Surmodics Inc (SRDX) 2007 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen. Thank you so much for standing by, and welcome to the SurModics fourth-quarter 2007 earnings conference call. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded today, Tuesday, the 6th of November, 2007.

I would now like to turn the conference over to Mr. Phil Ankeny, Senior Vice President and Chief Financial Officer for SurModics. Please go ahead, sir.

Thank you very much, Michael.

Good afternoon, and welcome to SurModics fiscal 2007 fourth-quarter and full-year conference call. Thank you for joining us today.

With me on the call is Bruce Barclay, our President and Chief Executive Officer.

Before we begin, let me remind that you some of the statements made during this call may be considered forward looking. The 10-K for fiscal year 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 10-K and subsequent filings are available through the company or on-line.

Now I would like to give you a brief overview of the topics that will be addressed during today's calls.

First, I will cover the fourth-quarter and full-year fiscal 2007 financial results. Bruce will then highlight operating achievements for the quarter and full year 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 fourth-quarter financial results and will follow that with specifics on discreet line items. Next, I will discuss significant revenue drivers, and then I will break down revenue by component and business segment before turning to the full-year financials. Finally, I will cover expenses and review our balance sheet and cash flow.

Fourth quarter revenue was $21.3 million, up 21% from $17.6 million on a year-over-year basis and up to 20% sequentially. The company reported an operating loss of $13.8 million, compared with operating income of $9.2 million in the prior-year period. A net loss of $13.9 million, compared with net income of $6.3 million in the same period last year, and diluted loss per share of $.78, compared with earnings of $.34 per share in the fourth quarter of fiscal 2006.

Results include a $15.6 million one-time charge for in-process research and development, or IPR&D, in connection with the acquisition of Brookwood Pharmaceuticals, Inc. Excluding this charge, non-GAAP results were as follows: Adjusted operating income of $1.8 million, adjusted net income of $1.7 million, and adjusted diluted earnings per share of $.09.

Before moving on to revenue drivers, the accounting for the Merck agreement bears further discussion as it falls into a very complex arena of accounting principles.

Without going into unnecessary detail, the Merck agreement falls within the emerging-issues task force, or EITF, No. 00-21, the accounting guidance related to revenue arrangements with multiple deliverables. As a result of this accounting treatment, SurModics's revenue and cash flow in the near term are likely to be significantly impacted by this agreement. Let me explain.

Under EITF 00-21, we will amortize the $20 million upfront license fee over the economic life of the technology we license to Merck. Generally, this amounts to the patent life, which in our analysis is 16 years. This accounting treatment and the resultant amortization will also apply to future milestone payments, which could total $288 million, as well as the commercial R&D dollars we are paid by Merck.

During the quarter, we performed roughly $1 million in billable work for Merck in connection with their various development programs. Because of the long period of time over which these payments are amortized, the GAAP revenue in the quarter from the Merck agreement was quite modest, under half a million dollars.

That said, our cash flow will be very favorably impacted by the Merck agreement over the near and long term. Even though we won't be able to recognize all the revenue immediately under GAAP, we will be receiving cash for R&D work and potentially milestone payments. The $20 million upfront license fee and the $1 million of billable R&D work flow directly to the cash flow statement. In essence, against roughly $21 million in cash, we booked less than half a million in revenue in the quarter.

Given this unique accounting treatment and especially since we will be spending to ensure progress under the agreement, we will give you some insight into the cash flow view of our arrangement with Merck going forward. In combination with reporting GAAP revenue, as usual, we believe this will give you the most meaningful way of evaluating our current and future business performance.

Let's now turn to the revenue driver that has historically been most important for SurModics, Cypher.

Johnson & Johnson, the parent company of Cordis Corporation, reported worldwide sales of the Cypher Sirolimus-eluting Coronary Stent of approximately $375 million during the quarter, down 40% year over year and down approximately 17% sequentially. This is the lowest level of quarterly Cypher stent sales in more than three years.

Despite the decrease in sales, the Cypher stent has an estimated 43% market share in the United States for the quarter. Overall market softness due to the combination of lower penetration rates reduced prices and increased competition outside the United States continue to be the main factors impacting quarterly results for the Cypher stent and the rest of the drug-eluting stent market.

While SurModics revenue related to Cypher decreased 32% compared with the prior year period, the rest of our business continued its strong growth trend, with non-Cypher-related revenue growing 55% from the year-earlier period and 34% sequentially. The gain marks the 13th consecutive quarter of non-Cypher revenue growth. Our ability to generate strong revenue for the quarter in the face of this decline further highlights the strength of our unique and evolving business model and the value of our broad portfolio of royalty-bearing products.

Every year we disclose the revenue attributable to J&J from the Cypher drug-eluting stent, as well as other J&J products that incorporate SurModics technologies. In fiscal 2007, J&J constituted 33% of total revenue. This figure is down from 47% of total revenue in fiscal 2006 and is substantially less than its peak at 52% in fiscal 2004. In the three years since then, our non-J&J revenue, essentially the rest of our business, has more than doubled, growing at a 27% compound annual growth rate.

Now I will review revenue components for the fourth quarter.

Royalties and license fees were $13 million, down 4% from the year-ago quarter, as gains in non-Cypher-related royalties and license fees almost entirely offset the significant decline in Cypher-related royalties and license fees. On a sequential basis, royalties and license fees were down 3%.

Product sales remain strong in the fourth quarter, increasing 38% year over year to $4.5 million from $3.3 million in the prior year period. Growth was driven by strong performance across the portfolio, particularly in reagent and in vitro products. Product sales include the new products from our BioFX acquisition, as well as some modest early sales of extra cellular matrix products to Corning.

Turning to our last revenue component, we generated $3.8 million in research and development revenue in the fourth quarter of 2007, a significant increase from $0.8 million in the year-ago quarter.

R&D revenue includes $2.3 million in R&D revenue from Brookwood Pharmaceuticals. Recall that we closed the Brookwood transaction on July 31, so our results include only two months of Brookwood operations.

