Description
Filed with the SEC from Aug 09 to Aug 15:
SurModics (SRDX)
Investment fund Starboard Value reported ownership of 1,812,700 shares (10.3%) after selling 276,060 from Aug. 8 through Aug. 13 at prices that ranged from $17.58 to $17.77.
BUSINESS OVERVIEW
Overview — Recent Sale of Pharmaceuticals Business
SurModics, Inc. (referred to as “SurModics,” “the Company,” “we,” “us,” “our” and other like terms) is a leading provider of drug delivery and surface modification technologies to the healthcare industry.
In December 2010, we announced that the Board of Directors of the Company had authorized the Company to explore strategic alternatives for our Pharmaceuticals business, including a potential sale of that business. This decision by the Board reflected our focus on returning the Company to profitable growth, and our renewed commitment to pursuing growth opportunities and investments in our Medical Device and In Vitro Diagnostics businesses. On November 1, 2011, we entered into a definitive agreement (the “Purchase Agreement”) to sell substantially all of the assets of our wholly-owned subsidiary, SurModics Pharmaceuticals, Inc. (“SurModics Pharmaceuticals”) to Evonik Degussa Corporation (“Evonik”). We closed the sale (the “Pharma Sale”) on November 17, 2011. The total consideration received from the sale was $30.0 million in cash. Of the total consideration, $3.275 million was placed in escrow at closing for any inventory shortfall and the payment of certain contingent consideration obligations related to our acquisition of SurModics Pharmaceuticals in July 2007.
Under the terms of the Purchase Agreement, the entire portfolio of products and services of SurModics Pharmaceuticals and its Current Good Manufacturing Practice (“cGMP”) development and manufacturing facility located in Birmingham, Alabama, were acquired by Evonik. As part of the Pharma Sale, we agreed not to compete in the restricted business (as defined in the Purchase Agreement) for a period of five years and to indemnify Evonik against specified losses in connection with the SurModics Pharmaceuticals business, including certain contingent consideration obligations related to the acquisition by SurModics Pharmaceuticals of the portfolio of intellectual property and drug delivery projects from PR Pharmaceuticals, Inc. (“PR Pharma”). We also retained responsibility for certain obligations of the SurModics Pharmaceuticals business, including contingent consideration obligations of $2.9 million related to our acquisition of SurModics Pharmaceuticals in July 2007 and repayment obligations related to an agreement with various governmental authorities to obtain financial incentives associated with creation of jobs in Alabama. The foregoing summary of the Purchase Agreement is qualified in its entirety by reference to the full text of the Purchase Agreement, which is attached as Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on November 7, 2011. We refer you to the Purchase Agreement for more details on the Pharma Sale.
We acquired SurModics Pharmaceuticals in July 2007 to increase our drug delivery capabilities in the areas of proprietary injectable microparticles and implant technology, both of which are based on biodegradable polymers, to provide sustained drug delivery. A significant part of that business included manufacturing services for clinical trial materials as well as for commercial products through the state-of-the-art cGMP facility we constructed and qualified.
In November 2008, we acquired a portfolio of intellectual property and collaborative drug delivery projects from PR Pharma, a drug delivery company specializing in injectable, biodegradable sustained release formulations. Total consideration paid through September 30, 2011 was $5.6 million and the sellers of PR Pharma are still eligible to receive up to an additional $3.0 million in cash based on successful achievement of specified milestones.
Because the Pharma Sale closed subsequent to our fiscal year ended September 30, 2011, the discussion of the Company and its business operations and financial results in this Form 10-K for all applicable periods prior to such sale includes the Company’s Pharmaceuticals segment, unless the context indicates otherwise. We will report the Pharmaceuticals segment as discontinued operations beginning in the first quarter of fiscal 2012, as disclosed in Note 1 to the consolidated financial statements.
Overview — General
Our mission is to exceed our customers’ expectations and enhance the well-being of patients by providing the world’s foremost, innovative surface modification technologies and in vitro diagnostic chemical components. We partner with many of the world’s leading and emerging medical device, diagnostic and life science companies to develop and commercialize innovative products designed to improve patient diagnosis and treatment. Our core offerings include surface modification coating technologies that impart lubricity, prohealing, and biocompatibility characteristics; and components for in vitro diagnostic test kits and microarrays. Our strategy is to build on our product and technical leadership in our core fields of surface modification technologies and in vitro diagnostic products, and expanding our core technologies to provide us with opportunities for longer term sustained growth.
Our surface modification technologies are utilized by our customers to alter the characteristics of the surfaces of devices and biological materials (e.g., lubricity or hemocompatibility). For example, our patented PhotoLink ® technology enhances the maneuverability of minimally invasive devices (e.g., dilatation catheters and guidewires) within the body by improving the lubricity of the device surface.
Additionally, our surface modification technologies can create new functions for the surfaces of the devices (e.g., lubricity or heomcompatability). For example our patented drug technologies can create new device capabilities by enabling site specific, extended release drug delivery in cases where devices (e.g., stents or balloon catheters) are themselves necessary to treat a medical condition and in cases where devices serve only as a vehicle to deliver a drug (e.g., ophthalmology implants and drug delivery depots).
We believe that site specific, localized drug delivery from medical devices has the potential to improve life changing therapies. Drug-eluting stents are one of the first manifestations of how drugs and devices can be combined to dramatically improve patient outcomes. We believe that drug coated balloons may also show great promise, and that additional opportunities exist for site specific drug delivery from a range of other medical devices. Working with medical device companies, we believe we are poised to exploit this market opportunity as drugs and devices converge to create improved products and therapies.
In June 2011 we received an announcement from Cordis regarding the cessation of the manufacture of the CYPHER ® and CYPHER SELECT ® Plus stents by the end of 2011. This event is more fully discussed in Item 7 “Management’s Discussion and Analysis of Financial Condition and Result of Operations” of this Form 10-K.
In October 2010, we announced initiatives intended to reduce our cost structure. As part of these initiatives, the Company implemented a change in its organizational structure to reflect our complementary, but distinct business units:
• Medical Device, 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. End markets include coronary, peripheral, neuro-vascular, and urology, among others.
• In Vitro Diagnostics, consisting of component products and technologies for diagnostic test kits and biomedical research applications. Products include microarray slide technologies, protein stabilization reagents, substrates and antigens.
• Pharmaceuticals, incorporates a broad range of drug delivery techniques for injectable therapeutics, including microparticles, nanoparticles, and implants. As noted above, we sold substantially all of our assets related to our Pharmaceuticals business to Evonik in November 2011, including its cGMP manufacturing facility.
In August 2007, we acquired BioFX Laboratories, Inc. (“BioFX”). BioFX is a leading provider of innovative reagents and substrates for the biomedical research and medical diagnostic markets. BioFX offers both colorimetric and chemiluminescent substrates, as well as other products for use in in vitro diagnostic applications. This acquisition expanded our product offerings for customers developing diagnostic test kits. In fiscal 2011 we consolidated all of our In Vitro Diagnostics business into BioFX and renamed the entity SurModics IVD, Inc. (“SurModics IVD”).
We commercialize our drug delivery and surface modification technologies primarily through licensing and royalty arrangements with medical device manufacturers. We believe this approach allows us to focus our resources on the further development of our core technologies and enables us to expand our licensing activities into new markets.
Revenue from our licensing arrangements typically includes research and development revenue, license fees and milestone payments, minimum royalties, and royalties based on a percentage of licensees’ product sales. In addition to licensing fees and research and development fees, we generate revenue from the manufacture and sale of a variety of products. We manufacture and sell the chemical reagents used by our customers in coating their products. Additionally, through our CodeLink ® microarray slide product line we manufacture and sell microarray slides to the diagnostic and biomedical research markets. Other immunoassay diagnostic products include a line of stabilization products used to extend the shelf life of immunoassay diagnostic tests, substrates used to detect and signal a result in immunoassay diagnostic tests and recombinant human antigens through our role as exclusive North American distributor for DIARECT AG.
The Company was organized as a Minnesota corporation in June 1979. We make available, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) on our website, www.surmodics.com , as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC. We are not including the information on our website as a part of, or incorporating it by reference into our Form 10-K.
