Surmodics Inc (SRDX) 2012 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, thank you for standing by. Welcome to the SurModics' second-quarter 2012 earnings conference call. During today's presentation, all participants 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 Tuesday, May 8, 2012.

I would now like to turn the conference over to Mr. Tim Arens, Vice President and Interim Chief Financial Officer. Please go ahead, sir.

Thank you, Lily. Good afternoon and welcome to SurModics' fiscal 2012 second-quarter earnings call. Also with me on the call is Gary Maharaj, our Chief Executive Officer. Our press release reporting our full second-quarter results was issued earlier this afternoon and is available on our website at surmodics.com.

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 2011 identifies certain factors that could cause the Company's actual results to differ materially from those projected in any forward-looking statements made during this call. The 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 provide an overview of our financial results and highlights for the quarter, Gary will then discuss our key achievements for the quarter and provide an update on our growth drivers and strategy, including additional detail on our newly announced share repurchase program. Following this discussion we will open the call to take your questions.

Unless otherwise noted, second-quarter financial results discussed today exclude the $200,000 second-quarter loss associated with discontinued operations. Thus the financial information that I discuss relates to our continuing operations and is in many cases on a non-GAAP basis. As in past quarters, I'll provide insight and performance comparisons excluding the financial impact related to the discontinuation of Cordis' Cypher and Cypher Select Plus drug-eluting stents. You will recall that in prior periods, we have generated both product and royalty revenue based on sales of these Cordis products which have incorporated our proprietary drug delivery and hydrophilic coating technologies.

Our earnings announcement issued earlier this afternoon provide supplemental non-GAAP financial information that adjust for Cypher and certain event specific charges. We believe that these adjustments provide meaningful insight into our core operating performance and an alternative perspective of our operating results.

Our financial performance after adjusting for Cypher resulted in modest revenue growth while our core businesses generated record operating income during the quarter. Revenue for the second quarter totaled $12.2 million, an 8% decline from the $13.3 million recorded in the second quarter of last year. On a comparative basis, our second-quarter revenue growth when adjusting for the $1.6 million in revenue associated with Cypher, increased 4% from the year ago period. We delivered solid bottom-line results during the quarter with operating income of $3.7 million. On a non-GAAP basis, operating income was $3.8 million, up 41% from the prior year. Non-GAAP operating margin was 31%, up 800 basis points compared with the prior-year period driven by strong contributions from last year's productivity and cost actions and continued pull through on our organic growth initiatives.

On a GAAP basis, our diluted earnings per share was $0.11 for the second quarter compared to diluted earnings per share of $0.16 from the year-ago period. Excluding the impact of Cypher, an $800,000 charge related to our equity investment in OctoPlus, non-GAAP diluted earnings per share in the second quarter grew 27% and was $0.14 compared to non-GAAP diluted earnings per share of $0.11 from the year-ago period driven by higher core revenue and contributions from last year's cost actions.

I will now turn our discussion to performance by business unit. For the second quarter, Medical Device sales, which includes revenue from both our hydrophilic coatings and device drug delivery technologies, totaled $8.7 million, down 12% from the $10 million reported in the year-ago period. Adjusting for Cypher, Medical Device revenue grew 5%. Device drug delivery revenue declined $1.3 million from last year's second quarter. This decline was largely attributable to Cypher. Second-quarter results include hydrophilic coatings revenue of $8.7 million which was flat compared with a year-ago period. During the quarter, our hydrophilic royalty revenue excluding Cypher increased 4% from last year's second quarter.

During the quarter, we experienced a 9% decline in our non-Cypher royalty revenue associated with the Medical Device coronary and cardiac rhythm management market segment. As a point of reference, the first quarter generated 8% growth in this market segment after adjusting for Cypher. Based upon multiple customer interactions, we believe that this quarter's coronary and CRM segment performance may have been impacted by factors such as delayed customer product introductions and ongoing international pricing pressures. On a positive note, recent feedback from coronary and CRM customers suggest a sense of improvement going forward.

Additionally, we continue to see strength in other Medical Device market segments. We saw strong double-digit royalty revenue growth in several key Medical Device growth segments including neurovascular, peripheral and transcatheter heart valve repair and replacement. An additional revenue driver during the quarter was research and development, which increased 50%. Driving this performance was a continued increase in the number of Medical Device customers leveraging our coating services to support their preclinical, clinical and commercial activities. Although a very early indicator, today's research and development activities can lead to tomorrow's royalty revenue.

