Surmodics Inc (SRDX) 2007 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the SurModics third quarter 2007 earnings conference call. (OPERATOR INSTRUCTIONS) I would now like to turn the conference over to Phil Ankeny, Senior VP and CFO. Please go ahead, sir.

Thank you, Mary. Good afternoon. Welcome to SurModics fiscal 2007 third quarter conference call. Thanks for joining us today. I am joined by Bruce Barclay, President and Chief Executive Officer, and Loren Miller, Vice President and Controller, who will be available for the Q&A session. Before we begin, let me remind you that some of the statements made during this call may be considered forward looking. The 10K for fiscal 2006 identifies certain factors that could cause the company's actual results to differ materially from those projected in any forward-looking statements made during this call. The 10K and subsequent filings are available through the company or online.

Now I would like to give you a brief overview of the topics that will be addressed during today's call. First I will cover the quarter's financial results. Bruce will then highlight recent achievements and review progress against our fiscal year 2007 company goals. And lastly we will open up the call to your questions.

I will begin with an overview of third-quarter financial results and a discussion of significant future and current revenue drivers. Then I will break down revenues by component and operating segment. Finally I will cover expenses and review our balance sheet and cash flow.

Third-quarter revenue was $17.8 million, down 2% from $18.1 million on a year-over-year basis but up 2% sequentially. Operating income decreased 21% to $7.5 million from $9.5 million in the prior-year period. Net income decreased to $5.6 million from $6.4 million in the same period last year. Diluted earnings per share was $0.31 compared with $0.34 in the third quarter of fiscal year 2006. SurModic's unique royalty-based business model continues to demonstrate excellent profitability, producing a quarterly operating margin of 42% and a net margin of 31%.

As most of you know going forward SurModics' revenue is likely to be significantly impacted by the license and research collaboration agreement with Merck announced on June 27. While Bruce will provide further details about the agreement in his comments, I will highlight some of the key financial elements now. Under the terms of the agreement SurModics will receive an upfront licensing fee of $20 million and will be eligible to receive up to an additional $288 million in fees and development milestones associated with the successful product development and attainment of appropriate US and EU regulatory approvals for various I-vation products. In addition Merck will reimburse SurModics for its development activity and SurModics will be responsible for the manufacture and supply of clinical and commercial products. Finally we will also receive royalties on product sales.

Regarding the $20 million upfront licensing fee, we expect to amortize that payment over some period, but we are still analyzing the contract to determine the appropriate accounting treatment for its various elements. We did not recognize any revenue from the $20 million license fee in the third quarter.

Let me add some additional perspective to the agreement. Over the last roughly 10 years SurModics has generated approximately $130 million from the CYPHER agreement in total revenue including royalties, reagent sales and R&D revenue. By comparison, the Merck joint development and license agreement has the potential to well exceed that total through milestone payments alone. When you factor in revenue from upfront license fees, potential milestones, R&D revenue, manufacturing revenue and royalties, this agreement provides the framework to become the largest customer agreement in the history of SurModics. We believe this agreement underscores the power of our unique business model which we have been evolving to capture more of the final product value. We are leveraging the model in new ways while continuing to rely on our core competencies.

Now I will discuss the recent performance of the revenue driver that has been most important to SurModics historically, the CYPHER drug-eluting stent. Johnson & Johnson, the parent company of Cordis, reported worldwide CYPHER sales of $450 million, down 35% year-over-year and down 14% sequentially. Despite the decrease in sales, CYPHER maintained its leading position in the worldwide market for drug-eluting stents with an estimated 44% market share. Cordis also retained its market position in the US with J&J recording an estimated 46% share for CYPHER in the quarter.

The main factor impacting quarterly results for CYPHER and the rest of the drug-eluting stent market continues to be overall market softness due to a combination of lower penetration rates, lower prices and increased competition outside the United States. CYPHER also faced competition in Japan for the first time this quarter as Boston Scientific received Japanese approval for and launched its TAXUS Express 2 drug-eluting stent.

Total SurModics revenue associated with CYPHER decreased 31% compared with the year-earlier period. However, the rest of our business is strong and growing. We achieved record non-CYPHER revenue during the period, increasing 19% year-over-year and up 11% sequentially. An examination of the results on a sequential basis reveals that despite a 14% decline in CYPHER sales compared with the March quarter, total revenue for SurModics actually increased 2% in the June quarter. In addition this marks the 12th consecutive quarter of growth in non-CYPHER revenue. Recent weakness in CYPHER-related revenue serves to further underscore the value of our diversified and growing portfolio of royalty-bearing products.

Next I will review revenue components for the quarter. Royalties and license fees were $13.4 million, down 4% from the year-ago quarter as non-CYPHER-related royalties and license fees offset almost entirely the significant decline in CYPHER-related royalties and license fees. On a sequential basis royalties and license fees were up 3%.

Continuing on, product sales were strong during the quarter, increasing 11% year-over-year to $2.9 million from $2.7 million in the prior-year period. Growth was driven by strength across the portfolio in reagent and our in vitro products.

Turning to our last revenue line item, we generated $1.4 million in research and development revenue in the third quarter, down 9% from the year-earlier period but up 47% sequentially. If you recall our comments on the previous earnings call, we anticipated that quarterly R&D revenue would increase significantly in the second half of 2007. We expect the Merck agreement and other customer activity to drive additional R&D revenue going forward. For the fourth quarter, we believe our R&D revenue will continue to increase. But for the full fiscal year we may fall a bit shy of the fiscal 2006 level of $5.7 million.

