Summary of SURMODICS INC - Yahoo! Finance

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Understanding Our Financial Information
References in the Management's Discussion and Analysis of Financial Condition and Results of Operations to "Company," "we," "our," or "us," refer to SurModics, Inc. together with its consolidated subsidiaries. The following discussion and analysis provides information management believes to be relevant to understanding the financial condition and results of operations of SurModics, Inc. For a full understanding of financial condition and results of operations, you should read this discussion along with Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended September 30, 2008. In addition, you should read this discussion along with our condensed consolidated financial statements and related Notes thereto as of March 31, 2009. Overview
SurModics is a leading provider of drug delivery and surface modification technologies to the healthcare industry. In November 2008, we announced a change in our organizational structure into four clinically and market focused business units: Cardiovascular, Ophthalmology, In Vitro Technologies, and SurModics Pharmaceuticals (formerly Brookwood Pharmaceuticals). We believe that this structure will improve the visibility, marketing and adoption of the Company's broad array of technologies within specific markets and help our customers in the medical device, pharmaceutical and life science industries solve unmet clinical needs. In addition, a new centralized research and development function has been formed to serve the needs of the Company's clinically and market focused business units. SurModics Pharmaceuticals' research and development operations will remain unchanged.
The reorganization change announced in November 2008 resulted in the Company being comprised of new operating segments. The "Therapeutic" segment contains:
(1) the Cardiovascular business unit, which provides drug delivery and surface modification technologies to customers in the cardiovascular market; (2) the Ophthalmology business unit, which is dedicated to the advancement of treatments for eye diseases, such as age-related macular degeneration (AMD) and diabetic macular edema (DME), two of the leading causes of blindness; and (3) the SurModics Pharmaceuticals business unit, which provides proprietary polymer-based drug delivery technologies to companies developing improved pharmaceutical products. Revenue results in the Therapeutic segment are presented by the clinical market areas in which our customers participate (Cardiovascular, Ophthalmology and Other Markets). The "Diagnostic" operating segment contains the In Vitro Technologies business unit, which includes our microarray slide technologies, our stabilization products, antigens and substrates for immunoassay diagnostic tests, our in vitro diagnostic format technology and our synthetic ECM cell culture products. Revenue is derived from three primary sources: (1) royalties and license fees from licensing our patented drug delivery and surface modification technologies and in vitro diagnostic formats to customers; the vast majority (typically in excess of 90%) of revenue in the "royalties and license fees" category is in the form of royalties; (2) the sale of polymers and reagent chemicals, stabilization products, antigens, substrates and microarray slides to the diagnostics and biomedical research industry; and (3) research and development fees generated on customer projects. Revenue should be expected to fluctuate from quarter to quarter depending on, among other factors: our customers' success in selling products incorporating our technologies; the timing of introductions of licensed products by customers; the timing of introductions of products that compete with our customers' products; the number and activity level associated with customer development projects; the number and terms of new license agreements that are finalized; the value of reagent chemicals and other products sold to customers; and the timing of future acquisitions we complete, if any. For financial accounting and reporting purposes, we treat our operating segments as one reportable segment. We made this determination because each operating segment has similar economic characteristics; a significant percentage of our employees provide support services (including research and development) to each operating segment; technology and products from each operating segment are marketed to the same or similar customers; each operating segment uses the same sales and marketing resources; and each operating segment operates in the same regulatory environment. In June 2007, we signed a collaborative research and license agreement with Merck & Co., Inc. ("Merck") to pursue the joint development and commercialization of the I-vationTMsustained drug delivery system with triamcinolone acetonide and other products that combine Merck proprietary drug compounds with the I-vation system for the treatment of serious retinal diseases. Under the terms of our agreement with Merck, we received an up-front license fee of $20 million and had the potential to receive up to an additional $288 million in fees and development milestones associated with the successful product development and attainment of appropriate U.S. and EU regulatory approvals for these new combination products. In September 2008, following a strategic review of its business and product development portfolio, Merck gave notice that it was terminating the collaborative research and license agreement, as well as the supply agreement entered into in June 2007. This decision was not based on any concerns about the safety or efficacy of the I-vation system. The termination was effective December 16, 2008, and we have recognized revenue of approximately $45 million in the first six-months of fiscal 2009, principally from amounts that previously had been deferred and amortized under the accounting treatment required by Emerging Issues Task Force Issue No. 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables," ("EITF 00-21") which totaled