Medical Device generated $4.1 million of operating income during the quarter, a 12% decline from the year-ago period. Excluding Cypher, Michael Device operating income grew 34% from the year-ago period driven by improved product gross margins of 72% compared with 62% in last year second quarter, and lower operating expenses associated with last year's cost reduction efforts.

Looking at our In Vitro Diagnostic business units, our IVD sales for the second quarter totaled $3.5 million, an increase of 3% compared with $3.4 million in the second quarter of fiscal 2011. Our IVD business unit has now generated six consecutive quarters of year-on-year revenue growth. Notably, our second quarter IVD product sales was our highest-- our second highest ever. However our growth rate of 3% was lower this quarter mainly due to the timing intervals of several of our key customers. When looking to gain insights relative to our IVD revenue growth and performance, it may be useful to look at two quarters to eliminate some of the timing intervals that can be associated with key customer orders. In fact on a six-month basis our diagnostic revenue has grown over 7% compared with the year-ago period.

Our In Vitro Diagnostic performance will continue to benefit from executing on our organic growth strategy, including growing our diagnostic test kit customer base, introducing new products and leveraging our new website and e-commerce channel to drive awareness and orders. IVD generated $1.3 million of operating income during the quarter, an 8% increase from last year's second quarter.

Now let's discuss our revenue summary by category. Royalties and license fees, which are generated primarily in our Medical Device business unit, were $6.3 million, down 18% from the $7.6 million reported last year. Excluding the impact of Cypher, royalty and license fees grew 4% in the second quarter of fiscal 2012. Product sales of $5.1 million were basically flat from the year-ago period. Growth in IVD product sales was offset by lower hydrophilic coating reagent sales. Lastly, R&D revenues in the second quarter was $860,000, an increase of 53% from the $560,000 reported last year. Coating services support for certain of our hydrophilic customers drove the increase in R&D revenue.

Moving on, we generated product gross margin of 68% in the second quarter of fiscal 2012 compared with 64% last year. This 400 basis point improvement was primarily from the consolidation of our diagnostic manufacturing activities into our Eden Prairie facility. This consolidation has allowed us to leverage our fixed operating expenses over higher production volumes.

SG&A expenses in the second quarter of fiscal 2012 were 28% of revenue compared with 26% in the year-ago period. Excluding Cypher revenue, SG&A during the second quarter of fiscal 2011 was approximately 29% of revenue. SG&A expenses declined 2% from last year mainly as a result of our cost reduction efforts.

Research and development expenses were 29% of second quarter revenue compared with 28% in the second quarter of fiscal 2011. Adjusted for Cypher, R&D expenses were 32% of revenue during the second quarter of fiscal 2011. R&D expenses declined 8% from the year-ago period. Last year's productivity and cost actions contributed to this quarter's lower expense.

Taking a quick review of our balance sheet, our cash and investments totaled $102.4 million. Included in this balance is a $2.9 million released from escrow established in connection with the sale of our Pharmaceutical assets. All escrow amounts associated with that transaction have now been released. We continue to generate solid cash flow during the quarter, cash flow from operations was $4.2 million during the second quarter. In just a moment, Gary will provide an update on our activities pertaining to the use of cash to create shareholder value including our share repurchase program.

Finally, turning to guidance. As you saw on our press release we've confirmed our revenue and earnings per share outlook for the full fiscal year 2012. As a reminder, our full-year revenue outlook remains unchanged and is expected to be in the range of $47 million to $51 million. GAAP diluted earnings per share from continuing operations also remains unchanged and is expected to be in the range of $0.45 to $0.53 per share. Our outlook is based upon a diluted shares count of 17.6 million shares. At this point, I would like to turn the call over to our Chief Executive Officer, Gary Maharaj. Gary?

Thank you. This is our first full quarter without the Pharmaceutical business that was sold in November 2011. Our reported financial results today demonstrate the return to profitability. On the last earnings call, I said that our actions during the second year, year two of my time here at SurModics will be defined by three areas. First, our ability to expand our core businesses to generate profitable growth and cash flow. Second, our investment in internal R&D to drive organic growth and optimize long-term returns from this pipeline. And third, our strategy for use of cash on the balance sheet. With that overview, let's review each of these strategic priorities in more detail.

First, our ability to profitably expand our core businesses is critical to our long-term growth. In both our Medical Device and IVD businesses, our customers are facing increasing headwinds in the form of healthcare costs, regulatory scrutiny and lower overall industry growth. So our ability to provide right solutions to our customers that improve results, reduce costs and mitigate regulatory risk, continues to make SurModics an invaluable strategic partner.

