Surmodics Inc (SRDX) 2008 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the SurModics first quarter 2008 earnings conference call.

(OPERATOR INSTRUCTIONS)

This conference is being recorded today, Wednesday, January 23, 2008.

I would now like to turn the conference over to Maggie Knack. Please go ahead, ma'am.

Thank you, operator.

Good afternoon, and welcome to SurModics' fiscal 2008 first quarter conference call. Thank you for joining us today.

My name is Maggie Knack, and I'm the new Director of Investor Relations at SurModics. I'm very pleased to be working with the SurModics management team. With me on the call today is Bruce Barclay, President and Chief Executive Officer, and Phil Ankeny, Senior Vice President and Chief Financial Officer.

Before we begin, it's my duty to remind you that some of the statements made during this call may be considered forward-looking. The 10-K for Fiscal Year 2007 identified 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 online.

Now I would like to give a brief overview of the topics that will be discussed during today's call. First, Phil will cover the Company's quarterly financial results. Bruce will then highlight quarterly achievements, discuss pipeline opportunities and update you on the status of our fiscal 2008 corporate goals. And finally we will open up the call to your questions.

With that, I'll turn the call over to Phil.

Thank you, Maggie. We're delighted to have you join the team as well.

I will begin with an overview of the first quarter financial results and follow that with specifics on discrete line items. Next, I will discuss the significant revenue drivers and break down revenue by business segment and component. Finally I will cover expenses and review our balance sheet and cash flow.

First quarter revenue was a record $23.8 million, a 42% increase from $16.7 million in the year earlier period. This quarter marked the first full quarter of revenue from Brookwood Pharmaceuticals and BioFX Laboratories, both of which we acquired in the fourth quarter of fiscal 2007. The results include $4.2 million in revenues from Brookwood and $1.1 million from BioFX, and both companies had positive contribution in profit during the quarter. We plan to break out the revenue contributions from these recently acquired companies for the remainder of fiscal 2008 so that you can understand their added value.

First quarter results also represent a record for quarterly revenue in our legacy business, excluding Brookwood and BioFX, and this is true in spite of the modest revenue contribution from Merck, as I'll discuss in a moment. The Company reported operating income of $7.6 million, down 7% from $8.1 million in the prior year period. Net income was $5.6 million during the period, down 6% from $6 million in the same period last year. Diluted earnings per share was $0.31, down 3% from $0.32 in the first quarter of fiscal 2007.

Earnings growth did not keep pace with revenue growth for two principal reasons -- first, the accounting treatment for revenue and expenses associated with our Merck agreement, as I'll discuss in more detail shortly; and, second, a changing mix of revenue sources. As I'll detail in a moment, our business has transitioned, at least for now, to a lower mix on a percentage basis of royalties and license fees, our most profitable revenue source. Our recent acquisitions of Brookwood and BioFX are driving a higher mix of product sales and R&D revenue, both of which generate lower margins than royalties and license fees.

First quarter EPS was also negatively impacted by higher diluted share count than the fourth quarter, principally as a result of our strong stock price performance, as well as a higher tax rate. First quarter results also included a gain on one of our investments. In October 2007 QLT acquired ForSight Newco II, a company founded by InnoRx founder, 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 was reported in investment income in our first quarter results. In addition, we are eligible for potential future payments and retain certain intellectual property rights to the acquired technology for back-of-the-eye applications.

Before continuing on to revenue drivers, we thought it would be helpful to revisit the complex accounting treatment associated with the Merck agreement. As we discussed last quarter, the agreement falls within Emerging Issues Task Force, or EITF, No. 0021, the accounting guidance related to Revenue Arrangements with Multiple Deliverables. As a result of this accounting treatment, SurModics' reported revenue and cash flow in the near term are likely to be significantly impacted by the Merck agreement and potentially other agreements if they would fall under this same accounting treatment.

Under EITF 0021, SurModics is amortizing the $20 million upfront license fee over the economic life of the technology we licensed to Merck, or 16 years. This accounting treatment and the resulting amortization will also apply to license fees and milestone payments which could total up to $288 million under the agreement, as well as the commercial R&D dollars we are paid by Merck.

During the first quarter we performed roughly $1.9 million in billable R&D work for Merck in connection with their various development programs. Because of the long period of time over which these payments are amortized, the R&D revenue recognized in the quarter from the Merck agreement was modest, at less than $100,000. The remaining $1.8 million sits in deferred revenue and will be amortized over time. The total balance in deferred revenue related to Merck was $22.1 million as of December 31. Including amortization of the $20 million upfront license fee, total revenue recognized from Merck was still under half a million dollars in the quarter.

However, the Merck agreement likely will have a significantly favorable impact on our cash flow in both the near and long term. Although under GAAP we will not be able to recognize all of the revenue immediately, SurModics will be receiving cash for R&D work and potentially milestone payments as the R&D programs progress. The $1.9 million of billable R&D work and any license fees or milestone payments we receive will flow directly to the cash flow statement.

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

On the expense front, all of the costs of the R&D work we perform for Merck are expensed in the period. In addition to the cost of our scientists and engineers, first quarter R&D expense includes about $600,000 of out-of-pocket expenses incurred in connection with the Merck projects, such as clinical research organization costs.

In sum, while we have recognized less than $100,000 in R&D revenue from the $1.9 million we billed for work performed on Merck projects during the quarter, we incurred well in excess of $1 million in expense. While some might look at the face of the P&L and ask why are we losing money on Merck, we believe this agreement has the potential to add significant value for shareholders and for those patients who suffer from back-of-the-eye diseases such as AMD and DME.

For shareholders, there are at least two reasons the Merck agreement can add value. First, our arrangement with Merck generates positive cash flow. And second, and perhaps more importantly, our collaboration with Merck may lead to the successful development and commercialization of products incorporating SurModics' I-vation Sustained Delivery platform, which under our agreement will trigger milestone payments as certain events are achieved, and ultimately royalties based on sales of the underlying I-vation products.