Next I will review results across our operating segment line. Revenue for the In Vitro segment was a record $5.1 million, up 28% year-over-year and up 10% sequentially. Our in vitro technologies business units enjoyed strong results in diagnostic royalties and the stabilization business, including a nice contribution from the antigen products that we are distributing for DIARECT under the relationship announced last July.

Moving on to our Hydrophilic and Other segment, we again achieved record revenue of $6.9 million during the period, up 25% year-over-year and up 5% sequentially. This segment continues to have the largest number of licensed customers. Also note that the year-over-year growth rates for both In Vitro and Hydrophilic and Other segments have accelerated relative to the corresponding growth rates in our second quarter.

Finally the Drug Delivery segment generated revenue of $5.8 million in the third quarter, a 33% decrease year-over-year and a 15% decrease sequentially. The decrease from the year-earlier period reflects the decline in CYPHER royalties of 35% year-over-year principally as a result of the softness in the drug-eluting stent market as well as new competition in Japan as I discussed earlier.

For the first nine months of fiscal 2007 we achieved the following operating segment results. Drug Delivery produced revenue of $18.6 million, down 27% from the prior year. Hydrophilic and Other segment revenue was $18.7 million, up 17% year-over-year. And In Vitro segment revenue was $14.5 million, up 35% from the first nine months of fiscal 2006.

On the expense front, excluding product costs, total operating expenses for the third quarter were $9 million, compared with $7.8 million in the same period of 2006. SurModics continues to invest heavily in research and development, dedicating $6.2 million to R&D in the third quarter. This total represents an increase of $0.9 million or 17% from the prior-year period and corresponds to 35% of total revenue. Further, R&D expense constituted 69% of total operating expenses excluding product costs.

The principal driver of the increase in R&D expense for the quarter was an increase in non-cash charges, some of which were one-time in nature. First, some performance-based shares of SurModics stocks vested in combination with the signing of the Merck agreement. The result was an increase in stock-based compensation to $2.2 million in the quarter compared with $1.6 million in the year-earlier quarter and $1.5 million in the second quarter of fiscal 2007. In addition we had a one-time $350,000 non-cash charge resulting from the cancellation of a technology end license. When we license the end technology from third parties, we amortize the license fees over time. When we cancel a license as we did here the unamortized amount is expensed entirely at that time. I would add that our strategy of licensing end technology continues to enhance our technology portfolio, and the structure of these agreements offers a very cost effective way to gain access to the technology and then determine the fit with our other technologies and customer applications.

R&D expense also reflects the continued investment in our development organization and funding for our various preclinical and clinical efforts. We believe the investments in internally funded R&D projects such as preclinical studies will generate value in both the near and long term. This value is evident in our recent agreement with Merck. Funding studies such as the Phase 1 I-vation trial helps accelerate the dialogue with customers regarding the incorporation of our technology into their product pipeline. The preclinical studies we fund surrounding our FINALE pro-healing coating technology has also proven to be a good investment for SurModics. We continue our work with six paid customer projects on FINALE, and as announced just last week we signed our first stent license for this technology with Paragon Intellectual Properties and its newly formed subsidiary, Apollo Therapeutics.

Let me also highlight another benefit of the Merck agreement. As you may recall we had budgeted expenses for advancing the clinical trials surrounding I-vation TA into a Phase 2 clinical trial. Under our agreement with Merck, those expenses will now be borne by Merck.

Now I will discuss the balance sheet. As of June 30, SurModics had a cash and investment balance of $94.1 million and no debt. Cash flow from operations was $7.1 million in the quarter compared with $8.4 million in the year-earlier period. For the first nine months of fiscal 2007 cash flow from operations was $23.6 million compared with $27.1 million in the first nine months of fiscal 2006. I'll also draw your attention to our accounts receivable. You will note on the balance sheet a $20 million receivable related to the license fee from Merck as of June 30 which we expect to receive later this month. Our cash balance will of course increase at that time.

Our business development pipeline continues to be robust as we evaluate potentially compelling opportunities. Last week's announcement that we made a $3.5 million equity investment in Paragon and Apollo demonstrates the kinds of opportunities our business development pipeline can generate. Bruce will further discuss the exciting partnership formed between Paragon and SurModics as it relates to our FINALE pro-healing coating technology for stents.

In addition to providing us with the ability to continue investing in the business, our significant cash flow has allowed us to return capital to our shareholders, further enhancing long-term shareholder value. As a reminder in September 2006 SurModics' Board of Directors authorized the repurchase of up to $35 million of the company's outstanding common stock, the first share repurchase in our history. We completed the repurchase in full during the second quarter, well ahead of our end of calendar year 2007 goal. In total we purchased in excess of 1 million shares of SurModics stock, retiring roughly 5% of the outstanding shares. Our average purchase price was $34.76 per share. We are very pleased with the outcome of our repurchase program and regard it as a vital tool in our capital allocation strategy over the long term.

With that, I will now turn to call over to Bruce.

Thank you, Phil, and thanks to everybody for joining us on the call today. I want to begin by updating you on some exciting developments taking place at SurModics. Next I will get you up to speed on our key opportunities and our product pipeline. I will conclude by revisiting our fiscal 2007 corporate goals and highlight the significant progress we've made this quarter in achieving them.