Drug Delivery and Surface Modification Markets
Medical Device Industry
Advances in medical device technology have helped drive improved device efficacy and patient outcomes. Pacemakers and defibrillators have dramatically reduced deaths from cardiac arrhythmias. Stents, particularly drug-eluting stents, have significantly reduced the need for repeat intravascular procedures, and they have diminished the need for more invasive cardiac bypass surgery. Hip, knee and spine implants have relieved pain and increased mobility. Acceptance of these and other similar innovations by patients, physicians and insurance companies has helped the U.S. medical device industry grow at a faster pace than the economy as a whole. The attractiveness of the industry has drawn intense competition among the companies participating in this area. In an effort to improve their existing products or develop entirely new devices, a growing number of medical device manufacturers are exploring or using drug delivery and surface modification technologies as product differentiators or device enablers. In addition, the continuing trend toward minimally invasive surgical procedures, which often employ catheter-based delivery technologies, has increased the demand for hydrophilic, lubricious coatings and other technologies.
Convergence of the Medical Device, Pharmaceutical and Biotechnology Industries
The convergence of the pharmaceutical, biotechnology and medical device industries, often made possible by drug delivery and surface modification technologies, presents a powerful opportunity for major advancements in the healthcare industry. The dramatic success of drug-eluting stents in interventional cardiology has captured the attention of the drug and medical device industries. We believe the benefits of combining drugs and biologics with implantable devices are becoming increasingly valuable in applications in cardiology, ophthalmology, orthopedics, and other large markets. In addition, the ability to create sustained release formulations of drugs and biologics presents another opportunity for the Company.
SurModics’ Drug Delivery and Surface Modification Technologies — Overview
We believe SurModics is positioned to exploit the continuing trend of incorporating drug delivery and surface modification technologies into the design of products such as devices and drugs, potentially leading to more efficient and effective products as well as creating entirely new product applications. We have a growing portfolio of proprietary technologies, market expertise and insight, and unique collaborative research and development capabilities — all key ingredients to bring innovation together for the benefit of patients, the Company, and the healthcare industry.
Coatings for Drug Delivery and Surface Modification
Our drug delivery coating technologies allow therapeutic drugs to be incorporated within our proprietary polymer matrices to provide controlled, site specific release of the drug into the surrounding environment. The release of the drug can be tuned to elute quickly (within minutes to a few days) or slowly (ranging from several months to over a year), illustrating the wide range of release profiles that can be achieved with our coating systems. On a wide range of devices, drug-eluting coatings can help improve device performance, increase patient safety and enable innovative new treatments. We work with companies in the pharmaceutical, biotechnology and medical device industries to develop specialized coatings that allow for the controlled release of drugs from device surfaces. We see at least three primary areas with strong future potential: (1) improving the function of a device which itself is necessary to treat the medical condition; (2) enabling drug delivery in cases where the device serves only as a vehicle to deliver a drug to a specific site in the body; and (3) enhancing the biocompatibility of a medical device to ensure that it continues to function over a long period of time.
We offer customers several distinct polymer families for site specific drug delivery. Our Bravo ™ Drug Delivery Polymer Matrix (“Bravo”) is a durable coating and has been used in a variety of applications. In addition, we offer several biodegradable polymer technologies that can be used for drug delivery applications. Because some biodegradable polymers can deliver proteins and other large molecule therapeutic agents, they have the potential to expand the breadth of drug delivery applications we can pursue. Biodegradable polymers can be combined with one or more drugs and applied to a medical device where the drug can then be released as the polymer degrades in the body over time.
Our proprietary PhotoLink ® coating technology is a versatile, easily applied, coating technology that modifies medical device surfaces by creating covalent bonds between device surfaces and a variety of chemical agents. PhotoLink coatings can impart many performance enhancing characteristics, such as advanced lubricity (slippery) and hemocompatibility (preventing clot formation), when bound onto surfaces of medical devices or other biological materials without materially changing the dimensions or other physical properties of devices. Our PhotoLink technology utilizes proprietary, light activated (photochemical) reagents, which include advanced polymers or active biomolecules having desired surface characteristics and an attached light reactive chemical compound (photogroup). When the reagent is exposed to a direct light source, typically ultraviolet light, a photochemical reaction creates a covalent bond between the photogroup and the surface of the medical device, thereby imparting the desired property to the surface. A covalent bond is a very strong chemical bond that results from the sharing of electrons between carbon atoms of the substrate and the applied coating, making the coating very durable and resilient.
Our proprietary PhotoLink reagents can be applied to a variety of substrates. Our reagents are easily applied to the material surface by a variety of methods including, but not limited to, dipping, spraying, roll coating, ink jetting or brushing. We continue to expand our portfolio of proprietary reagents for use by our customers. These reagents enable our customers to develop novel surface features for their devices, satisfying the expanding requirements of the healthcare industry. We are also continually working to expand the list of materials that are compatible with our drug delivery and surface modification reagents. Additionally, we develop coating processes and coating equipment to meet the device quality, manufacturing throughput and cost requirements of our customers.
Key differentiating characteristics of our coatings are their durability, flexibility and ease of use. In terms of flexibility, coatings can be applied to many different kinds of surfaces and can immobilize a variety of chemical, pharmaceutical and biological agents. This flexibility allows customers to be innovative in the design of their products without significantly changing the dimensions or other physical properties of the device. Additionally, the surface modification process can be tailored to provide customers with the ability to improve the performance of their devices by choosing the specific coating properties desired for particular applications. Our surface modification technologies also can be combined to deliver multiple surface-enhancing characteristics on the same device.
In terms of ease of use, the PhotoLink coating process is relatively simple and is easily integrated into the customer’s manufacturing process. In addition, it does not subject the coated products to harsh chemical or temperature conditions, produces no hazardous byproducts, and does not require lengthy processing or curing time. Further, our Photolink coatings are generally compatible with accepted sterilization processes, so the surface attributes are not lost when the medical device is sterilized.
CEO BACKGROUND
Robert C. Buhrmaster (Class III) has been a director of the Company since 2008. Mr. Buhrmaster has been a private investor since 2004. Prior to that, he served as the President and Chief Executive Officer of Jostens, Inc., from 1994 to 2004 and as Chairman from 1998 to 2004. Prior to joining Jostens, Mr. Buhrmaster spent 18 years at Corning, Inc., serving in various roles, including senior vice president and general manager of several businesses, corporate controller and director of strategic planning. Mr. Buhrmaster is also a director of The Toro Company.
Mr. Buhrmaster brings to the board business leadership, corporate strategy and operating expertise. He also serves on the board of another public company. As our chairman, Mr. Buhrmaster draws on his management and boardroom experiences to foster active discussion and collaboration among the independent directors on the board, and to serve as an effective liaison with management.
José H. Bedoya (Class I) has been a director of the Company since 2002. Mr. Bedoya is President and Chief Executive Officer of Otologics, LLC, a Colorado-based technology company he founded in 1996 to develop implantable devices to assist the severely hearing-impaired. From 1986 to 1996, Mr. Bedoya held a number of positions at Storz Instrument Company, then a division of American Cyanamid and later a division of American Home Products, including Director of Operations, Director of Research and Director of Commercial Development. Prior to that, he served as Vice President of Research and Development for Bausch & Lomb’s surgical division.
Mr. Bedoya brings to the board significant business, operational and management experience in the medical device, medical instruments and related industries. Additionally, his experience brings executive decision making, analytical and strategic planning skills gained as a chief executive. Mr. Bedoya serves as the chairman of our Corporate Governance and Nominating Committee.
John W. Benson (Class II) has been a director of the Company since 2003. Mr. Benson retired from 3M Company in February 2003 where he served in various capacities for 35 years. Prior to his retirement, he served as Executive Vice President, Health Care Markets. Mr. Benson previously served on the Board of Regents at St. Olaf College.
As a former senior executive at 3M, Mr. Benson brings to the board extensive strategic planning and management skills from a large, diversified technology and consumer products company. His extensive knowledge of corporate leadership, governance and the healthcare industry gained at 3M make Mr. Benson a valued director. Mr. Benson serves as the chairman of our Organization and Compensation Committee.