The rest of our business generated $1.5 million in R&D revenue, including only a modest amount of revenue from Merck. Please note, as I described earlier, the bulk of the roughly $1 million we billed for activities in support of Merck will remain on the balance sheet as deferred revenue and will be amortized over time.

Next I will review results across business segments.

Revenue for the in vitro segment was $5.6 million for the quarter, up 41% year over year and 11% sequentially. In vitro enjoyed strong results in diagnostic royalties and stabilization in antigen product sales. In addition, the BioFX product line contributed approximately half a million dollars to in vitro revenue during the quarter. Recall we closed that acquisition August 13, so we benefited from only about half a quarter of sales from BioFX.

Moving on to our hydrophilic and other segment, revenue was $7.8 million during the quarter, up 24% year over year and up 13% sequentially. The growth in this segment was principally driven by strength in royalty revenues, which are generated by a broad and growing range of license customers.

And, lastly, the drug-delivery segment generated revenue of $7.9 million in the quarter, a 7% increase year over year and up 37% sequentially. The increase from the year-earlier period reflects strong R&D revenue from ophthalmology and other drug-delivery customers, which offset a 40% year-over-year decrease in Cypher royalties. In addition, Brookwood Pharmaceuticals contributed approximately $2.4 million to drug-delivery segment revenue.

Let's turn now to full-year results.

Total revenue for fiscal year 2007 was $73.2 million, a 5% increase from $69.9 million in 2006. This marks the tenth consecutive year of record revenue since our IPO in 1998. The company reported operating income of $9.9 million, compared with $36.2 million in the prior year; net income of $3.3 million, compared with $20.3 million, and diluted earnings per share of $.1, compared with $1.09 in fiscal 2006.

Excluding the IPR&D charge, non-GAAP results were as follows: Adjusted operating income of $25.5 million, adjusted net income of $18.9 million, and adjusted diluted earnings per share of $1.04.

On a revenue-component basis, total royalties and license fees decreased less than 1% to $52.7 million from $53 million in fiscal 2006. Despite a significant decrease of 29% in Cypher royalties for the year, the growth in royalties and license fees from the rest of our diversified portfolio was able to keep total royalties and license fees nearly flat.

Research and development revenue was $6.9 million in fiscal 2007, up 22% compared with $5.7 million in fiscal 2006.

And product sales increased 21% to $13.5 million from $11.2 million in fiscal 2006.

(Inaudible) segment hydrophilic and other revenue increased 19% year over year to $26.5 million, in vitro segment revenue was $20.2 million in fiscal 2007, up 37% from the prior year, and drug-delivery revenue segment revenue decreased 20% year over year to $26.5 million.

Next I will turn to a review of operating expenses.

To ensure appropriate transparency and allow our shareholders to evaluate our underlying business performance, we will provide several discreet items that were included in the quarterly results.

As I discussed earlier, the fourth quarter results include a $15.6 million one-time charge for in-process research and development in connection with the acquisition of Brookwood Pharmaceuticals.

The results also include a $200,000 non-cash charge to record amortization of intangible assets in connection with our two acquisitions, Brookwood Pharmaceuticals and BioFX Laboratories. For your modeling purposes, going forward the amortization of intangibles from Brookwood and BioFX will be approximately $300,000 per quarter.

Non-cash compensation for the quarter was approximately $5.1 million. This figure includes both expensing of stock options as required under SFAS 123R and non-cash charges for performance shares issued under the company's equity incentive compensation plans.

In addition, the results include a $2.2 million accrual for cash bonuses to be paid to all employees under the fiscal 2007 bonus plan. The company had not accrued for a bonus or performance shares in the first three quarters given the year-to-date results the company had achieved at the time. The important point here is that the net effect is a full-year hit from the bonus expense and performance shares coming in a single quarter rather than being smoothed across multiple quarters.

Also, as you compare the fourth-quarter results to the prior year, recall that our consolidated financials also include the operations of Brookwood Pharmaceuticals and BioFX Laboratories, and they definitely add to the expense base. For the two months of operation, it was part of SurModics, Brookwood was modestly diluted.

In addition, SurModics continues to invest heavily in R&D, accelerating our leadership position in innovation and technology. We have been building our technical team and capabilities to better support our customers today and in the future. In fiscal 2007, we dedicated $28.5 million to R&D, representing 39% of total revenue.

One final comment on operating profitability.

As you know, royalties and license fees effectively have a gross margin of 100%. As our mix of revenue has shifted somewhat from the past with a higher percentage coming from product sales and R&D revenue and a correspondingly lower percentage coming from royalties and license fees, there is an impact on operating margin. Said differently, product costs and operating expenses have grown in concert with and in support of the growth of these revenue streams.

With that said, however, it's important to remember that our R&D revenue is one indicator of the strength of our product pipeline of possible license products that are capable of generating additional royalty and license fee revenue going forward.

Now I will discuss the balance sheet, which continues to be in excellent shape.

As of September 30, SurModics had a cash and investment balance of $70.2 million.

Cash flow from operations was $27.1 million in the quarter and $50.7 million for the full year, an increase of 44% compared with fiscal 2006 cash flow.

Both of these operating cash flow figures are records for the company and reflect the ability of our business model to generate cash flow even before products are commercialized and in spite of our inability to recognize all the cash immediately as revenue.

We were very active in fiscal 2007 in the deployment of capital with a goal of enhancing shareholder value. We are pleased to have completed our $35 million share-repurchase program during the year, and in the full repurchase program we retired in excess of one million shares at an average price of $34.76 per share, facilitating a reduction of approximately 5% in total shares outstanding.

We also completed the acquisition of Brookwood Pharmaceuticals and BioFX Laboratories. Despite having used over $86 million in these various initiatives, our cash and investment balance is still over $70 million.

We believe our activities and accomplishments in fiscal 2007 have strengthened our ability to build long-term shareholder value.

