ward - KBW

That’s right, negative 14,595.

Jeff McGroarty

Yes, that includes really everything from our partner companies. It includes the $1.3 million Pixel impairment; it includes the $4.8 million unrealized loss on the mark-to-market of our holdings in NuPathe, and that also includes the net equity loss that we’ve picked up for our pro rata share of our equity method partner companies.

Troy Ward - KBW

Okay, all right great. And then Steve, can you speak to a minute, you talked about the Crescendo. Can you speak to the relationship with their financing and the optionality that one of the previous lenders has there.

Steve Zarrilli

You mean prior – previous lenders, you mean capital providers.

Troy Ward - KBW

Capital providers, I’m sorry yes.

Steve Zarrilli

Well actually I think what you may even be more specifically thinking about it Myriad.

Troy Ward - KBW

Correct.

Steve Zarrilli

Yes. So there is a contractual opportunity for Myriad to take advantage of the opportunity. They will acquire Crescendo at some pre-determined values, within a prescribed period of time. Once certain financial metrics have been achieved, which are anticipated to occur before the end of the year, then the question becomes whether or not that option is pursued by Myriad.

We don’t have any specific insight, other than we know that if publicly Myriad had spoken about Crescendo and has indicated that it could be important to their future platform, Crescendo clearly would view that as an opportunity. They would also look at other potential ways to unlock shareholder value. I think they haven’t lost sight of the fact that foundation medicine went out through an IPO recently.

So I think Crescendo is actually in the catbird seat from the standpoint of having a number of different paths that they can potentially pursue, and management and the board of that company is, and the investor group is looking at all of those opportunities in determining the best way to create shareholder value.

Troy Ward - KBW

Okay, great. I’ll hop back in the queue. Thanks.

Operator

Our next question comes from Robert Labick of CJS Securities.

Arnie Ursaner - CJS Securities

Hi, good morning. You actually have Arnie Ursaner backing up Bob this morning. My first question relates to a comment Eli Lilly made yesterday in their earnings release and on their conference call, where they said they continue to look for acquisitions in the animal health space. Do you need any help finding their phone number as it relates to Putney.

Steve Zarrilli

I don’t believe we do Arnie, but thank you for that offer.

Arnie Ursaner - CJS Securities

Do you care to comment more generally about the likelihood of larger companies looking for companies like Putney for acquisitions?

Steve Zarrilli

I sure can, I thought you were asking about the phone number. I think Putney recognizes that they are pursuing a market opportunity that is big, probably bigger than many anticipate. They have some terrific ways in which they go about their business in bringing product to the market. Their CEO was at our Investor Day. I think she tried to size up the opportunity for Putney in the next couple of years, and she’s put some numbers our there in the market place that we’ve actually again highlighted this morning.

We are building a great company and obviously at some point in the future there might be an opportunity for someone else to have a stake in that company and I think the comments that Lilly made with regard to the market are just further evidence that this is going to be a very important market going forward.

Any other questions Arnie?

Operator

Our next question is from Jim MacDonald of First Analysis.

Jim MacDonald - First Analysis

Yes, good morning guys.

Steve Zarrilli

Good morning Jim.

Jim MacDonald - First Analysis

Look Steve, you mentioned that you are still working towards your goal of getting a couple of exits this year. Can you talk a little bit more about that and if anything in particular is held back your progress toward that goal.

Steve Zarrilli

Well, as I mentioned and have over the course of the couple of quarters, we continue to strive to find appropriate exits for a number of our companies, assuming that the terms and conditions of those exists represent proper value to our shareholders.

We’ve had our times, found ourselves in situations where we may have a particular interest expressed in one of our partner companies and that interest may actually be formalized through a formal discussion and maybe even some exchange of paper work, but we found that the values have fallen short to where we think it’s appropriate.

We are not looking to take the last nickel off the table. We look for a well timed, risk adjusted exit, and having said that we still think that there is a number of dialogs that are occurring as we speak, that could ultimately result in one of those goals being achieved by the end of the quarter.

I’m fond of saying football is a four quarter game, where in the fourth quarter of our game we have about 70 days left on the clock and we are taking advantage of every one of those days as we work through those opportunities.

Jim MacDonald - First Analysis

Thanks, and just a follow-up related to MediaMath. I know the decision is not your specifically, but what are your feelings on what MediaMath should do now that some other companies have taken a lot of money in this space and gone public.

Steve Zarrilli

Yes, MediaMath is a phenomenal company that has demonstrated an ability to grow profitability. So I think you got to start with that as the backdrop to any discussion.

Joe and his team are focused on ensuring that they have a operating infrastructure and a platform that can continue to grow over a long period of time, and he has shown in the past an ability to find opportunistic ways in which to acquire other technologies to expand that platform.

Joe and his board continuously evaluate the market for what is right for MediaMath, as it relates to either capital development or fund raising for the future growth of that business and in other ways in which they maybe able to begin the process of unlocking value for shareholders.

We do have a seat at that table. We are not a controlling shareholder in MediaMath as I know you know, but we do have the opportunity to express our views and opinions to Joe and to the rest of the board as that collective group evaluates the opportunities that MediaMath is faced with.

