Surmodics Inc (SRDX) 2005 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the SurModics fourth quarter and fiscal year 2005 earnings conference call. At this time all participants are in a listen-only mode. Following today's presentation instructions will be given for the question and answer session. If you should require assistance at any time during the conference, please press the star followed by the zero on your touchtone phone. As a reminder this conference is being recorded today and today is Wednesday, October 26, 2005. I'd now like to turn the conference over to Mr. Phil Ankeny, the Chief Financial Officer and Vice President of Business Development. Please go ahead, sir.

Thank you, Don. Good afternoon and welcome to the fiscal 2005 fourth quarter and full year conference call for SurModics. Thanks for joining us today. With me on the call today are Bruce Barclay, President and Chief Executive Officer, and Loren Miller, Vice President and Controller, who is available for the Q and A session. Before we begin I must preface all comments with the Safe Harbor statement. Some of the comments made today will be forward-looking and are made under the Private Securities Litigation Reform Act of 1995. Actual results may differ and factors that may cause such results to differ are identified beginning on page 14 of the Company's fiscal 2004 Form 10-K Annual Report and in the MD&A section of the Company's Forms 10-Q filed after the 10-K. Now I would like to provide a brief overview of the contents of today's call. First, I will cover the quarter and full year operating and financial results. Bruce will then follow with a strategy update and review of fiscal 2005 and finally we along with Loren will open up the call to your questions.

As you will note from our Earnings Release we had a strong fourth quarter and fiscal 2005. I will start with an overview of the fourth quarter financial results and then break down the numbers by revenue components and business segments before turning to the full year financials. Revenue in the fourth quarter was 16.1 million, a 19% increase from 13.5 million in the year earlier period. During the quarter the Company recorded a non-cash asset impairment charge of 2.5 million in connection with the sale of our contract manufacturing facility in Bloomington, Minnesota. Including the charge operating income was 6.3 million and net income was 4.8 million or $0.25 per diluted share. Excluding the charge operating income grew 6% to 8.8 million from 8.3 million in the prior year period. Net income increased 18% to a record 6.4 million from 5.4 million in the same period last year and diluted earnings per share was a record $0.33 compared with $0.30 in the fourth quarter of fiscal 2004. Our business model continues to be very profitable with an operating margin of 55% and a net margin of 40% for the quarter. Again, these figures exclude the impairment charge.

I'll spend a minute now on CYPHER, the Sirolimus-eluting Coronary Stent from Cordis Corporation, a Johnson & Johnson company. CYPHER continues to benefit from clinical data that reinforces what many physicians believe to be at superior safety and efficacy. In addition, Cordis continues to increase product supply contributing to substantial CYPHER market share gains in the United States. Specifically, J&J reported that CYPHER's share of the US market has grown to 46%, up from 41% for the June quarter and 35% in the year earlier period. Also significantly, J&J reported that CYPHER has gained worldwide drug eluting stent market leadership for the first time since Cactus [ph] was approved for sale in the United States back in March of 2004. On another positive note internationally analysts expect CYPHER to retain sole control of the highly profitable Japanese drug eluting stent market until calendar 2007.

Now I will take you through the revenue components for the quarter. Royalties and license fees were 12.5 million, up 28% from the year ago quarter. These results highlight the value of our broad portfolio of royalty generating products. Non-Cordis revenue continues to generate strong growth. This quarter is the sixth consecutive quarter in which non-Cordis revenue exceeded Cordis revenue. The accomplishment is particularly impressive given the robust growth seen in Cordis revenue over the past twelve months.

Let's turn now to the other lines of revenue. Product sales increased 7% to 2.4 million, mostly attributable to growth in stabilization sales, which offset lower sales of reagents and genomics lines. Research and Development revenue was 1.1 million, which was roughly flat sequentially and 21% lower compared to the fourth quarter of 2004. Our Research and Development organization continues to be very busy with customer projects in key internally funded technology development projects.

Now looking at the business along segment lines, revenue in our drug delivery segment was 7.4 million in the fourth quarter, increasing 29% from the year earlier period. Hydorphylic and other came in at 5.2 million growing only modestly compared with the year earlier results but up 24% if you exclude the $1 million back royalty from the fourth quarter of fiscal year 2004. Diagnostics revenue increased 38% to 3.4 million primarily driven by our amended agreement with Abbott Laboratories as well as growth in stabilization product sales.

Turning now to the full fiscal year, total revenue for 2005 was 62.4 million, a 25% increase over fiscal year 2004. This marks the eighth consecutive year of record revenue SurModics has reported since our IPO in 1998. I've already mentioned the asset impairment charge in the fourth quarter. In addition, during the second quarter the Company recorded a $30.3 million non-cash charge for in-process research and development in connection with the acquisition of InnoRx, which was completed in January of 2005. Including these charges the Company reported operating income of 3 million and a net loss of 8.2 million or $0.45 per share. Excluding the charges operating income grew 33% to a record 35.7 million from 27 million in the prior year period. Net income increased 34% to a record 23.6 million from 17.6 million last year and diluted earnings per share was a record $1.27 compared with $0.99 in fiscal 2004.