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

Thanks, Phil, and let me extend my thanks to everyone as well for joining us today on the call.

Before I update you on the execution of our strategy in 2007, I want to briefly touch on the financial results.

As Phil mentioned earlier, SurModics generated good financial results and, in particular, excellent cash flow in fiscal 2007. For the tenth consecutive year since our IPO in 1998, we achieved record revenue. During those ten years, SurModics revenue has grown at a compounded annual rate of 25%. And these record results were achieved even though we recognized less than a half a million dollars from the Merck agreement in fiscal 2007.

SurModics continues to experience strength throughout its broad and growing portfolio thanks to the ongoing dedication and teamwork of our very talented employees. We've established a leadership position as experts in the development of biomaterials, surface modification, and drug-delivery technologies. While our history has strong ties to the cardiovascular market, our growing presence in ophthalmology, orthopedics, pharmaceuticals, and biotech industries positions the company very favorably for years to come. We take great satisfaction in our role in improving the health and quality of life of millions of people touched by our technologies and products.

SurModics has long articulated a strategy of accelerating its technology leadership. During the past year, we've made even more significant progress in this area and are excited to see the fruits of our efforts emerge.

One of the most critical pieces of our strategy is our effort to climb the value chain by offering customers more elements of the final product and more data supporting product utility. This allows us to enhance the royalty rates and other licensing terms earned on our product and technology offerings. A compelling illustration of this success in climbing the value chain occurred when we announced the first license of our sustained drug-delivery technology platform in the large and strategically important ophthalmology market.

The agreement with Merck demonstrates how we can benefit from climbing the value chain. The enabling nature of the technology allowed us to offer more value to Merck, which in turn allowed us to negotiate a more comprehensive and lucrative agreement for both near- and long-term success. Under the agreement, which we finalized in June after two years of successful collaboration, Merck will lead and fund all future development, clinical, and commercialization activities for selected I-vation combination products. Additionally, Merck will fund and assume responsibility for the Phase 1 clinical trial for I-vation TA, as well as all subsequent clinical trials for I-vation TA.

Additionally, Merck has agreed to utilize SurModics as the exclusive manufacturer for all clinical and commercial products. We believe this is a natural extension of our ophthalmology strategy and one that utilizes our technical know-how and experience to add additional value to Merck and other potential partners.

This license agreement does not preclude SurModics from working with other partners who have compounds not within the scope of the Merck agreement. SurModics views ophthalmology as a significant growth opportunity. We will continue to aggressively pursue other partnership opportunities.

To this end, SurModics currently has six active ophthalmology development projects targeting back-of-the-eye diseases afforded by our customers. This figure counts Merck only once even though we have multiple projects with them, and we have ongoing discussions with other customers that could result in additional projects in the future.

All of these active projects leverage our drug-delivery platforms and polymer-matrix technologies for sustained delivery of these companies' proprietary drugs to the back of the eye, including both large and small molecule compounds. Our progress underscores the enormous opportunity we see in ophthalmology and the demonstrable progress were making with our partners.

Another central element of our growth strategy is our emphasis on increasing revenue diversification. During the past year, SurModics's stent-related revenue has been impacted by a substantial contraction of the DES market and competitive activities outside the United States. While drug-eluting stents remain an important revenue generator for SurModics and has the potential to rebound over time, the current situation highlights the need for and benefits of revenue diversification. We made significant progress on this front in the past few years.

As Phil mentioned, revenue derived from J&J has declined from 52% of total revenue in fiscal 2004 to 33% in fiscal 2007. Concurrently, non-J&J revenue has grown at a 27% compound annual growth rate during the same time period. The company's revenue diversification efforts include broadening our scope within the stent market, and we're pleased to have expanded our reach to include new partners.

Additionally our research efforts are actively advancing the development of next-generation solutions to help address late-stent thrombosis, a key issue that will likely have continued impact on the market going forward.

SurModics has funded various preclinical and clinical efforts of our technologies, and we have grown our development organization. We believe that the investment on internally funded R&D projects will generate value both in the near and long term. The opportunities afforded by those investments are clearly demonstrated by the Merck agreement. Funding studies such as the Phase 1 I-vation trial and preclinical studies for our biodegradable polymer coatings and Finale coatings allowed us to accelerate our dialogue with customers regarding incorporation of our technologies into their product pipelines. In particular, the preclinical studies we funded relating to Finale have also proven to be a good investment.

During the week of October 21, SurModics's employees attended the TCT meeting in Washington, D.C., which is one of the largest meetings of the year for our cardiovascular customers. Overall, the TCT meeting was very positive for SurModics. Investigators presented preclinical animal data from two technologies, one on our Finale pro-healing coating technology, and the other relating to our SynBiosys biodegradable polymer. Both presentations were very well received.

As an example, Apollo Therapeutics, which is the stent-development unit of Paragon IP, presented very encouraging data for their Protex pro-healing stent. Their product combines a novel bare-metal stent with SurModics Finale pro-healing coating technology. The animal data they presented supports their plans to commence a clinical trial in 2008.

Another opportunity for revenue diversification has been our technology partnerships with Donaldson and Corning. Together we are developing and distributing extra-cellular matrix products that provide cell-growth conditions more closely resembling those found in the body. These products have the potential to improve outcomes in cell culture, cell-base bioassays and other in vitro cell-related applications.

In April, Corning launched two initial products, a 96-well micro plate and a 100-millimeter research dish into an existing market for lab ware that is estimated at approximately $600 million. The product launch rollout continues to track according to Corning's plan, and additional products are making their way through the development stages.

As Phil mentioned, the fourth quarter marked the first inclusion of ECM product sales. Our agreement with Corning allows us to capture a percentage of Corning's product sales as revenue essentially one quarter after Corning recognizes the sales. While the revenue impact was modest in the quarter, we expect these sales to grow over time.

