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TMCNet:  SURMODICS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[February 08, 2013]

SURMODICS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis provides information that we believe is useful in understanding our operating results, cash flows and financial condition. The discussion should be read in conjunction with both the unaudited condensed consolidated financial statements and related notes included in this Form 10-Q, and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2012. This discussion contains various "Forward-Looking Statements" within the meaning of the Private Securities Litigation Reform Act of 1995. We refer readers to the statement entitled "Forward-Looking Statements" located near the end of Part I of this report.


Overview SurModics is a leading provider of surface modification and in vitro diagnostic technologies to the healthcare industry. In fiscal 2012 our business performance was driven by growth in our Medical Device hydrophilic coatings royalty revenue.

The Medical Device segment overcame the termination of Cordis Corporation's exclusivity arrangements under one of its license agreements by increasing new license agreements and continued expansion of activities with other Medical Device customers. It is anticipated that we will continue to sign new license agreements in fiscal 2013 and broaden our hydrophilic coatings royalty stream.

Our In Vitro Diagnostics segment generated solid revenue growth in fiscal 2012 from existing products, new product launches and the addition of new diagnostic test kit manufacturer customers. We anticipate that these fiscal 2012 activities as well as additional product launches and the addition of new diagnostic test kit manufacturer customers in fiscal 2013 will result in continued product sales growth for our In Vitro Diagnostics segment.

On November 1, 2011, we entered into a Purchase Agreement to sell substantially all of the assets of SurModics Pharmaceuticals (the Pharmaceuticals segment) to Evonik Degussa Corporation ("Evonik"). Under the terms of the Purchase Agreement, the entire portfolio of products and services of SurModics Pharmaceuticals, including its cGMP development and manufacturing facility located in Birmingham, Alabama, were sold. The Company retained all accounts receivable and the majority of liabilities associated with the SurModics Pharmaceuticals business incurred prior to closing. The sale (the "Pharma Sale") closed on November 17, 2011. The total consideration received from the Pharma Sale was $30.0 million in cash.

We have reported the Pharmaceuticals segment as discontinued operations beginning in the first quarter of fiscal 2012, as disclosed in Note 3 to the condensed consolidated financial statements. Accordingly, all results of operations, cash flows, assets and liabilities of SurModics Pharmaceuticals for all periods presented are classified as discontinued operations. All information in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" includes only results from continuing operations (excluding the Pharmaceuticals segment) for all periods presented, unless otherwise noted.

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company is organized into two segments as follows: (1) the Medical Device unit, which is comprised of surface modification coating technologies to improve access, deliverability, and predictable deployment of medical devices, as well as drug delivery coating technologies to provide site-specific drug delivery from the surface of a medical device, with end markets that include coronary, peripheral, and neuro-vascular, and urology, among others, and (2) the In Vitro Diagnostics unit, which consists of component products and technologies for diagnostic test kits and biomedical research applications, with products that include protein stabilization reagents, substrates, antigens and surface coatings.

We derive our revenue from three primary sources: (1) royalties and license fees from licensing our proprietary drug delivery and surface modification technologies and in vitro diagnostic formats to customers; the vast majority (typically in excess of 90%) of revenue in the "royalties and license fees" category is in the form of royalties; (2) the sale of reagent chemicals to licensees and the sale of stabilization products, antigens, substrates and surface coatings to the diagnostic and biomedical research markets; and (3) research and development fees generated on customer projects. Revenue fluctuates from quarter to quarter depending on, among other factors: our customers' success in selling products incorporating our technologies; the timing of introductions of licensed products by customers; the timing of introductions of products that compete with our customers' products; the number and activity level associated with customer development projects; the number and terms of new license agreements that are finalized; the value of reagent chemicals and other products sold to customers; and the timing of future acquisitions we complete, if any.

For financial accounting and reporting purposes, we report our results for the two reportable segments noted above. We made this determination based on how we manage our operations and the information provided to our chief operating decision maker who is our Chief Executive Officer.

20 -------------------------------------------------------------------------------- Table of Contents Overview of Research and Development Activities We manage our customer-sponsored research and development ("R&D") programs based largely on the requirements of our customers. In this regard, our customers typically establish the various measures and metrics that are used to monitor a program's progress, including key deliverables, milestones, timelines, and an overall program budget. The customer is ultimately responsible for deciding whether to continue or terminate a program, and does so based on research results (relative to the above measures and metrics) and other factors, including their own strategic and/or business priorities. Following the Pharma Sale in the first quarter of fiscal 2012, customer R&D programs are mainly in our Medical Device segment.