Royalties and license fees grew 37% to a record 47.6 million. Royalties and license fees represented 76% of total revenue in fiscal 2005 compared to 70% of total revenue in fiscal 2004. Product sales were 9.4 million, a decrease of 10% from the prior year reflecting the previously announced contractual decrease in reagent pricing to Cordis, which was partially offset by growth in both stabilization and slide sales.

R&D revenue for fiscal 2005 was 5.4 million, a 33% increase over fiscal 2004. Although fiscal year 2005 R&D revenue was negatively affected by our acquisition of InnoRx, which transitioned the Company from customer to business unit, we were still able to grow R&D revenues on a year-over-year basis driven by a growing number of exciting customer projects.

Looking at the full year in segment terms revenue for drug delivery was 29.7 million in fiscal 2005, up 16% from the prior year period. In the hydrophylic and other segment revenue increased 23% year-over-year to 19.1 million on across the board growth in royalties, reagent sales and R&D revenue. Lastly, diagnostics revenue increased 60% year-over-year to 13.6 million resulting principally from our amended agreement with Abbott Laboratories signed a year ago as well as growth in stabilization products and genomic slides.

Let's briefly review a few more metrics for the full fiscal year, again excluding the charges relating to the Bloomington facility and InnoRx acquisition. Our operating margin came in at 57% and our net margin was 38%. And return on equity was 22.5% for the year. On the expense front, again excluding certain charges, total operating expenses for the fourth quarter excluding product costs were 6.5 million compared with 4.4 million a year ago and a bit down sequentially from the 6.6 million reported in the June quarter.

SurModics is deeply committed to R&D investment and protecting the results of those innovations. We dedicated 27% of revenue to R&D during the fourth quarter up from 23% of revenue in the prior year period. Further, R&D expense constituted 67% of total operating expenses excluding product costs and charges. For the full year R&D expense increased 27% to 16.1 million at 26% of revenue. Some of the increase in expenses can be attributed to the new ophthalmology division and our funding of the I-vation clinical trial. In the long term we hope to offset some of these expenses by signing agreements with development and distribution partners interested in the InnoRx technology.

Another contributor to the growth in R&D expense was patent related legal costs. Bruce will discuss how our investment in intellectual property protects innovation at SurModics and is generating positive results. In September SurModics entered into an agreement for the sale of the Company's Bloomington, Minnesota contract manufacturing facility. The decision to sell this facility was consistent with our previously articulated growth strategy. Management firmly believes the Company's capital is best utilized securing access to and developing technologies that our customers need rather than investing in brick and mortar to support a contract manufacturing strategy. Moreover, the projected savings of approximately $1 million in annual operating expenses following our exit of the facility will positively impact our future profitability. We expect to fully vacate the Bloomington facility by the fourth quarter of fiscal year 2006.

Now on to the balance sheet, which continues to be in excellent shape. As of September 30th we had a cash and investment balance of 73.3 million and no debt. The Company regards its cash position as a valuable asset since it enables us to aggressively pursue opportunities that support our growth strategy, enhance our market positioning and continually add shareholder value. During fiscal 2005 we acquired InnoRx, licensed technology from Rutgers [ph] and made strategic investments in OctoPlus, ThermopeutiX and CardioMind. Our business development pipeline is extensive and we are actively evaluating additional opportunities to put our strong balance sheet to work.

Now let's take a brief look at cash flow. Cash from operations was 9 million for the fourth quarter and 27 million for the full year. And lastly I want to provide an update to the Company's Sarbanes-Oxley compliance efforts. We are making excellent progress on Section 404 and believe that our internal controls are adequate and effective. We are quite proud of the work our team has done to document and test our internal controls and we will be working with our auditors as they review our work in connection with the year end audit. At this time I will turn the call over to Bruce Barclay.

Thanks, Phil, and thanks to everyone for joining us on the call this afternoon. Before I begin my strategy update and 2005 review, I'm happy to again report that Forbes Magazine has just recognized SurModics for the sixth consecutive year in its list of 200 best small companies. At number 24 SurModics is the highest ranked of the 9 Minnesota companies on this year's list. Further only 17 of the 200 companies have six or more consecutive years on the Forbes list. This extended record of success is a reflection of the hard work and dedication of our employees and we thank them for that.