Moving on, I will now discuss Cypher, a revenue driver that has historically been very important to SurModics. Johnson & Johnson, the parent company of Cordis Corporation, reported worldwide sales of the Cypher Sirolimus-eluting Coronary Stent of approximately $415 million, down 28% year over year, but up approximately 11% sequentially. Despite the decrease in sales, the Cypher stent has retained an estimated 45% market share in the United States for the quarter. Multiple headwinds, including lower penetration rates, reduced prices and increased competition outside the U.S., continue to result in softness for the drug-eluting stent market in general and for the Cypher stent specifically. Going forward, increased competition is likely in the U.S. market with the anticipated approval of the new stents from Medtronic and Abbott in 2008.

While total SurModics revenue associated with Cypher decreased 18% compared with the prior year period, our remaining businesses continued their strong growth trend, with non-Cypher-related revenue growing 81% from the year earlier period. If you exclude the new revenue from Brookwood and BioFX, the rest of our business grew 29% year over year. Our sustained ability to generate robust revenues despite declining Cypher revenue underscores the success of our unique business model and the value of our broad and growing portfolio of products, both royalty-bearing and not.

Before reviewing revenue components for the quarter I will revisit a discussion from our Investor Day in November. As stated previously, the fourth quarter of fiscal 2007 additions of Brookwood and BioFX into the SurModics portfolio will continue to further diversify our business and revenue mix among royalties and license fees, product sales and R&D revenue. Overall, SurModics' mix of revenue in the first quarter breaks down as follows -- 55% generated from royalties and license fees, 22% from product sales and 23% from research and development revenue. For the first quarter of fiscal 2007, royalties and license fees accounted for 79%, product sales were 16% and R&D revenue was 5%.

Let me provide some additional color on the shift in our revenue mix. As many of you know, BioFX, which is part of our in vitro segment, generates only product sales, while Brookwood today generates mostly R&D revenue and a lesser amount of product sales through its Lakeshore Biomaterials polymer business. These two acquisitions, combined with the declining royalty stream from Cypher, are expected to increase SurModics' mix of R&D revenue and product sales, at least in the near term. In the longer term, however, Brookwood's impressive pipeline has the potential to generate royalty and license fee revenue, much like the legacy SurModics business, which could reverse this near-term effect. Furthermore, the license fees and royalties generated by Merck and the rest of SurModics' portfolio are also likely to have a significant impact on the overall mix going forward.

Now let's discuss revenue components for the quarter. Royalties and license fees were $13.2 million during the period, approximately even with 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. Product sales were very strong in the first quarter, increasing 93% year over year to a record $5.2 million, from $2.7 million in the prior year period. Growth was driven by strong performance across the portfolio, particularly in reagents and in vitro products. Product sales include the new products from our BioFX acquisition as well as polymer sales from Brookwood. Recall that this quarter marked the first full quarter with both Brookwood and BioFX in our results.

Turning to our final revenue component, we generated a record $5.4 million in R&D revenue for the first quarter of 2008, a significant increase from $0.8 million in the year-ago quarter. We generated this record level of R&D revenue even though the bulk of the roughly $1.9 million billed for activities in support of Merck will remain on the balance sheet as deferred revenue and be recognized over time. As I said earlier, less than $100,000 for Merck was recognized as R&D revenue in the period.

Next I will review results across business segments. The drug delivery segment generated revenue of $10.8 million in the quarter, a 68% 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 29% year-over-year decrease in Cypher royalties. In addition, Brookwood contributed approximately $4.2 million to drug delivery segment revenue.

Moving on to hydrophilic and other, we generated revenue of $7.6 million during the period, up 43% year over year, driven by growth across the board, in royalties, reagents and R&D revenue. Our significant growth in this segment illustrates strong customer traction for SurModics' hydrophilic technologies and the Company's broad and growing portfolio of licensed customers.

And, lastly, revenue for the in vitro segment was $5.5 million, up 14% year over year. Growth in product sales, including BioFX, offset a modest decrease in royalties.

Next I will turn to a review of operating expenses. Recall that our operating expenses now include a full quarter of operations from Brookwood and BioFX. We are investing heavily in R&D, as SurModics continues to build its technology leadership and innovation. In the first quarter we dedicated 37% of revenue, or $8.7 million, to R&D. Overall, R&D expense constituted 65% of total operating expenses, excluding product cost.

I'm also pleased to report that we are continuing to grow our technical team, adding capabilities to better support our customers today and in the future. With the addition of Brookwood and BioFX and these additions we are making to our organization, total R&D expense is up 68% from last year. As I mentioned earlier, we are expensing all of our costs to support Merck, including out-of-pocket costs, in the quarter, even though we recognize the R&D revenue over a 16-year period under EITF 0021.

Again, both Brookwood and BioFX had positive profit contribution in the quarter. However, because of Brookwood's stage in the evolution of its business model, with no contribution from royalties yet, it has much lower margins today than most of SurModics' other business units.

One final comment on operating profitability. As you know, royalties and license fees effectively have a gross margin approaching 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 correspondingly a lower percentage coming from royalties and license fees, there is an adverse impact on operating margins, which we believe is more than offset by the benefits of a more diversified business.

SG&A expense is roughly double the year-ago level, largely because of the addition of Brookwood and BioFX and as we expand our organization to support our growing business. Also included in this quarter's expenses was amortization of intangibles from Brookwood and BioFX totaling approximately $300,000. Noncash stock-based compensation was approximately $2 million for the quarter. Expenses also included an accrual for bonuses that may be paid for fiscal 2008 performance under our bonus plan.

Lastly, this quarter marks our first period of applying FASB interpretation No. 48, or FIN 48, accounting for uncertainty in income taxes. The net income on our tax provision was not material. Our effective tax rate for the quarter was approximately 39%, which we believe is a reasonable rate to use in modeling our results for the balance of the fiscal year.

Now let's turn to the balance sheet. As of December 31, SurModics had a cash and investment balance of $72.5 million. As you know, we have a bond portfolio that is managed by an outside investment manager. In light of the current credit crisis, we reviewed our portfolio with the manager. Given our conservative investment policy and the investments the manager has selected, we do not believe our portfolio has any significant exposure.