Corning remains comfortable with the adoption rates of the ultra-web cell-culture products to date based on their internal models for adoption rate for new technologies within the cell-culture market. We continue to closely monitor this activity and the progression from early adopters to broad mass-market utilization. We're pleased to report that ultra-web cell-culture products have been sold and shipped to every global region Corning serves. In addition, pharma and biotech customers represent a large percentage of the early sales.

Another key aspect of our strategy is leveraging our expertise in the convergence of drugs and devices to penetrate new markets. In particular, we've extended our reach to address both systemic and site-specific drug-delivery needs for our partners in ophthalmology, urology, orthopedics, diabetes, central nervous system, oncology, and alcoholism markets, among others.

SurModics has steadily and effectively leveraged its innovative technology and expertise to penetrate additional markets, resulting in new and lucrative revenue opportunities in a business-development pipeline that continues to be robust.

During the quarter, we demonstrated the ability to seize opportunities that our strong cash position affords us with two exciting acquisition announcements.

On August 1, SurModics announced the acquisition of Brookwood Pharmaceuticals, a leading provider of drug-delivery technology primarily to the pharmaceutical industry. Brookwood is our largest acquisition ever and was the first since InnoRx.

On August 13, we acquired BioFX Laboratories, a provider of substrates to the in vitro diagnostics industry.

Integration of both companies continue to go well, and I remain excited about the prospects both transactions offer going forward.

Just a reminder, Brookwood Pharmaceuticals is a drug-delivery company that provides its proprietary polymer-based technology to companies developing improved pharmaceutical products. The company has over 30 customer-paid development projects in progress with top pharmaceutical, biotechnology, and medical device customers, as well as smaller public and private companies. Brookwood has particular expertise in proprietary injectable microparticle and implant technology based on their biodegradable polymer families. The acquisition strengthened our drug-delivery polymer expertise, particularly through the application of bioabsorbable materials and Brookwood's combination of focused polymer (inaudible) with their unique commercial pharmaceutical capability. Based on this expanded platform of polymers, we see multiple opportunities for technology synergies as we cross-pollinate Brookwood polymers in the device arena and SurModics polymers in the systemic drug-delivery arena.

The systemic drug-delivery and pharma markets are larger than the device based coatings market. While we're working with some pharmaceutical companies on our ophthalmology technologies, SurModics's previously developed technology offerings have been more applicable to the medical-device customers. With the acquisition of Brookwood, we can address the needs of an almost entirely new group of customers in the pharma industry.

In the medical-device industry, there are only a few markets that exceed $1 billion in size. By contrast, there are over 100 pharma products on the market today with sales in excess of $1 billion each, and that's just products, not markets. As more and more highly effective drugs reach patent expiration, we will utilize our proprietary technologies to define new ways to formulate these drugs, many with customers, but potentially even some not supported by customers. This approach can offer both improved patient benefits and extend the patent life for these new drug products.

As we gain new exposure to markets such as oncology and diabetes, we see a very large opportunity for our company that was not previously available to us. Through Brookwood, we are participating more in the drug-development market. It's important to understand, though, that we are not involved in the drug-discovery side of the pharmaceutical industry.

SurModics has also made meaningful progress this year toward penetrating new markets beyond the Brookwood acquisition. Public announcements on this topic include the signing of an expanded corporate technology agreement with St. Jude Medical for use of the company's cardiovascular and cardiac rhythm management products and our August acquisition of BioFX Laboratories.

BioFX offers both colorimetric and chemiluminescent substrates, as well as other products for use in in vitro diagnostic tests. We believe the opportunity to sell our existing products to BioFX customers offers significant growth potential and that by combing BioFX products with our own, we can offer more high-value critical components to a broader customer base in the in vitro diagnostics market.

Another positive development on the business development front for SurModics happened last month. As you may have seen, QLT acquired ForSight Newco II, a company founded by retinal surgeon Dr. Eugene de Juan, that has developed a drug-delivery implant technology to treat glaucoma. SurModics held a small equity stake in ForSight Newco II for which we received an initial payment of over $900,000 in cash. This gain will be included in our first quarter fiscal 2008 financial results. In addition, we retained certain intellectual property rights to the acquired technology for back-of the-eye applications.

I'd now like to turn your attention to our product pipeline.

We now have a total of 92 license customers, several with multiple licenses, compared with 83 in the prior-year period. Currently, SurModics has 100 customer product classes on the market generating royalty revenue, compared with 83 a year ago. The total number of license products not yet launched was 94, up from 84 in the prior-year period, and major non-license opportunities stands at 75, compared with 69 a year ago.

In total, the company now has 169 potential commercial products in development, and these numbers do not include the 31 projects in development at Brookwood Pharmaceuticals. As the numbers suggest, the magnitude of the R&D work we are doing on behalf of customers is a testament to the significant value of our pipeline.

I'll conclude my remarks with a discussion of the company's outlook and a review of the progress made in achieving our fiscal 2000 goals we unveiled at our annual meeting in January. We provide this information to help investors gage our progress toward implementing our strategic efforts and offer insight into how we manage our business and provide a view of the company's future opportunities.

Let me begin with the corporatewide goals.

I'm proud to report that SurModics signed six new licenses with its customers during the fourth quarter, including an agreement with Paragon relating to a license for our Finale pro-healing coating, as well as some other very exciting products in the cardiovascular arena. Our overall fiscal year total was a record 27 new licenses, far eclipsing our goal of 18, as well as our fiscal 2006 record of 21 licenses. SurModics's licensing efforts are a key indicator of our growing pipeline of royalty-generating opportunities. We believe that the dramatic increase in license count indicates continued strong customer interest in our technology.

Eighteen months ago, we told you that we expected our customers to launch 30 new product classes by the end of fiscal 2007. This represents roughly double the historic annual launch rate by our customers. Our customers launched a total of 27 product classes during this period, an excellent number, but just shy of our expectations.

In addition, looking at the fiscal-year 2007 portion of that 18-month window, we expected customers to launch 20 new product classes in the fiscal year, but the total came in at 17. While we narrowly missed our goal, our customers continued to make tremendous progress for getting their products closer to launch.

