Surmodics Inc (SRDX) 2010 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the SurModics first quarter 2010 earnings conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). This conference is being recorded today, Wednesday, January 27, 2010. I would now like to turn the conference over to Phil Ankeny. Please go ahead.

Good afternoon. And welcome to SurModics' fiscal 2010 first quarter conference call. Thanks for joining us today. Our press release reporting quarterly results was issued earlier this afternoon, and is available on our website at www.surmodics.com. Joining me on the call today is Bruce Barclay, our President and Chief Executive Officer.

Before we begin, it is my duty to inform you that this conference call is being webcast and is accessible through the Investor Relations section of the SurModics website, where the audio recording of the webcast will also be archived for future reference. I will remind you that some of the statements made during this call may be considered forward-looking. The 10-K for fiscal year 2009, identifies certain factors that could cause the Company's actual results to differ materially from those projected in any forward-looking statement made during this call. The Company does not undertake any duty to update any forward-looking statements as a result of new information or future events or developments.

On today's call, I will address the Company's quarterly financial results, Bruce will then highlight quarterly achievements. And finally we will open the call to your questions. I will begin by reviewing key first quarter financial results and then provide more detailed commentary around a few line items.

For the first quarter of fiscal 2010, revenue was $17.4 million, diluted earnings per share was $0.11, and cash flow from operations was $8.2 million. Looking at results on a non-GAAP basis, including the $3.5 million upfront license fee from Genentech which is being amortized over 20 years under GAAP, revenue was $21 million and diluted earnings per share was $0.24.

In reviewing our financial results, I will focus my commentary on the sequential comparison of first quarter results to fourth quarter results. We believe this is a more relevant comparison for the time being. Please refer to the press release for the year-over-year comparisons. Looking at our results, on more of an apples to apples basis, if you exclude revenue related to Abbott from the fourth quarter of fiscal 2009, non-GAAP revenue increased 17% sequentially.

Next let's turn to individual revenue line items. Royalties and license fees for the first quarter were $9.2 million, down only 3% sequentially even though this figure includes only a fraction of the $3.5 million upfront license fee from Genentech. Furthermore, if you exclude the $1.25 million Abbott settlement from fourth quarter results, royalties and license fees were up 12% sequentially.

Moving on to product sales, after generating sequentially increasing product sales in each of the past three quarters, product sales for the first quarter were $4.5 million, down 18% sequentially. Our product sales have largely recovered from the difficult economic environment experienced a year ago. However in the first quarter, despite strength in several product categories, we did see some sluggishness, in our diagnostic products. We do expect sales of our diagnostic products to improve in the second quarter.

Turning to our third revenue component, R&D revenue for the first quarter was $3.6 million, down 13% sequentially. As we have discussed in the past, SurModics R&D revenue is prone to fluctuate from quarter to quarter as a result of ebbs and flows of activity in our various customer development programs.

One factor that negatively impacted first quarter results was the completion of clinical trial materials for one of our customers. This customer was a prominent driver of R&D dollars through the fourth fiscal quarter. However after getting them armed to launch their clinical trial, the customer generated very few R&D dollars in the first quarter.

Regardless of the near term fluctuations in R&D revenue, SurModics is continuing to add new customers to our R&D pipeline and we remain confident in our R&D prospects. Going forward in fiscal 2010, we expect to see R&D revenue increase as we have multiple large programs requiring our support, including the program with Genentech.

Now let's turn to our revenue break-out by market, starting with therapeutic. Cardiovascular revenue for the first quarter was $10.7 million, up 9% sequentially. Our cardiovascular results continue to benefit from the breadth of customers we have assembled. For the quarter, cardiovascular constituted 62% of total revenue.

Growth in cardiovascular is particularly gratifying against the backdrop of the continuing decline in ear-over-year Cypher sales. Johnson and Johnson reported that sales for the quarter of the Cypher Sirolimus-eluting Coronary Stent were approximately $223 million, down 18% year-over-year. While Cypher sales were lower, overall drug-eluting stent penetration rates once again increased and now stand at an estimated 77% in the United States, up from 73% in the year earlier period. This trend is important as SurModics participates in a number of other partnered products and development efforts in the drug-eluting stent area beyond Cypher. In addition, we are pleased that earlier this month, J&J received regulatory approval for Cypher Select Plus in Japan.