In another recent development, I'm pleased to report that earlier this month the note receivable from the sale of our Bloomington, Minnesota facility was paid off in entirety. Accordingly, we received an additional $5.8 million in cash following the close of the quarter. This transaction will be reflected in our second quarter results, and in the current real estate environment we believe it was prudent to eliminate exposure to that real estate asset.

Cash flow from operations was $4.4 million during the quarter, compared with $11.8 million in the year-ago quarter. The decrease in operating cash flow principally reflects timing of tax payments both in the first quarter of fiscal 2008 and in the first quarter of fiscal 2007. Also recall that the $20 million upfront license fee for Merck was taxable immediately for tax purposes, even though we will be recognizing the $20 million as revenue over the course of 16 years. The corresponding tax payments were made in December.

SurModics is harnessing its balance sheet strength and robust cash flows on two fronts -- business development and repurchase of SurModics shares.

Recent business development activity included the Brookwood and BioFX acquisitions, which we completed during the fourth quarter of fiscal 2007.

Our strong financial position has also allowed us to return capital to our shareholders, further enhancing long-term shareholder value. After completing our first ever share repurchase program in fiscal 2007, in November we announced that SurModics' Board of Directors approved a new $35 million share repurchase program. No shares have been repurchased yet under this new authorization, as we were in our blackout period for most of the time since the authorization was approved. This new share repurchase program reinforces our commitment to effective capital allocation as well as our belief that the activities and accomplishments of fiscal 2007 and the first quarter of fiscal 2008 have strengthened our ability to build long-term shareholder value.

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

Thanks, Phil, and thanks to everyone for joining us this afternoon.

My comments today will briefly highlight quarterly achievements, review our key opportunities and update you on the product pipeline. I'll also provide an update on progress made against SurModics' fiscal 2008 corporate goals that we originally introduced at the Investor Day in November.

As you saw from the release and heard from Phil's earlier comments, our business is strong. SurModics generated record revenue and solid cash flow during the period and double-digit revenue growth in each of our three operating segments. First quarter results also included record revenue in our legacy business, which, as you heard, we define as SurModics without Brookwood or BioFX. Achieving these results despite a soft DES market and the continuing decline in Cypher sales year over year underscores our unique position in the market. In particular, while much of the significant growth in non-Cypher-related revenue came from our two recent acquisitions, our legacy business, excluding Cypher, still grew 29% year over year. And, again, remember, we've achieved these results even though we recognized less than $500,000 of revenue from Merck in the quarter.

SurModics' continued success is predicated on three key pillars -- our ability to continue to grow and diversify revenue; our sustained commitment to customers, when coupled with innovation in technology leadership, which allows us to derive value from solving multiple customer problems; and our continued strong financial results and effective capital allocation, which allows us to generate increasing value to our shareholders on multiple fronts. We continue to believe SurModics is well positioned for years to come.

We're making excellent progress with Merck, and our technical teams are being kept extremely busy supporting Merck's various development programs. The level of activity is abundantly evident in the billable R&D work, which totaled roughly $1.9 million in the quarter, double what we billed in the fourth quarter, and by itself more than double what we reported for all of R&D revenue in the first quarter of fiscal 2007.

In addition to our development programs with Merck, our scientists and engineers are also busy on other ophthalmology development products for back-of-the-eye and front-of-the-eye diseases with numerous customers. These projects leverage our drug delivery platforms and polymer matrix technology for sustained delivery of customers' proprietary drugs to the eye, again including both large and small molecules. The customer demand for our R&D services reinforces the opportunity we see in sustained drug delivery applications in ophthalmology. We will discuss some of our technical developments at our Annual Shareholder's Meeting next Monday.

Next I'll touch on developments at SurModics' Brookwood Pharmaceuticals business unit. As previously mentioned, Brookwood's proprietary polymer-based technology provides site-specific and systemic drug delivery solutions to companies developing improved pharmaceutical products. Based on an 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 release arena. Encouragingly, technical teams in Minnesota continue to work very well with our colleagues in Alabama, and results are already emerging on certain projects. You may have seen from our shareholder letter pictures of projects that reflect some of this joint development work.

Brookwood has nearly 30 customer-paid development projects in progress with top pharmaceutical, biotechnology and medical device customers, as well as smaller public and private companies. One of Brookwood's important partners is Genzyme Pharmaceuticals, one of the top five biotech companies in the world. Genzyme Senior Vice President and General Manager, Mr. Daniel Hayden, will be presenting at our Annual Meeting on January 28. We hope you can join us for Dan's discussion on Genzyme's strategic collaboration with Brookwood Pharmaceuticals.

As you know, this was the first full quarter with Brookwood and BioFX as part of our operations. We're pleased with how well the integration of these two companies is going, and feedback from customers on each transaction has been exceptional. I'm also pleased that both organizations had positive profit contribution in the quarter.

Now I'd like to comment on the drug-eluting stent marketplace. SurModics' stent-related revenue continues to be impacted by multiple market conditions, including a substantial contraction in the drug-eluting stent market. While penetration rates have decreased, DES remains an important revenue generator for SurModics, and we continue to believe in the opportunities in the DES market.

I'd now like to turn your attention to our product pipeline, which I'll quantify as of the close of the quarter December 31. We had a total of 100 licensed customers, several with multiple licenses, compared with 85 in the prior-year period. SurModics had 100 licensed product classes on the market generating royalty revenue, compared with 89 a year ago. The total number of licensed products not yet launched was 105, up from 80 in the prior-year period, and major non-licensed opportunities stood at 93, compared with 80 a year ago.

In total, the Company had 198 potential commercial projects or products in development as of December 31. All of these numbers include Brookwood's customers and projects. As the numbers suggest, the magnitude of 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 today by reviewing our progress against selected fiscal 2008 goals originally unveiled at our Investor Day event in November. We offer this information to investors so you can track our progress as we implement the Company's stated strategic initiatives. These goals also offer insight into how we manage our business and provide a view of the Company's future opportunities. Since we discussed the goals in detail at our Investor Day and also included them in our recent shareholder letter, I won't repeat them here.