As Phil stated, we are very pleased with the financial results we achieved in 2005. Phil discussed how well CYPHER is doing in the marketplace. Although we are very happy to be associated with the success of that product, we are also aggressively taking action to affect one of our strategic directives, that of diversifying our revenue concentration. SurModics is focused on gaining access to promising new markets and technologies and maintaining balance among our various revenue streams by growing our customer base and portfolio of products. One measure of the success of our revenue diversification efforts can be seen in the declining percentage of revenue coming from Cordis. In fiscal year 2004 you may recall that Cordis represented 52% of our total revenue. I am pleased to report that despite year-over-year growth in Cordis revenue the percentage contribution decreased to 46% in fiscal year 2005. Looked at another way total revenue from Cordis grew 11% from fiscal year 2004 to fiscal year 2005 while non-Cordis revenue grew 41% year-over-year.

You already heard about our segment revenue but I wanted to highlight a noteworthy trend within these results. We continue to be particularly pleased with the growth in hydrophylic and other, which grew 23% year-over-year. This growth is a tribute to the growing portfolio of royalty generating customer relationships in our hydrophylic segment. In fact, the segment achieved an all-time record level of revenue of 5.2 million in the fourth quarter of fiscal 2005. One of our customers in this business segment, Fox Hollow Technologies, announced their results today posting another quarter of record revenue of $36.1 million and sequential growth of 26% over the June quarter. Further, the Company provided calendar 2006 revenue guidance I the range of $230 to $250 million. We are very pleased to provide the hydrophylic coating for their products.

Now an update on SurModics pipeline. During the fourth quarter we signed 5 new licenses bringing our total for the year to 20, far outdistancing the goal we set of 12 for the fiscal year. This compares favorably to the 17 licenses we signed in 2004, 14 licenses in '03 and 8 licenses in 2002. We believe our results on the licensing front benefit from our growing portfolio of technologies, our strong track record of success and our abilities to help customers accelerate time to market for their products. I want to take a moment to thank our employees for their tremendous efforts in achieving this new Company record for fiscal 2005. For fiscal 2006 our goal is to sign 15 new license agreements with our customers.

Last year we commented that one of our strategic initiatives was to accelerate our technology leadership through internal development and external acquisition of new technologies. As Phil discussed in his comments earlier, we made great progress on both fronts in 2005. However, to ensure that our unique position in the market is protected including our growing stable of technologies and applications, we filed 51 new patent applications in fiscal 2005, a record number for SurModics. This significantly expands the portfolio protection around our current technologies, yet it also includes 22 patent applications on new technologies, concepts, and innovations. As of September 30 we had a total of 76 licensed customers, several with multiple licenses, compared to 69 in the prior year period. Currently SurModics has 80 licensed product classes on the market generating royalty revenue versus 77 a year ago. The total number of licensed products not yet launched was 72, up from 64 a year ago. Major non-licensed opportunities as of September 30 stood at 64. While this figure is down from 73 a year ago, it is up from 51 at the close of June quarter. Recall that we had done some significant pruning in our pipeline earlier this year to better optimize the portfolio. In total the Company now has 136 potential commercial products in development with exciting opportunities in each of the Company's distinct business units.

Based on our efforts to better optimize the portfolio, we feel even more confident about the projects in the pipeline today in terms of their revenue potential and the quality of our partners. During fiscal year 2005 our customers launched 7 new product classes into the marketplace. We did not reach our goal of 10. I would note though that several product line extensions were launched by SurModics' customers in addition to these 7 product classes. Although these product line extensions do not fit our customary definition of product launches and so we did not include them into the fiscal '05 count, we believe some of them could become significant and meaningful royalty generators in the future. Our customers continue to make tremendous progress getting their products closer to launch. In fiscal year 2006 we expect 12 product classes to be launched by our customers.

Now I'd like to add some color regarding a few of our exciting emerging technologies. Today I will specifically discuss InnoRx, NovaCell, Donaldson [ph] and news from our collaboration with the University of Arizona previously announced this year. We believe that these projects serve to further our goals of strengthening customer relationships improving our pipeline and demonstrating progress toward exploiting the convergence of drugs and devices. I will start with SurModics InnoRx technology and the sustained release I-vation drug delivery system. For those of you new to the story, our InnoRx technology serves as an enabling technology in the market for retinal disease, one that industry experts anticipate will reach $2.5 to $7 billion within six years. Our I-vation product offering combines cutting edge technology from SurModics' ophthalmology division with the Company's drug delivery polymer expertise to attack two of the leading causes of blindness in our country, age related macular degeneration or AMD and diabetic macular edema or DME.

The phase one trial, while still at a very early stage having just been initiated in June, is on track to reach full enrollment of 30 patients by the end of the calendar year. This will allow us to have six months of follow-up data in hand roughly by the end of June 2006. As discussed before, the primary purpose of the clinical data will be to validate the platform in conjunction with our polymers as potential partners evaluate technology as a drug delivery system for use with their own drugs. Currently discussions with potential partners are ongoing. As we've said before though, SurModics does not feel any rush to enter into an agreement unless acceptable financial terms can be reached, as we believe in the technology and expect the trial results will confirm the validity of the platform. Accordingly we think that after phase one trial data is in hand our negotiating position will only get stronger and resulting terms of a deal should improve.