Moving on to opthalmology, revenue was $2.5 million for the quarter, up 35% sequentially. GAAP revenue included only $44,000 amortization of the $3.5 million upfront license fee from Genentech. On a non-GAAP basis, opthalmology revenue was $6.2 million for the quarter. Bruce will provide more detail on our opthalmology business in his remarks.

SurModics has elected to early-adopt EITF 081, which we believe provides more favorable accounting treatment for the Genentech agreement than our accounting for the Merck agreement under EITF 0021. Rounding out therapeutic, other markets revenue was $1.9 million, down 35% sequentially. The majority of revenue in other markets is R&D related and lower R&D revenue contribution from the customer for whom we completed clinical trial materials in the fourth quarter was a significant factor in our sequential decrease in other markets revenue. As is the case with broader R&D revenue, other markets' performance is prone to quarter-to-quarter fluctuations in our various customer development programs.

Finally, I will review results from our diagnostic market. For the first quarter, diagnostic revenue was $2.3 million, down 51% sequentially. Excluding the $1.25 million Abbott settlement from fourth quarter results however, diagnostic revenue was still down 32% sequentially. As diagnostic has become largely a product business, following the expiration of the Abbott patent, results were impacted by the softness in diagnostic products that I mentioned earlier. However, we believe the softness is a near-term issue related to inventory levels and timing of purchases by our customers. We expect to see improved diagnostic product sales in the second quarter.

Now, let's return -- let's turn to a review of operating expenses. We are continuing to manage costs and expenses well. Operating expenses, excluding product costs, were $12.7 million in the first quarter, down 3% sequentially. The decrease in operating expenses has been somewhat offset by an increase in costs associated with the new cGMP manufacturing facility. The capital investment is largely behind us, and we expect to invest approximately $3 million to $4 million on facility-related equipment in the remainder of fiscal 2010.

We began depreciating the facility in December, which added approximately $160,000 total depreciation in the quarter. Going forward, we would expect depreciation related to the facility to be roughly $0.5 million per quarter. Also remember that we will be consolidating SurModics' other two Alabama locations into this new facility, and expect savings from the consolidation once completed.

We anticipate that the cGMP facility will begin generating revenue in the second quarter. Looking forward, the most significant returns from the investment we have made will be realized in the form of customer agreements that generate royalties and license fees over time.

There is a significant near-term cash benefit from the facility I would like to highlight. When SurModics was successful in completing the facility in calendar 2009, we qualified for a tax benefit against our federal taxes. Current tax law allows us to take accelerated depreciation against a substantial component of our facility investment, effectively saving us approximately $4 million in cash tax payments in fiscal 2010. In addition, over time we expect to benefit from state and local tax incentives.

Lastly, let me turn to our balance sheet, which is in great shape. As of December 31, SurModics' cash and investments increased to $51.5 million from $47.9 million at September 30. And we have zero debt. Given our optimism in the Company's potential for long-term growth, we will continue to leverage our strong balance sheet to invest in our business. In this regard, we strive to balance our deployment of capital for share repurchases, facilities-related investments, and business development. With that I will now turn the call over to Bruce.

Thank you, Phil. Welcome to today's call. During SurModics' first quarter of fiscal 2010, we continued to make important progress in a number of key areas, including our opthalmology, cardiovascular, and SurModics Pharmaceuticals businesses. The most significant accomplishment in the quarter came when we announced our agreement with Genentech in October -- licensing our drug delivery technology and opthalmology.

In addition, our license partner OrbisNeich initiated a first in man clinical trial with a new drug-eluting stent employing our SynBiosys biodegradable polymer. Finally, we officially opened our new cGMP facility in Alabama which will be a vital component of our long-term growth. And as a testament to our financial strength, we accomplished these results while preserving a strong balance sheet, growing our cash balance and generating solid operating cash flow.

As we have discussed previously, our Genentech agreement is a major advancement toward realizing our strategic vision to develop technologies that address important clinical needs in the large and growing opthalmology market. The prospect of developing a sustained delivery formulation that uses our proprietary biodegradable micro particles in combination with a known, approved and highly successful drug in Lucentis, is a tremendous opportunity for SurModics. And if successful, would be an important validation of our critically enabling technologies.

