Gary Maharaj - President & CEO Andy LaFrence - VP, Finance, and CFO.

Jan Wald - The Benchmark Company James Sidoti - Sidoti & Company.

Well good day, ladies and gentlemen, and welcome to SurModics’ Fourth Quarter and Fiscal Year 2014 Earnings Conference Call. Today’s conference is being recorded. And I will now turn the conference over to Mr. Andy LaFrence, Vice President of Finance and Chief Financial Officer. Please go ahead, sir..

Thank you, Kelsey. Good afternoon and welcome to SurModics’ fiscal 2014 fourth quarter earnings call. Before we begin, I would like to remind you that during the course of this call we will make forward-looking statements.

These forward-looking statements are covered under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and include statements regarding SurModics’ future financial and operating results or other statements that are not historical facts.

Please be advised that actual results could differ materially from those stated or implied by our forward-looking statements resulting from certain risks and uncertainties including those described in our SEC filings.

SurModics disclaims any duty to update or revise our forward-looking statements as a result of new information, future events, developments or otherwise. We will also refer to non-GAAP measures because we believe they provide useful information for our investors. Today’s news release contains a reconciliation table to GAAP results.

Finally, this conference call is being webcast and is accessible through the Investor Relations section of the SurModics website where the audio recording of the webcast will also be archived for future reference. A press release disclosing our quarterly results was issued earlier this afternoon and is available on our website at www.surmodics.com.

On today’s call I will provide an overview of our financial results, highlights for the fourth quarter and outlook our expectations for fiscal year 2015. Gary, then, will cover our key achievements and discuss our growth drivers and strategies. Finally, we will open the call to your questions. I’ll start with the financials.

Revenue for the fourth quarter of fiscal 2014 rose to $15.3 million compared with $14.3 million in the fourth quarter of last year. Revenue growth at 7% in the fourth quarter exceeded the 2% increase in fiscal 2014.

On a GAAP basis our diluted earnings from continuing operation totalled $0.18 per share compared with $0.26 per share in the year-ago period. Let me take you through the various pieces. The fiscal 2014 fourth quarter included an $0.08 per share other than temporary impairment charge for our strategic investment in ThermopeutiX.

The prior year quarter benefited from a $1 million or $0.04 per diluted share recovery of legal fees associated with the SRI litigation partly offset by $0.5 million or $0.02 per diluted share restructuring charge.

Excluding the impacts of these three items non-GAAP earnings per share from continuing operations increased 8% to $0.26 per share in the fourth quarter of fiscal 2014 compared with the prior year quarter. We delivered operating income of $5.4 million in the fourth quarter of 2014 compared with $5.6 million in the prior year period.

Operating margin was 35% versus 39% a year earlier. As adjusted for the previously noted fiscal 2013 legal recovery and restructuring charge operating margin in the prior year was 36%.

Turning now to our two business units, Medical Device is the larger business, it contributes approximately three-quarters of our total revenue and it performed well this quarter. Revenues derived from both hydrophilic coatings and device drug delivery coatings, revenue rose to $11.2 million increasing 9% from the year-ago period.

Fourth quarter hydrophilic coating royalty revenue totalled $7.9 million compared with $7.4 million last year. Coronary royalties return to positive growth with a 2% gain.

The medical device business also benefited from an increase in research and development revenue primarily associated with contract coating services to support customer clinical trials and select product launches. This unit generated $6.2 million of operating income in the fourth quarter, an increase of 16% from a year ago.

Higher revenue and the timing of our drug-coated balloon R&D investment contributed to the segment’s gains in the operating income. For In-Vitro Diagnostics unit, fourth quarter fiscal 2014 revenue totalled $4.1 million, a 3% increase compared with the prior year quarter.

In the fourth quarter, we continue to realize expected revenue improvement in this business. Product gross margin was 59% in the fourth quarter compared with 62% in the prior year quarter. IVD operating income increased 8% to $1.2 million -- decreased 8% to $1.2compared with the fourth quarter of 2013.

Our diagnostics operating margin for the quarter declined to 29% versus 32% in the prior year quarter mainly resulting from lower gross margins as our product mix included higher sales pursuant to our distributor arrangement of lower margin antigen products. We believe that IVD revenue will strengthen in fiscal 2015.

Now I’d like to discuss our fourth quarter 2014 revenue summary by category. First, royalty and license fees, which are generated primarily in our Medical Device business, were $8.1 million increasing 8% from last year. Second, fourth quarter 2014 product sales totalled $6.2 million again a 6% from the year ago period.