In the Medical Device business, our growth initiatives within the core are focused on expanding our leadership in hydrophilic coatings with our next generation hydrophilic platform, generation five, let's call it Gen 5 for short. The Gen 5 coating provides the same low friction capabilities expected from earlier generations of SurModics' coatings and provides improved durability which is a critical need for multiple vascular applications. We're conducting evaluations on Gen 5 with select clients and are in the process of expanding its capabilities to multiple substrates and even more challenging applications. Importantly, our time to revenue from this Gen 5 coating will depend on our customers' product development and regulatory approval timelines. We do believe that our Gen 5 coatings sets the new standard and demonstrates our commitment to improving hydrophilic coatings technology as well as our product readership in this important market.

We're pleased with our progress in this area both in our on time commercialization of these proprietary reagents and the number of active collaboration programs with established clients that we are conducting. Expediting the optimization and commercialization of Gen 5 coatings on our clients unique devices remains a key element of securing future royalties from this advanced platform.

Our hydrophilic coatings business continues to see new products come to market. This past quarter, Medtronic's Endeavor Resolute drug eluting stent, which uses our hydrophilic coatings for the stent delivery systems received FDA approval. We remain excited about more products in these categories where we are being selected as a coating technology of choice be commercialized in both the US and Europe.

In our IVD business, we continue to execute on our plans for organic growth in this core business. We have now achieved six consecutive quarters of year-on-year revenue growth. During the last quarter, we gained five you diagnostic kit customers who incorporate these products as components in their kits. Also this past quarter, we launched our new website with new e-commerce capabilities which allows our customers to shop for our IVD products in a far more convenient manner than had been previously available. The enhanced website was also an important tool for improving the awareness of our products and our brand. Feedback to date has been excellent and we're already seeing strong customer response to the site.

Let's now talk about a second area of focus, R&D, which is key to long-term value creation and growth for SurModics. As I said before, our R&D pipeline consists of three portfolios, ideas, experiments and projects. In our IVD business unit, we continued to move a healthy pipeline of ideas into experiments and projects culminating in new product introductions. This past quarter, we launched our StabilCoat family of blocking reagents. StabilCoat represents SurModics' newest offerings of our Stabile brand of quality market-proven, immunodiagnostic reagents that enhance sensitivity and minimizes the background in blotting application. These are important market needs as we strive to improve the performance of our customers diagnostic test kits.

We also plan to launch additional IVD products in the back half of this fiscal year. And we look forward to sharing more details on these launches in the future. We remain on plan to launch at least two new products each year and our R&D team remains on plan for the rest of this year in launching those products we discussed.

In Medical Device R&D, we have had two key areas of focus. First, as described earlier, we are working to optimize our Gen 5 coatings of multiple substrates and devices. Our second big area of focus has been our drug coated balloon project. As you may recall, drug coated balloons may offer better alternatives than current therapies in areas of the vasculature where placing a stent is not ideal. Examples of this interventions in the peripheral vessels such as the superficial femoral artery and in coronary vessels to treat in-stent restenosis. The worldwide market potential for drug coated balloons is predicted to be over $1 billion annually. During the past three months, we have experimented with a coating formulation on multiple balloon catheter designs, both coronary and peripheral and different substrates as we work with multiple potential partners.

We have also begun work on process optimization at the even very early stage in order to understand the effects of this coating on balloons of different sizes and lengths. Our work is being tested with informative In Vivo pre-clinical experiments. We recognize our aim of setting a high standard of consistent control of the drug on the surface of the device will require deep understanding from multiple and iterative experiments. We are very excited about our accomplishments over this past quarter and are aggressively supporting this project to advance it as quickly as possible.

Finally, let's talk about our third strategic priority. That is, how to best deploy our capital and create value for our shareholders. We're pleased to announce that after careful and deliberate consideration, our Board has authorized the largest share repurchase of up to $50 million. This represents a major step in our commitment to both create value and return cash to our shareholders. Our objective here was to strike the right balance between our priorities continuing to fund the organic growth through investments in our R&D pipeline while maintaining the financial flexibility to be both optimistic and to manage risk while returning cash to our shareholders. Given where our business stands today, we felt that a strong balance sheet of $102 million and consistent cash flows will allow us to establish a share repurchase program while continuing to make the necessary investment to grow our business. In conjunction with our Board, we will continue to carefully evaluate the appropriate balance of these three uses of cash. Cash deployment to create value. Cash returns to shareholders to redistribute value and cash reserves to be both opportunistic and manage risk.