Lucentis is the only treatment proven to maintain and improve vision in patients with wet, age-related macular degeneration, or AMD, a leading cause of blindness in people over 50. Because AMD generally affects older adults, the incidence of AMD is expected to increase significantly as the baby boom generation ages and overall life expectancy increases. Additionally, Lucentis is in late-stage clinical trials in patients with DME and RVO. Since signing the agreement, the teams from SurModics and Genentech are working well together and making good progress against our development plans.

It is also important to note that the agreement with Genentech has not affected our other customer programs and relationships in opthalmology. Since our last update in November, we continue to support a number of opthalmology projects with several different customers. Of importance, three of these current customers in opthalmology are top 10 pharma companies, including Roche-Genentech as one.

We believe our portfolio of customer projects and opthalmology is healthier than it has ever been and will be a significant source of growth for years to come. Further, we believe our technologies and capabilities to deliver large molecule biologics sets SurModics apart from the competition.

Since our announcement of the Roche-Genentech agreement in October, some investors have asked us to compare our new agreement with Genentech to the one we signed with Merck in 2007. Let me be clear on this point. We believe the Genentech agreement is much more valuable to SurModics than the Merck agreement at the time of signing. There are several important factors supporting this belief.

First, Lucentis is already a significant product in terms of sales, suggesting that potential sales of the ultimate sustained release product could be significant as well. Second, Genentech already has an established, very strong position in the market with Lucentis, a strong contrast to Merck who did not have any existing FDA approved products for the treatment of AMD. Third, while we cannot disclose the royalty rate in the agreement, we can assure you that it exceeds the royalty rate we received from Cypher.

And fourth and perhaps most importantly, Lucentis has already been approved for the treatment of AMD by the FDA. We believe this is a -- this is significant as it reduces the development risk of the program, compared to the one that includes a yet-to-be-proven drug. Overall, we see more upside opportunity at a lower risk. We are pursuing large and growing market opportunities with a drug treatment already approved by regulatory agencies, and in partnership with a market leader like Genentech.

In addition to our exciting opthalmology projects, there are several additional prominent revenue-generating opportunities in other parts of our business. While Cypher-related revenues have been decreasing, our overall cardiovascular franchise is strengthening. In the stent market, our portfolio of licensed customer product opportunities both on the market and in our pipeline, is substantial.

For example, on December 1 our license partner OrbusNeich announced that it had enrolled the first patient in its remedy clinical trial, which is a randomized clinical trial for their combo, bio engineered Sirolimus-eluting stent. The combo stent combines the pro-healing technology used in OrbusNeich's Genous bio engineered R stent for rapid endothelial coverage with an adluminal Sirolimus drug-eluting coating for control of neointimal proliferation.

The low dose Sirolimus solution is accomplished using the SynBiosys biodegradable polymer matrix from SurModics. We were particularly pleased by the comments from Renu Virmani, President and Medical Director of CVPath Institute, regarding the potential benefit from biodegradable polymers in these next generation stents and the positive animal data she observed from her pre-clinical work with SynBiosys. This ability to generate solid, pre-clinical data that demonstrates the value of our various polymer families has been a strategic initiative of ours for some time as it helps create customer interest and is a strong competitive differentiator.

As Phil mentioned, we are pleased to report that earlier this month, J&J announced regulatory approval of the Cypher Select Plus Sirolimus-eluting Coronary Stent in Japan. In the press release, J&J highlighted the enhanced delivery system for this product, and in particular, that the product has "an innovative coating technology that is significantly more lubricious than previous Cypher stent products." As you know, this lubricious coating is licensed from SurModics.

In addition to the -- In addition, the product contains a second licensed technology, that being the drug delivery polymer on the stent. As such, we will receive two royalties on this new product, and we will also sell two different types of associated re-agents. This approval is significant as Japan is the second largest market in the world for drug-eluting stents. Product will be launched following reimbursement approval.

We are also taking important steps to diversify our exposure beyond stents within the cardiovascular space. In particular, our work with drug-eluting balloons continues to progress and remains a very active area of interest for us. Also, I'm pleased to report that Invatec, an existing royalty generating customer of SurModics, will be acquired by Medtronic, as announced on Monday of this week.