Mary K. Brainerd (Class II) has been a director of the Company since 2009. Ms. Brainerd is President and Chief Executive Officer of HealthPartners, Inc., a family of non-profit Minnesota health care organizations headquartered in Minneapolis, Minnesota. She has been with HealthPartners since 1992 and has served as President and Chief Executive Officer since 2002. Prior to joining HealthPartners, Ms. Brainerd held senior level positions with Blue Cross and Blue Shield of Minnesota. Ms. Brainerd also serves on the boards of Minnesota Life/Securian, The St. Paul Foundation, Greater MSP, Alliance of Community Health Plans, and the Federal Reserve Bank of Minneapolis.
As the President and Chief Executive officer of HealthPartners, Inc., Ms. Brainerd brings significant business, operational and executive management expertise to the board. Her extensive experience within the healthcare industry permits her to contribute valuable strategic management and organizational development insight to the Company.
David Dantzker, M.D. (Class I) has been a director of the Company since January 2011. Dr. Dantzker has been a Partner at Wheatley Partners L.P., a venture capital fund, since January 2001. He manages Wheatley’s Life Science and Healthcare investments. From 1997 to 2000, Dr. Dantzker was President of North Shore-LIJ Health System, a large academic health care system. He also co-founded the North Shore-LIJ Research Institute to direct and coordinate basic science research for the North Shore-LIJ Health System. He is a former Chair of the American Board of Internal Medicine, the largest physician-certifying board in the United States. Dr. Dantzker served on the board of directors of Datascope Corp. from January 2008 until its sale in January 2009. Dr. Dantzker holds a B.A. in Biology from New York University, and received his M.D. from the State University of New York at Buffalo School of Medicine. Dr. Dantzker sits on the boards of directors of several Wheatley MedTech portfolio companies including Oligomerix, Comprehensive Neurosciences, NovaRay Medical, Inc. and Visionsense, Ltd., a private high-end medical technology company. Dr. Dantzker has also served on the faculty and in leadership positions of four major research-oriented medical schools, has authored or co-authored 130 research papers and five textbooks and is an internationally recognized expert in the area of pulmonary medicine and critical care.
His extensive management experience in a variety of roles, and board and board committee leadership experience, as well as his extensive knowledge of the medical industry, enable Dr. Dantzker to provide the Company with valuable financial and executive insights.
Gerald B. Fischer (Class II) has been a director of the Company since 2002. Mr. Fischer is President Emeritus, and Vice President, Senior Philanthropy Advisor of the University of Minnesota Foundation, a foundation dedicated to advancing the mission of the University of Minnesota, and served as its President and Chief Executive Officer from 1990 through August 2008. From 1985 to 1989, Mr. Fischer was with First Bank System, now U.S. Bancorp, serving as Executive Vice President, Chief Financial Officer and Treasurer. Previous to that, he spent 18 years in various finance positions at Ford Motor Company and its affiliates.
Mr. Fischer brings many years of leadership, strategic planning and governance experience to the board. His financial expertise, experience in the oversight of risk management and perspectives on financial markets provides valuable insight to the Company. Mr. Fischer serves as the chair of our Audit Committee and qualifies as an “audit committee financial expert” as defined by SEC rules.
Susan E. Knight (Class III) has been a director of the Company since 2008. Since 2001, Ms. Knight has served as Vice President and Chief Financial Officer of MTS Systems Corporation, a leading global supplier of test systems and industrial position sensors. Prior to her position with MTS Systems, from 1977 to 2001, Ms. Knight served in various executive and management positions with Honeywell Inc., last serving as the Chief Financial Officer of the global Home and Building Controls division. Ms. Knight also serves on the board of the Greater Metropolitan Housing Corporation. Ms. Knight also served on the board of Plato Learning, Inc., from 2006 to 2010, where she served on the Audit Committee, including as Chair from 2009 to 2010, and on the Governance and Nominating and a Special Committee from 2009 to 2010.
As the Chief Financial Officer of MTS Systems Corporation, Ms. Knight brings significant audit, financial reporting, corporate finance and risk management experience to the board. She has extensive understanding of the board’s role and responsibilities based on her prior service on the board of another public company. Ms. Knight qualifies as an “audit committee financial expert” as defined by SEC rules.
Gary R. Maharaj (Class I) has served as a director and our President and Chief Executive Officer since December 2010. Prior to joining SurModics, Mr. Maharaj served as President and Chief Executive Officer of Arizant Inc., a provider of patient temperature management systems in hospital operating rooms, from 2006 to 2010. Previously, Mr. Maharaj served in several senior level management positions for Augustine Medical, Inc. (predecessor to Arizant Inc.) from 1996 to 2006, including Vice President of Marketing, and Vice President of Research and Development. During his 24 years in the medical device industry, Mr. Maharaj has also served in various management and research positions for the orthopedic implant and rehabilitation divisions of Smith & Nephew, PLC. Mr. Maharaj holds an M.B.A. from the University of Minnesota’s Carlson School of Management, an M.S. in biomedical engineering from the University of Texas at Arlington and the University of Texas Southwestern Medical Center at Dallas, and a B.Sc. in Physics from the University of the West Indies. Mr. Maharaj holds over 20 patents, all in the medical device field.
Mr. Maharaj brings to the board strong experience in the medical technology industry, as well as leadership, strategic planning, and operating experience gained as a chief executive officer of a medical technology company.
Jeffrey C. Smith (Class III) has been a director of the Company since January 2011. Mr. Smith is a Managing Member, Chief Executive Officer and Chief Investment Officer of Starboard. Prior to founding Starboard, Mr. Smith was a Partner Managing Director of Ramius LLC, a subsidiary of Cowen Group, Inc. (“Cowen”), and the Chief Investment Officer of Ramius Value and Opportunity Master Fund Ltd. Mr. Smith was also a member of Cowen’s Operating Committee and Cowen’s Investment Committee. Prior to joining Ramius LLC in January 1998, he served as Vice President of Strategic Development for The Fresh Juice Company, Inc. Mr. Smith serves on the Board of Directors of Regis Corporation. He has also served as the Chairman of the Board of Phoenix Technologies Ltd., a provider of core systems software products, services and embedded technologies, from November 2009 until its sale in November 2010. He also served as a director of Actel Corporation, a provider of power management solutions, from March 2009 until its sale in October 2010. Mr. Smith is a former member of the board of directors of S1 Corporation, Kensey Nash Corporation, The Fresh Juice Company, Inc., and Jotter Technologies, Inc., an internet infomediary company.
As the Chief Executive Officer and Chief Investment Officer of Starboard, Mr. Smith has significant experience evaluating companies from a financial, operational, and strategic perspective to identify inefficiencies and the resulting opportunities for value creation. Mr. Smith’s extensive experience in a variety of industries together with his management experience in a variety of roles enable him to provide the Board with valuable financial and executive insights.
Scott R. Ward (Class I) has been a director of the Company since 2010. Mr. Ward is President of Raymond Holdings, a firm founded in 2011, with activities in venture capital, strategy and transactional advisory services. He has over 30 years of experience in the healthcare industry, including 15 years as an operating business leader. From 1981 until 2010, he served in a variety of positions at Medtronic, Inc., most recently as Senior Vice President and President of the CardioVascular business where he was responsible for all worldwide operations of the CardioVascular business including the Coronary, Peripheral, Endovascular, Structural Heart Disease (SHD) and Revascularization and Surgical Therapies (RST) businesses. Previously, Mr. Ward served as Senior Vice President and President of Medtronic Neurological and Diabetes, with responsibility for the global Neurological, Neurologic Technologies, Diabetes, Gastroenterology and Urology businesses; Vice President and General Manager of the Medtronic Drug Delivery Business; and Director of Medtronic NeuroVentures. Mr. Ward is Chairman of the Board of MAP Pharmaceuticals, Inc. He received his Bachelor’s Degree in Genetics and Cell Biology in 1981, and his Masters Degree in Toxicology in 1983, both from the University of Minnesota.
As a former senior executive at Medtronic, Inc., Mr. Ward brings to the board leadership, strategic planning, mergers and acquisitions and operating experience from a large, diversified medical technology company. He also serves on the board of another public company.