Our R&D activities are engaged in the exploration, discovery and application of technologies that solve meaningful problems in the diagnosis and treatment of disease. Our key R&D activities include efforts that support and expand our core offerings. These efforts include completing development activities associated with our next generation (Gen 5) hydrophilic coating platform and completing activities that support the development of our coating technologies that enhance drug-coated balloons. Additional planned activities include initiation of surface modification experiments that improve medical device performance and developing chemistries to support molecular diagnostic applications.

For our internal R&D programs in our segments, we utilize R&D review committees to prioritize these programs based on a number of factors, including a program's strategic fit, commercial impact, potential competitive advantage, technical feasibility, and the amount of investment required. The measures and metrics used to monitor a program's progress vary based on the program, and typically include many of the same factors discussed above with respect to our customer R&D programs. We typically make decisions to continue or terminate a program based on research results (relative to the above measures and metrics) and other factors, including our own strategic and/or business priorities, and the amount of additional investment required.

With respect to cost components, R&D expenses consist of labor, materials and overhead costs (utilities, depreciation, indirect labor, etc.) for both customer R&D and internal R&D programs. We manage our R&D organization in a flexible manner, balancing workloads/resources between customer R&D and internal R&D programs primarily based on the level of customer program activity. Therefore, costs incurred for customer R&D and internal R&D can shift as customer activity increases or decreases.

Critical Accounting Policies Critical accounting policies are those policies that require the application of management's most challenging subjective or complex judgment, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Critical accounting policies involve judgments and uncertainties that are sufficiently likely to result in materially different results under different assumptions and conditions. For a detailed description of our critical accounting policies, see the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2012.

Results of Operations - Three Months Ended December 31 Revenue. Revenue during the first quarter of fiscal 2013 was $13.9 million, an increase of $1.9 million, or 16%, compared with the first quarter of fiscal 2012. The increase in revenue, as detailed in the table below, is further explained in the narrative below.

Three Months Ended December 31, December 31, Increase (Dollars in thousands) 2012 2011 (Decrease) Change Revenue: Medical Device $ 10,531 $ 8,867 $ 1,664 19 % In Vitro Diagnostics 3,320 3,049 271 9 % Total revenue $ 13,851 $ 11,916 $ 1,935 16 % Medical Device. Revenue in Medical Device was $10.5 million in the first quarter of fiscal 2013, an increase of 19% compared with $8.9 million for the first quarter of fiscal 2012. The increase in total revenue was attributable to higher royalty revenue, product sales and R&D revenue, partially offset by lower license fees. Continued growth in our hydrophilic coatings offerings as well as $0.6 million from a royalty revenue catch-up payment led to the increased revenue result.

In Vitro Diagnostics. Revenue in In Vitro Diagnostics was $3.3 million in the first quarter of fiscal 2013, an increase of 9% compared with $3.0 million for the prior-year period. This increase was attributable to $0.6 million of higher sales of antigen and stabilization products, partially offset by $0.2 million of lower sales of other products.

21 -------------------------------------------------------------------------------- Table of Contents Product costs. Product costs were $2.0 million in the first quarter of fiscal 2013, an increase of 23% compared with $1.6 million for the first quarter of fiscal 2012. Overall product margins averaged 63% in the first quarter of fiscal 2013, compared with 66% for the prior-year period. The decrease in product margins reflected the mix of products sold in the first quarter of fiscal 2013, as there were higher levels of lower margin diagnostic product sales compared with prior year results.

Research and development expenses. R&D expenses were $3.4 million for the first quarter of fiscal 2013, a decrease of 8% compared with $3.6 million for the first quarter of fiscal 2012. The decrease was primarily a result of $0.1 million of lower license fee expenses and $0.1 million of lower compensation expenses in the first quarter of fiscal 2013.

Selling, general and administrative expenses. Selling, general and administrative expenses were $3.7 million for the three months ended December 31, 2012, an increase of 5% compared with $3.5 million for the prior-year period. The increase was primarily attributable to $0.3 million of higher professional services and consulting expenses, offset partially by $0.2 million of lower compensation expenses.