In addition, SurModics Pharmaceuticals continues to be an important growth driver for our future. This business has reached an encouraging inflection point by converting three sustained drug delivery partnership programs into licenses in the past few months. As we said previously, and consistent with our strategy, converting this business to our licensing business model and changing the mix of revenue to more royalties and license fees, is critical to our long-term success, and we are making good advances.

The license agreements we have signed have attractive financial terms and represent solid growth opportunities for the Company. Further, they demonstrate the important progress we are making with our business model as well as our success in licensing our proprietary drug delivery technologies to pharma and biotech customers. One of these agreements is with an as-of-now undisclosed partner for the development of an oncology product.

Another agreement, which we announced November 2, is with NuPath and relates to the development and commercialization of a sustained release formulation of their drug NP201 for the treatment of Parkinson's Disease, a significant, unmet clinical need in a large and growing market. Analysts estimate that the global market for Parkinson's Disease is approximately $2 billion to $3 billion per year and growing.

The use of our proprietary drug delivery implant technology is an ideal match in this clinical area, as dose levels must be carefully controlled to achieve optimal clinical outcomes. Over time we expect to see the progress we are making with these licensed customers and others going forward, to change our mix of revenue to include more royalties and license fees, which will be the strategic payoff from our acquisition of this business.

And as you saw from our press release on January 21, we had the official grand opening of our new world class cGMP manufacturing facility in Birmingham with the Governor of Alabama in attendance to help commemorate the event. It was a great day for everyone, and especially for our employees. The agreement with NuPath as well as the oncology program, anticipates use of this facility to support multiple clinical and commercial products. These opportunities and our previously announced Genentech serve as good examples of how the cGMP facility broadens our scope of customer engagement and makes us a more valuable partner.

We are excited that in the current quarter we will begin to generate revenue from customer paid work in the 16,000 square feet of clean room production space. The facility is truly state-of-art. Each of the four clean room suites has independent air handling systems, enabling SurModics to accommodate multiple drug compounds in the same facility at the same time. We have outfitted the facility with the appropriate support utilities and equipment to meet the needs of our drug delivery customers, including aseptic manufacturing processes, which are typically required to handle therapeutic proteins and other large molecules.

It is truly an impressive facility and has already attracted, and we believe will continue to attract, new customers. We believe the facility offers significant benefits to our customers, including reduced risks for their development programs and potentially shortening their time to market.

Finally, we continue to advance our broad pipeline, which we view as a portfolio of opportunities that will enable future growth and diversification for years to come. We have more than 100 licensed products generating royalties, and nearly 190 customer projects in our pipeline, not yet on the market.

As of December 31, we had a total of 107 licensed customers, several with multiple licenses, up from 104 a year ago. SurModics customers had 104 licensed product classes on the market, generating royalty revenue, up from 99 a year ago. Total number of licensed products not yet launched was 108 up from 107. Major non-licensed opportunities stood at 80 compared with 87 a year ago. In total, the Company has 188 potential commercial products in development.

In our November conference call, I provided you with SurModics' fiscal 2010 objectives. As in previous years, these goals are designed to offer insight into how we manage our business as well as where selected growth opportunities exist. Some of these goals are aspirational in nature, as we often don't control the timing related to our customer-dependent objectives. In our first quarter of fiscal 2010, we made significant progress against these goals.

Our first goal was to sign 18 new license agreements with SurModics customers. In Q1 we signed six new licenses, including our major license agreement with Roche and Genentech in opthalmology. Second, among these 18 new licenses, we expect to sign new two licenses relating to SurModics Pharmaceuticals' drug delivery technology. And that's in addition to the agreement already signed with Genentech. We are on track to sign one SurModics Pharma license agreement in the near term, and at least two in total by the end of fiscal 2010.

Third, we expect our customers will launch ten new product classes incorporating SurModics' licensed technology. As you know, launches are significant, because they mark the point in our business model when the flow of royalties begins for us. In the first quarter one of our customers launched a new product class. Fourth, we expected one of customers to initiate a human clinical trial for a product using SurModics drug delivery technology. And as I mentioned before, in the first quarter, our partner OrbusNeich initiated a human clinical trial using our SynBiosys biodegradable polymer, therefore achieving this goal.