MANAGEMENT DISCUSSION FROM LATEST 10K
Overview
SurModics is a leading provider of drug delivery and surface modification technologies to the healthcare industry. As further discussed in Item 1 Overview — Recent Sale of Pharmaceuticals Business , in December 2010 we announced that the Board of Directors of the Company had authorized the Company to explore strategic alternatives for our Pharmaceuticals business, including a potential sale of that business. This decision by the Board reflected our focus on returning the Company to profitable growth, and our renewed commitment to pursuing growth opportunities and investments in our Medical Device and In Vitro Diagnostics businesses. On November 1, 2011, we entered into a Purchase Agreement to sell substantially all of the assets of SurModics Pharmaceuticals to Evonik. The Pharma Sale closed on November 17, 2011. The total consideration received from the sale was $30.0 million in cash. Of the total consideration, $3.275 million was placed in escrow at closing for any inventory shortfall and the payment of certain contingent consideration obligations related to our acquisition of SurModics Pharmaceuticals in July 2007.
Because the Pharma Sale closed subsequent to our fiscal year ended September 30, 2011, the discussion for all fiscal years includes our Pharmaceuticals segment results as reported. We will report the Pharmaceuticals segment as discontinued operations beginning in the first quarter of fiscal 2012, as disclosed in Note 1 to the consolidated financial statements.
In October 2010, we announced a change in our organizational structure moving from a functional structure into one consisting of three business units: Medical Device, Pharmaceuticals, and In Vitro Diagnostics. We believe this structure improves the visibility, marketing and adoption of the Company’s broad array of technologies within specific markets and helps our customers in the medical device, pharmaceutical and life science industries better solve unmet clinical needs.
The October 2010 organizational change resulted in the Company presenting revenue and operating results according to its three 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. End markets include coronary, peripheral, and neuro-vascular, and urology, among others; (2) the Pharmaceuticals unit, which incorporates a broad range of drug delivery technologies for injectable therapeutics, including microparticles, nanoparticles, and implants addressing a range of clinical applications including ophthalmology, oncology, dermatology and neurology, among others. Based in Birmingham, Alabama, the Pharmaceuticals business includes our cGMP manufacturing facility; and (3) the In Vitro Diagnostics unit, which consists of component products and technologies for diagnostic test kits and biomedical research applications. Products include microarray slide technologies, protein stabilization reagents, substrates, and antigens.
Our revenue is derived 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 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 fluctuates 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 report our results for the three 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.
In June 2007, we entered into a License and Research Collaboration Agreement and separate Supply Agreement with Merck related to our I-vation ™ TA intravitreal implant. Under the terms of the Merck agreements, we received an upfront license fee of $20.0 million and were eligible to receive up to an additional $288.0 million in fees and development milestones associated with the successful product development and attainment of appropriate U.S. and EU regulatory approvals, as well as payment for our research and development activities. In September 2008, following a strategic review of Merck’s business and product development portfolio, Merck gave notice to SurModics that it was terminating the collaborative license and research 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 in December 2008, and we recognized revenue related to the termination of approximately $45.0 million in fiscal 2009, principally from amounts that previously had been deferred and amortized under the accounting treatment required by accounting guidance for revenue arrangements with multiple deliverables. The $45.0 million included a $9.0 million milestone payment from Merck associated with the termination of the triamcinolone acetonide development program.
Overview of Research and Development Activities
We manage our customer-sponsored R&D programs (“Customer R&D”), 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. Customer R&D programs are mainly in our Medical Device and Pharmaceuticals segments and the processes do not differ significantly.
For our internal R&D programs (included in “Other R&D”) in our three segments, we utilize R&D review committees 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 varies based on the program, and typically includes 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 in each of our three segments consist of labor, materials and overhead costs (utilities, depreciation, indirect labor, etc.) for both Customer R&D and Other R&D programs. We manage our R&D organization in a flexible manner, balancing workloads/resources between Customer R&D and Other R&D programs primarily based on the level of customer program activity. Therefore, costs incurred for Customer R&D and Other R&D can shift as customer activity increases or decreases. As a result of the recent economic conditions, some customers have delayed, slowed or cancelled development projects, which has affected the R&D expense mix between Customer R&D and Other R&D.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. (“GAAP”). The preparation of these financial statements is based in part on the application of significant accounting policies, many of which require management to make estimates and assumptions (see Note 2 to the consolidated financial statements). Actual results may differ from these estimates under different assumptions or conditions and could materially impact our results of operations. We believe the following are critical areas in the application of our accounting policies that currently affect our financial condition and results of operations.
Revenue recognition. In accordance with accounting guidance, revenue is recognized when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) shipment has occurred or delivery has occurred if the terms specify destination; (3) the sales price is fixed or determinable; and (4) collectability is reasonably assured. When there are additional performance requirements, revenue is recognized when all such requirements have been satisfied. Under revenue arrangements with multiple deliverables, the Company recognizes each separable deliverable as it is earned. The Company licenses technology to third parties and collects royalties. Royalty revenue is generated when a customer sells products incorporating the Company’s licensed technologies. Royalty revenue is recognized as our licensees report it to us, and payment is typically submitted concurrently with the report. For stand-alone license agreements, up-front license fees are recognized over the term of the related licensing agreement. Minimum royalty fees are recognized in the period earned.
Revenue related to a performance milestone is recognized upon the achievement of the milestone and meeting specific revenue recognition criteria. Product sales to third parties are recognized at the time of shipment, provided that an order has been received, the price is fixed or determinable, collectability of the resulting receivable is reasonably assured and returns can be reasonably estimated. Our sales terms provide no right of return outside of our standard warranty policy. Payment terms are generally set at 30-45 days. Generally, revenue for research and development is recorded as performance progresses under the applicable contract.
Revenue arrangements with multiple deliverables have been accounted for based on accounting guidance in existence at the time the arrangement commences. Prior to October 1, 2009, arrangements such as license and development agreements were analyzed to determine whether the deliverables, which often include a license and performance obligations such as research and development, could be separated, or whether they must be accounted for as a single unit of accounting in accordance with accounting guidance.
The Company had one significant multiple element arrangement prior to October 1, 2009 that was accounted for as a single unit of accounting resulting in deferral and recognition of all related payments received for license and research and development activities using a time-based model. This arrangement was terminated during the first quarter of fiscal 2009.
In October 2009, the FASB amended the accounting standards for multiple deliverable revenue arrangements to:
(i) provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the consideration should be allocated;
(ii) require an entity to allocate revenue in an arrangement using estimated selling prices (“ESP”) of deliverables if a vendor does not have vendor-specific objective evidence of selling price (“VSOE”) or third-party evidence of selling price (“TPE”); and
(iii) eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.
We elected to early adopt this accounting guidance at the beginning of our first quarter of fiscal 2010, on a prospective basis, for applicable transactions originating or materially modified on or after October 1, 2009. In connection with the adoption of the amended accounting standard we also changed our policy prospectively for multiple element arrangements, whereby we account for revenue using a multiple attribution model in which consideration allocated to research and development activities is recognized as performed, and milestone payments are recognized when the milestone events are achieved, when such activities and milestones are deemed substantive. Accordingly, in situations where a unit of accounting includes both a license and research and development activities, and when a license does not have stand-alone value, the Company applies a multiple attribution model in which consideration allocated to the license is recognized ratably, consideration allocated to research and development activities is recognized as performed and milestone payments are recognized when the milestone events are achieved, when such activities and milestones are deemed substantive.
The Company enters into license and development arrangements that may consist of multiple deliverables which could include a license(s) to SurModics’ technology, research and development activities, manufacturing services, and product sales based on the needs of its customers. For example, a customer may enter into an arrangement to obtain a license to SurModics’ intellectual property which may also include research and development activities, and supply of products manufactured by SurModics. For these services provided, SurModics could receive upfront license fees upon signing of an agreement and granting the license, fees for research and development activities as such activities are performed, milestone payments contingent upon advancement of the product through development and clinical stages to successful commercialization, fees for manufacturing services and supply of product, and royalty payments based on customer sales of product incorporating SurModics’ technology. Our license and development arrangements generally do not have refund provisions if the customer cancels or terminates the agreement. Typically all payments made are non-refundable.
Under the accounting guidance, we are still required to evaluate each deliverable in a multiple element arrangement for separability. We are then required to allocate revenue to each separate deliverable using a hierarchy of VSOE, TPE, or ESP. In many instances, we are not able to establish VSOE for all deliverables in an arrangement with multiple elements which may be a result of SurModics infrequently selling each element separately or having a limited history with multiple element arrangements. When VSOE cannot be established, SurModics attempts to establish a selling price of each element based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately.