As Phil touched on earlier, June 27 was truly a historic day for SurModics and its employees as it marked the announcement of the first license of our sustained drug delivery technology platforms in the large and strategically important ophthalmology market. The current unmet clinical needs relating to retinal diseases is significant. In fact industry experts anticipate that this will develop into a multibillion-dollar market over the next five years. The agreement with Merck is a tremendous financial success made possible in part by the flexibility of our technology licensing business model. The enabling nature of the technology we licensed to Merck allowed us to negotiate an agreement with various components, driving both near- and long-term revenue. Further, the Merck agreement validates our business strategy and the evolution of our business model, which seems to penetrate new markets and leverage our core competencies to contribute more components of the final product including the development of biomaterials, service modification and drug delivery technology.

As you may recall our presence in ophthalmology expanded dramatically in January 2005 when we acquired InnoRx. With this acquisition rights to the implant were added to our strength in drug delivery polymers, and we continue to build value by making investments in products and clinical development. In addition, we completed several business development transactions to gain access to a variety of biodegradable polymer systems which we are leveraging into our product development activities today including ophthalmology. By operating our capabilities and fortifying our technology portfolio, we have positioned the company to create greater shareholder value.

After acquiring InnoRx, we launched our ophthalmology division and initiated a Phase 1 clinical trial for I-vation TA. The I-vation sustained delivery system offers considerable advantages over existing therapeutic treatment to patients suffering from Age-related Macular Degeneration or AMD and Diabetic Macular Edema or DME. Our drug delivery system can deliver a variety of drugs to the back of the eye on a sustained-release basis. It can be implanted in a minimally invasive procedure and may be removed once the drug has been fully released or in the event of complications, which any procedure is susceptible to. We are pleased to report that the clinical data from the six- and nine-month patient follow-ups demonstrate a strong safety profile as well as an encouraging trend in efficacy.

SurModics has built a long-standing, effective collaboration with Merck. During the past two years SurModics has collaborated with Merck on several ophthalmic development activities. This relationship, built on hard work and mutual respect, led to a new and more comprehensive development agreement. Under the agreement Merck will lead and fund all future development, clinical and commercialization activities for selected I-vation combination products. Additionally, Merck will assume responsibility for the Phase 1 clinical trial for I-vation TA. Currently Merck is reviewing its options for the next stage of clinical trials for I-vation TA. Going forward, all expenses of running the trials for I-vation TA will be funded by Merck.

Merck has also agreed to utilize SurModics as the exclusive manufacturer of all clinical and commercial products. Accordingly, we will be responsible for coating and manufacturing the GMP specifications, the I-vation products for both clinical and commercial use. We believe this is a natural extension of our ophthalmic strategy and one that utilizes our technical know-how and experience to add additional value to Merck and other potential partners.

While we currently possess a strong proficiency in coating the ophthalmic implants, we plan to supplement our expertise and infrastructure to become a world-class manufacturer of these products on a commercial scale. We believe that this is an attractive business opportunity for SurModics and our partners.

[All] in our conference call related to the Merck agreement, some investors asked if the manufacturing opportunity in the Merck agreement represents a shift in strategy. The answer is absolutely not. Manufacturing the I-vation product is a natural extension of our core competencies. We are recognized as the world experts in coating devices and we believe that is the most critical step in the manufacturing process. By manufacturing the product ourselves, we retain the expertise in-house which advances our goal of better protecting our proprietary position and better assuring the quality and availability of the product. Since we have so much potential revenue on the line in the form of royalties, we do not want a lack of product availability to interrupt that important revenue source.

As a final note on this topic, we are highly optimistic about the potential technology and the products that will potentially emerge from the joint development agreement with Merck. Demand for this treatment is significant and growing, and we believe that we have the right solution at the right time. It is also important to note that the agreement grants Merck licenses to I-vation for use with TA and selective proprietary Merck compounds but does not preclude SurModics from working with other partners who have compounds not included within the scope of the Merck agreement. While we are delighted with the agreement signed with Merck, SurModics views ophthalmology as a significant growth opportunity. We will continue to aggressively pursue other partnership opportunities.

To this end as we mentioned before the Merck announcement, we have currently six customer support ophthalmology projects in paid development. These projects also leverage our drug delivery platforms and polymer matrix technology for sustained delivery of these companies' proprietary drugs to the back of the eye. It is our expectation that at least five of these customers including Merck will continue to work with us on their programs and additional programs beyond these five are currently in discussions.

These ophthalmology projects are helping to drive the 47% sequential increase in R&D revenue we achieved this past quarter. Our progress underscores a significant opportunity we see in ophthalmology and is demonstrable progress we are making with our partners.

Next I'd like to discuss our interests in the area of cell culture labware products. As we have previously announced, SurModics is collaborating with the Donaldson Company and Corning Life Sciences on the development of innovative cell culture products. [These DC end] products provide cell growth conditions that more closely resemble those found in the body, leading to improved outcomes in cell culture, cell-based bioassays and other in vitro cell-related applications. As a reminder, the existing market for labware is estimated at approximately $600 million.

In April Corning launched two initial products, a 96-well microplate and a 100 millimeter research dish which is similar to a petri dish. Other product formats are under evaluation. Under our revenue-sharing arrangement with Corning, we expect revenues to begin to flow for SurModics in our fourth quarter, essentially a quarter in arrears, similar to how our royalty revenues are recognized. Corning reports that the product launch is on track as many customers have been trying the products and conducting experiments to validate the capabilities and advantages of the Ultra-Web product in their applications.