We're also excited about the positive steps taken by NovaCell. Recall that last year NovaCell filed an IND application with the FDA as a condition to commence a human clinical trial of its encapsulated islet cell approach to diabetes. Earlier this year NovaCell filed its response to questions from FDA. I am pleased to report today that NovaCell has received FDA approval of its IND and the Company expects to commence the first in man phase one-two trial by the end of this calendar year. The Company has also made significant progress in its ongoing work with human embryonic stem cells. We are pleased with these new developments and remain cautiously optimistic about NovaCell's prospects.

I would next like to talk about SurModics' joint development agreement with Donaldson Company. This collaboration combines Donaldson's nanofiber [ph] technology with SurModics' surface modification coatings to provide dramatically improved cell culture media. We believe the resulting products will be important tools for scientists conducting drug discovery and cell research. Some industry experts estimate the opportunities to be as large as $100 million for the cell research market and $500 million for the drug discovery high throughput screening market. The feedback received by us on the initial product has been very encouraging. Prototype products are currently in the hands of scientists at our beta sites. We expect product evaluations to be completed during the next two quarters and because there's no FDA approval process for these products since they are invitro, it's conceivable to launch to a new product offering very shortly.

Lastly, our agreement with the University of Arizona could offer a promising approach to address the problem of stent thrombosis. Thrombosis or clotting remains a significant challenge for both bare metal stents and drug eluting stents and something that the medical community needs solved. In fact, the Wall Street Journal ran an article last week highlighting the severity of the issue for cardiologists and their patients. Evidence suggests that improper ingrowth [ph] of healthy endothelial cells following the placement of stents may be a factor in these late thrombosis events. By providing technology to promote growth of endothelial cell tissue after implantation of a stent we believe the pro healing technology from the University of Arizona could help prevent late thrombosis. In fact, we have already received strong customer interest in this new technology and we have other technologies that could help solve this problem as well.

I'd now like to transition from project update and walk through an annual review of the Company to illustrate the tremendous strides we've made over the past year. A year ago we outlined our new strategy and seven-point revenue growth plan with the goal of maintaining sustainable growth for our Company. Throughout the year we have focused on the execution and implementation of this strategy and plan. I will now review our execution against the strategy and that revenue growth plan. The first element of our growth plan is to exploit the convergence of drugs and devices. Given the experience gained during the development of CYPHER, our strong track record and reputation and our broad portfolio of technologies, we are uniquely positioned to exploit this trend. SurModics has multiple drug eluting stent programs and interest I the technology remains strong. The Company signed a license agreement with CardioMind in July using our Encore polymer. The licensing agreement couples Encore with CardioMind's ultra low profile stent system for use in complex lesion applications where traditionally sized stent delivery technologies have difficult accessing. For the engineering minded, CardioMind's stent has a crossing profile of 1/14,000th of an inch, which is the same diameter as a typical coronary guide wire, very remarkable technology.

Investors remind us often of how big the DES market is today and that fact is not lost on us. What we love about our business model and our broad technology portfolio is that there are multiple ways for us to participate in a DES market. Drug delivery polymers are not the only way to participate. In fact, the three business units that serve the cardiology field, drug delivery, regenerative technologies and hydrophilic technologies, are all working on ways to participate in the DES market. For example, the drug delivery business unit offers polymers like Bravo and Encore to provide slide specific controlled release of drug delivery. Regenerative technologies offers antithrombotic and pro healing technologies that could play a role in DES as previously mentioned. And hydrophilic technologies offer slippery hydrophylic coatings on drug eluting stent delivery catheters. Our technologies in ophthalmology provide yet another example of devices acting as platforms from which drugs can be delivered on a sustained release basis with the intent of achieving improved clinical outcomes.

Second, enhance the business model, while our current business model is a great asset we believe it can be improved by extending new value added technologies to multiple customers. We are working to capture more elements of the value chain by controlling more than one element of the medical device. We believe this approach has the potential to dramatically increase the royalty rates SurModics will earn in the future. The InnoRx acquisition completed earlier this year illustrates this strategy. By bringing two potential partners, both the coating for biomaterial and the device platform, we believe we could be able to demand a higher royalty rate and negotiate better financial terms. The intravitreal implant fits perfectly into SurModics' existing business model of licensing technology to multiple customers and gives us more components of value to potentially license.

Third, expand the portfolio of technology offerings. One of SurModics core strengths is its ability to internally develop or externally access new technologies and then collaborate with customers to integrate those on their products. The more offerings we make available to our customers, the more value we think there will be. In the past year we've added several technologies for the benefit of our customers. We acquired InnoRx in the ophthalmology business. We expanded our portfolio of polymer systems to a total of 8 with the addition of 2 biodegradable polymer families from Rutgers to the many internally developed polymer technologies and the 2 biodegradable polymers previously announced and licensed from OctoPlus. During the year we named Dr. Aaron Anderson as our Chief Scientific Officer. Aaron provides a tremendous amount of input into the technology evaluation efforts that our business development activities require and we continue to be very pleased with the number of interesting and relevant technologies that we have under review in business development.