When we are unable to establish a selling price using VSOE or TPE, we use ESP in our allocation of arrangement consideration. The objective of ESP is to determine the price at which SurModics would transact a sale if the product or service were sold on a stand-alone basis. ESP is generally used for highly customized offerings.
SurModics determines ESP for undelivered elements by considering multiple factors including, but not limited to, market conditions, competitive landscape and past pricing arrangements with similar features. The determination of ESP is made through consultation with the Company’s management, taking into consideration the marketing strategies for each business unit.
Costs related to products and services delivered are recognized in the period revenue is recognized except for services related to the Merck agreement, which were recognized as incurred. Customer advances are accounted for as a liability until all criteria for revenue recognition have been met.
Valuation of long-lived assets. Accounting guidance requires us to periodically evaluate whether events and circumstances have occurred that may affect the estimated useful life or the recoverability of the remaining balance of long-lived assets, such as property and equipment and intangibles. If such events or circumstances were to indicate that the carrying amount of these assets may not be recoverable, we would estimate the future cash flows expected to result from the use of the assets and their eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) were less than the carrying amount of the assets, we would recognize an impairment charge to reduce such assets to their fair value.
In the fourth quarter of fiscal 2011, we recognized asset impairment charges totaling $17.9 million associated with our Pharmaceuticals segment. We wrote down long-lived assets (fixed assets of $14.8 million and intangibles of $3.1 million), associated with our Pharmaceuticals segment, based on the current valuation of the assets relative to their carrying value. The Company had been exploring strategic alternatives for the Pharmaceuticals segment, including a potential sale. The assets of the Pharmaceuticals business did not qualify as held-for-sale as of September 30, 2011, because we had not committed to a plan to sell at that time. However, our assessment of options available as of September 30, 2011 resulted in a probability-weighted value of expected future cash flows below the carrying value of these assets, which required us to determine the fair value of the long-lived assets of the Pharmaceuticals segment using the probability-weighted value of the expected future cash flows. Asset impairment charges of $17.9 million were recognized based on this assessment. Subsequently, the Company sold substantially all of its Pharmaceuticals assets for $30.0 million on November 17, 2011. See Note 1 to the consolidated financial statements for further information regarding the sale of SurModics Pharmaceuticals.
In fiscal 2010, we recognized asset impairment charges totaling $4.9 million. We wrote down facility-related assets in Alabama by $1.9 million to their fair value based on a decision to sell the assets, however based on further analysis of various factors associated with the consolidation of facilities we later decided not to sell the facility. The carrying value of the facility was $2.1 million at September 30, 2010, which was based on a real estate appraisal obtained during our negotiations. We also wrote down certain project- and technology-related assets totaling $1.7 million, as there were no ongoing business opportunities expected in light of current market conditions and general economic environment. SurModics also recognized a charge of $1.3 million associated with certain construction-in-progress fixed assets in Minnesota, given the level of business activity and overall economic conditions. Each of these events included analysis of expected future cash flows or real estate market data which was compared with the carrying values of the assets to determine the impairment charges that were recognized. The assets associated with these charges had limited remaining value and as such were written down to zero value at September 30, 2010.
Goodwill. We record all assets and liabilities acquired in purchase acquisitions, including goodwill, at fair value as required by accounting guidance for business combinations. The initial recognition of goodwill requires management to make subjective judgments concerning estimates of how the acquired assets will perform in the future using valuation methods including discounted cash flow analysis.
Goodwill is not amortized but is subject, at a minimum, to annual tests for impairment in accordance with accounting guidance for goodwill. Under certain situations, interim impairment tests may be required if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.
Evaluating goodwill for impairment in fiscal 2011 was based on new goodwill accounting guidance which was early adopted by SurModics in the fourth quarter of fiscal 2011. The new accounting guidance involves assessment of qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test becomes unnecessary.
Evaluating goodwill for impairment involves the determination of the fair value of our reporting units in which we have recorded goodwill. A reporting unit is a component of an operating segment for which discrete financial information is available and reviewed by management on a regular basis.
We have determined that our reporting units are our SurModics Pharmaceuticals subsidiary, the In Vitro Diagnostics operations known as our In Vitro Diagnostics reporting unit which contains the BioFX branded products, and the SurModics drug delivery and hydrophilic coatings operations known as our Medical Device business unit. The reporting units with goodwill resulted from the acquisitions of SurModics Pharmaceuticals and SurModics IVD in fiscal 2007. Inherent in the determination of fair value of our reporting units are certain estimates and judgments, including the interpretation of current economic indicators and market valuations as well as our strategic plans with regard to our operations.
The $8.0 million of goodwill at September 30, 2011 is related to the In Vitro Diagnostics reporting unit. We performed our annual impairment test of goodwill as of August 31, 2011, and did not record any goodwill impairment charges as there were no indicators of impairment associated with the In Vitro Diagnostics reporting unit.
We recognized a goodwill impairment charge of $5.7 million in the first quarter of fiscal 2011 associated with our SurModics Pharmaceuticals reporting unit. Two milestone events were achieved associated with the July 2007 acquisition of SurModics Pharmaceuticals and $5.7 million of additional purchase price was recorded as an increase to goodwill. During our annual test of goodwill in the fourth quarter of fiscal 2010, we determined the goodwill related to our SurModics Pharmaceuticals reporting unit was fully impaired and we recognized a non-cash goodwill impairment charge of $13.8 million. There had been no substantial changes in operating results for SurModics Pharmaceuticals in the first quarter of fiscal 2011 when compared with fiscal 2010, and as such we concluded that the goodwill associated with the milestone events was fully impaired.
Prior to testing goodwill for impairment in fiscal 2010, we tested our definite-lived assets, property and equipment as well as intangible assets, under the provisions of the accounting guidance for impairment or disposal of long-lived assets, and determined that there were no impairments of these assets.
The goodwill impairment in fiscal 2010 reflected a significant decline in the estimated fair value of our reporting units, mainly our SurModics Pharmaceuticals reporting unit, which resulted from a slowdown in business activity which was most pronounced in the fourth quarter of fiscal 2010, higher operating costs with our cGMP manufacturing facility, and a significant decrease in our stock price during fiscal 2010. Our stock price declined from $24.13 per share at October 1, 2009 to $12.03 per share at the date of our annual impairment test, which was August 31, 2010. While we continually evaluated whether any indications of impairment are present that would require an impairment analysis on an interim basis, no such indicators were considered present prior to the fourth quarter of fiscal 2010. Prior to the fourth quarter, based on our outlook for future results and the fact that our market capitalization exceeded our book value by a margin of 64% at June 30, 2010, we did not believe that the events and circumstances in existence at our interim reporting dates indicated that it was more likely than not that the fair value of any of our reporting units would be less than its carrying amount.
In evaluating whether goodwill was impaired in fiscal 2010, we compared the fair value of the reporting units to which goodwill is assigned to their carrying values (Step 1 of the impairment test). In calculating fair value, we used the income approach as our primary indicator of fair value, with the market approach used as a test of reasonableness. The income approach is a valuation technique under which we estimate future cash flows using the reporting units’ financial forecasts. Future estimated cash flows are discounted to their present value to calculate fair value. The market approach establishes fair value by comparing our company to other publicly traded guideline companies or by analysis of actual transactions of similar businesses or assets sold. The income approach is tailored to the circumstances of our business, and the market approach is completed as a secondary test to ensure that the results of the income approach are reasonable and in line with comparable companies in the industry. The summation of our reporting units’ fair values was compared and reconciled to our market capitalization as of the date of our impairment test.
In the situation where a reporting unit’s carrying amount exceeds its fair value, the amount of the impairment loss must be measured. The measurement of the impairment (Step 2 of the impairment test) is calculated by determining the implied fair value of a reporting unit’s goodwill. In calculating the implied fair value of goodwill, the fair value of the reporting unit is allocated to all other assets and liabilities of that unit based on their fair values. The excess of the fair value of a reporting unit over the amount assigned to its other assets and liabilities is the implied fair value of goodwill. The goodwill impairment is measured as the excess of the carrying amount of goodwill over its implied fair value.