Let's start with our corporate goals. We expect our customers to launch 10 new product classes in fiscal 2008. In the first quarter customers launched two new product classes into the market. Since the close of the quarter one of our customers launched a very exciting new product which we are very proud to be associated with. Earlier this month Medtronic announced the U.S. market launch of the AneuRx AAAdvantage Stent Graft on the Xcelerant Hydro Delivery System. The delivery system for this abdominal aortic aneurysm device features SurModics' hydrophilic coating to aid navigation and delivery of the stent graft within the body.

We also anticipate signing at least 18 new licenses with customers in fiscal 2008. SurModics had a very strong first quarter, signing nine new license agreements with customers, including one, as we previously announced, with a major orthopedics customer. This remarkable progress demonstrates our customers' noteworthy commitment to SurModics technologies.

Additionally, we are extremely pleased with the agreement announced with OakRiver Technology to collaborate on the development, manufacture, distribution and ongoing support of advanced coating equipment for the medical device industry. Specifically OakRiver has licensed SurModics' coating process know-how and other intellectual property and will build highly automated equipment for medical device customers using our first-in-class coatings. The jointly developed equipment will benefit SurModics' customers by simplifying manufacturing processes, enhancing yields and lowering manufacturing costs.

The final goal that was laid out in the corporate category was to exceed $10 million in cash for paid R&D. I reference cash because some of this work will be -- will come from Merck, and we know that it will not all be recognized as revenue when received. As of the end of the first quarter we generated (inaudible) million in GAAP revenue for paid research and development plus another roughly $1.8 million from Merck that was not recognized in the quarter.

One of our fiscal 2008 goals for Brookwood Pharmaceuticals is to generate $17.5 million in revenue, and the first quarter came in at $4.2 million. Our goal for in vitro technology was to exceed $4 million in revenue from BioFX products. In the first quarter BioFX generated $1.1 million in revenue.

We remain confident in our ability to achieve most or all of our fiscal 2008 goals as we did for the majority of our goals in fiscal 2007. SurModics will attempt to meet these objectives by focusing on our plan, accelerating our technology leadership and remaining committed to operational efficiency and effective capital allocation. Delivering on these goals will allow us to generate increasing value to our shareholders on multiple fronts. We will review the status of these goals each quarter to help investors track our progress throughout the year. The accomplishments of these milestones has, in my opinion, the potential to create significant value for SurModics and all of our shareholders.

Before concluding I want to take a moment to address the upcoming transition on our Board of Directors. As previously announced, Dale Olseth and David Koch are not standing for reelection and will retire from the Board at the conclusion of the Annual Meeting next Monday. On behalf of our entire Board and all of our employees at SurModics, I want to extend our thanks to Dale and David for their years of dedicated service to SurModics.

Dale's vision, leadership and character during his career as CEO and later Executive Chairman of the Board have been critical in fostering our environment of innovation, accountability and success. His impact is carried forward in the many SurModics employees, investors and Board members that he has inspired. In November the Board recognized Dale's years of service by naming him Chairman Emeritus.

David's contributions to the Company also span nearly 20 years of service on the Board of Directors, and his counsel and leadership have unquestionably helped SurModics become the successful company it is today.

We will host a reception to honor Dale and David following our annual meeting next Monday. For those of you planning on attending the meeting, we hope that you will join us for the reception so you can personally congratulate these two gentlemen.

In closing, SurModics continues to demonstrate leadership and expertise in the development of biomaterials, surface modification and drug delivery technologies. These attributes enable us to exploit the opportunities presented by the convergence of drugs and devices. Importantly, we are successfully executing on our strategy, allowing us to consistently deliver strong financial performance. I'm excited about our future and the benefit our technologies can bring to physicians and their patients, and I'm confident we can continue to deliver sustainable long-term value for our shareholders.

Operator, that concludes our prepared remarks. We'd now like to open up the call to any questions.

Thank you, sir.

(OPERATOR INSTRUCTIONS)

Our first question comes from the line of Richard Rinkoff, with Craig-Hallum. Please go ahead.

Thank you. A couple of questions. Orthopedic, anything new there?

Continues to progress actively in terms of development projects and customer interest, but nothing to report specifically publically, I would say, Rick.

But you had a partnership that you kind of mentioned a couple of months ago. Any elaboration on that?

No, not yet. We did announce in October that we signed our first major orthopedic customer. That's still true, and that relationship still continues to go well. Others are interested, as well, in the technology and in the area.

Any financial contribution from Corning?

Minimal in the quarter. As you know, we launched four new products back in April of 2007. Corning continues to call on customers and get feedback on the product, continues to be interest from customers. But I would say the uptake has been somewhat slow to this point, so at least in the quarter there has been minimal revenue recognized.

And on the deferred revenue, it was roughly $1.8 million went into that category. Should we expect it to be $1.8 million additional every quarter, or will that number ramp up, or how should we look at that?

Yes, that's a good question. I can tell you that our teams here are incredibly busy, and Merck is completely engaged in the project on multiple fronts, not only with the I-vation product but with other compounds of interest as well. So I can't speculate, Rick. I can just tell you that we are very busy, and at least through today and January we remain very busy.

And what about the R&D expenses? Any forecast going forward?

We are hiring to support the need from our customers, not only Merck but other companies, as well, and I will update a little bit at the Annual Meeting on Monday, but we continue to have a lot of interest not only in the back-of-the-eye technologies developed here in Minnesota but also front-of-the-eye technologies developed in Birmingham. A lot of customer interest. We are, as we speak, hiring to support additional work that needs to be done for customers in those areas. I'll provide an update on Monday.

Thank you.

Thank you.

Thank you. The next question comes from the line Daniel Owczarski, with Avondale Partners. Please go ahead.

Yes, thanks. Hi, Bruce. Hi, Phil.

