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SRDX > SEC Filings for SRDX > Form 10-Q on 10-May-2013All Recent SEC Filings

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Form 10-Q for SURMODICS INC


10-May-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis provides information that we believe is useful in understanding our operating results, cash flows and financial condition. The discussion should be read in conjunction with both the unaudited condensed consolidated financial statements and related notes included in this Form 10-Q, and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2012. This discussion contains various "Forward-Looking Statements" within the meaning of the Private Securities Litigation Reform Act of 1995. We refer readers to the statement entitled "Forward-Looking Statements" located near the end of Part I of this report.

Overview

SurModics is a leading provider of surface modification and in vitro diagnostic technologies to the healthcare industry. For the six months ended March 31, 2013, our business performance has been driven by growth in our Medical Device hydrophilic coatings royalty revenue. The Medical Device segment has overcome the termination, in fiscal 2011, of Cordis Corporation's exclusivity arrangement under one of its license agreements by entering into new license agreements and through continued expansion of activities with other Medical Device customers. We have continued to sign new license agreements in fiscal 2013 and broadened our hydrophilic coatings royalty stream which we believe will result in continued growth in the second half of fiscal 2013.

Our In Vitro Diagnostics segment has also generated revenue growth in fiscal 2013 from our existing products, new product launches and the addition of new diagnostic test kit manufacturer customers. We anticipate continued product sales growth for our In Vitro Diagnostics segment in the remainder of fiscal 2013.

On November 1, 2011, we entered into a Purchase Agreement to sell substantially all of the assets of SurModics Pharmaceuticals (the Pharmaceuticals segment) to Evonik Degussa Corporation ("Evonik"). Under the terms of the Purchase Agreement, the entire portfolio of products and services of SurModics Pharmaceuticals, including its cGMP development and manufacturing facility located in Birmingham, Alabama, were sold. The Company retained all accounts receivable and the majority of liabilities associated with the SurModics Pharmaceuticals business incurred prior to closing. The sale (the "Pharma Sale") closed on November 17, 2011. The total consideration received from the Pharma Sale was $30.0 million in cash.

We have reported the Pharmaceuticals segment as discontinued operations beginning in the first quarter of fiscal 2012, as disclosed in Note 3 to the condensed consolidated financial statements. Accordingly, all results of operations, cash flows, assets and liabilities of SurModics Pharmaceuticals for all periods presented are classified as discontinued operations. All information in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" includes only results from continuing operations (excluding the Pharmaceuticals segment) for all periods presented, unless otherwise noted.

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company is organized into two segments as follows: (1) the Medical Device unit, which is comprised of surface modification coating technologies to improve access, deliverability, and predictable deployment of medical devices, as well as drug delivery coating technologies to provide site-specific drug delivery from the surface of a medical device, with end markets that include coronary, peripheral, and neuro-vascular, and urology, among others, and (2) the In Vitro Diagnostics unit, which consists of component products and technologies for diagnostic test kits and biomedical research applications, with products that include protein stabilization reagents, substrates, antigens and surface coatings.

We derive our revenue from three primary sources: (1) royalties and license fees from licensing our proprietary 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 reagent chemicals to licensees and the sale of stabilization products, antigens, substrates and surface coatings to the diagnostic and biomedical research markets; and
(3) research and development fees generated on customer projects. Revenue fluctuates from quarter to quarter depending on, among other factors: our customers' success in selling products incorporating our technologies; the seasonality of certain disease states and patient biases regarding the timing of medical procedures; 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 report our results for the two reportable segments noted above. We made this determination based on how we manage our operations and the information provided to our chief operating decision maker, who is our Chief Executive Officer.


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Overview of Research and Development Activities

We manage our customer-sponsored research and development ("R&D") programs based largely on the requirements of our customers. In this regard, our customers typically establish the various measures and metrics that are used to monitor a program's progress, including key deliverables, milestones, timelines, and an overall program budget. The customer is ultimately responsible for deciding whether to continue or terminate a program, and does so based on research results (relative to the above measures and metrics) and other factors, including their own strategic and/or business priorities. Following the Pharma Sale in the first quarter of fiscal 2012, customer R&D programs are mainly in our Medical Device segment.