Other income, net. Other income was $1.2 million in the first quarter of fiscal 2013, compared with $0.1 million for the first quarter of fiscal 2012. The first quarter of fiscal 2013 includes the gain of $1.2 million from the sale of our ownership interest in Vessix Vascular, Inc. ("Vessix"). Income from investments in fiscal 2013 decreased approximately $0.1 million compared with the prior-year period primarily from lower yields on our investment balances.

Income tax provision. The income tax provision associated with continuing operations was $1.9 million and $1.2 million for the three months ended December 31, 2012 and 2011, respectively, representing effective tax rates of 30.6% and 36.0%, respectively. The lower income tax provision for the three months ended December 31, 2011 was a result of lower pre-tax income. The difference between the U.S. federal statutory tax rate of 35.0% and the Company's effective tax rate for the three months ended December 31, 2012 and 2011 reflects the impact of state income taxes, permanent tax items and discrete tax benefits. The three months ended December 31, 2012 also reflects the impact of a gain on sale of Vessix for which there is tax expense recognized which has been offset by the reversal of a valuation allowance. Discrete tax benefits were $0.2 million in the three months ended December 31, 2012 resulting from lapses of the statute of limitations in various jurisdictions. Discrete tax benefits were less than $0.1 million in the three months ended December 31, 2011.

Income from discontinued operations. There was no statement of income impact associated with discontinued operations for the three months ended December 31, 2012. Income from discontinued operations, net of income tax provision, for the three months ended December 31, 2011, was $1.6 million. Revenue from the Pharmaceuticals segment was $5.3 million for the first quarter of fiscal 2012.

The Pharmaceuticals segment results for the first quarter of fiscal 2012 include the period from October 1, 2011 to November 17, 2011, the date of the Pharma Sale.

Loss on sale of discontinued operations. Loss on sale of discontinued operations recorded in the first quarter of fiscal 2012 related to the Pharma Sale was $1.1 million ($1.7 million on a pre-tax basis), which was principally related to transaction closing costs.

Segment Operating Results Operating income for each of our reportable segments, which excludes the results from our Pharmaceuticals segment, was as follows (in thousands): Three months ended December 31, 2012 2011 Operating income (loss): Medical Device $ 5,840 $ 3,932 In Vitro Diagnostics 751 906 Corporate (1,714 ) (1,616 ) Total operating income from continuing operations $ 4,877 $ 3,222 Medical Device. Operating income was $5.8 million in the first quarter of fiscal 2013, compared with $3.9 million in the first quarter of fiscal 2012. The increased operating income resulted from $0.9 million of higher royalty and license fee revenue, of which $0.6 million was associated with a royalty revenue catch-up payment, $0.3 million of higher R&D revenue as well as the gross margin impact from $0.5 million in higher reagent sales. Direct operating expenses were similar in each period. Allocated corporate costs decreased approximately $0.3 million in the first quarter of fiscal 2013 when compared with the first quarter of fiscal 2012.

In Vitro Diagnostics. Operating income was $0.8 million in the first quarter of fiscal 2013, compared with $0.9 million in the first quarter of fiscal 2012. The revenue increase of $0.3 million compared with the prior-year period did not offset the $0.1 million of additional direct operating expenses incurred since the additional revenue did not generate a gross margin increase based on the product mix in the first quarter of fiscal 2013.

22 -------------------------------------------------------------------------------- Table of Contents Corporate. The Corporate category includes expenses for administrative corporate functions, such as executive, corporate accounting, legal, human resources and Board related, that have not been fully allocated to the Medical Device and In Vitro Diagnostics segments. Corporate also includes expenses, such as litigation, which are not specific to a segment. Operating loss was $1.7 million and $1.6 million in the first quarter of fiscal 2013 and 2012, respectively.

Outside service costs increased $0.2 million in the first quarter of fiscal 2013 compared with the first quarter of fiscal 2012 and these expenses were partially offset by decreased compensation expenses in the first quarter of fiscal 2013 compared with the first quarter of fiscal 2012.