This reflects high reagent sales in our medical device unit as well as antigen and micro ray slide shipments in our in-vitro diagnostics business unit. And third, R&D revenue was $1.1 million, up from $1 million in the prior year quarter.

SG&A expenses in the fourth quarter of fiscal 2014 returned to a more normal level of 23% of revenue, compared with 16% a year earlier. On a dollar basis, SG&A in the fourth quarter totalled $3.6 million versus $2.3 million a year ago. As previously discussed, the prior year quarter benefited from a $1 million recovery in SRI litigation legal fees.

During the 2004 fourth quarter, we continued to advance our corporate development activities and, therefore, SG&A included incremental corporate development expenditures of $0.4 million or $0.02 per share. As a percentage of total revenue fourth quarter R&D expense were 26% versus 28% in the year ago period.

R&D expenses of $4.1 million for the fourth quarter increased 3% from last year, resulting from the timing of our drug-coated balloon development investment. Income tax expense was 43.2% of pre-tax income in the fourth quarter compared with 33.3% in the prior year period.

The change in tax rates between periods is largely the result of the strategic investment charge in the fourth quarter of fiscal 2014. We did not record an income tax benefit for this impairment as we current have capital loss carryforwards with the full valuation allowance.

During the fourth quarter of fiscal 2014, we realized a net of tax discontinuing operation loss of $100,000 compared with $47,000 in the prior year period. In October 2014, we acquired legal rights that extinguish certain of our indemnification obligations to Evonik under our 2011 agreement concerning the sale of our SurModics pharmaceutical assets.

While certain general indemnity obligations to Evonik continue, we believe that we have now effectively settled all known legal and contractual matters relating to our former pharma business. Let’s now turn to SurModics full fiscal year 2014 results. Revenue for the year totalled $57.4 million, up 2% from fiscal 2013.

Revenue in 2013 included both a one-time $0.6 million catch up royalty payment and a $0.5 million in non-recurring license milestone payment. Excluding these two payments revenue in fiscal 2014 increased 4% over a very strong prior year. Medical Device rose 5% in fiscal 2014 on a GAAP basis and was up 7% excluding the two payments.

We delivered operating income of $18.6 million in fiscal 2014 versus the prior year’s $18.8 million. Operating margin in fiscal 2014 was 32% compared with 34% in fiscal 2013. Non-GAAP operating margin was 34% in fiscal 2014 compared with 33% in fiscal 2013.

Earnings in fiscal 2014 and 2013 were also impacted by a gain in one of SurModics’ strategic investments. We realized a benefit of $0.7 million or $0.05 per share in fiscal 2014 for milestone payments associated with the fiscal 2013 sale of Vessix Vascular to Boston Scientific.

In 2013, the company recognized a gain of $1.2 million, or $0.08 per share from the Vessix sale. The fiscal 2014 results were adversely impact by an other than temporary charge of $0.08 per share for the ThermopeutiX investment which I mentioned in my fourth quarter comments.

Non-GAAP earnings per share from continuing operations rose 13% to $0.96 per share in fiscal 2014 from $0.85 in the prior year. Schedules of pro forma adjustments are included in our fourth quarter press release. Looking at our balance sheet, it continues to be strong.

Our cash and investments totalled $63.4 million and we had no debt outstanding at September 30, 2014. We continue to generate solid operating cash flow. Cash flow from operations was $18.5 million for fiscal 2014.

We also received $0.7 million for milestone payments related to Vessix and invested $2.3 million in property, plant and equipment and return $12.5 million to our shareholder through stock buybacks.

And we are also pleased to report that the board of directors has approved an additional share repurchase authorization of $30 million Our current cash and investment balances and our operating cash flows combined with SurModics’ $20 million line of credit and the $175 million shelf registration provide appropriate capacity to support our corporate strategic initiatives.

I want now turn to our expectations for fiscal 2015. We estimate revenue for fiscal 2015 to be in the range of $57 million to $60 million which is essentially flat to up 4% over fiscal 2014. While SurModics 2014 fourth quarter growth was more robust at 7% we are not modelling that kind of increase for 2015.

We anticipate GAAP diluted earnings to be in the range of $0.85 to $0.95 per share. On a GAAP basis, the fiscal 2015 earnings per share guidance includes an increase of approximately 5% to 7% in research and development investment over fiscal 2014 primarily related to the drug coated balloon activities Gary will outline shortly.