In determining the fair value of our SurModics Pharmaceuticals reporting unit under the income approach, the expected cash flows of SurModics Pharmaceuticals were affected by various assumptions. Fair value on a discounted cash flow basis used forecasts over a ten-year period with an estimation of residual growth rates thereafter. We used our business plans and projections as the basis for expected future cash flows. The most significant assumptions incorporated in these forecasts for the fiscal 2010 goodwill impairment test included annual revenue changes based on then current customer programs and expected progression of these programs into different phases of development. A discount rate of 15% was used in the fiscal 2010 analysis to reflect the relevant risks of the higher growth assumed for this reporting unit. Given the significant difference between the reporting unit’s fair value and carrying value, any change in the discount rate would not have changed the evaluation of impairment.
In estimating the fiscal 2010 fair value of our company under the market approach, we considered the relative merits of commonly applied market capitalization multiples based on the availability of data. Based on our analysis, we utilized the guideline public company method to support the valuation of the reporting units in fiscal 2010.
Based on the goodwill analysis performed as of August 31, 2010, the $13.8 million of goodwill in the SurModics Pharmaceuticals reporting unit failed Step 1 of the impairment test, and Step 2 of the impairment test indicated that goodwill was fully impaired. The indicated excess in fair value over carrying value of the Company’s In Vitro Diagnostics reporting unit in Step 1 of the impairment test at August 31, 2010 was approximately 82% and as such the $8.0 million of goodwill related to this reporting unit was not impaired. To the extent that actual results or other assumptions about future economic conditions or potential for our growth and profitability in this business changed, it is possible that our conclusion regarding the goodwill could change, which could have a material effect on our financial position and results of operations. The SurModics drug delivery and hydrophilic coatings operations do not have any goodwill and were included in the fiscal 2010 analysis to assist in reconciling the fair value of all reporting units to the Company’s market capitalization at August 31, 2010. See Note 2 to the consolidated financial statements for further information.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Overview
SurModics is a leading provider of surface modification and in vitro diagnostic technologies to the healthcare industry. In December 2010, we announced that the Board of Directors of the Company had authorized the Company to explore strategic alternatives for our Pharmaceuticals business, including a potential sale of that business. This decision by the Board reflected our focus on returning the Company to profitable growth, and our renewed commitment to pursuing growth opportunities and investments in our Medical Device and In Vitro Diagnostics businesses. On November 1, 2011, we entered into a definitive agreement (the “Purchase Agreement”) to sell substantially all of the assets of our wholly-owned subsidiary, SurModics Pharmaceuticals, Inc. (“SurModics Pharmaceuticals”), to Evonik Degussa Corporation (“Evonik”). The sale (the “Pharma Sale”) closed on November 17, 2011. Under the terms of the Purchase Agreement, the entire portfolio of products and services of SurModics Pharmaceuticals, including its Current Good Manufacturing Practices (“cGMP”) development and manufacturing facility located in Birmingham, Alabama, were sold. The Company retained all accounts receivable and the vast majority of liabilities associated with the SurModics Pharmaceuticals business incurred prior to closing. 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 Notes 1 and 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.
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. Beginning in the first quarter of fiscal 2012, following the sale of SurModics Pharmaceuticals which was previously reported as a separate operating segment, the Company is now 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 microarray slide technologies, protein stabilization reagents, substrates, and antigens.
Our revenue is derived 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 polymers and reagent chemicals, stabilization products, antigens, substrates and microarray slides to the diagnostics and biomedical research industry; and (3) research and development (“R&D”) 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 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.
Overview of Research and Development Activities
We manage our customer-sponsored 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.
For our internal R&D programs in our two segments, we utilize R&D review committees 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/A for the fiscal year ended September 30, 2011.
Medical Device. Revenue in Medical Device was $10.3 million in the third quarter of fiscal 2012, an increase of 7% compared with $9.6 million for the third quarter of fiscal 2011. The increase in total revenue reflected higher R&D revenue and product sales, partially offset by lower royalty revenue and license fees. Our royalty and product revenue from Cordis Corporation, a subsidiary of Johnson & Johnson (“Cordis”), decreased $1.1 million in the third quarter of fiscal 2012 compared with the third quarter of fiscal 2011. Offsetting this negative impact was continued growth in our hydrophilic coatings offerings, including R&D revenue, to other medical device customers.
As we have disclosed in previous filings, Medical Device has historically derived a substantial amount of revenue from royalties and license fees and product sales attributable to Cordis, on its CYPHER® Sirolimus-eluting Coronary Stent. The CYPHER® stent incorporated a proprietary SurModics polymer coating that delivers a therapeutic drug designed to reduce the occurrence of restenosis in coronary artery lesions. The CYPHER® stent faced continuing competition from Boston Scientific Corporation, Medtronic, Inc. (“Medtronic”) and Abbott Laboratories. In June 2011, Cordis announced the cessation of the manufacture of the CYPHER® and CYPHER SELECT® Plus stents by the end of calendar 2011. In July 2011, Cordis notified the Company of its intention to terminate the exclusivity arrangements under the license agreement, which also resulted in a termination of the minimum quarterly royalty requirements beginning in the first quarter of fiscal 2012. For the last several years, royalty revenue and reagent product sales have decreased as a result of lower CYPHER® stent sales, and we had anticipated that royalty revenue from CYPHER® stents would continue to decrease. Beginning with the first quarter of fiscal 2012, since the minimum royalty requirements have been eliminated, royalties under the license agreement are based on a percentage of CYPHER® stent sales until the products are no longer sold.
In Vitro Diagnostics. Revenue in In Vitro Diagnostics was $3.7 million in the third quarter of fiscal 2012, an increase of 7% compared with $3.4 million for the prior-year period. This increase was attributable to $0.3 million of higher sales of our stabilization and antigen products, partially offset by $0.1 million of lower sales of other products.
Product costs. Product costs were $2.3 million in the third quarter of fiscal 2012, compared to $1.3 million in the prior-year period. The $1.0 million increase in product costs principally reflected higher manufacturing costs and the mix of products sold in the third quarter of fiscal 2012. Overall product gross margins averaged 61% in the third quarter of fiscal 2012, compared with 74% for the prior-year period.
Research and development expenses. R&D expenses were $3.5 million for the third quarter of fiscal 2012, a decrease of 10% compared with $3.9 million for the third quarter of fiscal 2011. The decrease was primarily a result of $0.5 million of lower compensation costs offset partially by higher temporary labor costs.
Selling, general and administrative expenses. Selling, general and administrative expenses were $3.4 million for the three months ended June 30, 2012, a decrease of 3% compared with $3.5 million for the prior-year period. The decrease was primarily attributable to lower compensation costs resulting from our fiscal 2011 restructurings, offset partially by higher general legal expenses.
Other income (loss). Other income (loss) was income of $0.1 million in the third quarter of fiscal 2012, compared with income of $0.3 million for the third quarter of fiscal 2011. The decrease primarily reflects $0.2 million in realized gains associated with our investment portfolio in the third quarter of fiscal 2011.
Income tax provision. The income tax provision associated with continuing operations was $1.8 million and $1.5 million for the three months ended June 30, 2012 and 2011, respectively, representing effective tax rates of 35.6% and 33.3%, respectively. The higher income tax provision for the three months ended June 30, 2012 was a result of higher pre-tax income. The difference between the U.S. federal statutory tax rate of 35.0% and the Company’s effective tax rate for the three months ended June 30, 2012 and 2011 reflects the impact of state income taxes, permanent tax items and discrete tax benefits. Discrete tax items were a benefit of $0.1 million in each of the three months ended June 30, 2012 and 2011.
(Loss) income from discontinued operations. (Loss) income from discontinued operations, net of income tax provision or benefit, from the Pharmaceuticals segment, was a loss of less than $0.1 million for the third quarter of fiscal 2012 and income of $0.8 million for the third quarter of fiscal 2011. Revenue from the Pharmaceuticals segment was zero and $5.0 million for the third quarter of fiscal 2012 and 2011, respectively. Expenses recorded in the third quarter of fiscal 2012 relate to the Pharmaceuticals segment income tax provision and represent adjustment between the tax provision from fiscal 2011 and the filing of fiscal 2011 income tax returns in the third quarter of fiscal 2012.
Loss on sale of discontinued operations. Loss on sale of discontinued operations recorded in the third quarter of fiscal 2012 related to the Pharma Sale was $0.1 million, which is a result of settlement of minor contractual matters that arose in the third quarter of fiscal 2012 and related tax impact.