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approximately $35 million and a $9 million milestone payment associated with the termination of the triamcinolone acetonide development program.
In November 2008, we acquired a portfolio of intellectual property and collaborative drug delivery projects from PR Pharmaceuticals, Inc., a drug delivery company specializing in injectable, biodegradable sustained release formulations. Total consideration paid through March 31, 2009 was $4.0 million and PR Pharmaceuticals, Inc. is eligible to receive up to an additional $5.2 million in cash upon successful achievement of specified milestones. The proprietary technologies we acquired complement and enhance the existing portfolio of drug delivery capabilities available from SurModics and SurModics Pharmaceuticals by providing a broader toolkit for protein delivery and the ability to use smaller gauge needles for microparticle injections. In addition, the multiple customer development programs we assumed complement the diversified portfolio of customer projects at SurModics Pharmaceuticals and we believe will further leverage the investment we are making in cGMP manufacturing facilities. Critical Accounting Policies
Critical accounting policies are those policies that require the application of management's most challenging, subjective or complex judgment, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Critical accounting policies involve judgments and uncertainties that are sufficiently sensitive to result in materially different results under different assumptions and conditions. For a detailed description of our critical accounting policies, see the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended September 30, 2008.

Results of Operations

                         Three Months Ended March 31,
                           2009                 2008           $ Increase       % Increase
                            (Dollars in thousands)             (Decrease)       (Decrease)
  Revenue:
  Therapeutic
  Cardiovascular      $        9,570       $       12,408     $     (2,838 )            (23 )%
  Ophthalmology                3,710                3,036              674               22 %
  Other Markets                2,925                4,772           (1,847 )            (39 )%

  Total Therapeutic           16,205               20,216           (4,011 )            (20 )%
  Diagnostic                   4,720                5,491             (771 )            (14 )%

  Total revenue       $       20,925       $       25,707     $     (4,782 )            (19 )%

Revenue. Revenue for the second quarter of fiscal 2009 was $20.9 million, a decrease of $4.8 million, or 19%, compared with the second quarter of fiscal 2008. The decreases in Therapeutic and Diagnostic segment revenue, as detailed in the table above, are further explained in the narrative below.
Therapeutic. Revenue in the Therapeutic segment was $16.2 million in the second quarter of fiscal 2009, a 20% decrease compared with $20.2 million in the prior-year period. The decrease in total revenue is driven by lower royalties and license fees as well as lower research and development revenue. Therapeutic revenue is further characterized by the market-focused areas detailed above.
Cardiovascular derives a substantial amount of revenue from royalties and license fees and product sales attributable to Cordis Corporation, a Johnson & Johnson company, on its CYPHERŽ Sirolimus-eluting Coronary Stent. The CYPHERŽ stent incorporates a proprietary SurModics polymer coating that delivers a therapeutic drug designed to reduce the occurrence of restenosis in coronary artery lesions. The CYPHERŽ stent faces continuing competition from Boston Scientific, Medtronic, and Abbott. These stents compete directly with the CYPHERŽ stent both domestically and internationally. We also receive a royalty on sales of the Medtronic EndeavorŽ drug-eluting stent system incorporating our hydrophilic technology, which recently received regulatory approval in Japan. In addition to competition among the various players, the total size of the drug-eluting stent market has decreased significantly in the past two years as a result of concerns about product safety, mostly related to potential clotting associated with stents. Therefore, future royalty and reagent sales revenue could decrease due to lower CYPHERŽstent sales as a result of the overall market contraction and the ongoing and expected future competition. We anticipate that quarterly royalty revenue from the CYPHERŽ stent may be volatile throughout fiscal 2009 and beyond as the various marketers of drug-eluting stents compete in the marketplace and as others enter the marketplace.
Cardiovascular revenue decreased $2.8 million, or 23%, in the second quarter of fiscal 2009, compared with the second quarter of fiscal 2008 principally as a result of lower royalties and license fees and research and development revenue. Our broad portfolio of revenue streams helped dampen the decrease in royalty revenue from Cordis as a result of 37% lower CYPHERŽsales.
Ophthalmology revenue increased $0.7 million, or 22%, in the second quarter of fiscal 2009, compared with the second quarter of fiscal 2008. Increased research and development revenue, including final billings to Merck associated with services rendered and materials provided, was the key contributor, as our technical teams are working on multiple customer projects spread across various platforms for drug delivery in the eye.