Hi, Dan.

I had a question on the royalty line. If we look at what Cordis did in trying to extrapolate non-Cordis royalties for the quarter, it looks like it was down on a sequential basis. Is that -- can you give us any insight what's going on there with non-Cordis royalties just sequentially?

Yes, it is down slightly when you look at it strictly now what the Cypher contribution would be. And a lot of that is due to some seasonality and just timing, that not every quarter with every customer is (inaudible). And so I wouldn't say that there's anything terribly systemic to that. It's just some seasonality on some of the licensing.

Okay. And then to go back to this Merck and the billable R&D number, so the $1.9 million is a billable R&D, but not necessarily your R&D cost, so there's some markup between what your costs are and people cost is versus what you're billing? Is that correct?

That's correct. We do bill out at essentially hourly rates, and the modeling for that is that we do have some margin in the rate that we bill out.

Okay. And then the $600,000 out of pocket, that's in addition to the man hours that you would be --

That's correct.

-- the people. Okay. All right. Then should we -- I guess to build on the previous question, should we assume that with this dramatic acceleration in the Merck, anywhere closer to -- are they anywhere closer to starting a Phase II trial?

Every day they're closer is the easy answer, I guess, Dan. They are, as I said, very actively engaged in the I-vation TA product, which is the product that will next be in the -- in the next phase coming to trial. So they are still progressing, as I alluded to generally. And, as you know, that's one of our goals for fiscal 2008, and we still think that at least as of now that next phase of the trial will start in fiscal 2008.

Okay. And then just one last question touching on the drug-eluting stents, Endeavor possibly getting approval any day from the FDA; Xtent, I think, has submitted for a CE mark; are there are any other milestones close with your partners or any other data that we should be looking for in the ACC or even the PCR, any kind of milestones stent-wise that would be in the next couple of quarters in nature?

We have a customer, CardioMind, that we have mentioned in the past that we believe is close to entering its first-in-man implant in the near future. We also expect by the end of this fiscal year for Paragon to enter its first-in-man implant as well with the Prohealing Coated Stent. So those are the two that we're actively working with today that we're anxious to see them reach that next milestone, very significant milestone, obviously. Phil, I don't -- no others come to mind.

I think those are the significant ones that we're certainly tracking.

Okay. Thank you.

Thanks, Dan.

Thanks, Dan.

Thank you. Our next question comes from the line of Charley Jones, with Barrington Research. Please go ahead.

Good afternoon. Thanks for taking my questions. Can you hear me okay?

Yes, we can.

Okay, great. First, were there any additional stent companies that are working with your Prohealing coating (inaudible)?

I don't believe we've disclosed the nature of the other customer activity.

Right. You didn't say "stent." I'm saying, I think you just said "Prohealing" (inaudible) specifically to stent.

Right. Yes. There are companies, both stent and non-stent, working with the coating, but we haven't specified the identity of the companies at this point.

No, but the number. Is the number the same?

Yes.

Could you review your comments on the cash revenue you received, or the cash you received from Merck in the quarter towards the end of your comments? You were breaking up.

Well, essentially, we bought $1.9 million worth of, or performed that level of work, and that's effectively what the cash revenue would be for the quarter if you wanted to look at it that way. The way that obviously gets accounted under GAAP is that some of that gets recognized into GAAP revenue, and that's under $100,000. The remainder sits in deferred revenue, and that will get amortized into revenue over the ensuing 16 years.

So there were no additional payments from Merck other than -- or anything billable. (Inaudible) comments at the end.

That's -- well, so the other revenue that was recognized in the quarter, other than the under half a -- under $100,000 in R&D revenue is an additional -- essentially another quarter's amortization of the $20 million upfront license fee. And that -- so when you roll those both together, R&D and the license fee amortization, it's still under half a million.

Okay. Thank you. Phil, what is your state tax rate on income taxes?

Well, we're -- so our total effective tax rate is a little more than 39% for the quarter. So the state would be net about a little more than 4% on top of the 35% federal.

Bruce, I have a kind of a management question here. Are you guys finding it difficult to work on some of the projects that you have been working on over the last year as a result of Merck, and do you think you're going to need to accelerate spending maybe a little bit more over the next two quarters to be able to realize some of those other opportunities that you have with maybe different customers? Or are you pretty comfortable with your growth plans, that it's going to be a fairly moderate increase in people over the next few quarters?

You know, one of the things I think we do a very good job of, but we continually obsess over it, if you will, is to manage our business as a portfolio and make sure that we are prioritizing the most important projects first and working on those as best we can and then making sure that in order of priority we're working on the remaining projects so that we're creating the most value we can in the period that we're working on. We have increased our expense in R&D over time, as you've seen from the announced results. We have and are in the process of hiring additional people into R&D. And I feel comfortable that at least based upon the plan that we have today we'll be able to meet the most significant value opportunities in the pipeline, but we constantly evaluate that.

We continue to invest in what we call internal R&D projects, which are not customer supported, but we want to make sure that we are continually sharpening the saw, if you will, and making sure that we are creating new innovations and new technologies for customers in new areas going forward. But we constantly evaluate whether the amount we spend is commensurate with the opportunities in front of us. We constantly evaluate the projects in front of us and the portfolio. You know, we talk a lot about making sure that we're not in a spike versus a trend, and I'm confident that in several of our areas we are in definite trends up in terms of customer interest. So we are hiring against that.

So it's a good question. I would say we do spend a lot of time talking about trying to best match expenses with cash flow and revenue potential or actual revenue from products and technologies.

I understand you guys don't give guidance, but is this a fairly reasonable base from which to grow G&A by, and can we assume something less than maybe $500,000 a quarter of sequential increase, maybe $250,000 as you grow that? And similar for R&D, is that a good assumption, that this is a good base and we're going to see something less than maybe $500,000 a quarter in increase from here, other than R&D expense related to Merck revenue?