Our R&D activities are engaged in the exploration, discovery and application of technologies that solve meaningful problems in the diagnosis and treatment of disease. Our key R&D activities include efforts that support and expand our core offerings. These efforts include completing activities that support the development of our coating technologies that enhance drug-coated balloons. In the second quarter of fiscal 2013 we completed development activities and launched our next generation hydrophilic coating platform which is now commercially available under the tradename Serene™ (formerly referred to as Gen
5). Additional planned activities include initiation of surface modification experiments that improve medical device performance and developing chemistries to support molecular diagnostic applications.

For our internal R&D programs in our segments, we utilize a R&D review committee to prioritize these programs based on a number of factors, including a program's strategic fit, commercial impact, potential competitive advantage, technical feasibility, and the amount of investment required. The measures and metrics used to monitor a program's progress vary based on the program, and typically include many of the same factors discussed above with respect to our customer R&D programs. We typically make decisions to continue or terminate a program based on research results (relative to the above measures and metrics) and other factors, including our own strategic and/or business priorities, and the amount of additional investment required.

With respect to cost components, R&D expenses consist of labor, materials and overhead costs (utilities, depreciation, indirect labor, etc.) for both customer R&D and internal R&D programs. We manage our R&D organization in a flexible manner, balancing workloads/resources between customer R&D and internal R&D programs primarily based on the level of customer program activity. Therefore, costs incurred for customer R&D and internal R&D can shift as customer activity increases or decreases.

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 likely 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 fiscal year ended September 30, 2012.

Results of Operations - Three and Six Months Ended March 31

Revenue. Revenue for the three and six months ended March 31, 2013 and 2012 was
as follows:



                                  Three Months Ended                      Six Months Ended
                                       March 31,                              March 31,
  (Dollars in thousands)     2013         2012       Change         2013         2012       Change
  Revenue:
  Medical Device           $  9,735     $  8,753          11 %    $ 20,266     $ 17,620          15 %
  In Vitro Diagnostics        3,960        3,457          15 %       7,280        6,506          12 %

  Total revenue            $ 13,695     $ 12,210          12 %    $ 27,546     $ 24,126          14 %

Medical Device. Medical Device revenue was $9.7 million in the quarter ended March 31, 2013, an increase of 11% compared with $8.8 million for the same prior-year quarter. Medical Device revenue was $20.3 million in the first six months of fiscal 2013, an increase of 15% compared with $17.6 million for the same prior-year period. The increase in the total revenue for both the three and six months ended March 31, 2013 was attributable to higher royalty revenue ($0.7 million and $2.0 million, respectively), product sales ($0.2 million and $0.7 million, respectively) and R&D revenue ($0.1 million and $0.4 million, respectively), partially offset by lower license fees ($0.5 million in the six months). The increase in royalty revenue and product sales revenue resulted from continued growth in our hydrophilic coatings offerings as well as $0.6 million from a royalty revenue catch-up payment which only impacted the six months ended March 31, 2013.


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In Vitro Diagnostics. In Vitro Diagnostics revenue was $4.0 million in the quarter ended March 31, 2013, an increase of 15% compared with $3.5 million for the same prior-year quarter. In Vitro Diagnostics revenue was $7.3 million in the first six months of fiscal 2013, an increase of 12% compared with $6.5 million for the prior-year period. The $0.5 million increase for the three-month period was attributable to strong demand for our stabilization and BioFX branded products as well as microarray slides, a component of our molecular diagnostics business. The increase for the six-month period was attributable to $0.8 million of higher sales of antigens, stabilization and BioFX branded products.