The final goal we laid out in the corporate category was to achieve R&D revenue in the last three quarters of the fiscal year of $5 million. Including Brookwood, the total was $6.1 million. Excluding Brookwood, we ended up at $3.9 million of R&D revenue on a GAAP basis.

Because the vast majority of the R&D work for Merck is not recognized as revenue, the actual billings are higher than our reported financials. If we include the Merck billings in this calculation, R&D revenue for the three quarters would have amounted to $4.8 million, again, excluding Brookwood.

Continuing on with our fiscal 2007 goals, in the cardiovascular space they were to, one, sign a customer license for a new drug-eluting device; two, secure a paid development program for a customer with Eureka, our internally developed biodegradable polymer; and, three, secure a paid development program with a customer for pro-healing during fiscal 2007. I'm happy to report that we achieved all three of these goals. Importantly, as it relates to Finale, SurModics has multiple paid development programs currently underway.

Our ophthalmology goals included signing our first customer license using SurModics implant technology, initiating our Phase 2 clinical trial for I-vation TA, developing a new platform other than I-vation TA for sustained drug delivery, and securing multiple paid programs with customers for drug delivery, including at least one for delivery of a large molecule.

The first goal was achieved with the signing of the Merck license. On the second goal, we consciously took our foot off the gas as we came closer to finalizing the agreement with Merck knowing that they would want to take over responsibility for the next stages of clinical trials and ultimately sales and marketing of the product. The third ophthalmology goal was realized with the development of a new delivery platform introduced at ARVO in May, and the final goal was met earlier this when we signed additional development agreements, including one related to large molecules.

Our orthopedics goal was to partner with a major orthopedics company. I'm pleased to report that we have signed an agreement with one of the leading orthopedic companies. Technically, we did not meet our fiscal year goal because the agreement was not signed by our orthopedic customer until October. While our partner has requested that we not disclose their identity or the nature of the agreement, we are very excited with this opportunity and the growing applicability of our technologies in the orthopedics market. In fact, we continue to have very encouraging discussions with other orthopedic companies as well for our technologies.

Our 2007 goal for in vitro technologies was to facilitate Corning's launch of the first cell-culture lab-ware products. As discussed previously, this goal was achieved in April when Corning brought to market the initial four cell-culture lab-ware products.

Our success in achieving these milestones has, in my opinion, favorably positioned the company to create significant value for SurModics and our shareholders. We plan to unveil our fiscal 2008 goals at our first ever investor-day meeting to be held November 15th at the NASDAQ market site in New York. If you haven't signed up for the event, we invite you to do so.

In closing, SurModics is squarely positioned in the middle of the growing convergence of drugs and devices. Our devotion to and success in accelerating our technology leadership afford us this very unique opportunity. We believe our best-in-class science, relentless efforts to climb the value chain, penetration of new and lucrative markets, and greatly enhanced revenue diversification all position us well for long-term success. We have many reasons to be optimistic about SurModics's future and the value we're creating for our shareholders.

Michael, that concludes our prepared remarks, and we'd now like to open up the call to address any questions that might exist.

All right. Thank you. (OPERATOR INSTRUCTIONS) Just one moment, please, for our first question.

Our first question is coming from Steve Ogilvie with ThinkEquity. Please go ahead.

Hey, guys. Congratulations on the quarter and the year.

Thanks, Steve.

I guess first thing I wanted to ask was you've done so much this year in terms of bringing in new technologies and large new licensing deals. Do you feel like you need time to digest everything, or do you feel like there are other opportunities out there with which you can use your $70 million in cash to go after much like you did this last fiscal year?

There are other opportunities out there, and as you know, Peter Ginsberg heads up our business development review here, and certainly that analysis and evaluation continues on. With that said, though, I think it is our primary objective to continue with the integration of the two companies that we acquired in August. So we're in no hurry, but I think it would be inappropriate given the importance of technology to our business going forward for us to completely shut down our discussions, or rather our analysis of those various technologies that exist out there.

But I think it's fair to say that we're going to stop, take a breath, and continue our integration, which, frankly, continues to go exceedingly well, and we've gotten great feedback from customers. In particular, we had some of our colleagues from Brookwood Pharmaceuticals at the TCT meeting, which in large part was a completely new set of customers and opportunities that they had not been exposed to before, and that gave us a chance to make some good introductions. So things are going quite well in that regard.

Okay. And then I don't know if you'll be able to answer this, but on the orthopedics deal, could you just qualitatively just say if that's going to have any financial impact on you guys in the near term? Is it a little hit to R&D, or is there some sort of payment upfront, or can you say?

Yeah. We really can't say much. I can tell you that there will be a positive cash flow impact, and there is going to be an additional increase in expense because we are both receiving and continuing to fund some activities there, but beyond that, we really can't say.

Okay. And then just wondering, do you plan to make goals for fiscal '08 and give them out publicly like you did last year, or were you going to do that at your shareholder meeting in January or maybe at this meeting in November?

Yeah, we'll do it next week at the investor-day meeting on Thursday.

Okay. And then just a few financial things. Hopefully, they'll be quick. So did you break out the BioFX contribution? I got the Brookwood number. Did you specifically say what BioFX contributed in the quarter?

It was about a half million in revenue, and it was positive operating profit contribution.

Okay. And then to understand the expenses better, obviously they were up significantly and there was a lot of -- about $7.3 million in bonus accrual. How much of that is something that will be happening in the future and is just kind of ongoing from the acquisitions, or is all of that just kind of a one-time thing and that won't be in the next quarter?

Well, we do have compensation plans, incentive compensation plans that have bonus and equity incentive mixed in with them as well, and this year the payout under those plans was higher than it was last year, which explains the larger-than-last-year expenses that you see in the full-year numbers. And of course they all hit in the fourth quarter because there was not any accrual for those programs earlier in the year. So that's kind of the impact there.