Next I'd like to comment on the drug-eluting stent marketplace. The scrutiny around late stent thrombosis has resulted in a near-term reduction in penetration rate. This in turn has impacted the drug-eluting stent market and factored into our financial results. However, DES remains an important revenue generator for SurModics. We continue to believe in the future of DES and think that penetration rates in the DES market will rebound over time.

SurModics own research efforts are actively advancing the development of next-generation solutions that help address the issue of late stent thrombosis. We're developing three different technologies that we believe may serve as potential solutions to the thrombosis issue, including pro-healing technology, biodegradable polymers and heparin coatings.

As Phil mentioned earlier, we recently signed a license agreement for a stent system which incorporates SurModics proprietary FINALE pro-healing coating technology with Paragon's unique low-profile coronary stent system that is designed to address late stent thrombosis. SurModics FINALE pro-healing coating technology incorporates extracellular matrix proteins designed to improve and exhilarate tissue healing of implantable medical devices through the body's own healing mechanisms. We are extremely encouraged by the results of our FINALE pro-healing technology produced in three clinical animal studies and are pleased to team up with Paragon and Apollo on this exciting new development effort. We believe that our FINALE pro-healing coating technology can speed recovery of the normal vessel architecture and intercell lining with the potential to not only eliminate late thrombosis but also reduce restenosis.

We are delighted to apply the first stent license incorporating our FINALE pro-healing technology and look forward to collaborating with the Paragon team to accelerate the commercialization of this exciting new product. In addition we are honored to become investors in Paragon and Apollo and join the ranks of fellow Paragon shareholders including Abbott Labs and Boston Scientific.

Moreover, our DES participation is broad and widening. We participate by offering drug delivery polymers, hydrophilic coatings and anti-thrombotic or pro-healing coatings. One of the licenses that we signed this quarter covers a drug-eluting stent. In total with this new DES customer and Paragon, there are now nine different companies with announced relationships with SurModics for drug-eluting stent products incorporating our various technologies.

We also remain well positioned on J&J's next-generation product offerings, CYPHER Select Plus and CYPHER Elite. CYPHER Select Plus is now being marketed in Europe and carries two SurModics technologies on it. Accordingly it generates two royalty streams. J&J recently announced that the FDA warning letter has been resolved. CYPHER Elite like CYPHER Select Plus has two technologies from SurModics and will generate two royalty streams.

One other quick update outside of DES. Earlier this week [Novacel] announced the closing of a $25 million Series C financing, and we congratulate them on this significant competent. The financing included participation by some of the existing investors and was led by Johnson & Johnson Development Corporation. Novacel continues to focus on its stem cell development program.

Next I'd like to turn your attention to our product pipeline. Overall we now have a total of 89 licensed customers, several with multiple licenses, compared with 81 in the prior-year period. Currently SurModics has 98 licensed product classes on the market generating royalty revenue, compared with 83 a year ago. The total number of licensed products not yet launched was 93, up from 81 in the prior-year period. Major non-license opportunities stood at 74, compared with 77 a year ago. In total the company now has 167 potential commercial products in development, representing each of the company's five focus markets, cardiovascular, ophthalmology, orthopedics, neurology and in vitro.

I'll wrap up my remarks with a discussion on the company's outlook as well as a review of the progress we have made in achieving the fiscal 2007 company goals unveiled at our annual meeting in January. This information is intended to help investors gauge our progress toward implementing the company's stated strategic initiatives. It will also provide insight into how we manage our business and view the company's future opportunities.

Let me begin with the corporate-wide goals. We set a goal of signing 18 new licenses with our customers in fiscal 2007. In the third quarter SurModics signed five new licenses with customers, bringing our year-to-date total to 21 licenses, equaling the record number of licenses signed in fiscal 2006 and already exceeding our 2007 goal. The enthusiasm for and commitment to SurModics technology exhibited by our customers continues to grow ever stronger. Our customers want three new product classes in the marketplace during the quarter, bringing our total launches for the year to 13. Our 2007 fiscal goal is 20 launches, and based on customer reports we are not optimistic that we will be able to achieve this goal. However, we do expect to exceed last year's record of 15 new product launches by our customers, which if that occurs is still a great outcome.

Moving on to cardiovascular, we presented three goals for this area at the annual meeting. Specifically our goals were to sign a customer license for a new drug-eluting device, secure a paid development program with a customer for our Eureka internally developed biodegradable polymer and secure a paid development program with a customer for pro-healing during fiscal 2007. I'm proud to report that our employees have achieved all three of these goals and in fact we have six paid development programs currently underway on pro-healing. We signed a license for a drug-eluting stent during this quarter, and we now have a paid development program incorporating our Eureka biodegradable matrix.

Let's now look at our ophthalmology goals, which include signing our first customer license using our implant technology, initiating our Phase 2 trial for I-vation TA, developing a new platform other than I-vation TA for sustained delivery and securing paid multiple programs for customers in the drug delivery space including at least one for a large molecule.

With the signing of a license agreement with Merck, the first goal has been achieved. Currently Merck is reviewing its options for the next phase of clinical trials for I-vation TA. Whether we can meet the second goal of initiating our Phase 2 in fiscal 2007 will depend on Merck's decision on how to proceed with the clinical trial for I-vation TA. The third goal in ophthalmology has already been realized with the development of a new delivery platform which we will discuss at the ARVO retinal specialist meeting in May. And as previously noted the fourth goal was achieved some time ago.