Well, you know, again, we don't give (inaudible) guidance here. I think your concept of thinking of today's expense level as a base is probably appropriate. I don't think we're planning to shrink the organization, either in R&D or in SG&A. And, as Bruce discussed, we work very hard at trying to understand the right investments to make to support customers on the R&D front. And the realities of running a more complicated business with subsidiaries in different parts of the country does put more demands on the SG&A front, as well, and so we need to continue to make the investment to support our business, and we're doing that. As it relates to any particular dollar guidance going forward, I'd be reluctant to do that at this time.

So maybe backing off the dollar guidance, what I'm really trying to get at is are you guys stretched? Are we going to need to see a fairly steep increase in spending over the next quarter? Or do you feel that you're actually somewhat right-sized and you're going to invest strategically and maybe a little bit more reasonably? You guys are in a growth phase, and I'm trying to figure out if you're in a hyper growth phase that's going to cause a significant increase in expenses over the next [three] quarters or if you guys are kind of already right-sized with the additional people you have from the two new organizations?

Much of the increase year over year was the addition of Brookwood Pharmaceuticals and BioFX -- as Phil said, lower operating margins than we're used to in our legacy business. So we certainly don't see an increase like that going forward since they're now fully into the income statement, given that they're in all three months of the quarter. So we don't see a significant increase.

I think, again, we need to make sure that we spend commensurate with the opportunity that we see in front of us, and I can tell you that there is a significant level of customer interest in a number of areas that we're working in. Ophthalmology is very, very active right now. Brookwood Pharmaceuticals is very, very busy right now. Prohealing is of great interest. Even our biodegradable polymers for application stent and non-stent is of interest. We need to make sure we support those things. But the level of increases you saw year over year, we're [not] talking about anything like that as of today. We're -- but we do need to make sure that we spend to support the opportunity we see in front of us going forward.

You guys do stick to your guns on guidance. I will give you that. Thank you for your comments. I do appreciate it.

You bet.

Finally, Phil, on the R&D expense side, could you go over again the -- it was difficult to hear you on the Merck R&D expense. You talked about $600,000 of clinical organization costs and then $1 million of R&D expense. Could you discuss that a little bit and kind of characterize any of that as maybe not ongoing if it's not? Thank you, guys.

Sure.

Thank you.

The numbers that I gave to try to give you a better feel for how the Merck accounting works are not intended to be precise. What I talked about was these out-of-pocket expenses, CRO, as an example, and other expenses that we incur on behalf of Merck to carry the development forward of the various I-vation platforms that they're developing. And so that figure was roughly $600,000 of out-of-pocket cost. You layer on top of that our -- the cost of our people, and so you're very quickly at north of $1 million in expense. And I was just contrasting that to the GAAP R&D revenue that we booked, which was under $100,000. So I did not intend to be precise with the level of labor cost that we are expending to support Merck, because we're not prepared to do that.

Okay. Thank you again.

Thank you.

Yes, thanks, Charley.

Thank you. Our next question comes from the line of Suraj Kalia, with Piper Jaffray. Please go ahead.

Congratulations, gentlemen.

Suraj, thank you.

Bruce, you just mentioned that SurModics scientists and engineers have been kept busy, and if I've heard it correctly they've been kept busy by a variety of programs by Merck and ophthalmology, and if I remember correctly Phil had mentioned wet AMD and DME. As highlighted in the Merck Analyst Day presentation on December 11, 2007, MK-0140 is the only compound in ophthalmology in Phase I out of 50 or so pipeline compounds. So is it safe to say that MK-0140 is not the compound on I-vation and that most of the programs for wet AMD and DME are in preclinical stages? How would you characterize -- can you -- if you can shed some color there?

Sure. Just a reminder, and I'm sure you know this, Suraj, but just to remind everyone, the product that they licensed from us exclusively was I-vation TA. That's triamcinolone, and that's the product that we had taken through Phase I clinical trial and we believe in the very near future will enter the next phase of clinical trials. So what you're now talking about are Merck compounds that would be applied to the I-vation system, and I cannot at all comment about what those compounds are or are not. Those would be questions that I would need to direct you to Merck to talk to them about if they want to disclose those. They're obviously very proprietary to them, and the activity that they've had going on there with us we treat extremely confidentially.

Fair enough. So is it fair to say that Merck is proceeding along with triamcinolone acetonide in development for DME?

Absolutely. Very actively.

Okay.

No question about it.

Phil, secondly, question for Phil. Phil, this is -- per the numbers we have from your press releases and reporting, this is the second straight quarter -- actually multiple quarters with increased number of licensed products generating revenues, and I'm saying specifically non-Cypher products. However, (inaudible) unless I'm missing something, this is the second straight quarter their known Cypher revenues in absolute terms are down. I don't understand your comment about seasonality. The previous -- one of the previous analysts asked a question on softness there, and if I remember correctly you had mentioned something about seasonality. Given Q3 and Q4, depending on which non-Cypher revenues you're recognizing in arrears and instantaneously, Q3 and Q4 usually are the stronger quarters for device companies. So can you help me reconcile the seasonality statements and the softer non-Cypher revs?

Yes, there are actually a number of things to your question, Suraj.

Yes, [pardon me], (inaudible).

First of all, I would just say that implicit in your question is sort of an assumption that each license is equivalent, and that is absolutely not the case with our business. Bruce already mentioned that we treat it very much as a portfolio, and Cypher, as an example, is one very large contributor. And we have other large contributors, and we have some more modest contributors in that portfolio. And so they do vary across a continuum in terms of how much royalty contribution they might have at any point in time. And so that's as you look across the portfolio.

In addition, each product that (inaudible) into the royalty-generating category has its own life cycle. And so as a customer might launch it, its sales trajectory is going to be dependent on a number of factors, depending on where that type of device is in terms of penetration and whether they need to feed the market or not, etc., etc.

The other question was sort of as to seasonality and what are typical peaking quarters versus non-peaking quarters for device companies. You have to remember, first of all, that with the exception of Cypher, all of our royalties are reported on a quarter lag. And so the sales peak quarter for the device company is going to be off from the royalty peak quarter for SurModics.