Fourth is leverage our technology into new markets. Our acquisition of InnoRx again has helped catapult us into ophthalmology. The I-vation product leverages the very same drug delivery polymer technology we developed in the cardiovascular market and adapted in powerful ways to address the specific needs of the ophthalmology market. Establishing a new Southern California office to house our new ophthalmology division under the leadership of Paul Lopez gives us great confidence in what this market can mean to SurModics. We have also just recently formed a new business unit to focus on orthopedics under the direction of Steve Keough. SurModics has always believed that orthopedics is a natural fit for our technology. However, what we have achieved to date is only a start. By dedicating a business unit to pursue opportunities in orthopedics, we believe that over time we can achieve results that will contribute more significantly to our business.

Fifth is portfolio management. We continue to expand the portfolio of customer projects at SurModics. We think of it as a portfolio and that's how we manage it. Our business unit organizational structure helps us manage the sheer volume of work but we remain disciplined in our project selection methodology. The Company is committed to managing a strong balanced portfolio. We've worked hard to improve the quality and the potential of that pipeline in 2005. We feel that the current pipeline holds more potential than it did in '04 and we remain very confident about our future.

Sixth is expand our distribution capabilities. Earlier this year we appointed Charlie Olson to head our US sales team and through the expansion of our US sales force we are raising our visibility with potential customers and expanding our distribution capabilities. The Company's distributor in Europe, JVS, continues to expand on our list of contacts there and expands our visibility and customer interaction in Europe. In addition, we have existing customers in Asia and we are continuing to evaluate opportunities for expanding our presence there.

And last but not least we are putting the balance sheet to work as Phil mentioned earlier. SurModics has effectively marshaled this resource with regularity during fiscal '05. The Company's strong balance sheet was leveraged to acquire InnoRx. It was also utilized to obtain exclusive rights to two classes of polymers from Rutgers and to make an equity investment in OctoPlus. Additionally in May the Company made a strategic investment in Thermopeutics [ph] which is developing medical devices for the treatment of vascular and neuro vascular diseases such as stroke. We also have an investment in CardioMind, technology we mentioned earlier. We continue to have an active business development pipeline as the technologies that we believe our customers would find relevant and valuable. That completes the review of our seven-point revenue growth plan and now I'd like to take a moment to highlight the stride we've taken on the customer disclosure front in fiscal '05.

In the last 12 months the following SurModics customers have been publicly announced; The Fox Hollow Technologies, EV3, Cabbage Medical, CardioMind, Robocon [ph], Thermopeutics and Spectranetics [ph]. These companies joined Cordis and the other major devise manufacturers; Medtronic, Boston Scientific, Guidant, Saint Jude and Abbot Labs, which until last year were among the much smaller list of companies we could publicly acknowledge.

The Company will continue to search for ways to give investors a better sense of our forward opportunities and provide more information on the contents of the pipeline, while maintaining our confidentiality obligations under our current business model. In closing, SurModics remains dedicated to enhancing the well being of patients by providing our customers with the world's foremost innovative surface modification and drug deliver technologies and products. We believe the continued success of CYPHER coupled with continued execution of our diversification strategy and broad based portfolio employing our high margin business model position the Company well for long-term success. Our technology creation and acquisition is accelerating and we have many reasons to be optimistic about our future and are encouraged by our achievements to date. We believe the continued execution and implementation of our strategy and revenue growth plan positions us well for sustainable growth and long-term shareholder value creation. That concludes our prepared remarks for today. We'd now like to open the call for questions. Operator?

[Operator Instructions] One moment please for our first question and it comes from the line of Richard Rinkoff with Craig-Hallum Capital.

Your R&D line from the June quarter to the September quarter was flat, the R&D fee income line and your royalty and license fee line was down sequentially from June to September and yet I know that you're very busy with a lot of projects. How do we reconcile those two?

The realities of our business model, as you all probably know, is that we never have the ability to forecast with precision exactly when revenue will flow. The pipeline in the R&D area continues to be extremely active and there is some seasonality as well as peaks and valleys that happen with customer projects as they move through the various stages of their pre-clinical and clinical development and so there are some sequential changes that do happen as a result of that and so we still remain extremely optimistic about the pipeline of things that are going through the development pipeline in our R&D line there. With respect to the royalties and license fees, we do have occasionally some smaller milestone types of payments that do flow. There were some in the third quarter and correspondingly there were very, very small amount of milestones in this quarter and so the sequential comparison there did impact that.

Okay, Bruce, at the very end you said you're searching for ways to tell investors to tell investors to tell investors what you're working on without violating the confidentiality of the customers. What are some of the ways that you think you can do that?