Liquidity and Capital Resources Operating Activities. As of December 31, 2012, we had working capital of $33.0 million, a decrease of $0.1 million from September 30, 2012. Our cash, cash equivalents and available-for-sale securities totaled $64.0 million at December 31, 2012, an increase of $5.9 million from $58.1 million at September 30, 2012. The increase in cash resulted from cash generated by our first quarter operating results as well as $1.3 million of proceeds that we received from the sale of our Vessix shares. Our investments consist principally of U.S. government and government agency obligations, mortgage-backed securities and investment grade, interest-bearing corporate and municipal debt securities with varying maturity dates, the majority of which are five years or less. The Company's investment policy requires that no more than 5% of investments be held in any one credit or issue, excluding U.S. government and government agency obligations. The primary investment objective of the portfolio is to provide for the safety of principal and appropriate liquidity while meeting or exceeding a benchmark ("Merrill Lynch 1-3 Year Government-Corporate Index") total rate of return. Management plans to continue to direct its investment advisors to manage the Company's securities investments primarily for the safety of principal for the foreseeable future as it assesses other investment opportunities and uses of its cash and securities investments, including those described below.

We had cash flows from operating activities from continuing operations of $5.4 million in the first quarter of fiscal 2013, compared with $1.9 million in the first quarter of fiscal 2012. The increase compared with prior-year results reflects increased net income as well as stronger cash generated by accounts receivable and lower cash disbursements related to accounts payable and accrued liabilities.

Investing Activities. We invested $0.9 million in property and equipment in the first quarter of fiscal 2013, compared with $0.2 million in the prior-year period. The property and equipment investment in the first quarter of fiscal 2013 is higher than our investment in the first quarter of fiscal 2012 as the Company increased spending principally on building improvements of $0.3 million and computer equipment and software of $0.3 million. We anticipate spending in the remaining quarters of fiscal 2013 to decline slightly. We received cash proceeds from the sale of our Vessix shares of $1.3 million in the first quarter of fiscal 2013. In the first quarter of fiscal 2012 we received cash from our discontinued operations, associated with the Pharma Sale, which totaled $24.5 million.

Financing Activities. In May 2012, our Board of Directors authorized the repurchase of up to $50.0 million of the Company's outstanding common stock through open-market purchases, private transactions, block trades, accelerated share repurchase transactions, tender offers, or by any combination of such methods. On August 6, 2012, we commenced a "modified Dutch auction" tender offer which expired on September 5, 2012 and resulted in the repurchase of $55.0 million in value of common stock, consisting of 2,894,253 shares at a price of $19.00 per share. No shares were repurchased under this authorization during the three months ended December 31, 2012 and as of December 31, 2012, $0.3 million remains available for future share repurchases. The repurchase authorization does not have a fixed expiration date.

In January 2013, our Board of Directors authorized the repurchase of up to an additional $10.0 million of the Company's outstanding common stock through open-market purchases, private transactions, block trades, accelerated share repurchase transactions, tender offers, or by any combination of such methods.

The repurchase authorization does not have a fixed expiration date.

We do not have any credit agreements and believe that our existing cash, cash equivalents and available-for-sale securities, which totaled $64.0 million as of December 31, 2012, together with cash flow from operations, will provide liquidity sufficient to meet the below stated needs and fund our operations for the remainder of fiscal 2013. There can be no assurance, however, that SurModics' business will continue to generate cash flows at current levels, and disruptions in financial markets may negatively impact our ability to access capital in a timely manner and on attractive terms. Our anticipated liquidity needs for the remainder of fiscal 2013 may include, but are not limited to, the following: general capital expenditures in the range of $1.5 to $2.5 million, obligations remaining after the Pharma Sale, including indemnification obligations to Evonik related to contingent consideration payments and payments in the range of $0.3 to $0.5 million related to our agreement with various governmental authorities associated with creation of jobs in Alabama.

Discontinued Operations. Our Pharmaceuticals discontinued operation generated operating cash of $0.1 million in the first quarter of fiscal 2013 and used operating cash of $2.3 million in the first quarter of fiscal 2012. Cash provided by investing activities of $26.9 million in the first quarter of fiscal 2012 related principally to proceeds received from the Pharma Sale. Cash used in financing activities of $0.1 million in the first quarter of fiscal 2013 and $24.5 million in the first quarter of fiscal 2012 related to transfers of cash to the continuing operations of the Company and consisted of cash generated from payments related to a retained accounts receivable balance in fiscal 2013 and principally to the Pharma Sale in fiscal 2012.

23 -------------------------------------------------------------------------------- Table of Contents Customer Concentrations. Our licensed technologies provide royalty revenue, which represents the largest revenue stream to the Company. We have licenses with a diverse base of customers and certain customers have multiple products using our technology. Medtronic, Inc. ("Medtronic") was our largest customer comprising 19% of total revenue for fiscal 2012. Medtronic has several separately licensed products that generate royalty revenue for SurModics, none of which represented more than 6% of SurModics' total revenue. No other individual customer using licensed technology constitutes more than 10% of SurModics' total revenue.