As for orthopedics, before we close fiscal 2007 we intend to partner with a major orthopedics company. We have no announcement to make today; however, we are continuing to have active dialogue with multiple parties interested in our orthopedic technologies and product offerings and are making notable progress with our trauma wound [spacer] product. We remain on track to achieve this goal and expect to provide further updates as the fiscal year progresses.

Finally 2007 for in vitro technologies our goal was to facilitate Corning Life Sciences launch of the first cell culture product with Donaldson and SurModics. As previously discussed this goal was achieved in April when Corning brought to market the initial four cell culture labware products.

We will revisit these goals and report on our progress in our fourth quarter and full-year conference call. The accomplishment of these milestones has in our opinion the potential to create significant value for SurModics and our shareholders. We also plan to unveil our fiscal 2008 goals sometime this fall once fiscal 2007 is concluded.

Signing our agreement with Merck and making strong progress on our 2007 goals does not in any way make us complacent. In fact, just the opposite has occurred. We see the opportunity in front of us more clearly than ever. We know we have a lot of work ahead of us, and the entire company is motivated to make our current customers successful. Our employees are 100% focused on those things we can control and not those things we can't. And toward that end, the Merck agreement coupled with our strong non-CYPHER revenue position us to deliver value to our shareholders well into the future. SurModics is at the forefront of convergence of drugs and devices and remains positioned at the cutting edge of science and innovation in this important area. Our prospects are bright, and we look forward to further updating you on our results.

Mary, that concludes our prepared remarks, and we would now like to open up the call to questions.

(OPERATOR INSTRUCTIONS) Our first question comes from Rick Rinkoff with Craig-Hallum. Please go ahead.

Thank you. I just wanted to confirm one thing that you said on the call. Q3 stock-based compensation all-in was $2.2 million.

That's correct, Rick.

And the previous quarter, the March quarter, was $1.7 or $1.5?

That was $1.5 million.

$1.5 million. So it's $700,000 up.

Correct.

Okay. On the orthopedic, you're talking with multiple companies. Is that separate from the Wound Care B product, or does that include that?

It's not limited to the Wound Care product, but it does include that.

And if you were to sign a relationship with anyone, would we be looking at Merck-type dollars or something much, much smaller than that?

It's premature to say that, although Merck-type dollars don't come along every day, so I don't want to leave you with the impression that it'll be anything like that. But it's not done, so I'll defer that until hopefully we can get it done.

Okay. And are we likely to see any part of the Merck $20 million in the September quarter?

We will need to revisit that until we complete the final analysis, to the extent we amortize it over some period that we find conclusive. We will be recognizing it in the period as that begins. We should also have revenue from Merck related to R&D revenue as a development program commences.

In Q4.

In Q4, correct.

What are the range of outcomes for amortization period? Are we talking about maybe on the low end one year and the high end 10 years?

I'd prefer not to frame that range right now just because we need to review that, and I think it would be inappropriate to set an expectation at this point in time until we've concluded the analysis with our auditors.

Okay. One more question. Should we expect anything meaningful from Corning in the quarter?

Won't be able to say until we have that number from Corning.

Thank you.

Thank you.

Thank you. Our next question comes from Steve Ogilvie with Think Equity. Please go ahead.

Thanks. You mentioned in the press release that you signed something on the Eureka technology. Can you give us any more info on that?

Yes. Eureka is actually being used in paid development programs today in both our cardiovascular--with our cardiovascular customer and also with our ophthalmology customers. The specific projects and company names have not been authorized at this point, but to our great pleasure it is being widely accepted into a lot of different applications and we expect that to continue going forward.

Okay. You mentioned that you'd signed a new drug-eluding stent license. What correlation is that to their time to market? At what point do you sign a license? When it's close to market or could you sign it at any point in time?

Really it's any point in time. We've signed them from early stage to when the companies had product and inventory on the shelf. So it really ranges, and unfortunately we've not been given approval to mention the company name at this point, but the fact that it was DES related and occurred in this quarter, we can't say.

Okay, thanks. And then I was curious why you made an equity investment in Paragon? Was that necessary or were you looking at the rest of their patents and were interested?

We believe that the team that's assembled at Paragon coupled with -- and the development they've created coupled with our technology is a great opportunity for our time and for our money. And so licensing technology and also investing in them was really driven by the fact that we think there's great value there. Because they're a private company, we also believe that investing in the company would help them accelerate development activities on our technology and hopefully get us into the clinic and hopefully get us on the market much sooner than had we not made the investment. So a variety of factors that went into that decision. It's not unlike other investments we've made in start-up companies. For example InnoRx we invested in for the same reasons. We thought it was a nice investment, and we also thought that helping them accelerate the development of technology was the right thing to do.

So terrific team at Paragon. Dr. Bates I've had the great pleasure of working with before. He is absolutely a thought leader in this area in addition to being a very skilled physician and innovator in the product development area. So we couldn't be happier working with that team and look forward to furthering the development of the technology.

Great. And then one last question. You guys have this lawsuit now with Doctor Cooney. Can you explain that? I'm sure there's a lot of things you can't say about it. Can you just explain what it is and if there's any timelines that you're aware of that we could look out for.