Finally, we expected to qualify and bring our new cGMP facility online during the fiscal year to make it available to current and future customers for years to come. As mentioned earlier, construction is complete, the facility is officially open, and we are on schedule to have our first revenue-generating customer in the clean rooms by March 31. As we have done in the past, we will keep you updated on progress against these goals throughout the year.

In closing, our portfolio of opportunities is significant and we believe a source of future growth for years to come. We have many exciting opportunities in front of us and remain confident in our position as we look to the future. Operator, that concludes our prepared remarks. We would now like to open up the call to any questions. Operator?

Yes, thank you. We will now begin the question-and-answer session. (Operator Instructions). Our first question comes from the line of Ross Taylor with CL King. Please go ahead.

Hi. I'd just start with two financial questions. It looks like the royalty and license fee revenue kicked up sequentially from September quarter if we adjust for that $1.25 million payment you got in September. And I just wondered if you can detail at all what might have caused that sequential increase. The other question I had is with the new facility in Alabama opening up, I wondered what that does to your depreciation expense in the current quarter or going forward.

Sure. Let me take those, Ross. First of all, the royalties and license fees line was a strong result for the quarter, and there was some sequential improvement in Cypher, as you know, based on J&J's results. They're down 18% year-over-year, but sequentially they were up a little bit. So that certainly was a factor. But there was some good strength across the portfolio in royalties -- cardiovascular and others. So that was a good portfolio contribution really for the quarter.

In terms of depreciation, what we added in this quarter was about $160,000 that was from one month's worth of depreciation because we brought the facility online in December. And going forward, we would expect that quarterly run rate on that facility to be about $500,000.

Okay. And last question, have you disclosed at all which technologies you have licensed to Invatec?

No, we have not.

Okay. That's all my questions. Thanks very much.

Thank you.

Thanks, Ross.

Thank you. Our next question comes from the line of Brian Jeep with Sidoti & Company. Please go ahead.

Afternoon, gentlemen.

Good afternoon.

Hi Brian.

I had a question about customer R&D projects. It looks like the -- the margin there fell off pretty substantially. Is that because it was just lower revenue, or is there something else going on there that we should be looking at? And I guess what should we be thinking about for a run rate on that? Thank you.

So the margin definitely was compressed this quarter mostly because of the decline in R&D revenue. So it is really an allocation between the customer funded R&D, side of -- of R&D expense, to the other R&D expense which is really more about internal programs and the like. And so there's overhead that gets allocated between those two, and so effectively, it is an absorption issue because the R&D revenue was -- was sequentially down from the fourth quarter.

Okay -- I'm sorry, go ahead.

So if you remember last quarter, we were about 29%, 30%, and this quarter we are considerably under that. And it is really a function of that. And so the, the fourth quarter numbers are probably a little better ballpark of where we expect to be. But again, it depends on the level of R&D revenue, with the different parts of the Company.

I was just going to comment going forward as we alluded a little bit in the prepared remarks. I think for the rest of fiscal 2010, we do see a definite increase in our paid R&D number. Some of what we experienced in Q1, as Phil mentioned, is one particular customer. I would say there are other timing issues with a couple of other customers as well, but we see those timing issues starting to dissipate in terms of paid R&D for us, in the -- for the rest of the year. And we also see some new business coming in as well which we don't have yet, but we expect to close on soon. So, we think that this is timing, and we will see that improve for the rest of the year.

Okay. And -- I know you haven't given out too many specifics on the Genentech deal, but I was wondering if you can give us a sense of whether it is possible or even likely that you would achieve a milestone before the end of fiscal 2010?

We really can't talk about the size or timing of the milestones relative to the program, other than just what we announced at the initiation of the of the release, which was the total milestone package is approximately $200 million.

Okay. And I know you worked hard to get the Genentech agreement. You had the Merck agreement before that. Looking at these, I'm wondering, is it a coincidence that you signed two big ones in the last, say two-and-a-half, three years? Or should we expect the possibility that there is going to be another big one coming in the next year or two?