And then one other complicating factor that flows into that is many of our customer agreements in terms of licenses with royalty obligations back to SurModics have tiers in them. So effectively for the first $X million of sales they might pay royalties at some level, and then when they pass a certain threshold in that tier grid they would then pay a different royalty for the balance of sort of the contract year. And those contract years may tie back to their fiscal year, they may tie back to the agreement year. It's really all over the map. And so for lots of reasons, there is not necessarily a linear pattern throughout time for how much royalty revenue does flow from the average license, if you wanted to look at it that way.

So I apologize for the long answer, but it's a great question, but a very, very complicated bit of math to try to understand it.

Okay. And last question, Phil, from a housekeeping perspective, for Brookwood Pharma and BioFX, given that they generate R&D revs and product revs, respectively, how should we look at [GMs]? I know you all don't give specific guidance, just if you can send us in a particular direction, in these ranges, for housekeeping purposes.

We're not prepared to do that.

Fair enough. Gentlemen, many thanks for taking my questions.

Thank you, Suraj.

Thanks, Suraj.

Thank you. Our next question comes from the line of Aaron Lindberg, with Wm Smith & Co. Please go ahead.

Thank you. What progress are you guys seeing on the cross-selling of BioFX and SurModics customers?

Very good progress. We have been in front of BioFX customers with our stabilization and antigen products, and conversely our stabilization and antigen customers with the BioFX products, and we're actually seeing lots of interest there both ways. And I can't speak in specifics, but the original -- or the premises that we saw in doing the acquisition we are seeing good customer interest in on both sides.

Can you comment on whether you've closed incremental business due to the cross-selling opportunities?

Yes, I can, and we have, yes.

Okay. And then when in 2008 do you anticipate receiving a development milestone on the I-vation platform?

We still feel comfortable with our goals, which are -- as you know, one of the ophthalmology goals is to receive a payment by the end of our fiscal year at September 30. So I can't comment more than that, other than today we still are comfortable that we'll receive at least one.

And is the next likely milestone the initiation of a Phase II trial with TA?

No, I can't comment on that. We've actually not connected the I-vation TA with a milestone payment, so I know they're listed one after the other on our list of goals, but I wouldn't necessarily assume that --

It's not necessarily the case. There may be --

It may or may not be. It just can't be that specific, because that's a detail that's been asked to be kept confidential.

Maybe an easier question would be, are the potential milestones, the initiation of a Phase I for a new compound, taking TA into a Phase II trial, what are the other potential milestones?

Well, as we've said, unfortunately, I'll probably give you the same answer, but I can't be specific other than just to remind everyone that they are development milestones, for the remaining $288 million are development milestones. They're not milestones that pay after products become commercialized following regulatory approval. So we are in development, and we're on development in a number of areas. And so we think potential is good.

Okay. And how many development -- ophthalmology development projects are currently active today?

You know, I'll update investors on Monday. If I can defer that until Monday I would prefer to do it then.

Okay. And then can you just provide some more color for us on the benefits you're seeing from the collaborations between SurModics and Brookwood on the R&D front?

Yes, absolutely. So I'll reference the shareholder letter. If you've had a chance to look at that, there are some pictures on there that we briefly explain, and again we'll talk a little bit more about that, or Dr. Tipton will, to be precise, on Monday at the shareholder's meeting. But one of the things that we saw as a potential was the use of our polymers we've developed here for making microparticles, and so that activity has begun.

The second thing that we were excited about was the potential of putting drugs into microparticles regardless of the polymer in Alabama and then incorporating those into coatings. And so what that gives you are a number of different options for incorporating the customer's drugs going forward. For example, delivering two drugs from a site-specific implant is possible with microparticles. To change, to vary release rates is also possible. And then obviously being able to put the microparticles on a device as opposed to injecting them at a local site in the body is also another option for customers. So, and those are just some examples of what we're seeing by combining the two areas of technology.

The collaboration has been extremely good, and we're extremely excited about the addition of Brookwood to the SurModics team. As you know, some customers gain a lot of comfort from the use of PLA and PLGA polymers with regulatory bodies because they have a long track record of safety and have been used in many products in the past, and that's also a benefit to some of the cross-fertilization that we're seeing. But, again, I will defer slightly to Dr. Tipton, who will talk about this on Monday when he addresses the shareholders from the podium on some of what he's seeing in terms of integration activity.

Great. Well, we'll look forward to hearing that on Monday. Last question, can you help us understand about the development timeline for the orthopedic products that you have underway?

Yes, we've been authorized to go public with that at this point. The one site license we have with a major orthopedic company, we, as I've said in the past, we hope to be able to go more public with that in the near future, but at least at this point we can't. And when we do, we'll hopefully be able to talk about some timing.

And have you initiated the work on that program, though?

Yes, absolutely. We had initiated the work last year, some time ago, before the license was even consummated, and the work continues, progress continues to be good.

Sounds great. Thanks so much.

Okay. Thanks for the call.

Thanks, Aaron.

Thank you. Our next question comes from the line of Blake Goodner, with Bridger Capital. Please go ahead.

Hey, guys. I'm just trying to reconcile something. I understand over the last couple of quarters we're trying to focus more on cash flow than earnings, but I just want to make sure, I'm just looking this quarter, so we reported $0.31. The payment from QLTI, was that just a one-quarter payment, the $900,000? That's not going to continue, right?

Correct. Not -- it's not a recurring quarterly item. There are [three] potential future additional payments in connection with sort of a payout, an earn-out, on that transaction, but it's not something that would recur on an every single quarter basis.

Okay. So that means that, if I were to adjust out for that, then the GAAP earnings is more like $0.28, which kind of annualizes to about $1.12. And I'm just looking at a consensus figure out there at $1.49. And I'm just trying -- or $1.46 -- and I'm just trying to understand, am I missing something? Is there something in the second, third and fourth quarters of the year that's going to cause a significant ramp in just the GAAP earnings?