Well, I think it's-- I would say first of all we believe and we've gotten good feedback from investors over the last 12 to 18 months and we are disclosing more than the Company had earlier and I think part of how we're doing that is making the concerted effort to ask I would say is one thing, to make sure that we're really understanding what the concerns are with our customers and trying to find ways to meet their needs on the one hand and still allow us to at least make a reference or some form of disclosure on the other. Last 12 moths we've also benefited by the fact that some of the smaller companies at least have gone public, which as they consider us a critical component supplier it necessitated them to disclose it and so we've sort of ridden along with that rising tide and I think it's a constant effort on our part to try to figure out ways that we can better tell the story with probably no one answer. +

All right and last question, options. How are you going to treat the expensing of options in fiscal '06?

In 2006 we will be using rule 123R, which does require the expensing of options in the GAAP results and so we will be doing that per the requirement. We are still evaluating exactly how it will impact our financials and we anticipate that in all likelihood we will use the Black Scholes [ph] model to value the options and, as you probably know, there are a number of inputs and assumptions that you need to make in connection with that calculation and we have not arrived at conclusions yet as to what those inputs are going to be relative to what you might have seen in our past foot notes to the financials with respect to equity compensation. So we do not know exactly the level at which the P&L will be affected, but we do plan to begin expensing beginning with the first quarter of '06.

Thank you.

Suraj Kalia with Robin and Renshaw [ph].

Congratulations on a good quarter. Bruce, I've got first a quick question for you regarding your last statement on the University of Arizona, the statement of stent thrombosis. I guess I have a more fundamental question. Today stent thrombosis is like roughly from all the med analysis 1% for CYPHER 1.5% for TAXUS and there is a lot of debate on the use of Plavix and any sort of anti-coagulants from three to six months up to a year plus dual anti-platelet therapy. Can you help us to whatever extent you can, what makes you optimistic about this University of Arizona deal? What is it that will help you, or rather provide incremental value related to the shift stent thrombosis because I'm already-- from what is being seen in the technical landscape, there are already certain elements that can help a stent thrombosis? What would be different from this University of Arizona deal that you'll assign?

Well, I think it's several things. It's the data that they've generated to date. As we've said, we've had conversations with potential customers and we've shared some of that early data with them. Dr. Stew Williams [ph] is the person that is actually running the program at the University of Arizona who is extremely well know in this industry and so we like the fact that we are associated with him on a potential solution here. And then lastly, I just came out of TCT, it's the belief by many people much smarter in this area than I am that the promotion, the early promotion of new endothelial cell growth once the stent has been placed to more quickly and better incorporate the stent into the vessel wall should help with, or in theory could help with the reduction of especially long-term late thrombosis. It's a combination of things that we believe we've got access to and that we are developing that with Doctor Williams that give us good confidence. Obviously, there's much more data that needs to be generated, but we believe that there is an opportunity there for our technology.

Okay, NovaCell and maybe I missed it on the last few-- I believe I don't remember the issue of embryonic stem cells being brought up and if I did I apologize. The question I have is do I see a shift in terms of where NovaCell was with islet cells and now they're going on to embryonic stem cells or was it a dual strategy already adopted that maybe I missed in the past?

It's a good question Suraj. About a year ago they acquired this company called Zythera [ph] that is doing the work around embryonic stem cells and trans-differentiating those cells into insulin producing cells and it was really part of their strategy all along. Their technology today and the early technology was really looking at taking cadaveric islet cells, encapsulating those and implanting those into diabetic patients. The limitation around that approach is that there is not a big enough population of organ donors to provide enough cells for the very, very large diabetic population and so they recognized that fact and were willing to go very early to lock up a cell source approach, which was this company Zythera developing the stem cell approach to generating the islet cells and so it's been a strategy for them for well over a year now and the good news here is they continue to make great progress with that technology.

So, Phil, help me on this end. I just want to make sure I understand it correctly. ESCs or embryonic stem cells, as we all know, are mired in controversy. That it's an issue of separation, sterilization, delivery. I personally don't know of many technologies out there that have been very effective in delivering stem cells to the target organ of interest. I mean most of the documented data shows they either end up in the lungs, or kidneys, or some other place and really don't get the desired effect, but why embryonic stem cells. I guess, how do we extrapolate the data point because there are mesenchymal, there are adipose based stem cells and embryonic and, obviously, our of all the three embryonic is the biggest controversy, can you help us understand how to look at this, especially given the environment in which embryonic stem cells are today?

Well, I'd offer a couple of comments Suraj. First of all, with respect to the ethical controversy surrounding it, first of all, NovaCell through their acquisition of Zythera already has access to several presidential lines of stem cells and so they do have coverage on some of the cells that they've got. Furthermore, they are based in California where there's a tremendous amount of state funding that will be available and so I'm sure California will be very progressive in resolving those issues around the ethical acceptance and acceptability of that technology. And furthermore, with respect to sort of the efficacy issues you've sited the NovaCell approach does not rely on implantation into any specific organ. The islet cells are just implanted subcutaneously and pre-float [ph], if you will, because they're encapsulated and that protects them from the immune system, so it's not been tested in animals yet because they're still working on the technology, but they are very optimistic about their approach.