In summary, we continue to be excited about our opportunities going forward in three critical areas that we have defined. Growth from our core products, our R&D opportunities that are catalysts to future growth and finally the strategic yet disciplined use of cash to create return and protect value for all shareholders. We feel good about the strategic plan and what we have in place and we are very confident we'll be able to achieve long-term sustainable double-digit growth. Operator, this concludes our prepared remarks. We would now like to open the call to questions. Thank you.

Thank you. We will now begin the question-and-answer session. (Operator Instructions) Ross Taylor with CL King. Pardon me. Ernie Andberg.

You talked about the operating margins and they look very good and as best as I can separate out the effect of Cypher over the years and all the extraordinary items they're probably as high as they've been in these two businesses. Are they sustainable up at this 30% plus area over the balance of the year and next year or was there something unusual in the quarter?

We believe they are sustainable Ernie, but I'll ask Tim to go into the details.

Ernie, this is Tim. I would say that the way we would ask you and others to think about the operating margins going forward would be, they should be within a couple hundred basis points of what we delivered here in this second quarter.

Okay, fair enough. The other and I suspected that it could be a potential issue in the overall revenue progress in the quarter was, you described it as buying patterns, stocking patterns of your major customers. You described first half-- first quarter versus second quarter, any absolute idea of the potential drag in the quarter of stocking patterns, Tim?

So Ernie this is something that we monitor and we pay particular attention to. I can tell you that some of the timing issues only pertain to several key large customers. We do speak with our customers as you can imagine on a consistent ongoing basis. Our view is based upon the customer feedback that we've received, we're not concerned about the revenue growth performance this quarter.

But you described a potential impact on the quarter. Do you care to be more specific or are you just going to leave it in general terms, Tim?

Yes, I'd leave it in more general terms, Ernie. In fact my comments really pertain to Q2, our fiscal Q2. In terms of the customer feedback that we've received and how I'm articulating how to think about this going forward, it pertains more to Q3.

All right, thank you very much.

Ross Taylor with CL King.

Hi, just wanted to start maybe with the repurchase program you all announced. Any sense on how quickly you might be able to act and begin buying back shares or any sort of parameters you've set in that regard at this point?

It is a large amount of reauthorization and the timing depends on a number of factors, price, market conditions and such. So that's as much clarity as we can give. I think we're pleased to have gotten the authorization and in terms of implementation, the timing. As we said in the press release, it will depend on those conditions.

Okay. I might also ask, I mean given that your stocks not real liquid at this point, does that restrict you in anyway or maybe make you want to be more opportunistic in trying to buy blocks from some of your larger shareholders?

So Ross, this is Tim and clearly it is a large repurchase that's been authorized. You make a great point about the liquidity and the volume. We will look to be as effective and as efficient as we can in repurchasing shares. But you make a very good point.

Okay. And second and then final question is related to your new Gen 5 coating is sort of the feedback and maybe timing at which some of your customers may be able to move forward with this product, I mean does it seem to be on track with some of your original expectations when you first began discussing this several months ago?

Yes, so we-- I think we said on the previous calls that we're going to begin the commercialization in this calendar year. And given the product development and regulatory pathways of our customers, we're excited for those who have actually evaluating it on specific devices. Each of those devices have a different time line. I expect in fiscal 2013 we will see some revenues come on line for that. I would say probably a little bit later in 2013 and that's purely because of the timing.

Okay.

Not because of the acceptance of the product but of the timing of the introduction.

Okay, all right good. And actually just one last question with the drug-eluting balloon, you also mentioned looking at that in coronary indications. And how much more of a difficult process is that from a development standpoint? I guess some questions there, just how likely is it you'd see something develop for that market in addition to peripheral?

From the end viewpoint, the clinicals required for demonstrating superiority in coronary will be -- that's probably be the long pole in the tent of end of this. So the reason we were doing it on coronary (inaudible) is we wanted to understand the impact of small balloons, small lengths, small sizes as well as the peripheral balloons which are certainly sized differently in many respects. So it's not necessary that we're heading down for coronary indications, that would be for some future customers if I was to decide that. But really we wanted to span the range to test the adaptability of our techniques.

Okay that's good color, thank you.

Jeffrey Warshauer from Sidoti & Company.

I just wanted to go back to the operating margins for a moment. So we're looking at 30% this quarter, a nice sequential improvement even on top of seeing some of the restructuring changes last quarter. Do you think additional leverage could be had as revenue starts to pick up again?