Recall that we said in SurModics third quarter conference call that certain R&D expenses were shift from fiscal 2014 to fiscal 2015. Further, fiscal 2015 SG&A expenses will be similar to fiscal 2014 levels. The fiscal 2015 earnings per share outlook also reflects a 33% to 35% income tax rate.

The earnings per share and income tax rate guidance excludes the impact of any investment gains or losses. Cash flow from operating activities especially to range between $16.5 million and $18 million for fiscal 2015. We also project capital expenditures to range between $2.2 million and $2.5 million.

The SurModics’ team has performed very well in fiscal 2014 and we’re very pleased with the results for the fourth quarter. Thank you to all SurModics employees for your efforts. At this time, I would like to turn the call over to Gary for his perspectives on our operations.

Gary?.

relevance, which I just described, and diversity. And diversity speaks primarily to reducing our dependence of hydrophilic coatings for catheter based delivery systems and even more specifically as applied to coronary interventions. The second part of our strategic intent is profitable growth with emphasis on profitable.

We have several constraints that we see in order to meet this commitment. First, transformation requires investments. We’ve spoken about this on prior calls and that these investments require patience and in a medium to longer term outlook in order to accomplish their transformative effect.

Second, our core customers are experiencing difficult market segments, market conditions and the segments that we serve them which they have led to slow revenue growth for us and more aggressive cost containment negotiations with these customers.

And third, over the next four or six quarters our financial results would be impacted by the expiration of patents protecting early generations of our hydrophilic coatings technology.

In recent years, we have successfully converted a number of our customers’ products using our early generation technologies to one of our advanced generation technologies including our Serene hydrophilic coating.

Despite our efforts in this regard these patent expirations represents significant potential headwinds for us and will be increasingly important for us to secure additional and new paths to growth.

Our intention is to drive core growth aggressively while continually assessing and balancing our investment in transformation to maintain the profitable growth that SurModics has generated during the last 11 quarters. The tri-factor of SurModics performance is a combination of these three things.

Positive revenue gains from the core business with continued significant operating margin and earnings and, thirdly, even as we invest substantially in transformative programs such as drug coated balloon platform.

So looking back on the fourth quarter of fiscal year 2014 through these vislens[ph] I am pleased with our performance against the tri-factor. The headlines are that our Medical Device business generated a 9% increase in revenue year-over-year and our IVD units continued to return to growth for two sequential quarters.

We generated excellent operating income and non-GAAP earnings even while investing in our drug coated balloon program. Finally, and quite exciting for all of our here at SurModics, we froze the design of our drug coated balloon which allows us to conduct our GLP preclinical study.

Our goals and outlook fiscal year 2015 represent the same intent to build our core revenue, maintain a high baseline of operating income and earnings and invest in the early clinical assessment of our Paclitaxel drug coated balloon, the SurModics Saveil[ph] drug coated balloon. Yes, it even has a name now.

Since Andy had laid out our financial guidance for fiscal year ’15, I want to spend my time discussing a little more about our DCB, drug coated balloon program. Our primary goal in this fiscal year is to treat the first patient in our first-in human study.

To this end we have assembled a world class clinical advisory board to guide our clinical trial design and execution. This board consist of key clinicians who have led or co-led as principal investigators all the major trials of devices used in the superficial-femoral artery today.

Now main factors will contribute to our ability to successfully accomplish this goal of treating the first patient this fiscal year including our trial design, the regulations and the geography where we decide to conduct the clinical and the ability to contract with sites and enrol candidate patients into the trial.

I will certainly update you throughout the year on our progress in these areas. In our preclinical studies, we continue to see dramatically increased drug transfer to arterial tissue as compared to the front runners in the United States market currently.

Moreover, recent testing in new pre-clinicals comparing our drug transfer to yet another recent entrant has shown that SurModics’ Saveil outperform these devices by a large margin. We are very excited about the year ahead. In fiscal 2015, we recognize that we face challenges of core business revenue growth because of continued headwinds industry-wide.

Our guidance that Andy shared with you reflects the situation. Despite these challenges, SurModics is now clearly in a profoundly and genuinely better position to pursue all the strategic intent of transformation than any prior year.

We believe that we can generate sustained favorable operating income, earnings and cash flow because of our business model and our lean cost structure. And we intend to accelerate our transformation to an even more relevant business by achieving significant milestones with the SurModics' Saveil drug-coated balloon program.