Yes, we have got a number of programs in place now, not only in opthalmology but also in our other areas of drug delivery that are not licensed at this point. And as we've said in the past, we don't control precisely the timing of the licensing of those technologies because of the value that we expect from that. A, it's an enabling technology and B our programs are in very large markets with, in many cases, very large companies. We have a high expectation of what the value of those deals should be.

So they're not things that get entered into unless there is some data from the programs that would support it and that was certainly our experience with Genentech. And we felt like it was worth the wait because of the magnitude of the program and the importance of the customer.

So the timing of those I can't comment on. I will tell you that, as I said, we have got other large pharma we are doing programs with that aren't licensed yet. And if those programs continue as we hope that they will, there's certainly no guarantee, they would have to license at some point down the road.

Okay. Thank you. I'll get back in the queue.

Thanks for the call.

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

Yes, hi Bruce, hi Phil.

Hi, Dan.

Just to return to the R&D number, can you quantify what that impact was sequentially when that customer went to the clinical trial, how sizable was it?

I don't know that number off the top of my head, I can't -- I don't know, it is one of several programs that we have.

Okay. And then moving that specific one, moving to the clinical trial, it sounds like it is not cardiovascular related or opthalmology. Or can you -- talk a little bit more about what is starting there?

No. That is neither of those programs, neither of those clinical areas as I think Phil alluded to. It is in the other markets area, which is a bucket of programs that we have that cover between eight to ten to 12 different clinical areas depending upon the quarter in which we are doing work. So it's a lot of different clinical areas. It's mostly made up of paid R&D and programs of various sizes and various progress along the development pathway.

Okay. Because then I was wondering if that -- is that a possibility of manufacturing in Birmingham, supporting that clinical trial. Is that something along that pathway?

Yes. Absolutely. I think it is our, -- it is our hope and I would say expectation with some programs, contractual commitments in some cases, that as we begin to work with customers on the GMP animal studies and then move into Phase I and Phase II clinical trials, that we will do that work naturally because there's a close connection between the scale-up required for those test -- for that testing with the R&D work that is done by our scientific teams.

And while there's a lot of science with the manufacturer of these products, there is also a fair amount of art with it as well. And I think being able to have the close connection between the bench-top work, and then the animal and early clinical scale-up is really important. That's critical to the success of our cGMP facility, and our customers believe that that connection is important as well.

And then the question becomes once you have done the GMP animal Phase I and Phase II, will you be an option for Phase III and commercial. It is not a given, but once you have reached that point and there is continued good data coming out of the clinic, we think it's more likely than not that customers would want to stay with us for the large scale Phase III and then the commercial. FDA, requirements I think are significant and if you can keep all of that done in one site, we think there's a significant advantage for us.

We are also seeing trends in the industry that suggests that pharmaceutical companies are increasingly comfortable with farming out the manufacture of these clinical and commercial product manufacturing requirements. And again, I think we're counting on that going forward with our facility. So, long answer to your question. I apologize, but there is definitely a connection between the early work that we are doing for clinical studies and then the Phase III and large commercial manufacturing components.

I think we have been -- articulated this in the past and Bruce spoke to it well. But the phrase we hear from customers all the time is risk. And how being able to have the program go through its various stages. And particularly if you get to Phase III clinical trial material production, a customer typically does not want to ever consider moving that from that location to a different location because it adds risk to the FDA approval and to ultimately getting, -- getting a successful product that meets all of the GMP requirements et cetera.

And that just then backs up into the earlier stages, where if you cannot transfer even at any stage, you are just minimizing risk and reducing risks from each stage as you progress. And so that is a big reason behind why we felt that this investment in this new facility was so strategic and so compelling.

That is helpful color. Thank you.

Thanks for the call.

Thank you. Our next question comes from the line of Ernie Andberg with Feltl and Company. Please go ahead.

Good afternoon.

Hi Ernie.

Phil, you suggested that the diagnostic area softness was a timing issue and you expect revenues to improve. Ex the Abbott royalty, can they -- do you think they go back to where you were in the fourth quarter, ex the Abbott royalty? Or are we between that and where we are now? And I recognize I am asking you for a forecast. But how do we think about your comment?

I would -- it is probably a lot safer to give you the directional on it that we do see improvement there. More precise within a range I would feel a whole lot less comfortable. But we do have strong confidence in the ability to grow that line. But the rate of growth in when we get back to numbers you have seen in the past, it probably wouldn't be prudent to peg that down.