Jeff, that's exactly how I would encourage people to think about it. Clearly as we continue to drive revenue growth, we should see some benefit with the middle of the income statement leading to higher operating margins.

And I know you had in the past some staff reductions, have you guys been adding to staff or what's your status there?

Yes. We have been adding especially our operations and coating services areas. I've been very careful and as the Management team of what we add and when we add it because we want to add when we know there's ongoing need for capacity, not just a spike in capacity. And so, we've been back loading that a little bit with certainly temporary staff, but we continue to add full-time positions.

Great and just one last one. I know in your press release this quarter you made mention to three customers launching new products using your coatings. In the past, you had discussed signing new licensing-- new licenses. So just to try to get an idea of consistency going forward because I know there is timing in terms of those generating revenue. Licensing comes first and then you-- your customers will obviously launch products and then you'll start generating revenue. I mean is this-- do you think you'll be continuing to offer this type of information and would you be willing to retroactively offer old product launches?

So, Jeff, this is Tim, and we've thought long and hard about what's really valuable and insightful information to provide to our shareholders. We find that providing the information relative to the number of licenses signed each quarter doesn't-- isn't always that predictive in terms of future revenue or at least near term. Sometimes because you have a license doesn't mean that the product or products are actually commercialized. In other cases, it can take years to see something commercialized. And we continue to sign licenses. I would say that the quantity of licenses that we sign certainly rivals what we've done in the past. But our intention here going forward is really to focus more on the new products that are launched by customers.

Right. And so I mean-- so in an effort to improve transparency, would it be possible for you to go back and tell us how many products were launched over the previous year or six quarters or something like that?

I think we do this every quarter, Jeff. In fact if you look at this last several 10-- excuse me, earnings releases you'll see the numbers. I don't have them at my fingertips but they're out there and so we're going to continue to highlight that going forward. But for the last six quarters you'll for sure see that.

Okay, great, (inaudible) thanks.

Charley Jones with Barrington Research.

Hi, Gary and Tim, thanks for taking my questions. Congratulations.

Hi, Charley.

Yes, nice execution, it's a nice change here. Anyway I was hoping you could update us on a few things. Tim real quick one for you, I think, could you discuss what tax rate you have implied in your guidance for EPS?

We're using a 38% tax rate, Charley.

Okay, all right, great. I was of course real happy to see that authorization be a little bit higher than maybe we were thinking it could be, but I was hoping you could discuss a little bit. I know you guys talked about doing a very analytical review of it, what the puts and takes were for more or less. And I guess I'd particularly like to focus on what you guys thought about when you chose not to do more whether or not the issues were more around liquidity over having a conservative balance sheet or future acquisitions, thanks.

Sure, understood, Charley. The way I look at it, it's a very sound first step. The two words I would characterize when we considered this is we want to be both balanced and flexible and disciplined obviously. And the balance section was balancing the return with risks and opportunities in the business. And I'd focus less on risk but I'd more focus on opportunities in terms of making sure we had returned a reasonable amount. As these characterized too little of a return to our shareholders, we didn't want to send that signal.

On the other hand we didn't want to go overboard and reduced the balance of that primarily for flexibility in future cash generation and uses of cash, which can include future returns. And so, where we ended up was it was a sound first step right down the middle of the fairway, not too much, not too little arguably so obviously. But then it provided us really flexibility for future uses of cash. And I don't want to -- I say risks and opportunities, I mean that's small risk but really large opportunities. Part of those opportunities are still also future returns of even more cash to shareholders.

Yes that's certainly what we were hoping to hear. And I guess mostly because risks and opportunities where really synonymous in the past. I guess one more question on this line, and I apologize for asking this question, but I'm sure others are wondering. You obviously have a number of members on your Board who are investors. And I'm just curious whether or not you did look at a dutch here, what you thought about, and whether or not there are any restrictions in block purchases by-- from any of your Board members or for the shares of any of your Board members.

I know the Board considered certainly the size of the authorization and multiple mechanisms which we will certainly communicate at a future date, but that was certainly-- all mechanisms were considered and given the appropriate weighting. I don't believe I can comment with much education on the individual and certainly the Board members who controls it in blocks (inaudible) purchases at this point. There are some SEC regulations that will need to be filed if and so those things go into action and there will be transparency at that point for sure.

Great, I'll follow up off line. A couple more, I was hoping you could discuss the opportunity of your new IVD program and is there an existing market, and if there is, how big is it and then how big can it be? And what can operating margins can we expect from this product line, obviously you're probably not going to get into detail, but higher or lower than Company or IVD business segment?