Product costs. Product costs were $5.5 million in the first nine months of fiscal 2012, compared with $4.7 million in the prior-year period. The $0.8 million increase in product costs principally reflected the mix of products sold. Overall product gross margins averaged 65% in the first nine months of fiscal 2012, compared with 68% for the prior-year period. The decrease in product gross margins reflected the mix of products sold in the first nine months of fiscal 2012, as there were increased levels of lower margin diagnostic product sales compared with prior-year results and an increase in scrapped materials.
Research and development expenses. R&D expenses were $10.7 million for the first nine months of fiscal 2012, an increase of 4% compared with $10.2 million for the first nine months of fiscal 2011. The increase was primarily a result of the recognition of $0.8 million of therapeutic grant income (which was recorded as a reduction of expenses) in the first nine months of fiscal 2011, associated with awards received under the federal qualified therapeutic discovery project program and $0.5 million of higher temporary labor costs in the first nine months of fiscal 2012, partially offset by lower compensation costs resulting from our fiscal 2011 restructurings.
Selling, general and administrative expenses. Selling, general and administrative expenses were $10.3 million for the nine months ended June 30, 2012, a decrease of 4% compared with $10.7 million for the prior-year period. The decrease was primarily attributable to lower compensation costs resulting from our fiscal 2011 restructurings and Board expenses in fiscal 2012, partially offset by higher general legal expenses.
Restructuring charges. During the three and nine months ended June 30, 2012, we did not incur any restructuring charges. The charges for the nine months ended June 30, 2011 have been presented separately as restructuring charges in the condensed consolidated statements of income. In addition, all restructuring costs related to SurModics Pharmaceuticals are included in discontinued operations.
In October 2010, we announced initiatives to reduce our cost structure and renew our focus on business units to more closely match operations and cost structure with the current customer environment. As a result of the organizational change, we eliminated 30 positions, or approximately 13% 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 2011. We recorded total pre-tax restructuring charges of $0.6 million in the first quarter of fiscal 2011, which consisted of $0.6 million of severance pay and benefits expenses and less than $0.1 million of facility-related costs.
Cash payments associated with the two fiscal 2011 restructuring events (including the fiscal fourth quarter 2011 restructuring event) totaled $0.7 million during the nine months ended June 30, 2012, leaving a restructuring accrual balance of less than $0.1 million at June 30, 2012. There were also payments of less than $0.1 million during the nine months ended June 30, 2012 associated with facility-related costs related to a fiscal 2010 restructuring event, leaving a restructuring accrual balance of $0.2 million at June 30, 2012. The total remaining restructuring accrual balance of $0.2 million at June 30, 2012 relates to the fiscal 2011 and 2010 restructurings and is expected to be paid within the next 15 months.
Other income (loss). Other income (loss) was a loss of $0.2 million in the first nine months of fiscal 2012, compared with income of $0.9 million for the first nine months of fiscal 2011. The loss in the first nine months of fiscal 2012 principally reflects a $0.8 million 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 has been trading below its previous cost basis. Income from investments was $0.4 million, compared with $0.5 million in the prior-year period. The decrease primarily reflects lower yields on our investment balances. In addition, we recognized $0.2 million and $0.4 million in realized investment gains associated with our investment portfolio in the first nine months of fiscal 2012 and 2011, respectively.
Income tax provision. The income tax provision associated with continuing operations was $4.2 million and $4.7 million for the nine months ended June 30, 2012 and 2011, respectively, representing effective tax rates of 36.7% and 35.1%, respectively. The lower income tax provision for the nine months ended June 30, 2012 was a result of lower pre-tax income. The difference between the U.S. federal statutory tax rate of 35.0% and the Company’s effective tax rate for the nine months ended June 30, 2012 and 2011 reflects the impact of state income taxes, permanent tax items and discrete tax benefits. Discrete tax benefits were $0.1 million and $0.2 million in the nine months ended June 30, 2012 and 2011, respectively.
(Loss) income from discontinued operations. (Loss) income from discontinued operations, net of income tax provision or benefit, for the nine months ended June 30, 2012 and 2011, from the Pharmaceuticals segment was income of $1.2 million and loss of $8.6 million, respectively. Revenue from the Pharmaceuticals segment was $5.3 million and $11.8 million for the first nine months of fiscal 2012 and 2011, respectively. Activity related to the Pharmaceuticals segment for the first nine months of fiscal 2012 includes the period from October 1, 2011 to November 17, 2011, the date of the Pharma Sale. The loss from discontinued operations for the first nine months of fiscal 2011 included a $5.7 million goodwill impairment charge.
Loss on sale of discontinued operations. Loss on sale of discontinued operations recorded in the first nine months of fiscal 2012 related to the Pharma Sale was $1.0 million ($1.7 million on a pre-tax basis), which was principally related to transaction closing costs which totaled $1.7 million.
CONF CALL
Tim Arens - VP and Interim CFO
Good afternoon. And welcome to SurModics' fiscal 2012 third quarter earnings call. Also with me on the call is Gary Maharaj, our Chief Executive Officer.
Our press release reporting our full third quarter results was issued earlier this afternoon and is available on our website at surmodics.com. Also issued earlier this afternoon was our press release announcement plan to launch a tender offer to purchase up to $55 million of SurModics common stock. Details related to the tender offer will be set forth in our offer to purchase, which will be filed with the Securities and Exchange Commission.
Before we begin, it is my duty to inform you that this conference call is being webcast and is accessible through the Investor Relation 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 identified certain factors that could cause the company's actual results to differ materially from those projected in any forward-looking statements made during this call. The 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, highlights for the quarter and an update outlook for fiscal 2012. Gary will then discuss our key achievements for the quarter and provide an update on our growth drivers and strategies, including additional detail on our plans to launch a tender offer to purchase up to $55 million of our common stock. Following this discussion, we will open the call to take your questions.
Unless otherwise noted, third quarter financial results discussed today exclude the $112,000 third quarter loss associated with discontinued operations. Thus, the financial information that I discuss relates to our continuing operations and as in many cases on a non-GAAP basis.
As in past quarter's, I'll provide insights 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 events specific charges. We believe that these adjustments provide meaningful insight into our core operating performance in an alternative perspective of our operating results.
It is worth noting, that beginning with Q1 of fiscal 2013, the discontinuation of these Cordis products will no longer have a meaningful impact on our comparative numbers.
Our financial performance excluding Cypher resulted in strong revenue growth, while our core business has generated record operating income during the quarter. Revenue for the third quarter totaled $14 million, which is up 7% from the $13 million reported in the third quarter of last year.
On a comparative basis, our third quarter revenue growth, when adjusting for the net change of $1.1 million in revenue associated with Cypher increased 17% from the year ago period. We delivered solid bottomline results during the quarter with operating income of $4.8 million.
On a non-GAAP basis operating income was $4.6 million, up 55% from the prior year. Non-GAAP operating margin was 33%, up 800 basis points compared with the prior year period, driven by the strength of the Cordis revenue performance.
On a GAAP basis, our diluted earnings per share was $0.18 for the third quarter compared to diluted earnings per share of $0.17 from the year ago period. Excluding the impact of Cypher non-GAAP diluted earnings per share in the third quarter grew 42%, and was $0.17 compared to non-GAAP diluted earnings per share of $0.12 from the year ago period.
I will now turn our discussion to performance by business unit. For the third quarter, Medical Device sales, which include revenue from both our hydrophilic coatings and device drug delivery technologies totaled $10.3 million, up 7% from the $9.6 million reported in the year ago period. Excluding Cypher, Medical Device revenue grew 22%.
Third quarter results include hydrophilic coatings revenue of $10 million, which was up 18% compared with the year ago period. Hydrophilic coatings revenue growth was broad based with strong growth in each of our revenue lines.
Notably, we continue to see strong growth in our research and development revenue, which nearly doubled from the year ago period. Driving this performance was an increase in the number of Medical Device customers, leveraging our coating services to support their pre-clinical, clinical and commercial activities.
These research and development activities may lead to future royalty revenue. We continue to see strong double-digit royalty revenue growth in key Medical Device market segments, including neurovascular, peripheral and transcatheter heart valve repair and replacement.
During the quarter, we saw a return to royalty growth in the Coronary and Cardiac Rhythm Management market segment. After a 9% declined in the second quarter, the third quarter generated 5% growth in this market segment when adjusting for Cypher. This growth was primarily driven by recently launched customer products.