Going forward, we would expect -- we certainly budget for some payouts, but it depends on the attainment against the bonus plans because there are tiers to them. And we certainly don't budget for maximum payout, which can happen in some years, as it did this year.

Okay. And then just a follow up on that. I mean, your operating expenses for this quarter, even taking out the $16 million, I mean, that seems like an unusually high run rate?

Correct. Yeah. So the run rate for this quarter is probably not a fair way to look at it going forward because you had a full year's accrual in this single quarter. If you took the bonus and incentive comp numbers and quarterized those and probably ratcheted down somewhat because we don't plan for maximum payout, that just only happens when the attainment is there.

And then in addition you've got some other moving parts to the financials this quarter that contribute to the higher-than-normal total operating expenses. Part of it is mix. As we've got more product sales in the mix, the cogs portion or product costs, as it's gone out in the financial statement, is higher just because there's a higher level of product sales contributing to the revenue line.

And then in addition you've got the added expenses from Brookwood and BioFX and just the operations that they have that, if you looked at it on a SurModics-only basis, it would obviously be less than that.

Okay. And then one last quick thing on Cypher. Can you maybe qualitatively explain how Cypher's down 40% year over year and you guys are down 32% in terms of your Cypher royalties? And maybe that would also relate to, if you could qualitatively say, if J&J was 33% of your total revenue, how much of that was Cypher royalties?

So a number of things in that question, Steve. First of all, what we disclose is the total revenue related to Cypher, and that includes a couple of royalty streams. If the royalty stream from the drug-delivery polymer, which is the one that goes back to the launch of Cypher. It also includes the hydrophilic royalty stream that comes from Cypher Select Plus. It also includes product sales, which are reagents that we would sell to Cordis to both put the drug-delivery polymer on, as well as the hydrophilic coating on the product. And then third is R&D revenue for projects we do for J&J.

And so when you roll all that together, that's the reason it doesn't match the 40% decline in their sales. And so dampening that decline is really the increase in the royalties coming off Cypher Select Plus from the hydrophilic coating, as well as some product sales.

Great. Thank you.

Thank you.

Thank you. Our next question is coming from the line of Richard Rinkoff of Craig-Hallum. Please go ahead.

Thank you. I'd like to clarify further some of those expense lines. You say in the press release $7.4 million for stock comp. How much of that was Merck, and how much of that is what you would call ongoing incentive comp that we should expect in '08?

Well, there was some Merck-contract-related comp that happened back in the third quarter due to the signing of the agreement. The cash bonus and the performance shares that are included in the total incentive comp number for this quarter are really related to the overall incentive compensation packages for the company as a whole.

So if you just look at Q4, how much of the $7.4 million is what you would call normal, and how much was specifically for Merck?

I guess that's what I was trying to say before is that it's not specifically Merck that drives everything. It's the overall attainment of the entire company against the performance plans.

Well, what should we expect for '08 then? $7.5 million divided by four quarters?

Well, I was trying to suggest, when I was addressing the prior question, that I probably, from a modeling standpoint, think about something less than that because that would represent sort of on the upper end of payout against these plans, as opposed to where something would be in more of the middle of how these plans are designed.

Okay. On the revenue line, your R&D was $3.8, $2.4 was Brookwood. Where did the other $100,000 or so go? Or $2.3 was Brookwood. Where did the other $100,000 go?

Brookwood actually had about $100,000 of product sales. That's the polymer business that they have.

Okay. And where did the BioFX revenue go? Half million?

That's all in product sales.

Product sales. And where did the Merck go?

Merck is in R&D and license fees and royalties.

Okay. So we should assume that those numbers should grow in the December quarter compared to September because you've got the acquisitions that are in for the full quarter?

Yeah. Correct. Yeah, you're looking at less than a full quarter on those numbers. Correct.

Fine. And what kind of a tax rate did you pay in Q4, or is it almost incalculable?

Well, if you look at the tax rate when you back out the IPR&D charge, which is a nontax-deductable charge, it ends up at 41%, which is just sort of a quirk of some of the calculations here. We continue to model our business on a marginal basis with an effective tax rate of about 38 1/4%.

38 1/4%. Okay. Thank you.

Thank you.

Thanks, Rick.

All right. Thank you. Our next question is coming from the line of Ross Taylor with CL King. Please go ahead.

Hi. I'll start with a couple of accounting questions. First, with Brookwood, just to clarify, were the total revenues you received from Brookwood $2.4 million in the quarter?

That's correct.

Okay. And the revenue you received from Merck, is all of that in the R&D line?

No. It's partially in the royalties and license fees line, and in fact that's where most of it is because of the amortization of the $20 million upfront license fee, and then there's a modest amount in the R&D revenue line as well, and, again, that's amortization of essentially the million dollar in cash billings.

Okay. And I guess on that subject, I mean, going forward it sounds like you are going to be getting some cash payments from them for R&D work, but yet you're only going to recognize a minimal amount of revenue for that. I mean, how much is that differential likely to equate to on, say, a 12-month basis?

That'll be tough to say. If you look at the period over which we're amortizing these revenues from Merck, it's 16 years, which is a long time. And so that's the reason that we believe giving you the cash flow numbers will be helpful so that you can tie sort of the cash flow view of the business and reconcile that against the GAAP revenue.

Right. Okay. And going back to the $7.4 million in compensation expense for the quarter, I mean, can you break out how much of that was in your R&D line versus SG&A?

I don't believe I have that with me right now, but I could get back to you with that probably.

Okay. That's fine. And regarding the $20 million you've received from Merck, have you all paid any taxes on that yet, or when might those come due?

The answer to that is that we have not paid any taxes for that yet, but we have accrued a tax on that upfront license fee. The IRS loves payments like this because they believe it's taxable. And so what we've got is essentially a deferred tax asset, as well as a tax payable that will show up on the balance sheet. The payment of the tax will be going forward.

Okay. Let's see, and I think also Bruce might have mentioned during his remarks that with the Finale coating you have multiple projects there, and do you only have one licensing agreement at this point for Finale, or the balance of those projects are R&D projects, or can you just clarify that please?