Operator, this concludes our prepared remarks. We would now like to turn the call over to questions. Thank you..

(Operator Instructions). And we will go to Jan Wald with The Benchmark Company..

Hello. Good afternoon. And congratulations on the quarter. I guess I have two questions to ask.

The first question is, in terms of the new coating versus the legacy coating and the headwinds you’re going to run into in terms of patent expiration, could you give us a little bit of kind of color on what the headwind might look like? Do you see significant, let's call it, generic competition, just a give a name to it, and how will you respond? And I guess, how bigger threat is it? Do you expect it to be 30%, you expect it to be 10% of your market that’s in jeopardy? Could you give us a little more color?.

Sure. I'll let Andy speak a little more quantitatively, but I'll give you an example of the levers that we are facing. So since we launched Serene, we have been very successful in getting licenses signed with this next-generation technology with customers who are on the technologies that I believe are facing patent expiration.

Keep in mind that the signing of the license, while it's terrific, the real growth to the royalties depends on the regulatory possibly and then the commercial launch of these devices. As an example, Medtronic this week just recently got CE mark approval for their Resolute Onyx drug eluting stents in Europe.

And we are -- Serene is part of the delivery system of that device. And so we are glad to see things like this come to regulatory approval and commercialization. However, the license for Serene was signed some time ago. So when I look forward into those next quarter, six quarters, some of it is de novo signing of licenses as one of the levers.

But the second thing and the one that can pivot the acceleration or delay of these conversion really depends on the regulatory approvals of these devices and their successful commercial launch.

So I use the Resolute Onyx just as an example to say we are very happy to see things that we have been successful in signing in previous time period finally get the regulatory approvals and commercial launches..

Okay..

Andy is gearing up..

I'll add a little flavor around that as well. Jan, as you may recall from our third quarter queue that we filed that we didn't (inaudible) but an 18% of our total revenues, our forecast as for '14 would include our aims that were subject to patents that were going to be expiring in the near-term.

And that numbers have going to be too far off from the actual result. So this may be little bit high around 19% or so.

And as we also indicated that we would lose about 5% of revenues over a period of time, which would be through the next four to six quarters that we would see that decline in revenues and the remaining 13% or 14% of the revenues would be subject to a step down, a know-how step down that would believe the off over a number of different years.

And we have -- those numbers have not changed at all from our view point. I will tell you that the 2015 guidance does reflect some non-coronary applications that did come off a patent and actually in I think it was June of this last year and that well impacted our growth for '15 buyback 1% to 1.5%.

And as we have gone through and analyze the impact of the patent expirations are coming up, this came up -- came to life and especially as to talk to our customers and good or relative portion for our customers -- may times our customers are using a generation one, three or four technology and they are intertwine the mixture of that technology.

And these were specific applications that were only subject to that, actually a generation one patent had expired. So our view point has not changed since June materially in terms of what the impacts are going to be over the next several quarters. And we will continue to monitor that and report it to our quarterly reports with the SEC..

Okay. And this -- and let me -- just a follow-up on that. In terms of the patent expiration causing some revenue decline, are those customers coming back to you with -- and trying to use the Serene coating or they --.

Yes. I can answer that, Andy. In the specific case of this fiscal year it was a minority of customers that are not in the vascular space. And so, if you're in urology space, the issue of particulates is not a -- is simply not as critical as the vascular space.

So these customers really felt that in terms of Serene and what we'd do for them on the particulates it didn't apply to those particularly -- particular categories of products outside of the vascular space..

And are you still selling coatings but just at a lower price or are they going elsewhere?.

No. We still provide these reagents to these customers..

Okay..

Yeah..

Okay. And now, if you remember my second question. In terms of the drug coated balloon program, how far do you think you are going to have to go? It looks like now you are planning to do a first demand study.

And is that enough to convince others that you have something to offer and a strategic partner will come at that point, you have some kind of feeling that that's going to happen? Are you going to have to take it further?.

Yes..

Are you going to getting into medical device business?.

No. We -- our intention is to really help clinically de-risk our technology and demonstrate its potential advantages. The first-in-human trial will be a capstone of the differentiation we are already providing. And the capstone really is a really robust process, manufacturing process.

And we believe that the robustness of that process is directly related to variability, performance and cost of goods, each of which we think are very important as the competition in the segment heats up in the next several years.

The second thing we offer and it's clearly demonstrated, ready is, dramatic improvement in the efficiency of drug transfer.