Partially offsetting the strong growth in our hydrophilic coating technologies, device drug delivery revenue of $230,000 declined nearly $800,000 from last year's third quarter. This decline was largely attributable to Cypher.
On the bottomline, Medical Device generated $5.2 million of operating income during the quarter, representing a 13% increase from the year ago period. Excluding Cypher, Medical Device operating income grew 32% from the year ago period, driven by higher revenue.
Looking at our In Vitro Diagnostics business unit, our IVD sales for the third quarter totaled $3.7 million, an increase of 7% compared with $3.4 million in the third quarter of fiscal 2011. Our IVD business unit has now generated seven consecutive quarters of year-on-year revenue growth.
We achieved record diagnostic product revenue during the quarter. Our products revenue performance was broad based as we saw growth across most of our key product lines and customer segments.
I'd like to take a moment to provide some insight around this quarter's operating income. IVD generated $1.1 million of operating income during the quarter, down 26% from last year's third quarter.
IVD operating income was affected by a $650,000 increase in product cost from the year ago period. We anticipate that our IVD business unit will see a return to more normal operating margins going forward.
Now, let's discuss our revenue summary by category. Royalty and license fees, which are generated primarily in our Medical Device business unit were $7.1 million, down 5% from the $7.5 million reported last year. Excluding the impact of Cypher, royalty and license fees grew 11% in the third quarter of fiscal 2012.
Product sales of $5.7 million grew 15% from the year ago period. Broad based product revenue growth was seen in the quarter with hydrophilic coating reagent growing double digits and IVD product sales growing in the high single digit.
Lastly, R&D revenue in the third quarter was $1.1, and doubling from the $550,000 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 margins of 61% in the third quarter of fiscal 2012 compared with 74% last year. However, when looking at the year-over-year comparison it is worth noting that our fiscal 2011 third quarter product margin was highest seen in either fiscal 2011 or fiscal 2012. In the third quarter of fiscal 2012, we had increased product cost, which negatively impacted margins.
Other recent quarters have seen product gross margins range betweens 64% to 68%. Going forward, we expect that are product gross margins will return to our normal historical range. Reviewing operating margins, third quarter of fiscal 2012 operating margins were 34% compared with 33% last year.
SG&A expenses for the third quarter of fiscal 2012 were 24% of revenue compared with 27% in the year ago period. SG&A expenses declined 3% from last year, mainly as a result of last year's cost reduction efforts.
Research and development expenses were 25% of third quarter revenue compared with 30% in the third quarter of fiscal 2011. R&D expenses declined 10% from the year ago period, as result of last year's productivity and cost actions.
Taking a quick review of our balance sheet, our cash and investments totaled $108.2 million. We continue to generate solid cash flow during the quarter. Cash flow from operations was $5.8 million during the third quarter.
Management and the board regularly evaluate the use of our cash, and in just a moment Gary will provide an update on our plan to commence a tender offer to repurchase up to $55 million of our common stock. This tender offer is a fully subscribed, represents a return of approximately half of our total cash and investments to shareholders.
Finally, turning to guidance. As you saw in our press release, we've increased our revenue and earnings per share outlook for the full fiscal year 2012, as a result of our strong year-to-date performance. It is important to note that our outlook excludes any share count reduction and expenses associated with our planned self tender share repurchase.
Revenue from continuing operation for fiscal 2012 is now expected to be in the range of $51 million to $52 million, above our initial guidance of $47 million to $51 million. Diluted earnings per share from continuing operation is now expect to be in the range of $0.56 to $0.59 per share, above our initial guidance of $0.45 to $0.53 per share. Our outlook is based on a diluted share 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 Maharaj - CEO
Thank you, Tim. I'm pleased that our reported financial results demonstrate the continued execution of our over-watching goal to return SurModics to profitable growth. Our most recent results and corresponding positive momentum that we have generated over the course of this fiscal year is result of our strategic objectives and a testament to the efforts of our talented team of employees that have taken up this charge.
While we are proud of our recent accomplishments this quarter, rest assured that we will not be satisfied with only near-term progress. Our team's mindset here at SurModics is to ensure that we establish this type of performance as an ongoing consistent result. We remain as vigilant about ongoing goal to build a great organization as an industry leader, deliver strong results and has high impact in the markets that we serve.
In keep with the theme that we set out at the beginning of this fiscal year two, as I call it of SurModics' transformation, will continue to be defined by the following three areas: first, a focus in our ability to drive our core business to generate profitable growth and cash flow; second, discovery in R&D to drive organic growth and optimize long-term returns from more product development pipeline; and third, to define our strategy for use of cash on the balance sheet.
Let's review each of these strategic priorities in more detailed. First, our ability to profitability expand our core businesses to generate long-term growth. In the Medical Device business unit, our co-initiatives leave us well positioned in the fast growing area such as transcatheter valves, peripheral vascular applications. And we expect to see it become even more relevant to our revenues during the next year.
In the third quarter, as Tim said, we saw record quarterly hydrophilic coating revenue. And in addition, three Medical Device customers launched new products that license our hydrophilic coatings technology.
The number of feasibility studies with our next-generation hydrophilics coatings platforms, what I'd refer to as Gen 5, continues to increase. Gen 5 as you'll recall provide the same low friction capabilities expected from prior generations of SurModics' hydrophilics coatings and provides enhanced durability for multiple vascular applications. We are continuing to invest and expanding the capabilities of Gen 5 to the many variations of multiple substrate materials that exist in even more challenging applications.
In our IVD business unit, we continue to execute on our plan to create organic growth in our core business. These plans include adding new diagnostic test customers, increasing our sales of current products to existing customers and launching new products.
It pleases me to note that that business has now achieved seven consecutive quarter of year-on-year revenue growth. In fact during the last quarter, we gained six new diagnostic kit customers, who order our products as components to their kits. We feel really good about our progress we have made and opportunity we see across both these core businesses.
Our second area of focus that is part of our long-term growth strategy and helps (a failure 6-0.16) to is R&D. In Medical Devices, we have had two key areas of focus pertaining to R&D. As I have described earlier our Gen 5 hydrophilic coating and second our drug-coated balloon project.
During the past three months on our drug-coated balloon project, we have focused on optimizing the coating application process to improve the consistency and effectiveness of drug delivery and tissue uptake. Our aim is to offer our customers a consistent coating with a predictable target tissue uptake characteristic by minimizing unintended drug loss in the vascular tube. We remain very excited about our drug-coated balloon efforts and embrace the challenges inherent and the development of such a platform.
In July, our IVD business unit launched yet another product. This time in our BioFX colorimetric substrates line call BioFX TMBX, which improves both the dynamic range and the reproducibility of certain quantitative assays. This is a second product launch in fiscal 2012 by our IVD team.
Finally, let's talk about the third strategic area of focus that defines our year. The appropriate deployment of the cash on our balance sheet to create shareholder value. If you recall, last quarter we announced the authorization to repurchase up to $50 million of shares, with the details of the repurchase to be announce at a later date. Including the amount remaining under previously approved share repurchase authorization, we are now authorized to repurchase up to $55 million of our common stock.
Our objective here is to strike the right balance between continuing to fund the organic growth through investments in our R&D pipeline, while maintaining the financial flexibility to be both optimistic and manage risk while returning excess cash to shareholders.
Today, we are pleased to announce that our board of directors has authorized a modified Dutch auction tender process offer to repurchase up to $55 million of the company's common stock. This tender offer is expect to commence on or about Monday, August 06, 2012. And the details related to the tender offer will be set forth in our offer to purchase to be filed with the SEC.
The size of the standard offer represents more than 50% of our balance sheet cash. It demonstrates our commitment towards distributing value by returning excess cash to our shareholders.
In conjunction with our board, we will continue to evaluate the appropriate balance of three users of cash. Cash deployment to create value, cash returned to shareholder to redistribute value and cash reserves of both opportunistic investments and to manage risk.
In summary, we continue to make progress against and generate excitement around the three critical areas that we have defined as part of our transformational growth strategy, growth from our core products, our R&D opportunities, and finally the strategic and disciplined use of cash to create return and protect value for all shareholders.
We firmly believe that our commitment to executing against these key strategic objectives will continue to position the company to achieve our goal of delivering sustainable long-term double-digit growth.
Operator, this concludes our prepared remarks. We'd like now to open the call to questions. Thank you.
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