Yes, we can talk about it briefly. And you did comment correctly, it's an active lawsuit so we'll comment briefly. But we have licensed several patents and patent applications from Merck in our recently announced license agreement, and one of them has been alleged as having incorrect inventorship in this most recently filed litigation. We licensed this patent from Johns Hopkins University and there's no allegation at all that we are not the exclusive owners of the rights under the patent in question. We have every confidence that Johns Hopkins has listed the correct inventors on the patent and we intend to vigorously defend ourselves in this matter. But, I would just repeat that because it's an active lawsuit, we really can't respond more than that at this point.

Okay, thanks.

Thank you.

Thank you. Your next question comes from Ross Taylor with C.L. King. Please go ahead.

Hi, I had a couple questions. First, related to the drug-eluding stent licensing agreement, is that for your Bravo Polymer or some other technology? Can you make any comments on that?

Yes, that relates to our hydrophylic coating technology so it covers the delivery system on it to readily stent implant?

Okay, and is that stent that is already on the market or something that's in development still?

It is not on the market at this point.

And, let's see, I know in your most recent 10Q you mentioned that sequentially you thought In Vetro revenues in the third and fourth quarters would be down because of the seasonality but it looks like you had a strong quarter for the In Vetro segment this quarter. I wonder if you can comment at all on what your expectations for the revenues in that segment might be for the fourth quarter.

Yes, I think it's probably pre-mature to say what Q4 would look like. We tend not to give guidance at the aggregate level particularly when we don't necessarily know all of the various pieces of it. One comment on our Q3 is that it is definitely one of the quarters that benefit seasonally from the Abbott royalties with Strep and Flu [cap] as those are winter peaking kinds of products. And so whether that can continue going into Q4 is unlikely. We'll see how the whole segment unfolds in Q4 but the strength across the business there continues and we've been extremely pleased with the robustness of that business.

Okay. All right. And last question with regards to stock option expense. I don't know if you can break out how much that is buried in R&D and how much is in G&A?

You mean total expense for the quarter?

Yes. I think you said you had about $2.2 million and I just wondered how much was in R&D and how much was in G&A?

Just a second, Ross. I don't think we have that information right now, so, we will have to take that one up later then.

Okay, not critical. All right, thank you very much.

Thanks, Ross.

Thanks. And your next question comes from Dan Owczarski with Belmont Harbor Capital. Please go ahead.

Yes, thanks and good afternoon.

Good afternoon.

Bruce, maybe you could, I was wondering if you could give us a little, talk a little bit more about the pro-healing coating on the stent that's being developed Paragon. How should we think of it? Is it more of a bare metal stent with a simple coating or is it considered more of a drug-eluting stent or what's the FDA going to look at it like? Is it going to be regulated like a drug-eluting stent, do you think?

All good questions. I don't know that we have the answers to all those today but I can tell you that, let me just remind everyone that this technology we licensed out of University of Arizona in conjunction with work that we have been doing with Dr. Sue Williams for years. Dr. Williams continues to be a close associate of ours in the product development of this technology. What the technology is designed to do is to potentially work on either drug-eluting stents or non-drug-eluting stents, bare metal stents and leads the work that -- we've done work with both and I think what we're seeing is that there is potential in the drug-eluting stents scenario to maintain the good restenosis reduction potential that they exhibit but also then by recruiting inthelial cells to the stent more quickly than drug-eluting stents made today, is to reduce potentially or eliminate potentially the late thrombosis that you'd see in a rare number of circumstances that exist in some cases. Again, the bare metal stent scenario, what we have seen in early animal studies is the potential to recruit these new endothelial cells to the stem sooner so that not only are you reducing thrombotic either near or long term. But also, potentially having better restenosis rates from you get in bare metal stents today. So, the theory and now the animal data we're starting to generate, all of them very exciting to us and very promising to us.

And just comment briefly on again Paragon, what we like with that team is they have a very interesting, a very nice low profile, bare metal stent, great development capability and engineering capability and then this access through Dr. Bates and his associates and contacts on access to both pre-clinical and in clinical sites here and around the world. Coupling that with our technology plus our development activities and capability in the biomaterials area, we thought was just a great team to take this technology, early data and accelerate its development as quickly as we can. Our best guess today is we can actually be in the clinic in calendar 2008 with this combined technology, the Paragon stent and our Prohealing technology. And if we can pull that off, that would be a terrific accomplishment for our development team. If the data is as we hope and think it will be then we think we're on to something pretty significant. The questions about the FDA and [inaudible] pathway, I don't know the answer to today. And obviously [inaudible] will have to take a look at as we progress.

Okay. The actual coding itself or the proteins is it, are those being used elsewhere? Is the FDA familiar with them or has any other devices or anything like that that's been used with them?

Yes, FDA is familiar with the ones we're currently looking at and these are collagens. So there are collagen coatings on devices today. There is collagen that's used in implants today. So FDA is very familiar with those. We're not limited to collagen. There are other extra cellular matrix proteins that we could use in this scenario, in this application and we'll be looking at those going forward. Some of the work we've done to this point uses collagen and the FDA is very familiar with that substance.

Ok, perfect. I know Bruce, you gave a pretty comprehensive update of your development efforts and I don't know if I've missed it, but you did expand your relationship with St. Jude and now that that's kind of taken the next step is there any examples of how you two are working together better or faster that you could share with us?