Yes, I can. We have one license agreement. That's with Paragon for stent applications. The other projects are not yet licensed and there's, as I mentioned, multiple projects and more than one customer.

Okay. All right. Well, that's all my questions for now. Thank you.

Thank you.

Thanks, Ross.

All right. Thank you. Our next question is from the line of Aaron Lindberg with William Smith & Company. Please go ahead.

Thank you. First of all, can you just clarify how many ultra-web products are in the market now? I know that you said that two were launched originally and that others were in development, but have others launched since that initial two?

Yeah. I think you may have asked the same question in the last call, and I think I confused you probably then too. There are two different formats. One is a Petri dish, and one is a 96-well plate. And then there are two forms of the product for each of those formats. So I know in my remarks I said two products, and I later said four products. I apologize. There are actually four different products but two different formats.

Okay. And then do you have a sense of how many products you would anticipate by the end of '08?

You know, we have not been authorized to discuss that yet by our partners, but I can tell you there is very active development on future products, and we would hope that in the not-to-distant future we would be able to talk about those in more detail. But as you can imagine, you can coat different receptors coatings, if you will, on the ultra-web, and you can also put them into different formats other than 96-well plates or Petri dishes, and the team's looking at both of those.

And when do you anticipate seeing benefits from the Brookwood acquisition as it relates to specifically to site-specific drug delivery, and is the biggest near-term benefit there in ophthalmology?

We'll talk a little bit more about some deliverables from Brookwood at next week's investor day, and particularly when we talk about the goals for 2008, but suffice it to say they do have ophthalmology projects. They have a number of other projects as well, and some of those -- and I guess I couldn't rank those for you in terms of which may happen first. I think there's good progress being made in several areas to several different companies, and, again, we would hope to see some of that materialize in 2008.

Now, I understand some of the benefits of your coating process versus competitive processes, but can you just help me understand the strategy with Oak River? Does it make the sales process for you easier as you're going in to negotiate new deals? Is this a revenue-and expense-sharing agreement? What does that look like for you?

Sure. Just taking a step back for a second, one of the benefits we saw in creating business units is that each general manager has a different set of value drivers that their customers are looking for. In the hydrophilic technologies business, in particular, the technology is very, very good, but because it's used in such high-volume applications, the commercial component to that technology is very important to our customers. And so not only are we able to deliver good technologies that work well in a clinical setting, but also we can now, with Oak River technology, bring to customers exceptional equipment that works in a high-volume setting. Coupled with SurModics, we can provide onsite both chemistry support and also equipment support to make sure that the equipment is working properly over those hundreds of thousands of units that they process on an annualized basis. And so it's a way for us to go to customers and really offer them a more complete solution to their particular needs, not just in a development setting but also in a commercial setting as well. And so we would expect it to drive more revenue on the technology side, on the hydrophilic technology side, but also we do get a percentage of the sales of the equipment that Oak River would make so --

Do you carry a percentage of the expenses as well then? I presume they do really all the actual manufacturing and development?

They do. Yes, they do. I don't think we carry a material piece of the expenses. That's largely their expense to manufacture, their cost to manufacture that equipment, and then we participate in a percentage of revenue that's generated from the customer.

Can you help us understand what the financial benefit is to the customer? You know, if you put this in it's going to take 5% of the cost out of the coating process, or what does that look like?

Well, my general manager of hydrophilic technology is going to slap my wrist, I know, but I don't have that data in front of me, and I'm sure he does. But we can sit down with a customer and give them very precise information on what benefits the technologies bring in terms of being able to conduct the procedure at room temperature, be able to use water instead of organic solvents, but also be able to improve their through-put reliably, and that's an important word here, as they process, again, hundreds of thousands of units on an annual basis. If you think about coating dilatation catheters or stent delivery catheters or guide wires, there are hundreds of thousands of these manufactured and sold every year, and if you can reduce scrap or reduce weight, what have you, over time, it's a huge advantage for a customer. So we do have that quantification. I just don't have it off the top of my head.

No, that's fine. But the takeaway is that, yes, you'll get some revenue out of it, but the key reason for this strategy is that it's going to improve the sales process as you're going and selling the coating technologies?

That's exactly right. As long as we can keep customers selling products, that helps generate revenue for us, and obviously it solves their issues as well in terms of making sure that they can always provide products to their customers.

Couple of less-interesting questions. Can you break out -- now, in the product number that you reported, the $2.2 million, does that include the operating product cost as well as the cost of goods sold? There wasn't a cost of goods sold number in the release, I don't think?

Which specific product are you talking about?

The product cost of $2.188 million that you show on your operating lines.

Yes.

Does that include what you generally call cost of goods sold or your one line up that will drive your gross margin?

That is essentially costs Exactly right.

Okay. I just think in prior months that you'd broken out the cogs piece from the operating product cost but --

This is the common format, but that is the cogs number back up to the product sales line in revenue.

Okay. And then can you break apart the sales and marketing versus G&A?

Well, sales and marketing has been pretty consistent with the past, and since it's such a small percentage of revenue, we figured we'd do the world a service and not force everybody to model something that doesn't move around that much and just put everything into SG&A.

Is that going to be one line then going forward?

Going forward, that will be one line. Correct.

Okay. Great. Thank you much.

Thank you.

Thank you, Aaron.

All right. Thank you. And our next question is coming from Suraj Kalia with Piper Jaffray. Please go ahead.

Congratulations, gentlemen, on the quarter.

Thanks, Suraj.

Phil, I just want to make sure from a housekeeping perspective -- I'll back up ten steps because I haven't understood. To renew the Cypher numbers, Brookwood -- the number I have is to be clocked $2.4 million in the quarter, BioFX half a million, and Merck half a million in different subsegments of the revenue line item. Did I get that right so far?

Merck is actually under half a million, but we haven't specified exactly what it is, but so far you're correct.