I think that's right. I think I would say it is a -- it is more of a timing issue whether those return sales come in Q2 or beyond. We think Q2 will be better. We certainly haven't lost customers because of the reduced sales in diagnostics in Q1. It's more about, will they return exactly to the same level in Q2? We are hopeful, but I can't guarantee that.

There's no one event, no customer -- significant customer loss that happened. It is purely timing. And given the fact that the re-agents we sell are baked into scientific tests, many times FDA approved products, there's good comfort there that they will need to buy those products eventually from us.

Okay. Second question, just on line items. SG&A bounced up sequentially by about 10% and was probably higher than most of the quarters last year. Phil, how do we think about that line moving forward?

As we have looked at the need to continue to support the business and customers, we would see a bias upward in that through the balance of the year.

All right. That's a fair answer. Thank you.

Not strong, but bias upward.

Thank you. That's all.

Thank you for the call.

Thank you. Our next question comes from the line of Rick Rinkoff with Craig-Hallum. Please go ahead.

That was close enough. You are going to start a clinical trial soon. Would you anticipate a milestone payment?

I'm sorry, Rick. I missed the first part of your question. I was laughing.

When you start a clinical trial in the near future, as you've suggested, do you expect a milestone payment?

Typically, that's the case.

Would this be a number that we would be excited about, or is this kind of in the six figures?

Hard for me to figure out which numbers excite you.

Any number would excite me.

Yes. People like to look through $3.5 million sometimes and that really excites me.

You amortize that over 20 years. So this one you wouldn't. So should we expect a sizable payment, or should we expect something along the lines of the $43,000.

I can assure you, we cash both checks within five minutes after we reach the door. To me it doesn't matter how they are accounted for as much. I can't comment on the size, Rick. I can just tell you that starting clinical trial and progressing through the development process, are commonly significant events in the course of a program. And we think as they create value for our customers that we ought to share in that. And so that's a common philosophy for us.

You also said you are going to launch some new products where you have royalties. Would you expect any of those to be significant?

I think potentially, yes. We have talked about the Cypher Select product in Japan. It has done well in Europe, relative to the competition, and we think in part because of the improved deliverability. We have talked, not on this call, but we've talked in past about our participation with Evalve, which is now a part of Abbott Diagnostics and they reported at the JPMorgan Healthcare Conference that they would expect filing in 2010 and approval in the US in 2011.

It's already on the market outside the US in some select markets. There are many examples like that, most of which we don't have permission to discuss publicly. But we continue to believe that, as it was this quarter with more than half of our revenue coming from royalties and license fees, that that's an important line for us.

You -- your capital spending for the year is already not quite $4 million. You suggested another amount similar to that would be spent on building. What do you target capital spending for the full year to be?

I think the good news on the building in Alabama is that the facility spend is done. Now we are talking about the cost and timing of the equipment outfitting, some of which we have done of course. Some of which we'll be transferring equipment, from other facilities, and we'll be closing those down over time.

What we said for additional equipment at new facility kind of $3 million to $4 million max for the remainder of the year. Typically CapEx for the year for us beyond that is $2 million to $4 million. I'm looking to Phil and he is nodding his head --

Right.

So I think that is kind of the outside number, the sum of those two.

So once this facility is up and running, should we assume that the run rate capital spending should be $2 million to $4 million a year?

Yes, I think it is $2 million to $5 million probably. Depends on the year.

$2 million to $5 million, and historically you have delivered north of $30 million of operating cash flow a year. So free cash flow could be $25 million to $28 million, assuming the $30 million on the top.

Assuming 30 on the top.

Okay. And for the new building, if you were to look out a few years, what percent of the revenue that SurModics brings in do you think would be flowing through that facility?

Percent -- that's a tough one to gauge. It is -- ultimately the big piece is, is the royalties that it can generate, the programs that are done there. And then depending on the level of manufacturing work that we are doing, the manufacturing revenue can also be significant drivers. And so I think it really depends on the timing of when things are hitting the market and how much of that is coming through royalties, how much of it is R&D revenue and how much is really the manufacturing piece.

Okay. And where is the Genentech revenue going to be attributed to? Alabama? Or Eden Prairie or California?