I guess I might need to take this off-line because I might have a few other questions. One last question and I'll get back in the queue. Phil, the tax rate has changed, obviously, but this impairment charge, but even if I include the impairment, can you help me understand because that did have a slight effect on EPS from what I can see? Can you help me understand your rationale for the provision for taxes and how you-- to whatever extent you can?

Certainly, at the close of the fiscal year we reviewed our tax provision and the tax assumptions, both at the state and federal levels with our tax advisors and we were able to challenge some assumptions and arrive at some new conclusions that allowed us to get some tax savings on our effective tax rate and so going forward we've been roughly at a 37.2% effective tax rate historically and we'll be below 37% going forward is the likely direction on that.

That's great. Congratulations again, guys.

Mike Osmond with Peninsula Capital.

Great quarter, congratulations. Most of the questions have been answered, but I'd like to see if maybe expand on some of the opportunities that you guys see forward in front of you on the orthopedic side and maybe you can walk us through a few areas that you think are maybe some of the lowest hanging fruit out there?

Yes, we certainly can. I think one of the areas that we've spent a lot of time exploring and we believe there's application for our technology is in the area of antibacterial or anti-infective coatings. We have today in our regenerative technology business unit an extensive toolbox that ranges from what we call passivating [ph] coatings, which have no active agent in them but simply act like a slippery surface so bugs can't attach to them is kind of a lay way of thinking about it, all the way through coatings, which contain antibiotics or other anti-infectives to prevent infection, which is in some applications in the orthopedics area a significant concern. I think the ability to deliver drugs or growth factors is another area where we think our drug deliver technology could apply and so we've got some delivery vehicles today that actually, we think, work quite well in a setting, in a bone setting like orthopedics market would require and the ability to deliver growth factors. So those are a couple of the areas that we've identified early on. What Steve Keough has been able to do is really help educate us better with the opportunities, get us in front of several of the companies in the area and really just best understand where our technologies may apply.

That's great and then you guys mentioned at the launch on the Donaldson nanofiber [ph] may come shortly. Is this going to show up in the royalty and license product line or revenue line?

Exactly how we'll be reporting it is to be determined because exactly how the dollars will flow between Donaldson and customers and us is yet to be precisely nailed down.

Okay, great. Good job, guys.

Chris Sissone with Eagle Asset Management.

Good afternoon and a great quarter. I had a couple of questions regarding NovaCell to the extent that you can discuss it. Do you know roughly how many patients they're gong to have in this phase one trial?

In it's design currently it has a 12 patient, phase one-two and it will be two arms, six patients each and I believe it's six months of follow up in one of the arms and a one year follow up in the other arm.

So the six patients in each are-- is this a randomization or both get treated?

I believe they're all treated.

Okay and so what would be the difference between the two arms?

It's merely the length of time that the islet cells will be in the patients, so they will-- the discussions they've had with FDA have suggested that they might be able to use this six month arm for conversations around fast tracking the phase 3.

Wow, okay and how should we think about, you know, as this technology were to ramp up and given that I think the last statistics that I saw were that there's a million patients with type one diabetes, assuming that this became a gold standard in either absolute dollar terms or as a royalty rate, has there been any discussion as to what someone might charge for a therapy like this, which is effectively life changing at minimum?

That's a great question and I don't believe we've heard of any even hypothetical numbers that they've discussed. I believe they really want to roll the technology forward and prove that it can work and then begin to have those kinds of conversations.

Okay, another question I had was has there been, you know, as you talk about kind of more vertically integrating or capturing more of the value chain, have you contemplated acquiring either drugs by themselves or licenses to drugs for specific applications where you see a real opportunity to combine your technologies with a specific drug, so you're capturing more value?

The specific answer is, yes, we've contemplated it. I would say that that's something that would be a difficult thing for us to really consummate I think based upon our current expertise. We are extremely good at formulating products. I would say we are not a pharmaceutical company in terms of the understanding of drugs, so we think that there's much better opportunity for us to focus on a platform if there is one, in terms of a device and then, obviously, the polymer itself then formulating drugs that belong to other companies who are much larger, have a much broader portfolio of drugs to draw from and then have the ability to get to the marketplace with those through their own sales organizations. That's really where our focus has been. With InnoRx we did acquire the I-vation product, which is using this drug Triamcinalone, but that's a generic drug and so we acquired some resident knowledge with that, but I would say for down the list for us would be an interest in acquiring would be pharmaceutical.

You talked about the multiple companies that are currently-- that you're currently working with on drug eluting stems and at this point given the evolution of this segment of the industry, is there greater interest in bioerodable polymers amongst these players, or is there greater interest in more of the traditional coatings or both or how do we think about that?