Okay, let's say zero for the quarter even. So I'm just trying to understand the organic -- I know it's a pseudo term -- but organic non-Cypher revenues, excluding BioFX, excluding Brookwood, per my calculations, can you shed some light on what that number was for the quarter? Because that was a metric you all provided consistently over the past few quarters, and I just want to make sure what that number is in this quarter.

Well, if you back out the half million from BioFX and $2.4 million from Brookwood, your at $18.4 million for the rest of the business -- the organic.

So on a sequential basis, is it fair to say it was slightly down? At least that's the number I get per my calculations.

So in June quarter we reported $17.8 million of total revenue, and so organic, Suraj, would have been despite a decline in the Cypher royalty, a fairly sizable decline, we were actually up in total organic revenue.

I think the real (inaudible) on the financials, Suraj, is $73 million in GAAP revenue and for the year over $50 million in cash generation. That (inaudible) we see from our business.

Sure. Bruce, I guess my point I was trying to understand, at least from a housekeeping perspective, Brookwood -- correct me if I'm wrong -- most, if I remember what Art Tipton had said earlier, most of the products are in preclinical development. So I'm just trying to determine true product revenues and what is going on with the non-Cypher revenues, but I think I got your idea.

Second point, Bruce, just so that I understand it correctly, the Merck agreement, I heard you say Merck has taken its foot off the gas pedal. And, secondly, the 16 years, the $20 million we understand that amortized over -- for the patterns that are at the center of this agreement, is it fair to assume that they are also for $16 million -- 16-year development program? (Inaudible) look at the $280 million developmental fees.

Let me just make sure to clarify the first thing you said. You misunderstood what I said, and I think it's important to check the transcript to make sure you have this accurate. What I said was one of the reasons why we weren't able to complete our fiscal 2007 goal of initiating the next phase of clinical testing on I-vation TA is that SurModics took its foot off the gas pedal when it was clear we were going to likely consummate the agreement -- conclude the agreement with Merck. So we weren't able to initiate that trial in fiscal '07 because that was going to be Merck's product very soon. They had their own ideas on how they want to clinically test that and eventually market and sell it, and so Merck had a large influence on it. They have not taken their foot off the gas pedal. In fact, just the opposite. They have really embraced that product, and they are actively moving forward with that technology. And, again, next week we'll provide some updates in our goals discussion around what we would hope to see in fiscal 2008.

As for the patents, I think Phil carefully chose his words when he said they're using from an accounting standpoint 16 years, but we are constantly filing, issuing, and creating new inventions going forward around this technology. So we would fully expect to have new inventions coming out as for a long time in the future, both patentable and know-how, covering the technology.

And the other point I'd add to your question, Suraj, was I think you were asking about the development period, is that 16 years, and it will depend on how Merck chooses to deploy the platforms and their various license compounds that they have coverage for. But in all likelihood, no. These development programs proceed much more rapidly than that. Merck has not authorized us to say what the development timelines look like yet, so, unfortunately, I can't cite anything for when they're expecting to get products into certain phases of clinicals and to commercialization, but it's significantly under 16 years, and so I just want to clarify that for you.

Fair enough. And pardon me for not getting the foot off the gas pedal. Last question, Bruce, and I'll hop back in the queue.

Bruce, when you say you're trying to climb the value chain, obviously we see the margin impact, and this is a dedicated strategy which hopefully will pan out. The question I have is, when you connect all the dots, for a number of these products do you intend to sell these products, and would it entail building up your own sales force? And I repeat my question from two years ago that how do you intend selling some of these products on your own, which for the most part has been done by your partners so far? This is a different realm you're entering. Have the margin impact and SG&A impact so if you could kindly shed some brief comments on that?

Yeah. Sorry, I don't remember your question from a couple years ago, but we've been pretty consistent, I believe, in saying that we're not going to create our own sales and marketing organization to sell these products, especially when they're already large, established companies that have large, existing sales forces and a broad bag of product available to the physician and to the hospital.

The product line that we have are for reagents and components of other products, and as we've commented in the past, we have some folks dedicated sales here for that, but that's a fairly finite number, and they do a terrific job of generating the product sales that they have. So it's not our intention to extend climbing the value chain that far into the commercialization process. We will invest in preclinical animals, we'll invest in some clinical trials where it makes sense and where we think we can generate more return by ultimately licensing it to an established commercial partner, but you won't see us pursue a strategy like you may have seen from [OLSA] or others at least anytime in the near future.

Okay. Gentlemen, thank you for taking my questions.

Yes. Thanks for the call.

All right. Thank you. Our final question will be a follow up from Ross Taylor. Please go ahead.

Hi. Going back to the orthopedic product that you signed a license agreement for, have you talked at all about what market that's targeting or kind of what sort of product it is? And can you?

You know, we can't, unfortunately. I would love to, but, unfortunately, we can't. I would say that it would be our hope that in the not-to-distant future, but the nature of the process in terms of FDA filing and commercialization, etc., would allow us to be able to talk bout that, but at this point we can't.

And can you say whether it's more of a 510(k) versus a PMA filing?

It's our hope that it would be more of a 510(k).

All right. Thank you.

Thank you.

All right. Thank you. Please continue with any closing comments.

Sure. Thanks, Michael.

We want to again thank everybody for participating in this quarter's conference call.

Just again as a reminder, our first ever investor day will be held November 15th at the NASDAQ market site in New York. In addition to unveiling our fiscal 2008 goals, we'll host an interactive session with our extended leadership team. This will be a great opportunity for you to hear more about the exciting initiatives at SurModics across all of our business units. We look forward to your participation.

All right. Thank you, sir.

Ladies and gentlemen, this does conclude the SurModics fourth-quarter 2007 earnings conference call. If you would like to listen to a replay of today's conference in its entirety, you can do so by dialing 1 (800) 405-2236 or (303) 590-3000 and put the access code 11099728.

ACT Conferencing would like to thank you very much for your participation today. You may now disconnect. Have a very pleasant rest of your day.