The following is a summary of major costs and expenses as a percent of total revenue:

                                          Three months ended           Six months ended
                                               March 31,                   March 31,
                                          2013            2012         2013          2012
  Product costs                              14.2 %        13.2 %        14.2 %       13.3 %
  Research and development                   27.6          28.8          25.9         29.6
  Selling, general and administrative        28.1          27.8          27.2         28.4

Product costs. Product costs were 14.2% of total revenue in both the three and six months ended March 31, 2013, compared with 13.2% and 13.3% in the respective prior-year periods. Product gross margins were 66.2% and 64.9% in the three and six months ended March 31, 2013, respectively, compared with 68.1% and 67.0% in the prior-year periods. The decrease in product gross margins in the current year six-month period reflected the mix of products sold as there were higher volumes of lower margin antigen product sales pursuant to a distributor arrangement compared with prior-year results.

Research and development expenses. R&D expenses were 27.6% and 25.9% of total revenue in the three and six months ended March 31, 2013, respectively, compared with 28.8% and 29.6% in the respective prior-year periods. R&D expenses were $3.8 million for the three months ended March 31, 2013, an increase of 7%, compared with $3.5 million for the respective prior-year period. The increase was attributable to higher development expenses of $0.2 million and legal expenses of $0.1 million associated with our patent portfolio. R&D expenses were $7.1 million for the first six months of fiscal 2013, a decrease of less than 1% compared with $7.2 million for the first six months of fiscal 2012. The decrease was primarily a result of $0.1 million of lower temporary labor costs and license fee expenses in the first six months of fiscal 2013 partially offset by $0.2 million of higher legal and development expenses. We expect R&D expense to run between 25% and 30% of total revenue on a quarterly basis; however, these expenses for the remainder of fiscal 2013 could run above 30% as we continue to invest in our drug-coated balloon platform. We expect R&D expenses to accelerate in the second half of fiscal 2013 and increase by at least 8% for the nine-month period ended June 30, 2013 and year ended September 30, 2013 as compared with prior-year periods.

Selling, general and administrative (SG&A) expenses. SG&A expenses were 28.1% and 27.2% of total revenue in the three and six months ended March 31, 2013, respectively, compared with 27.8% and 28.4% in the respective prior-year periods. The SG&A expenses increase of $0.5 million in the three months ended March 31, 2013, or 13%, compared with the prior-year period was primarily attributable to $0.6 million of higher compensation costs partially offset by $0.1 million of lower administrative expenses. SG&A expenses increased $0.6 million in the six months ended March 31, 2013, or 9%, compared with the prior-year period primarily from $0.4 million of higher compensation costs associated with increased headcount and $0.3 million of higher outside service expenses mainly from legal expenses partially offset by $0.1 million of lower administrative expenses.

Other income (loss). Major classifications of other income (loss) are as follows:

                                                   Three months ended             Six months ended
                                                        March 31,                    March 31,
(Dollars in thousands)                             2013            2012          2013           2012
Investment income                                $      56        $  143       $     127       $  281
Gain on sale of strategic investments                  119            -            1,293           -
Other-than-temporary impairment of strategic
investments                                           (129 )        (804 )          (129 )       (804 )
Other                                                  163           162             165          170

Total other income (loss)                        $     209        $ (499 )     $   1,456       $ (353 )

Other income (loss) was $0.2 million and $1.5 million in the three and six months ended March 31, 2013, respectively, compared with $(0.5) million and $(0.4) million for the respective prior-year periods.

Investment income decreased in the current-year periods compared with the prior-year periods because our average investable balances decreased following the $55 million share repurchase in September 2012 and from a decrease in yields on our investment balances.


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We recorded a gain of $0.1 million in the quarter ended March 31, 2013 associated with the sale of our investment position in OctoPlus N.V. ("OctoPlus"). The six months ended March 31, 2013 also included a gain of $1.2 million from the sale of our ownership interest in Vessix Vascular, Inc. ("Vessix").

In the quarter ended March 31, 2013, we recorded a $0.1 million other-than-temporary impairment loss related to our investment in ViaCyte, Inc. In the quarter ended March 31, 2012 we recorded an $0.8 million other-than-temporary impairment loss on our investment in OctoPlus, based on a significant decline in the stock price of OctoPlus and length of time during fiscal 2012 when the stock price had been trading below its previous cost basis.