In the ophthalmology space I would say that there has been no preferred polymer of interest, at least communicated to us at this point. I think what they're more interested in is just being able to formulate their drugs onto a platform that can deliver drugs over an extended period of time for ophthalmology. For drug eluting stents there are lots of people that believe biodegradable polymers may be a better way to go in the future and that's one of the reasons why we are investing more heavily there than we have in the past but if your question was specific to ophthalmology, I would say at least at this point the focus has been more on outcomes than it has been on exactly how you generate the outcome.

But in-- those companies have come to you specifically for drug eluting stents, is there an increasing interest now in bioerodable polymers because it seems as though kind of at the forefront the thinking that maybe that that may be a better way to go.

I'd say, yes, there is with certain customers. There are-- biodegradable polymers create a whole different set of challenges, which is what happens when it degrades and what happens to those degradation products in the body after it's degraded and what effect does degradation of the polymer have on elusion of the drug if it's not completely eluted by the time the polymer starts to degrade, so depending on the company there is interest in biodegradable polymers. There are other polymers that have come to us who say, we got to get on this market and so let's take what you know and what you can do and let's figure out how quickly we can get on the market and those are the ones that, as a general rule, are very, very satisfied with a durable polymer.

And one final question, has J&J expressed any interest one way or the other towards looking at that, at biodegradable polymers?

You know, I really can't comment specifically on any one company.

Okay, okay. Thank you.

We now have a question of Jayson Bedford with Adams, Harkness.

I just have a few quick questions for you guys. Just on I-vation, how many patients have been implanted to date and how many centers are you guys looking at?

We've gotten approval from FDA for five centers. We have four approved and I believe two or three have really done all the enrollments at this point. We haven't commented publicly on the enrollment to date. We expect to make an announcement once the patients are enrolled and we expect that to occur by the end of this year. That's really all we've said publicly at this point.

Okay, so you'll make an announcement once all 30 have been enrolled?

Correct.

Okay and then just looking at potential partners out there, are you going to wait for the data after than six-month end point on the 30th patient or will you kind of tease people or at least show people the data as they come in?

To this point we've kept the data completely to ourselves. We've not shown it anybody even though we have had conversations and there has been expressed interest in seeing it and I suspect that will remain the same. Our primary obligation is to the FDA and to the patients in this trial and that's what will drive the release of the data.

Okay and then just looking at Donaldson, I was a little unclear. You have prototype product in the hands of customers right now, product evaluation over the next two quarters and then are you going to launch it in that third quarter or when should we look for an official product launch?

Still to be determined. The product is in what we call Beta sites today. We've gotten really good feedback from the folks that have evaluated the technology and that will be a decision we make jointly with Donaldson as to when we think we've got enough information to either take the product as it is or modify it, or go with it and begin the commercialization process, so that's going to be a joint decision with our partner. I think the point we were trying to make was, given the absence of FDA approval it could happen fairly quickly, but certainly not like this quarter for example.

Okay and are you guys recognizing revenue from the agreement now or will you next quarter, I guess?

We aren't now and, again, I can't time it, but we're not at this point.

Okay and then any thoughts on a distribution channel, how are you going to distribute this product.

Yes, we definitely acknowledge that particularly in the research market it's a very fragmented and so we believe that over the long haul we will likely want to contemplate a distribution partner and so we will kind of cross that bridge at the appropriate time, but it would definitely be something that we would consider as we gain more experience in this market.

Okay, just switching gears. Over the five new licensees this quarter, are any of those drug delivery polymer?

Of the five this quarter none were the drug delivery polymer.

Okay and then you may have mentioned this in your goals for 2006, but of the 72 license products but not yet launched, any idea how many of those could be launched in fiscal '06?

Yes, we have set a goal there of 12.

Okay, perfect and then I guess lastly, for you Phil. R&D as a percent of sales, 27% in this fourth quarter, is that a number that you expect going forward in that range?

We tend to look at R&D investment on a dollar basis and not on a percentage of revenue basis, just given the realities of our business model as we've discussed and so what I would suggest as a way to think about our R&D going forward is that we were at 4.3 million for this quarter and going forward into '06 we suspect it will be on the order of 4.5 to 5 million depending on the quarter and a lot of the factors that will drive that higher will be the timing of the stand on the clinical trial and so that's kind of the range that we'd look at going into fiscal '06.

Okay, great. Thank you.

At this time, Mr. Ankeny, I'd like to turn the call conference over to you for any closing statements you may have.

Well, thank you very much. We appreciate you all participating in this quarter's conference call and we're pleased to have, again, delivered record results in fiscal 2005 and we look forward to speaking with you again in January with our first quarter results and at our annual meeting of shareholders.

Ladies and gentlemen, that does conclude our conference for today. Thank you, for your participation. You may now disconnect. Have a very pleasant day.