So Charley, great question, this is Tim again. And so the way that I'd kind of characterize the StabilBlot family is it's more -- it's a product that's very important. It's important for those folks that are doing membrane-based applications. I would say with all our products that have been recently released or introduced, it does take time for real traction with revenue. It can take up to six quarters for customers to evaluate and incorporate it into their diagnostic test kits and receive approval and then actually commercialize and sell.

Margins will probably be not unlike what you see with other diagnostic products that we sell, which is high 60s. And I would say that relative to traction and uptake, we're real pleased with the initial customer interest. We have with all of our products that we release, the three product families that we released here over the last several quarters, we have over 100 customers or potential customers evaluating these products for inclusion into their diagnostic test kit. So we're pleased with the traction that we're getting so far in the early stage. And we look forward to that translating into conversion to actual product sales and use in kits in the future.

Well maybe you could help me a little bit better understand the potential opportunity from these new products that you're going out with. And I guess really if you could put it in perspective of your current business, is this as mid single, high single, low double-digit grower or could you-- or do you have some new products here that if they hit could be multiples, make it multiples?

Yes, so we'd characterize this in the past, Charley, as being a basic strategy. And we look at it as being something that would be additive to the overall organic growth for the existing products. So we see growth from our existing base and we're layering on top of that growth that will be coming from new products. And we'll layer on top of that growth coming from new channels like our e-commerce channel that we've highlighted today as well which is recently introduced. And hopefully that gives you a little bit of perspective in terms of how we think about these. For us, it's not just the ability to bring in new product and have that be levered to drive growth, one of the key things that we think about as we bring new products to market is it gives us an opportunity to engage existing customers.

I think I might have mentioned this before, but in a diagnostic test kit there can be upwards of six different chemical components that could be used, SurModics provides our customers with many of these chemical components. Not every customer is using all of the chemical components that we have available to them. So it often times opens up a discussion on what's new at SurModics and it gives us an opportunity to engage the customer around what their needs are and how we might be able to satisfy those needs. Whether it's with the new product or with existing products. So it's a bigger strategy for us than just going out and launching new products and generating revenue off of the new products. It also demonstrate commitment to the space.

Yes, no absolutely I guess I'd love to hear if you do have a general take on, maybe as a final follow up, which of these businesses you see better return on invested capital if there is a difference. But before you go there, my last question is around your coatings platform and I was hoping you could understand, help us understand a little bit about it's relative profitability to our current product line. And I guess you could-- I was hoping you could put it-- help us put your entire medical operating margins into perspective here. You've kind of been on a roller coaster and obviously things have changed as a result of Cypher being gone, but just hoping, if you could, give us some goals here, Gary, you talk when you first came out about a high 40s operating margin and obviously you're not there today, but maybe you could help us understand the potential of that business. Thanks a lot, guys.

Yes. So our generation 5 coating will be in the same margin bracketing. If we were offering substantial advantages with this platform to our customers than I think many are beginning to recognize that. The adoption time as you know, depends on the product launches. Where we are heading, though, I mean first of all we like our high [C] return on invested capital of both of these businesses. The issue is on an incremental basis, which one will give us the earlier cash flow. So in many respects I see them as very componentry. IVD certainly has an adoption time for products in the marketplace. Medical Devices I have always said has had a longer throttle response in terms of the cash flows we can get.

What it comes down to for me, Charley, is so we're focusing on strength in the core. We do have to start slowly and methodologically expanding the core. I mean the Medical Device business is a unique by materials Company based on surface modification. And so hydrophilic coatings it's really good for us right now, investing heavily in that. Cut certainly things like drug coated balloon, I see as a first child of many. And that's critical for investment going forward. Similarly the IVD is a unique reagent Company in the diagnostic space. And while we're exercising base hits, part of the reason we're doing that is we hadn't been up to bat for some time. And so our R&D team is really exercising the capabilities in the next couple of years in terms of the doubles and the home runs we want to hit. So those are clearly on tap.

As far as the operating margins, it's going to come down to a balance between our investments in R&D and other organic growth strategies, but really R&D is the big one. And to balance that, which has a longer term value creation especially in the Medical Device business with a short-term margin. And that is something we as Management are looking at, what margin can we get out of the current businesses and which part of that we do we consume for investment in long term businesses. My goals are still the same, but they will certainly average out over the long term.

I'd just like to repeat, thank you both for your hard work and getting this Company back on track here.

We appreciate it, Charley.

Thank you, Charley.

Ernie Andberg.