They are great opportunities. Rocket Fuel is just one example. I believe that there is some other companies, including a French based company that is contemplating or is in the process of an IPO and I think will add further validation to this space and will continue to influence the way MediaMath looks at its near and long term future.

Jim MacDonald - First Analysis

Right and just one more maybe if you could on Penn Mezzanine. You didn’t mention anything specific about it on the call. It seemed to kind of just be slugging away during the quarter. Any other comments there?

Steve Zarrilli

I’ll let Jeff answer that since he actually sits on the board with Brian Sisko on Penn Mezzanine.

Jeff McGroarty

If you remember, no new deployments or no follow on deployments in Penn Mezz in the quarter and the activity there as far as finding new opportunities to make Mezzanine loans have been less from what we had hoped a couple of years ago when we started this.

So they are continuing to – just like we do, they are continuing to look for the right opportunities to support capital and the right return profile and those have been fewer and further between to find, so its not been an emphasis of ours from a management’s time standpoint. So we wouldn’t expect necessarily that there will be any additional deployments before the end of the year.

But that being said, we’ve got several participating interest in these loans that are generating interest income and from companies that are doing well and a few of them that are positioning themselves for potential exist in the near term.

Jim MacDonald - First Analysis

Thanks Jeff.

Operator

(Operator Instructions). Our next question comes from Robert Labick of CJS Securities.

Arnie Ursaner - CJS Securities

Hi, it’s Arnie Ursaner again for Bob. Your analyst day covered a lot of the elements related to the company, so I wanted to shift gears Steve and talk a little about capital allocation. You have a lot of great companies that are reaching maturity or approaching exits and it sounds like you have more than enough cash on your balance sheet to support the investments you plan to make.

Can you talk a little bit more about, I’ll be pretty specific here, why not buy stock back now before these exists occur and before the value is realized in the market, and maybe you could highlight the boards approach or your approach or the decision making process about repurchases.

Jeff McGroarty

Yes. So the board actively discusses capital allocation. They look at concepts related to share repurchase, repayment of debt and other elements, including potentially dividends. During the third quarter we did not execute any share repurchases, however subsequent to the quarter end we made some modest share repurchases when the stock showed some short term weakness and we purchased less than 10,000 share since October 1.

Arnie Ursaner - CJS Securities

Again, not to pin you down, but can you be more specific about the criteria you use for share repurchase?

Jeff McGroarty

We generally don’t disclose that Arnie and its actually something that the board continues to dialog about and we’ll continue to evaluate on a very regular basis. So management and the board continually have that discussion and it’s a very fluid discussion and one that I think the shareholders will – they should take comfort about that we are actively discussing it quite frequently.

Arnie Ursaner - CJS Securities

In the same spirit, when you’ve had exits in the past you’ve reinvested immediately in other businesses. Could you care to comment, is there a thought process that maybe at some point a more formulaic approach to dividends or return to capital to your shareholders makes some sense.

Jeff McGroarty

Well again, one of the primary goals that I have is to show consistency in our operating model. I think I’ve been pretty consistent in that strategic element and in describing that. And what that really means is that I’m looking to insure that we not only can put capital to work in a very consistent fashion, and hold that thought for a second, because I want to touch on something else there, but that we are also bringing capital back into the organization through monetization.

And as the model matures and solidifies around those two cornerstones, the dialogue that can transpire in the boardroom then becomes much different as you can imagine. I mean, unfortunately we are sitting here today having waited thus far, almost a little over two years since our last exit and we recognize that.

We understand that its important that we get back on the monetization trail if you will, and we’re working very diligently to get that in place, and its not just that I want one or two by the end of the year; it’s a much broader discussion about how do we continue to keep that engine running, so that, yes, we are putting new capital to work, but we’re also returning capital to the business.

And as those two elements begin to flow with each other in a much more consistent fashion, the dialogue that the board is able to engage in can be much different as well, as you can well imagine. If there is consistency, predictability, a greater level of comfort, then your capital allocation discussions begin to take on different tones and different elements.

Having said that, two other points: one, we are not here just to build a big platform. So we are not into empire building. We want to make sure that the shareholders are getting the value that they anticipate, but we also recognize that we are doing a pretty good job of being a capital provider in the marketplace. We have some great companies that we refer to today and that we do need a certain amount of capital in order to be continually successful in the market, and we continually challenge ourselves to understand what that number is, how much do we need and how much might we not necessarily need for purposes of deployment.

I also believe that you need to understand that as we evolve, we want a greater number of companies in play at any given time, so this year we are trying to get to a number of 25 or 26 net of a couple of exits. Next year in ’14, you would probably see a similar number of deployments in quantity, meaning six to eight with an average deployment size of probably somewhere between five to 10, maybe sometimes a little more north of 10.

So that’s all being factored into a lot of the thought process that we go through in determining the capital allocation and how we think we should be using our capital to best benefit the shareholders. I hope that that long-winded answer gives you some further clarity.