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Other Markets revenue decreased $1.8 million, or 39%, in the second quarter of fiscal 2009, compared with the second quarter of fiscal 2008. Lower research and development revenue and product sales were the main contributors to the decrease. Other Markets revenue is derived from more than 50 customers.
Diagnostic. Revenue in the Diagnostic segment was $4.7 million in the second quarter of fiscal 2009, a decrease of 14% compared with $5.5 million in the prior-year period. This decrease was attributable to lower royalties and license fees in the second quarter of fiscal 2009. Royalties and license fees will likely decrease in the remaining quarters of fiscal 2009. Diagnostic derives a significant percentage of revenue from Abbott Laboratories. Royalty revenue generated under our diagnostic format patent license agreement with Abbott Laboratories (the "Abbott Agreement") decreased 28% compared with the three-months ended March 31, 2008 and is expected to cease following the expiration of the licensed patents, which occurred in December 2008. Product sales in the Diagnostic segment increased 37% compared with the first quarter of fiscal 2009 as customers increased their inventory investment.
Product costs. Product costs were $1.8 million in the second quarter of fiscal 2009, compared with $2.2 million in the prior-year period. The $0.4 million decrease in product costs principally reflects lower product sales. Overall product margins averaged 62%, compared with 54% reported last year. The increase in product margins reflects the changing mix of products sold in the current period.
Research and development expenses. Research and development expenses were $8.5 million for the second quarter, a decrease of 18% compared with the second quarter of fiscal 2008. The decrease principally reflects lower research and development outlays for materials, lower headcount, which has decreased by sixteen and eighteen employees compared with March 31 and September 30, 2008, respectively, and benefits of a more centralized research and development function which resulted from our November 2008 restructuring.
Selling, general and administrative expenses. Selling, general and administrative expenses were $4.4 million for the three months ended March 31, 2009, a decrease of $1.6 million, or 27%, compared with the three months ended March 31, 2008. The prior-year period included $1.6 million of additional stock-based compensation expenses principally as a result of transitions on our Board of Directors.
Other income. Other income was $0.4 million in the second quarter of fiscal 2009, compared with $1.2 million in the second quarter of fiscal 2008. Income from investments was $0.4 million, compared with $1.1 million in the prior-year period. The decrease primarily reflects lower investment balances and lower yields generated from our investment portfolio as interest rates declined over the past twelve months. In fiscal 2008 there was an additional $0.1 million in other income principally from realized gains in our investment portfolio.
Income tax expense. The income tax provision was $2.4 million in the second quarter of fiscal 2009, compared with $3.3 million in the prior-year period. The effective tax rate was 36.3%, compared with 38.9% in the prior-year period. The decrease in the effective tax rate is primarily attributable to state tax exposures and stock options which generated tax rate benefits of 0.8% and 0.5%, respectively.

                          Six Months Ended March 31,          $ Increase       % Increase
                           2009                2008           (Decrease)       (Decrease)
                            (Dollars in thousands)
   Revenue:
   Therapeutic
   Cardiovascular      $      19,973       $      24,875     $     (4,902 )            (20 )%
   Ophthalmology              48,482               4,513           43,969              974 %
   Other Markets               6,697               9,150           (2,453 )            (27 )%

   Total Therapeutic          75,152              38,538           36,614               95 %
   Diagnostic                  8,989              10,998           (2,009 )            (18 )%

   Total revenue       $      84,141       $      49,536     $     34,605               70 %

Revenue. Total revenue for the first six months of fiscal 2009 was $84.1 million, an increase of $34.6 million or 70% compared with the same period of fiscal 2008. The increase in Therapeutic segment revenue more than offset the decrease in the Diagnostic segment, as detailed in the table above and further explained in the narrative below.
Therapeutic. Revenue in the Therapeutic segment was $75.1 million in the first six months of fiscal 2009, a 95% increase compared with $38.5 million in the prior-year period. The increase in total revenue reflects the recognition of revenue of approximately $45 million associated with the terminated Merck collaborative research and license agreement. Excluding these significant event-specific items, revenue decreased $8.4 million, or 22%. Therapeutic revenue is further characterized by the market-focused areas detailed above.