Nothing I can talk specifically about at this point. I can tell you that the teams are working together very well on a broader basis than before the agreements were signed. And it would be our hope that in the near future we could start to talk about some specific applications and products there. I probably have nothing to give you more detail today at this point really.

Just the last one about St. Jude. Are you coating their leads for their ICDs and pacemakers right now and would you see a benefit from they're putting up at least a turn around in that market, the CRM market?

They are doing a very nice job in the CRM market and we do have our technology on some of their commercial products to date. But we haven't been able to publicly identify which products those are at this point.

Ok, thank you.

Thanks, Dan.

Your next question comes from Suraj Kalia with Piper Jaffray. Please go ahead.

Good afternoon, gentlemen. Congratulations on the nice quarter.

Thank you.

Bruce when you say that Merck is exploring its options for moving forward on Ivation TA. Can you help us understand what does that mean? Isn't there a roadmap. I mean the $288 million milestone number highlighted and obviously that has to be based on a roadmap. Can you help me reconcile the statement of Merck exploring its options?

Yes, I will certainly try to the extent I can. I would repeat what we mentioned during the call on the Merck announcement which is that we are working through as we speak with our counsel and then eventually with Merck counsel and what will be filed as an attachment to the next Q in terms of the redacted agreement. So, I need to be a little bit careful there because that process isn't completed. But, the agreement is very specific on when and under what circumstances we get paid development milestones going forward. And there are different pathways this product could take. For example, we had talked about starting a phase two on our own, but there is a potential that Merck could decide to accelerate that and actually do what's called a combined phase two and a phase three. And if they choose to do that then potentially that has a different impact on the agreement and would also accelerate the development of the product through the FDA. They're evaluating that as we speak and other things relating to clinical trial. As you can well imagine, they are experts in matters relating to the FDA. FDA has said this product is a drug not a device and that is in their sweet spot. We feel very good about the people we've interacted with and the robustness of the discussions that are going on right now. I'd say at this point all I can say Suraj, although as we can say more we certainly will.

And, Bruce, in terms of your negotiation to whatever extent you can share, a little trade off between the royalties on sales of products received back end and milestone payments received up front?

It's an order of magnitude question. When you start with a product that has potential that this one does and any other products that may pool from this, market that's as large as it is with the different technologies that we bring to the table and likeness eventually from Merck, we're talking about a very large potential. Within that, there are always tradeoffs. Any negotiation I've been a part of, there are always tradeoffs. But, where we came out we're very happy with. And again, depending on what eventually gets put into the redacted agreement, we could be more specific at that point based up that. You know as we said in the prior call, $308 million in development milestone speaks for itself. Being able to manufacture both clinical trial and commercial products and a royalty rate which we said were well more sub-Cypher and we stand by that. Coupled with R&D dollars that's an agreement that under anybody's definition is a terrific agreement.

Okay, perfect. Bruce, gentlemen, thank you for taking my questions. Congratulations again.

Sure. Thank you.

Thank you, your next question is a follow up from Steve Ogilvie. Please go ahead.

I just want to follow up if you could give us any color on Endeavor in Europe, if you see a quarterly change and if you can speak to that?

In terms of our revenue royalties?

Yes.

I mean the results for their quarter are not announced and that would flow into our Q4 anyway. And so, it's really a question of our royalty revenues on Endeavor really tracking to their reported results, which they do, and they're on a quarter lag as they show up in our financials.

Okay. Now, I may have missed this, but did you say what percent Cordis revenues were as a percent of total? Would you be willing to?

No, we've not been breaking that out, but if you were to look - the closest proxy I can give you is the percentage of revenue that is drug delivery and that percentage of total revenue has continued to decline. And so in the most recent quarter drug delivery actually fell to 32% of total revenue, and that as you know includes both Cypher as well as Ophthalmology. So that's probably the closet approximation that I can give you that would be most helpful in your question.

Okay and then just last, you made the investment, I believe, in the biggest industrial company Octo Plus. I mean is that something you're actively involved in. Is there any update on the projects that they're undertaking, anything that might hit near-term in terms of an agreement or revenue?

We're not actively involved in that, Steve. They are a public company and that's where I would send people who are interested in understanding what they are currently doing. We also have licensed [inaudible] the polymer technology from them and at least those polymers we have licenses to today are in active development projects for us. So, to that extent we can update you. Otherwise, I think probably the best thing we can is send people to the offerings that are available out of the public company.

Okay and then just one last thing. Obviously, so much of your revenue is tied to [inaudible] royalties; however royalties were up sequentially. It looks like that's due to hydrophilic. In terms of profitability, are the hydrophilic royalties any less profitable? And then going forward when you look at your royalties, do you see hydrophilic really filling in like it has for Cypher.

Well, let me speak to the profitability first. Essentially, we don't report profitability by business segment. But royalties are no matter what segment they come from come in at 100% gross margin essentially because there's no corresponding cost. The business units themselves are not dissimilar in number of employees and things like that. They all leverage the shared resources across SurModics. I think from a profitability standpoint they're pretty close. And yet the royalty revenue in hydrophilic continues to be a very strong trend and we're very pleased with that. As it relates to forward looking statements about that, we're not prepared to say anything at this point.

Is it safe to assume that your product sales were down a bit sequentially I imagine part of that's Cordis and there's a number of things there. As revenue would shift from product sales to royalties that would be a profitable shift for SurModics, is that a fit assumption?