In addition, in each of the three and six months ended March 31, 2013 and 2012 we recognized $0.2 million in realized investment gains associated with our investment portfolio.

Income tax provision. The reconciliation of the statutory U.S. federal tax rate of 35.0% and the Company's effective tax rate from continuing operations for the three and six months ended March 31, 2013 and 2012 is as follows:

                                                   Three months ended             Six months ended
                                                        March 31,                    March 31,
                                                   2013            2012          2013           2012
Statutory U.S. federal income tax rate                35.0 %        35.0 %         35.0 %        35.0 %
State income taxes, net of federal benefit             1.3           1.8            1.3           1.8
(Gain) loss on strategic investments                    -            1.9           (2.0 )         1.9
Discrete item - capital loss carryback                (6.0 )          -            (2.5 )          -
Discrete item - 2012 retroactive R&D federal
tax credit                                            (3.5 )          -            (1.4 )          -
Discrete items - other                                 0.2           0.6           (1.6 )        (0.2 )
Other                                                 (5.8 )        (0.3 )         (2.1 )        (1.0 )

Effective tax rate from continuing operations         21.2 %        39.0 %         26.7 %        37.5 %

The difference between the U.S. federal statutory tax rate of 35.0% and the Company's effective tax rate reflects the impact of state income taxes, permanent tax items, valuation allowance changes for capital losses and discrete tax items. The income tax provision associated with continuing operations was $0.9 million and $2.8 million, respectively, for the three and six months ended March 31, 2013 resulting in respective effective tax rates of 21.2% and 26.7%. The income tax provision associated with continuing operations was $1.2 million and $2.5 million for the three and six months ended March 31, 2012, respectively, resulting in respective effective tax rates of 39.0% and 37.5%.

The most significant variability in our effective tax rate is the result of changes in capital loss valuation allowances resulting from both other-than-temporary impairment losses and gains on the sales of certain strategic investments. We have historically recorded other-than-temporary impairment losses with no income tax effect as it has not been more likely than not that we would generate sufficient capital gains to realize these benefits. Consequently, the OctoPlus, Vessix and available-for-sale securities gains realized during fiscal 2013 resulted in a reduction in capital loss carryforward valuation allowances resulting in no book income tax effects associated with these capital gains. However, during the three and six months ended March 31, 2013 we did realize a 6.0% and 2.5%, respectively, reduction in our effective tax rate as we recognized capital loss carrybacks as a result of the tax capital losses generated by the sale of certain of our strategic investments. During the six months ended March 31, 2013, the effective tax rate was reduced by 2.0 percentage points for these capital gains, net of the other-than-temporary impairment loss on the ViaCyte strategic investment. For the three and six months ended March 31, 2012, the effective tax rate was increased by 1.9 percentage points, respectively, from our other-than-temporary impairment loss in OctoPlus, net of our capital gains from the sale of available-for-sale investments. We are eligible to receive additional proceeds of $4.2 million from the Vessix sale depending on achievement of future milestones. If we conclude that it is more likely than not that we will receive these additional proceeds, we will reduce our capital loss carryforward valuation allowance by the lesser of either our capital loss carryforwards or the tax effect of the more than likely realizable sales proceeds.

We recorded $0.1 million of calendar 2012 U.S. research and development tax credit benefits in the quarter ended March 31, 2013 resulting from the signing of the American Taxpayer Relief Act of 2012 in January 2013. This reduced our effective rate from continuing operations by 3.5 and 1.4 percentage points in the three and six months ended March 31, 2013, respectively.