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Cardiovascular revenue decreased $4.9 million, or 20%, in the first six months of fiscal 2009, compared with the first six months of fiscal 2008, with the decrease principally in royalties and license fees. Our royalty revenue from Cordis decreased approximately 36%, which is comparable to the decrease in Cordis CYPHERŽ sales.
Ophthalmology revenue increased $44.0 million, in the first six months of fiscal 2009, compared with the first six months of fiscal 2008. The significant increase relates principally to the recognition of approximately $35 million of previously deferred revenue associated with the terminated collaborative research and license agreement with Merck and $9 million from a milestone payment associated with the termination of the triamcinolone acetonide development program.
Ophthalmology revenue, excluding the Merck event-specific items in the first six months of fiscal 2009 and amortization of revenue in the first six months of fiscal 2008, decreased $0.1 million, or 3%, principally as a result of lower royalties and license fees.
Other Markets revenue decreased $2.5 million, or 27%, in the first six months of fiscal 2009, compared with the first six months of fiscal 2008. Lower research and development revenue and product sales were the main contributors to the decrease. Selected customers have delayed or slowed down projects in fiscal 2009 based on various factors including current economic conditions.
Diagnostic. Revenue in the Diagnostic segment was $9.0 million in the first six months of fiscal 2009, a decrease of 18% compared with $11.0 million in the prior-year period. This decrease was attributable to lower royalties and license fees as well as lower product sales in the first six months of fiscal 2009. Royalty revenue generated under our diagnostic format patent license agreement with Abbott Laboratories declined approximately 20% compared with the six months ended March 31, 2008.
Product costs. Product costs were $3.4 million in the first six months of fiscal 2009, compared with $4.1 million in the prior-year period. The $0.7 million decrease in product costs principally reflects lower product sales. Overall product margins averaged 61%, compared with 58% reported last year. The increase in product margins reflects the changing mix of products sold in the first six months of fiscal 2009.
Research and development expenses. Research and development expenses were $17.8 million for the first six months of fiscal 2009, a decrease of 10% compared with the first six months of fiscal 2008. The decrease was primarily driven by reduced outlays for materials, lower headcount, additional monitoring of expenses as well as benefits from our November 2008 restructuring.
Selling, general and administrative expenses. Selling, general and administrative expenses were $9.1 million for the six months ended March 31, 2009, a decrease of 15% compared with the prior-year period. The prior-year period included $1.6 million of stock-based compensation expenses principally as a result of transitions on our Board of Directors. Our headcount remained constant in both periods and lower outside service costs were offset by higher facilities expenses.
Purchased in-process research and development. In November 2008, we acquired certain assets comprised of intellectual property and collaborative programs from PR Pharmaceuticals, Inc. The fair value of $3.2 million associated with the in-process research and development intangible asset was determined by management and recognized as an expense in the six months ended March 31, 2009.
Restructuring charges. In November 2008, we announced a functional reorganization to better serve our customers and improve our operating performance. As a result of the reorganization, we eliminated 15 positions, or approximately 5% of our workforce. These employee terminations occurred across various functions, and the reorganization plan was completed by the end of the first quarter of fiscal 2009. The reorganization also resulted in our vacating a leased office facility in Eden Prairie, Minnesota, consolidating into its owned office and research facility also in Eden Prairie.
We recorded total restructuring charges of approximately $1.8 million in connection with the reorganization. These pre-tax charges consisted of $0.5 million of severance pay and benefits expenses and $1.3 million of facility-related costs. The restructuring is expected to result in $2.2 million in annualized cost savings. We anticipate the majority of the costs to be paid in the next twenty-one months.
Other income. Other income was $1.0 million in the first six months of fiscal 2009, compared with $2.9 million in the first six months of fiscal 2008. Income from investments was $1.1 million, compared with $2.0 million in the prior-year period. The decrease primarily reflects lower investment balances and lower yields generated from our investment portfolio as interest rates declined over the past twelve months. We also recognized our pro rata net loss on our equity method investments, partially offset by $0.3 million of gains on our investment portfolio in fiscal 2009. In fiscal 2008, other income included a $0.9 million gain on our investment in ForSight Newco II, which was acquired by QLT Inc. in October 2007. Partially offsetting this gain was our pro rata net loss on our equity method investments.
Income tax expense. The income tax provision was $18.6 million in the first six months of fiscal 2009, compared with $6.9 million in the prior-year period. The effective tax rate was 37.2%, compared with 39.1% in the prior-year period. The decrease in the effective tax rate is primarily attributable to differences related to state tax exposures and stock options which generated tax rate benefits of 0.8% and 0.5%, respectively.