Off-Balance Sheet Arrangements As of December 31, 2012, the Company did not have any off-balance sheet arrangements with any unconsolidated entities.

Forward-Looking Statements This Quarterly Report on Form 10-Q, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 2, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include expectations concerning our growth strategy, including our ability to sign new license agreements and broaden our hydrophilic coatings royalty revenue, product development programs, future cash flow and sources of funding, short-term liquidity requirements, future property and equipment investment levels, the impact of potential lawsuits or claims, and the impact of Medtronic, as well as other significant customers, including new diagnostic kit customers. Without limiting the foregoing, words or phrases such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "intend," "may," "plan," "possible," "project," "will" and similar terminology, generally identify forward-looking statements. Forward-looking statements may also represent challenging goals for us. These statements, which represent the Company's expectations or beliefs concerning various future events, are based on current expectations that involve a number of risks and uncertainties that could cause actual results to differ materially from those of such forward-looking statements. We caution that undue reliance should not be placed on such forward-looking statements, which speak only as of the date made. Some of the factors which could cause results to differ from those expressed in any forward-looking statement are set forth under "Risk Factors" in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended September 30, 2012. We disclaim any intent or obligation to update publicly these forward-looking statements, whether because of new information, future events or otherwise.

Although it is not possible to create a comprehensive list of all factors that may cause actual results to differ from the Company's forward-looking statements, such factors include, among others: • the Company's reliance on a small number of significant customers, which causes our financial results and stock price to be subject to factors affecting those significant customers and their products, the timing of market introduction of their or competing products, product safety or efficacy concerns and intellectual property litigation could adversely affect our growth strategy and the royalty revenue we derive; • general economic conditions which are beyond our control, including the impact of recession, business investment and changes in consumer confidence; • a decrease in the Company's available cash or the value of its investment holdings could impact short-term liquidity requirements and expected capital expenditures; • the difficulties and uncertainties associated with the lengthy and costly new product development and foreign and domestic regulatory approval processes, such as delays, difficulties or failures in achieving acceptable clinical results or obtaining foreign or U.S. Food and Drug Administration marketing clearances or approvals, which may result in lost market opportunities or postpone or preclude product commercialization by licensees; • the development of new products or technologies by competitors, technological obsolescence and other changes in competitive factors; • the Company's ability to successfully internally perform certain product development activities and governmental and regulatory compliance activities which the Company has not previously undertaken in any significant manner; • possible adverse market conditions, possible adverse impacts on our cash flows and competing cash needs could impact the ability to complete and timing of repurchases under any remaining repurchase authorization under our share repurchase program; and • other factors described in "Risk Factors" and other sections of SurModics' Annual Report on Form 10-K for the fiscal year ended September 30, 2012, which you are encouraged to read carefully.

24 -------------------------------------------------------------------------------- Table of Contents Many of these factors are outside the control and knowledge of the Company, and could result in increased volatility in period-to-period results. Investors are advised not to place undue reliance upon the Company's forward-looking statements and to consult any further disclosures by the Company on this subject in its filings with the SEC.

Use of Non-GAAP Financial Information.

In addition to disclosing financial results in accordance with generally accepted accounting principles, or GAAP, this report could include certain non-GAAP financial results, such as effective tax rate and segment operating results adjusted for one-time events. We believe these non-GAAP measures provide meaningful insight into our operating performance, excluding certain event-specific charges, and provide an alternative perspective of our results of operations. We use non-GAAP measures, including certain of those set forth in this report, to assess our operating performance and to determine payout under our executive compensation programs. We believe that presentation of certain non-GAAP measures allows investors to review our results of operations from the same perspective as management and our Board of Directors and facilitates comparisons of our current results of operations. The method we use to produce non-GAAP results is not in accordance with GAAP and may differ from the methods used by other companies. Non-GAAP results should not be regarded as a substitute for corresponding GAAP measures but instead should be utilized as a supplemental measure of operating performance in evaluating our business. Non-GAAP measures do have limitations in that they do not reflect certain items that may have a material impact upon our reported financial results. As such, these non-GAAP measures presented should be viewed in conjunction with our consolidated financial statements prepared in accordance with GAAP.

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