Gary, I think it was you who might have said that it could take up to six quarters to get customers up and running on your IVD products. I think we're roughly one or two quarters into that process, does that suggest you could start to see an improvement in the revenue stream on the growth side of the equation next fiscal year or is that how you're looking at that business?

Yes, so that is how we like to look at it. Because the adoption curve really is -- as they validated (inaudible) and start incorporating it and then start getting those kits out. We certainly are looking for better results from the new products in 2013.

And enough of your 100 people who are evaluating are far enough along in it, you're confident in that observation, Gary?

Well yes, I'll let Tim handle that a little bit. It depends on the validation is one step. It's really getting their kits and then the marketability of their kits as well. So we have a few more necking down (inaudible) of the process. But enough of them are validating to be able to get to the finish line. And that's how I'd characterize it.

That's right. It's a really good question, Ernie. And what I'll tell you if that we're already seeing customers order these new products. And I can tell you it's a small mix of our overall revenue from our Diagnostics business. I'll tell you that these are base hits. And basically the way I define a base hit is, we're talking several hundred thousand to $0.5 million of revenue per base hit per product. And that's how we think about it. Now there's a lot of factors that can go into revenue generation too. As you have your customers continuing to bring new products to market. So they might be in one diagnostic kit, Ernie, but as years go by you might be in 5 to 10 with the same customer, they might love the product and continue to use it in those others. You could actually see even greater revenue opportunity. And we're always hopeful for serendipity. Just because we might think it's a base hit, doesn't mean that that precludes it from being a home run and being able to generate over $1 million or several million dollars of revenue. But the goal here is to just continue to bring new products to market and fill the bag.

Okay, thank you. Let's go down the same line of thinking on drug-eluting balloons. And I don't know what you care to disclose, but do you have any customers actually in clinical trial late stage clinical trials in balloons in PAD in the US?

No, this is really-- this is all preclinical work. It certainly moved off the bench to up, but certainly in the preclinical trials certainly not in humans. So in the timeframe, this is for US market type timeframe it's seven plus years out in terms of what our customers can do with it. However, we don't bring products like this to market typically and so it would be in collaboration with customers. We continue to have conversations as we have over the past years with multiple parties who will be monitoring our progress and certainly have been working with their specific devices. So it's a fair ways off.

I might add--

That's helpful, thank you.

Ernie don't lose sight either that SurModics can generate revenue in a lot of different ways from our drug coated balloons project. I think you're well familiar with our licensing model, if we were to approach it from that same construct and view, you'd generate development revenue, you can generate milestones, licenses and ultimately you can get to relative revenue. But we're real optimistic about the program and we only mentioned this several quarters ago and we've made some really great progress here in the interim.

Thank you very much.

Jeffrey Warshauer with Sidoti & Company.

Thanks again. Just real quickly, I wanted to follow up on the write-down of OctoPlus, so not concentrating on your operating businesses here for a moment. And I remember, if I remember correctly, there were some other equity investments that you had. Was just wondering what happened there? And the status and the carrying value of your other equity investments?

Thank you, great question Jeff. What I'll tell you is we have about $2 million on the balance sheet of other strategic investments. OctoPlus was written down, it's traded down I think to Amsterdam exchange. We evaluate all of our strategic investments every quarter. We've got no concerns or any concerns relative to impairment on the other strategic investments. And OctoPlus was written down here really as a result of the trading price on the Amsterdam stock exchange over the last several quarters. I think we're carrying OctoPlus at about $900,000 on the balance sheet after this $800,000 write down.

So OctoPlus makes up 900-- or a good portion of --

So excluding OctoPlus, the other strategic investments are $2 million. Including OctoPlus, it's closer to $3 million.

Okay. That was it, thanks again.

You're welcome.

Charley Jones with Barrington Research.

Yes, thanks for the follow ups. A couple questions on the drug-eluting balloon program. I'd like to clarify a few things, are you just working on the coating? Are you looking to be able to buy some sort of drug, like a paclitaxel from somebody else wholesale and do both? Are you contemplating actually having a balloon at all here?

Right. No, we-- our current thinking is sticking to the core where we're really good at coating on devices. At this point I wouldn't characterize us as a device Company. And because as you can imagine bringing a product to this market requires a lot of device experience, not that we don't have it, but it's not core. And also a lot of clinical research expertise in designing and monitoring trials, which clearly we're not-- that's not our core. So our focus is rally being able to get the technology of getting the best drug coating release and control characteristics on a balloon. And then ensuring that our potential partners are able to then exploit this on their devices.