And that gives a -- and I'm using this word from a lay persons' view point not totally technically, but it gives the much broader therapeutic window when you are using these devices in unhealthy human vessels which is very variable by itself. And so those two, we already have those footings onto the back.

The foot is then showing from a primary safety endpoint and simply a clinical endpoint in a subset of patients or small number of patients that the device actually performs in unhealthy human vessel. So it's really that capstone to say the several indications of the value in the differentiation of what we have.

As far as going further, that's a substantial investment and certainly not something that SurModics is conserving at this point..

Okay. Thanks very much..

(Operator Instructions) We’ll move on to Jim Sidoti with Sidoti & Company..

Good afternoon.

Can you hear me?.

Yes..

We hear you, Jim..

Great. Andy, I don't know if you mentioned this or not in your commentary.

But how was SG&A up in the quarter?.

Yeah. The quarter versus last year was really driven by fat last. In 2013, we had a $1 million litigation or legal fee reimbursement related to SRI litigation. So --.

Okay.

So on a non-GAAP basis, how do they compare?.

It was -- is very comparable..

Okay..

It was very comparable, yeah..

All right.

And with the drug-coated balloon, when do you think you'll begin the trial and when do you think you'll announce a distribution strategy for it?.

Well, we -- I'll answer the second question first. Our intent is not to compete with our customers. As you know, we serve over 100 plus customers in in-vitro vascular medicine.

It really is to get to a point where it's clinically de-risked and the device is also de-risked from a process and manufacturing view point and then license that technology at what we believe at a higher valuation to the customer that wants to take it forward.

As far as the first question which is, when we can get this first patient? And it depends on primarily one thing, where we would like to conduct the clinical. You can choose to conduct a clinical in many regulatory geographies around the world, certainly Western Europe, Australia, New Zealand or even in the United States.

And so we have not made that decision yet. That decision will be driven by speed. And then, one thing that's very important to me personally is, this is SurModics' debut into developing a device like this. So we want to be impeccably incredible where it's conducted, how it's conducted and the quality of the data.

So that will help us decide which geography we may want to have it run as well. And then, the third thing is cost. And so when we get to that point, I’m sure I'll be talking a little bit more about that in the -- later in the year..

Okay. No, I've never expected you to sell the product on your own..

Yes. Right..

I guess the question was, when do you think you'll announce a partner?.

Oh, I see. I see. Right now, there are two elements. If potential strategic partners want to preempt our doing clinical trial, that certainly always a possibility.

However, we intended to conduct this first-in-human trial and then have those conversations or in parallel have conversations with prospective partners where the trial data will be the final diligence, if we think of that way for them to sign a deal, and that -- a clinical of this nature start-to-finish could take up to a year..

And how many patients do you think you will enrol?.

Again it depends, I would say between 50 to 70 is a good range..

And then do you think the fact that already drug coated balloon has been improved and is in the market, do you think that will speed up the process with the FDA, or do you think that it will not have any effect on your trial?.

Every drug-device combination is viewed as a different thing by the agency obviously, but what I like about having approved devices is that you can index on the actual clinical data.

We’re not concerned about fact that actually will be treating patients in United States because we actually want to see this category of product do very well for everyone. We just feel we have a third generation technology.

So we’re agnostic to the fact that, if anything, we’re mildly positive to the fact that there is already an approval existing in the United States..

All right. Thank you..

We have no further questions. I’ll turn the conference back to management for closing or additional remarks..

I think there is, before we close, there’s probably one comment that’s come up.

We have received a number of inbound inquiries about the recent acquisition of a Canadian drug coated balloon program and we, as management, view that positively new, that that program is under way, it’s been one of the things we talked about in prior investor calls and investor meetings, and for the success of the whole space we continue to hope that they are successful in developing that.

And as we view our current technology platform, we do believe that we have the third generation technology that is performing exceptionally well against the other two potential participants in the marketplace here in the U.S. So we’re very optimistic with that platform..

Yes, well said. Okay. Well, listen, thank you all for your questions. And as we close, I want to emphasize that the fiscal 2015 represents an exciting opportunity for SurModics to continue our profitable growth even during challenging market and while we increase our investment and opportunity for transformation.

Look forward to updating you on our first quarter fiscal 2015 performance and highlights in a few months. Thank you everyone..

And again, ladies and gentlemen, that does conclude our conference for today. We thank you all for your participation..