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Discontinued operations. The following is a summary of the operating results of SurModics Pharmaceuticals discontinued operations for the three and six months ended March 31, 2013 and 2012:

                                                    Three months ended             Six months ended
                                                        March 31,                     March 31,
(Dollars in thousands)                              2013            2012         2013           2012
Total revenue                                    $       -         $   -        $    -        $  5,311

Income (loss) from discontinued operations       $    1,015        $ (221 )     $ 1,015       $  2,309
Income tax provision                                   (333 )        (123 )        (333 )       (1,048 )

Income (loss) from discontinued operations,
net of income taxes                              $      682        $ (344 )     $   682       $  1,261

Income (loss) on sale of discontinued
operations                                       $       -         $   26       $    -        $ (1,634 )
Income tax benefit                                       -             95            -             701

Income (loss) on sale of discontinued
operations, net of income taxes                  $       -         $  121       $    -        $   (933 )

Income (loss) from discontinued operations. The Company's discontinued operations gains and losses are recorded net of the income tax impact of these transactions. The Company recorded discontinued operations income of $0.7 million for the three and six months ended March 31, 2013, compared with a loss of $0.3 million and a gain $1.3 million in the respective prior-year periods. The income in the fiscal 2013 periods reflects a $1.2 million pre-tax gain from the settlement of recapturable job creation financial incentives provided by the City of Birmingham, Alabama. In this settlement, the Company paid $325,000 of $1.5 million of the recapturable financial incentives which were previously fully accrued by the Company as a discontinued operations liability. This settlement gain was partially offset by a $0.1 million expense related to the SRI litigation matter based on facts known to date.

The Pharmaceuticals segment results in fiscal 2012 include the period from October 1, 2011 to November 17, 2011, the date of the Pharma Sale. Pre-tax expenses of $0.2 million were recorded in the three months ended March 31, 2012, related to the settlement of liabilities incurred prior to the Pharma Sale, which were initially accrued for using management's best estimate of outstanding liabilities at the time of the Pharma Sale. Revenue from the Pharmaceuticals segment was $5.3 million for the first six months of fiscal 2012 with pre-tax income from continuing operations of $2.3 million.

Income (loss) on sale of discontinued operations. The Company recorded income of $0.1 million and a loss of $0.9 million in the three and six months ended March 31, 2012, respectively. There was no discontinued operations income or loss in the current-year periods. Income on sale of discontinued operations recorded in the second quarter of fiscal 2012 related to the Pharma Sale was $0.1 million, which is comprised of the reversal of certain estimated closing costs of less than $0.1 million and additional recognition of a tax benefit of $0.1 million. Loss on sale of discontinued operations recorded in the first six months of fiscal 2012 related to the Pharma Sale was $0.9 million ($1.6 million on a pre-tax basis), which was principally related to transaction closing costs which totaled $1.7 million.

Segment Operating Results

Operating income for each of our reportable segments, which excludes the results
from our Pharmaceuticals segment, was as follows:



                                                Three Months Ended                        Six Months Ended
                                                     March 31,                                March 31,
(Dollars in thousands)                    2013          2012        Change         2013          2012        Change
Operating income (loss):
Medical Device                          $  4,785      $  4,121           16 %    $ 10,625      $  8,053           32 %
In Vitro Diagnostics                       1,267         1,271           -          2,018         2,177           (7 )%

Total segment operating income             6,052         5,392                     12,643        10,230
Corporate                                 (1,923 )      (1,703 )         13 %      (3,637 )      (3,319 )         10 %

Total operating income from
continuing operations                   $  4,129      $  3,689           12 %    $  9,006      $  6,911           30 %

Medical Device. Operating income increased by 16% to $4.8 million in the quarter ended March 31, 2013, compared with $4.1 million in the same prior-year quarter. Operating income increased by 32% to $10.6 million in the six months ended March 31, 2013, compared with $8.1 million in the prior-year six-month period. The increased operating income in the three and six months ended March 31, 2013, respectively, compared with the prior-year periods resulted from $0.7 million and $1.6 million of higher


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royalty and license fee revenue and $0.1 million and $0.4 million of higher R&D revenue, as well as the gross margin impact from $0.2 million and $0.7 million in higher reagent sales. The increase in royalty and license fee revenue for the six months ended March 31, 2013 included $0.6 million associated with a royalty . . .

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