You know, Blake, unfortunately, because we don't give actual quarterly guidance or even annual guidance, that's really something that we really can't comment on. We don't -- the consensus numbers are published by the analysts that [pulled] out their research, and we just are not in a position, because we don't give guidance, to really comment on their estimate.

Okay. And then just on -- back to free cash flow, so in the quarter we generated $4.4 million of operating cash flow, $1.2 million of CapEx, so $3 million of free cash flow. And there was $1.8 million from Merck in there, a $1.8 million payment from Merck?

That actually doesn't flow through in cash yet, because that's been billed but not paid yet.

Okay. So how much cash was paid for Merck? Was there anything residual from last quarter that was in this quarter?

Last quarter we had about $1 million, and so there'd be some cash there from Merck.

So in the $4.4 million this quarter, there is about $1 million from Merck.

In terms of -- yes, from carryover from last quarter, yes. But the larger -- the largest impact items for the quarter are really the tax payments, particularly there was -- in the first quarter of '07 there was actually no tax payment, and a lot of the income taxes were paid in January of last year rather than in December and then January. So effectively the first quarter '07 north of $11 million in cash flow was actually sort of artificially high, if you will, just based on timing. Here we would argue it's sort of artificially low because of the big cash payments for taxes in connection with the $20 million Merck cash obligation.

So what was the tax payment in the quarter, then, for this quarter? What was the tax payment?

The net income tax cash reconciliation is a use of cash of $3.3 million. But that's a boiled down, consolidated number. There's also -- you'd have to look at the specific tax payments, which are well in excess of that, going out the door in December to pay for the -- essentially the tax obligation on the $20 million.

Right. Well, I guess I'm just trying to get, I'm looking at a $4.4 million operating cash flow. If I add back the $3 million, that gets me back to like $7 million or $8 million of operating cash flow in the quarter, excluding the tax payments.

Okay.

I'm just trying to get to a run rate -- I'm just trying to get to a run rate free cash flow number for the quarter, adjusted for the tax payments.

Yes, the other negative cash flow items compared to kind of that $11 million figure from a year ago are on accounts receivable, where we had a benefit in the year-ago quarter approaching $2 million, and we were closer to $90,000 this quarter. And then also on the payables front we had a use of cash a year ago of about $1 million, and this quarter we're closer to $1.8 million use. So when you add up those three items you're at kind of relative to the year-ago quarter that's about $8.5 million of kind of negative comparison, if you will.

Got it. Okay. And my last question is just, on the Corning, that seems like a large market opportunity. You spent a lot of time over the last year talking about this is a several hundred million dollar market. But you characterized the launch as sort of the slow uptake. Why would it be a slow uptake? I mean, it seems like a logical product. What's causing it to be such a slow uptake?

We said once the product was launched, but it's a brand new technology, and it requires a different level of thinking from the customers that would be using it, both on the R&D side and on the pharmaceutical side. So the level of interest in the product from customers, it hasn't changed. What we said then and we say now is that customers need to try it, and that's what they're doing, and generate their own results and then go from there. So I don't know that -- you know, we were careful not to talk about time frames when the product was launched because it was a new product, it is out in a limited release in terms of being in only four different forms today. And we continue to see that as of today.

Okay. Thanks.

Thank you.

Thank you. Our next question comes from the line of Ross Taylor, with CL King. Please go ahead.

Hi. I think just about all my questions have been answered. But maybe I'll ask, I think, Phil, during your prepared remarks you said that the legacy in vitro business royalties declined during the quarter, and I just wonder if you could comment on what might've caused that. Is that something that's permanent or just temporary? And my second and final question would just be, noncash compensation I think you said was about $2 million in the quarter, and despite not liking to give guidance, do you think it's going to hover around that rate for the remainder of the year?

So first dealing with the question on the in vitro royalties, most of the decline there is really kind of seasonality related, and just some kind of mix of licensees in that bucket. So I'd say nothing that's more trend-related. And then with respect to the noncash compensation, I think we're probably roughly at that level, maybe with a slight upward bias going forward. We just -- we don't know for sure. And some of that also depends on stock price behavior.

Okay. That helps. Thank you.

Thank you.

Thank you. Our next question comes from the line of Charley Jones, of Barrington Research. Please go ahead.

Yes, Phil, the $1.9 million in R&D cash revenue that you haven't received yet from Merck, is that -- that does not go against the $288 million, correct? That's additive?

That's correct.

That said, I think I agree on the operating cash flow. It would help me a lot to see as much detail here as going forward. I think we've already seen the potential we're going to run into with the $1 million from the last quarter. I guess I don't understand. If you had a $20 million payment in fiscal year '07 why a $1 million would even carry over into the first quarter, why that would even affect the cash flow statement. But as much detail as we can keep -- as we can have in this part of the financial statements definitely will help us, I think. Thank you.

Sure. Again, as of -- as is our custom, we'll be filing a much more detailed cash flow statement in connection with the 10-Q that'll be filed in early February. So you'll find the detail there. And you need to make sure that you're not mixing apples and oranges with the $20 million and the R&D, which is completely separate from that. And then obviously the taxes, which are yet another item that (inaudible) forward.

So what was the $1 million that you were referring to?

That relates to the $1 million worth of R&D work that we did for Merck in the fourth quarter of fiscal '07.

Okay. So basically what we should do is each quarter you report the amounts (inaudible) for different programs, it's always going to be on a quarter lag, really.

The cash would be a quarter lag, yes. Because we effectively -- once we do the work we invoice Merck and then they pay.

I mean, and to your point about the 10-Q, at least for my purposes it's too late. We will need it at this release, so if we can maybe include it in the release, even, it would be very helpful to have it three weeks earlier. Thank you again, guys.

Thanks for the question.

Thanks, Charley.

Well, thanks, everybody, for your questions today. Thank you for participating in today's call. We look forward to speaking with you again next Monday at our annual meeting, and in April, when we announce our second quarter results.

Thank you. Ladies and gentlemen, this concludes the SurModics first quarter 2008 earnings conference call. Thank you for your participation. You may now disconnect.