That's correct, absolutely.

Thanks.

Thank you.

Your next question comes from Aaron Lindberg with William Smith and Co.

Just a quick clarification. How many products have been launched in the Donaldson collaboration? I think you said four but then earlier in the call I just put two.

I'm sorry if I misspoke, but there have been four.

There have been four. Do you expect before year end?

There are others in development. We haven't been authorized to talk about specific ones at this point, but there are clearly others in development at this point.

Then, do you expect the revenues from [inaudible] culture products to flow through royalties or product sales?

They would be through product sales.

Do you have an expectation for CapEx as it relates to beginning to manufacture the Ivation product for clinical applications and then eventually commercial?

At this point we really don't have an expectation of that. We are essentially evaluating what will be required to support the manufacturing efforts for Merck and other potential customers there. Until we go through that full exercise, it would be premature to give you some sort of a range on that because it's still under heavy review.

How about a sense on timing as to when you might initiate something like that?

It's under active discussion right now. Our intent is to be in a position to start making clinical trial product for them as soon as we can.

As soon as they start the next phase? Would that be fair?

That's correct. So, we don't want to be the gating item there.

And then will you comment on how many Prohealing licenses you had signed in Q? I think you said you had six signed last quarter from Q2.

Yes, we have six partners. So paid development partners or projects ongoing at this point, but just one license signed and that's with Paragon.

Ok and then have you come across constraints as it relates to drugs that can be delivered on the Ivation platform specifically as far as large versus small molecules, biologic, things like that?

Yes, this is going to be a hard answer to believe, but the answer is no. We actually, a combination of the technology we have in house and mostly the capability of our employees, we've had very good success delivering large and small molecules alike; Hydrophilic, hydrophobic drugs. Really I think the developments patented and also a lot of know-how being developed internally has been terrific. In fact, some that are harder than others I will tell you, but we've had success delivering everything.

That's excellent. Thank you very much.

Thank you.

Thank you. Next question comes from Chris Asuni with Eagle Asset Management. Please go ahead.

Good afternoon. I wanted to understand as your business model has evolved, your leverage with customers has probably also evolved. So, as we think about the Cypher royalties dinging, whatever have been disclosed 1 to 1 1/2% and then you look at the 90 some products that are not yet launched, would it be safe to say as we go forward as we think about the royalty rates on future products that they will likely be substantially higher than the first royalties that you first got with J&J?

Yes, I think Chris the best way to answer that is to say that our leverage over time since signing the J&J agreement has improved substantially. But I would also say that we are spending our time on products that are -- that have much more opportunity to them than maybe we spent on early in our history because we needed to spend our time on anything we could spend it on early in our history. That's not a Cypher comment, that's anything goes in Cypher in our early days. So, I think the combination of those two things would feasibly that general, yes, we do get better terms, but it's a generalization. I don't want that to necessarily apply to every single project. The evolution of the strategy is really try to emphasize that. That we're also bringing more to the table in either in terms of data or in terms of technology, not just polymers, but other technologies like an I-vation's case that divides itself and that creates more leverage and better financial terms. So, I think that the general answer to your question is yes and then if you think about it specifically there are exceptions, but in general the answer is yes.

Now if I were -- so right now you say that you have 98 licensed products generating royalty revenues. So there's two parts to that. One is the potential size of the market for each of those 98 products and the applied royalty rate and then there is the number of licensed products that aren't yet launched which is 93. Do we make the assumption that the majority of those will not be launched over the next year or two? But what you're basically saying is that both the royalty rate applied to those and the sizes of the markets for those individual products are going to be either larger or substantially larger than those that are currently generating royalties that are already growing at a double digit rate. Is that a fair way to look at this? At your business model?

Yes, you're talking in very large numbers here and I think you're directional commentary is spot on at the -- we've over time been able to drive to potentially higher royalty rates and our goal certainly is to participate in larger opportunities and obviously the pipeline itself has been growing. And so, that's sort of a virtuous mix of things that we have and a conscious decision of how we've been trying to create a portfolio not just working on only a few very very large opportunities that may have a higher data outcome. So, we really like the way we've set up the portfolio and it's hard to get really precise with how many are going to be come across the goal line in what period and how big they are going to be just because it is so diverse.

Right. Thanks. Just historically if you looked at the -- as you put up numbers that say the total numbers -- when you talk about license product classes not yet launched, I would think that the majority of those do in fact get launched. If you look historically at your business model. I mean, is it -- I would think it's rare that you have a product which you've done work that the customer has agreed to license the product; you've done the research and development and the product is ready to go and then they don't launch it. That's probably a rarity? Right?

It does happen but it's definitely well south of the majority when it does that.

Okay. I'm just trying to figure out if you just look at your -- just in the 98 products, those that are currently generating revenues and they're growth trajectory and then overlay it on top of that some assumptions for what percent of the ones that are in the pipeline will eventually a) get launched, b) how big their markets are and c) what the implied royalties are -- I would think that it's at least a doubling.

Yes, you'd have to make your own assumptions. We can't really comment on that, but as I said before, the way that you're doing your thought process is fair.

Okay. All right. Thank you.

Thank you and management there are no further questions. I'll turn it back to you for closing comments.

Great, thanks very much, Mary. We want to thank everybody again for participating in this quarter's conference call. We look forward to speaking with you again in October when we announce our fourth quarter and full year results.

Thank you.

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