Arnie Ursaner - CJS Securities

It was very thorough. Thank you very much.

Operator

Our next question comes from Paul Knight of Janney Capital Markets.

Paul Knight - Janney Capital Markets

Hi Steve. When is this market starting to get very active for diagnostics IPOs and other liquidity events? Are you seeing more active deal flow on the private side on this diagnostic space?

Steve Zarrilli

The deal teams are seeing definitely a quality deal flow for us to consider. I think some of our higher profile companies demonstrate that we’re pretty astute and intelligent investors. So we’re starting to have dialogue in a number of different areas that I think will provide future value as well in this segment for us.

Management goes off site for a day in November to talk about ’14 and then we bring that to the board in the first two weeks of January. So we’re going to be talking about that particular subject quiet thoroughly as it relates to capital allocation in that segment in 2014.

Paul Knight - Janney Capital Markets

Are you seeing more free IPO transactions, not uncertainty IPO windows, but it seems like I hear of that occurring. Are you seeing pre-IPO realms occurring at this point?

Steve Zarrilli

I can’t say Paul that I’m seeing that specifically. What I do know is that the space is getting a lot of attention. Obviously a couple of IPOs that had been recently completed have we highlighted the market environment for these types of companies. We clearly have two that we are very proud of, being a part of, and we think they have a lot of future value for safeguarding its shareholders and I think we’re able to take advantage of that and back to the first point that you were trying to convey or understand, we are seeing other opportunities substantially for capital to work in.

Paul Knight - Janney Capital Markets

And then lastly, I don’t know if you can comment on this or it’s a Don Hardison question and that is the nature of a GoodStart Genetics tests versus the tests at Verinata at Illumina. Can you talk to that or should I talk to Don?

Steve Zarrilli

You will be better served talking to Don. I would not do justice to that question.

Paul Knight - Janney Capital Markets

Okay, thank you.

Operator

Our next question comes from Ed Woo of Ascendiant Capital.

Ed Woo - Ascendiant Capital

Great, good morning.

Steve Zarrilli

Good morning Ed. How are you?

Ed Woo - Ascendiant Capital

Touching on some of the investment opportunities out there, have you seen any big changes in valuations or potential investments?

Steve Zarrilli

There are certain segments that tend to have some value parameters that are a little frothy and we are doing our best to ensure that we don’t get ourselves in a situation where the value of a company that we may be pursuing to deploy capital in, is way outside of a range that we’re comfortable with.

Because as you recall that and I think you and I have had some conversations about this in the past as I have with others, a lot of our success on the back end comes from the success of the dollar amount, the value that we get in at the beginning. So we’re very cognizant of what’s maybe transpiring out there with regard to valuations potentially getting a little frothy.

Now it’s a double edge sword, because on one end if we’re in the market wanting to potentially help a partner company reach a monetization event, that’s a good thing, and then on the other side of the equation as we’re looking to deploy new capital, we want to make sure that we’re not in our way looking at the world overpaying as we enter into the relationship.

So there is a lot of work that goes into evaluating companies based upon not only operating capability and scalability and management strength, but also valuation and valuation expectations.

There are areas that are starting to get a little ahead of themselves and we’ve seen this cycle play out before, and I think part of the value of the safeguard model is having this multi-pronged segment approach, because if one gets a little ahead of itself, we can pull our resources into a little bit of a different direction and still be able to hit our deployment goals.

Ed Woo - Ascendiant Capital

Do you think that will present any challenge trying to get to that 25 companies invested by the end of the year?

Steve Zarrilli

No.

Ed Woo - Ascendiant Capital

Okay, great. Well, thank you and good luck.

Steve Zarrilli

Thanks.

Operator

Our next question comes from Troy Ward from KBW.

Troy Ward – KBW

Thank you. Steve, just a quick follow-up. Can you speak to Sotera for a minute? I saw in the release where subsequent to the third quarter there was a positive FDA approval and can you give us a little bit of color on that and I know they are still in the initial revenue stage, but kind of what path are they on and then also can you speak to their capital needs and your ownership position. I know a 7% is kind of less than most of your other companies.

Steve Zarrilli

Yes, Sotera we’ve got some good FDA news posts at the end of the quarter. Actually Tom Watlington mentioned that he was actually waiting for it when he was up on the podium at our Investor Day and that really just allows him to be back in market with the product, the product that is starting to get some real good market traction.

We are working with Tom and the rest of the Investor group there to understand the capital needs of the business as they go into 2014. Our original intent was to be a part of that discussion and hence the reason for the deployment of capital earlier this year into Sotera or late last year, one of the other, and what we’re going to be doing over the next four or five months is assessing what the capital means are and how Safeguard might participate and through that process as you would hopefully expect, we’ll get a better sense as to where the real market opportunities lies for Sotera, and not only for the current principal product, but some of the other ambitions that the management team has in the marketplace.

Troy Ward – KBW

Okay, great. Thank you.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Steve Zarrilli for any closing remarks.

Steve Zarrilli

We’d just like to thank everyone or joining us today and we will continue to report on the progress. Thank you.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

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