Opthalmology.

It is in opthalmology.

And opthalmology is in Alabama?

Well, it is -- sorry, Phil. It is everywhere. It's -- big enough programs there, enough of them, that we're actually doing work at all three sites, billing work at all three sites.

Okay. But to have spent the $40 million or $50 million you must expect a sizable return on that in the future.

Absolutely. I think in a couple of different ways we've talked about in the past. It is growth of revenue from manufacturing, but also being able to reduce the risk on programs that have our license technology so that we can support the, hopefully, growth of the -- of the royalties and license fee milestone payment mix that we have come to enjoy over time. So, it is -- it's not just revenue line but also the mix of the revenue line will be supported by that facility.

Okay. Last question.

Sure.

We find out now after the fact that a clinical trial was completed in the September quarter and that is why the December numbers were low on the R&D line. Is there anything you want to tell us that might have been a one time item in the quarter just ended that we're going to find out about three months from now?

I'm not aware of anything at the moment, Rick.

Okay. Thank you.

Thanks for the call.

Operator, I think we have got time for one more question if we can queue up one more, please.

Yes we do. We have a question from the line of Dorsey Gardner with Kelso Management. Please go ahead.

Hi. I guess Bruce, if you had all four lines filled up in Birmingham, what do you anticipate the manufacturing revenue would be?

There's a lot of variables to that question, Dorsey. It depends upon the margin of the products of course, and the hours we put into the program themselves because oftentimes they will be less than eight hours a day, and sometimes they are more than eight hours a day. It is significant. It is tens and tens of millions of dollars potentially.

These are all -- the facility was built for drug release products, so they are typically the higher margin, higher volume type products. And oftentimes, if they are large molecules, which typically we are increasingly seeing and we're hearing from pharmaceutical customers. They're increasingly shifting the mix of their own clinical pipelines to larger molecules. That actually commands a premium for us as well because they are more difficult, and we are -- we have a much significantly advanced competitive advantage in that space as well. So, I don't have that answer off the top of my head other than just to say we would all be happy.

How long do you think it will take to fill up the plant?

We have a number of programs today that are in clean rooms not in that plant. So, what we have got going on now is new programs that we're starting out in the plant, like the Genentech program as an example of that. And then we have got other programs that we are transferring over from existing clean room space that is really sub-optimal for continued growth with those programs as we expect will occur.

And then we have got a number of new programs that we are talking about as well with customers that today aren't paid customers. And so if you look at the data we have in front of us we think that we can be very busy in that plant in a very short period of time. But some of that is within our control, and our customers' control in terms of how we transfer out of existing clean room space at our other two facilities down there. Our goal is to get out of those other facilities as quickly as we can, but reasonably so, such that we don't impact the development of the customers' programs.

Right. And -- do -- are some customers sort of more prime than others, that -- is there some art involved in deciding how you fill up the plant with which customers? Are some much more profitable than others?

Yes, there is a difference in profitability, thee is a difference in size of the programs, which we would prioritize. There is a difference in whether we are scaling up products that contain our own technology versus technology that maybe is more strategic in nature but not necessarily our own technology. Sometimes different drugs have to be brought in at different times because of FDA requirements that dictate how we stage those programs. We're not at that point at all.

We're at the point now where have got customers that are starting out even this quarter as we have said. Customers will transfer over over time, and then a number of customers that we are in active negotiations with right now to bring in some programs that we think are going to be pretty exciting. So as we go forward we'll update you as best we can on that. But we continue to believe that this is an investment that is gong to be worth making.

Okay. Thanks for answering my questions.

Thank you. I don't show any further questions at this time. Please continue.

Great. Thanks very much, operator. Thanks again to everybody for participating in our conference call today. As a reminder, our annual meeting of shareholders will be held here in Minneapolis on Monday, February 8. This year's meeting will be at a new location, the Century Room on the 21t floor of the Wells Fargo Center, still downtown. We hope you will be able to join us, and if not, listen in on the webcast. Look forward to speaking with all of you then.

For those of you who can't join us at the annual meeting, we look forward to talking to you in April when we announce the second quarter results. Thank you again.

Ladies and gentlemen, that does conclude the conference for today. Thank you for your participation. You may now disconnect.