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Liquidity and Capital Resources
As of March 31, 2009, the Company had working capital of $20.7 million. Working capital decreased $13.3 million compared with September 30, 2008 driven principally by lower cash and cash equivalents balances, lower accounts receivable and lower prepaid balances partially offset by lower deferred revenue as the contract with Merck was terminated. Our cash, cash equivalents and short-term and long-term investments totaled $58.9 million at March 31, 2009, a $13.1 million decrease from $72.0 million at September 30, 2008. The Company's investments principally consist of U.S. government and government agency obligations and investment grade, interest-bearing corporate debt securities with varying maturity dates, the majority of which are five years or less. The Company's policy requires that no more than 5% of investments be held in any one credit issue, excluding U.S. government and government agency obligations. The primary investment objective of the portfolio is to provide for the safety of principal and appropriate liquidity while meeting or exceeding a benchmark (Merrill Lynch 1-3 Year Government-Corporate Index) total rate of return. Management plans to continue to direct its investment advisors to manage the Company's investments primarily for the safety of principal for the foreseeable future as it assesses other investment opportunities and uses of its investments.
We had cash flows from operating activities of approximately $16.9 million in the first six months of fiscal 2009, compared with $8.9 million in the first six months of fiscal 2008. The increase compared with prior-year results primarily reflects receipt of a $9 million milestone payment from Merck in October 2008.
In November 2007, our Board of Directors authorized the repurchase of $35.0 million of the Company's common stock in open-market transactions, private transactions, tender offers, or other transactions. The repurchase authorization does not have a fixed expiration date. During the six months ended March 31, 2009, the Company repurchased 623,748 shares for $15.0 million at an average price of $24.05 per share, leaving $7.3 million remaining available for future purchases under the repurchase program.
In February 2009, we entered into a two-year $25.0 million unsecured revolving credit facility with Wells Fargo, N.A. as sole lead arranger and administrative agent. Borrowings under the credit facility, if any, will bear interest at a benchmark rate plus an applicable margin based upon our funded debt to EBITDA ratio. In connection with the credit facility, we are required to maintain certain financial and nonfinancial covenants. As of March 31, 2009, we had no borrowings outstanding under this credit facility and were not in violation of any of the covenants.
As of March 31, 2009, we had no debt outstanding. We believe that our existing cash, cash equivalents and investments, together with cash flow from operations and availability under the revolving credit facility, will provide liquidity sufficient to meet our needs for the foreseeable future. Our remaining anticipated liquidity needs for fiscal 2009 include but are not limited to the following: capital expenditures related to our Alabama facilities in the range of $14 million to $17 million; general capital expenditures in the range of $1 million to $5 million; contingent consideration payments associated with our fiscal 2009 acquisition of certain assets from PR Pharmaceuticals, Inc. in the range of $1 million to $2 million; contingent consideration payments associated with our fiscal 2007 acquisition of Brookwood Pharmaceuticals, Inc. (now SurModics Pharmaceuticals, Inc.) of $3 million; and any amounts associated with the repurchase of common stock under the authorization discussed above.
As of March 31, 2009, the Company did not have any off-balance sheet arrangements with any unconsolidated entities. Forward-Looking Statements
Certain statements contained in this report and other written and oral statements made from time to time by the Company do not relate strictly to historical or current facts. As such, they are considered "forward-looking statements" that provide current expectations or forecasts of future events. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements can be identified by the use of terminology such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "intend," "may," "plan," "possible," "project," "will" and similar words or expressions. Any statement that is not a historical fact, including estimates, projections, future trends and the outcome of events that have not yet occurred, are forward-looking statements. The Company's forward-looking statements generally relate to our growth strategy, financial prospects, expense expectations, product development programs, sales efforts, sufficiency of capital resources, the impact of the Cordis agreement and other significant customer agreements. You should carefully consider . . .