A couple of follow-up questions on this. Are you -- have-- does your coating work with several drugs or have you honed in on a drug or two?

Well we certainly have honed in but I probably can't comment on much more than that. But we certainly have honed in on basically the optimal combinations of the drug and the excipient.

Are you typically seeing that the companies out there that are designing balloons are using almost a three balloon strategy? My understanding is that blood wipes the 90% of the drug or whatever it was several years ago that everybody talks about off the balloon in 10 seconds or whatever. So is there-- do you actually use-- are any of them using a proximal balloon to prevent blood flow and then to have better contact with the drug and then-- or is it just a single balloon here?

There is any number of ways certainly there are those that are on the markets, but there's certainly quite a few start ups of trying unique and novel ways to achieve or to prevent as much drug loss. Our methodology really has to do with being able to keep it on the surface until you need to release it to the vessel wall. But yes, brighter minds them mine are trying that. But our approach really uses what we know about coatings and drugs and that competency that we have and so we're not pursuing unique mechanical means, if that's what you mean?

Okay, just a couple of other things here. Can you tell me at all how long you can actually have blood flowing over a balloon when you keep I don't know whatever number you want to say ex percent of drug? And is there a level of drugs that -- is there a time limit that you have here? And what do you think others capabilities are here?

Yes, my quick answer to that is that you need to keep enough drug in the balloon to get to the target lesion and not lose too much. But really what-- as you know, Charley, want you want to do is to have the maximum effect of having that drug [depot] in the vessel wall for high tissue penetration without having a large loading systemic circulation. I think that anybody who is in this industry, that's the general aim there. And our mantra is the right amount of drug at the right place for the right time. That's our mantra on control in our little setting of how we're approaching it. I'm sure other people are approaching it with similar or different angles. But that's really the core of what we want to achieve with this coating on a balloon.

I promise I'm getting close to the end here, a couple more though. On the coronary, are you-- why not the coronary it seems very obvious to most of us regardless of the trauma to the vessel? And then secondly, how quickly can you be in Europe? And I do have one last question.

Yes and so those things would be left up to our device partners and our device customers to devolve. And so if we are able to demonstrate that our coating works on coronary peripheral neuro balloons or whatever it may be, then really they best know the market approach strategies to this. We're just-- we're providing a great technology platform for potential partners to actually then deploy how they see both strategic (inaudible). So that's-- I'm out of my depth off of that Charlie in terms of the deployment and Europe and stuff. Certainly Europe is a first step on the regulatory pathway and then the US, but that'll be up to again potential partners to decide at the right time.

I guess the final thing I want you to maybe think about then if you can't answer today, is-- and can get back to us if you could help us understand a little bit of your licensing strategy here whether or not-- to me it makes more sense to have a non exclusive license here, but curious what your thoughts are there? Curious the opportunities for several indications such as coronaries and curious how many different partners you think you can have? And then finally, I guess the last piece is there's others out there obviously doing this. I mean this is-- you guys have been talking about it for a year or two, but we've been talking about it for three or five or whatever, so and probably longer. So I am curious, what-- how confident you are in your technical capabilities to do something that others don't here?

Yes and so we're very confident in our capabilities of manipulating drugs on surfaces, and balloon is certainly one of those [criteria]. As far as the licensing model, I'll say two words, stay tuned. We certainly will-- we believe we have something of value and we intend to work with the appropriate parties on that.

I guess just to push back a tiny bit on that, I mean this is such a huge market opportunity, if you get with the right leader, does it make sense to be exclusive? Or given the fickleness of interventional cardiologists with balloons in general to date, does it make sense to have in your opinion a broader strategy at first glance?

Broad is always comforting but then it depends on the deals that you can strike. And so that's what we'll certainly consider as we go forward in this strategy.

Thanks for all the conversation.

Great. Thanks, Charley.

I'd now like to turn the conference back to Mr. Maharaj for closing remarks. Please go ahead, sir.

Thank you. We continue to build momentum in the second quarter of 2012 with solid performances in our businesses and remain steadfast in our commitment to return SurModics to profitability and focused revenue growth in these businesses. At the same time, we're compelled to continue our investment in R&D and new product introduction. And we're pleased to be able to use the strength of our balance sheet to return cash to our shareholders in the form of a share repurchase. I want to thank everyone today for participating in this quarter's conference call and we'll look forward to providing further updates on next quarter's call. Thank you, everybody.

Ladies and gentlemen, this concludes the SurModics' second-quarter 2012 earnings conference call. ACT would like to thank you for your participation, you may now disconnect.