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

Ben Haynor - Feltl & Company.

Good day, and welcome to the Surmodics' Third Quarter 2016 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Andy LaFrence, Vice President of Finance and Chief Financial Officer. Please go ahead, sir..

Thank you, Tony. Good afternoon and welcome to Surmodics' 2016 third 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 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.

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 morning and is available on our website at www.surmodics.com.

On today's call I'll provide an overview of our third quarter financial results. Gary, will then cover our key achievements, provide an update on the integration of Creagh Medical and NorMedix and discuss our growth drivers and strategies. Finally, we will open up the call to take your questions.

Surmodics turned in a very strong performance for the fiscal third quarter ended June 30. Let's start with our income statement. Revenue for the third quarter of fiscal 2016 rose 25% to $20 million compared with $15.9 million in the third quarter of last year. This marks Surmodics fourth consecutive quarter a double-digit revenue growth.

Third quarter fiscal 2016 revenue included $1.2 million from Surmodics. Fiscal 2016 acquisitions as well as previously disclosed $2.9 million hydrophilic royalty catch-up payment, of which $2.6 million related to periods prior to fiscal 2016. GAAP earnings totaled $0.30 per share in both the current and prior year quarters.

GAAP earnings per share included the $0.14 per share benefit from the catch-up royalty payment and reflect $0.07 per share of acquisition related expenses. Non-GAAP earnings per share increased 19% to $0.37 in the third quarter of fiscal 2016 compared with $0.31 in the prior year quarter.

As we have mentioned before, our non-GAAP earnings excluded acquisition related transaction cost that is integration, amortization as well as foreign currency gains and losses related to our Euro denominated Creagh Medical contingent consideration obligations.

We delivered operating income of $6.6 million in the third quarter of fiscal 2016 up from $5.9 million in the prior year period.

This change in operating income was a result of increased revenue including the $2.9 million catch-up payment offset by acquisition related cost and higher operating expenses including stronger investment in R&D this year for future growth. Operating margin was 33% in the current year period as compared with 36.8% a year ago.

Turning now to our two segments; medical device accounts for about three quarters of our total business. Revenues arrived from our hydrophilic coatings, device drug delivery coatings and balloon catheter products. Revenue rose to $15.7 million increasing 34.6% from the year-ago period.

Third quarter hydrophilic coating royalty revenue and license fees totaled $10.5 million up 34% from last year that included the $2.9 million catch-up payment. Product sales increased $0.9 million or 39% to $3.3 million as a result of revenue from our recent acquisitions and strong reagent order volume.

The medical device customer research development and other revenue rose $0.5 million to $1.9 million for the quarter again due to the Creagh Medical and NorMedix acquisitions. This segment generates $6.7 million of operating income in the third quarter compared to $6.3 million in the prior year quarter.

My previous remarks regarding consolidated operating income being impacted by increased revenue acquisition and operating expenses accounted for the change in the medical device operating income. For In Vitro Diagnostics segment, third quarter fiscal 2016 revenue grew 0.8% to $4.3 million.

This gain was on top of very strong prior year quarter for IVD, when revenue rose 13%. As we previously stated, we expect the IVD business to achieve mid single-digit long-term revenue growth. We do expect challenges in the near-term to achieve that long-term revenue growth goal as we are lapping double digit growth over the past year.

This fiscal year, the IVD segment had realized exceptional revenue growth across all its major product lines encompassing protein stabilizer, BioFX branded products, micro array slides and antigens. Product gross margins for IVD was 63.5% in the third quarter compared with 65.2% in the prior year quarter.

This decrease stemmed from a change in sales mix as antigens, a product that we distribute comprised a higher percentage of the sales mix versus last year. IVD operating income increased to $1.7 million from $1.2 million in the third quarter fiscal 2015. Operating margin rose to 38.7% versus 27.8% in the prior year quarter due to lower legal cost.

Now I would like to discuss our third quarter fiscal 2016 revenue summary by category. First product sales; in the third quarter of fiscal 2016 rose to $7.5 million up 14% from the year ago period.

This increase reflects acquisition related product sales and higher reagent sales in our medical device segment as well as higher sales in vitro diagnostics business. Second, our royalty and license fees which are generated primarily in our medical device segment. This revenue category totaled $10.6 million up 33% from last year.

The increase was a result of previously mentioned catch-up payment without that payment royalty and license fees decreased 3.2% largely from the expiration of our third generation US patent in the first quarter of fiscal 2016.

We expect the impact of the patent expiration to grow in the upcoming quarters as customers deplete their inventories that were produced prior to their expiration in the patent. And third, research development and other revenue was $1.9 million up from $1.4 million a year ago due to our recent acquisitions.

As a percentage of revenue, third quarter R&D expenses were 23.4% versus 24.3% in the year ago period. On a dollar basis, R&D expenses of $4.7 million rose from $3.9 million from last year reflecting investments in our whole product strategy. SG&A expenses in the third quarter of fiscal 2016 were 22.4% of revenue versus 25.3% in the prior year period.

On a dollar basis, SG&A in the third quarter of fiscal 2016 totaled $4.5 million compared with $3.9 million a year ago. The dollar increase reflects an inclusion of Creagh Medical and NorMedix in our consolidated results. Income tax expense was 41.6% of pre-tax income in the third quarter up from 33% in the prior year period.

The increase and the effective tax rate of third quarter fiscal 2016 was expected and resulted from the non-deductible acquisition related cost including transaction cost, contingent consideration, accretion expense and related foreign currency gains.

Looking at our balance sheet it continues to be strong, our cash and investments totaled $44.2 million at June 30, 2016. We continue to generate solid operating cash flow. Cash flows from operations was $18.5 million in the first nine months of fiscal 2016.

During this time, we invested $4.9 million in property planning and equipment and used cash of $25.1 million to acquire Creagh Medical and NorMedix. Our current cash and investment balances and operating cash flows combined with Surmodics $20 million line of credit provide adequate capacity to support our corporate strategic growth initiatives.

Turning to our guidance, we've posted revenue growth of 19% in the first nine months of fiscal 2016. We are increasing full year revenue guidance to be in the range of $68 million to $70 million up from the previous range of $63 million to $66 million.

We are also increasing our diluted GAAP earnings in the range of $0.52 to $0.59 per share up from the previous range of $0.30 to $0.35 per share. Finally, non-GAAP earnings per share expected to rise to a range of $0.98 per share to $1.08 per share up from a range of $0.75 to $0.85 per share.

We are also reaffirming our anticipated capital expenditures in the range of $8 million to $9 million. The entire team continues to perform very well at Surmodics. Integration activities are progressing as planned and the team is delivering on the strategic and financial commitments for fiscal 2016. Thank you to the team and both.

Ireland and the US for the hard work and outstanding results. And now I will turn it over to Gary.

Gary?.

Thank you, Andy. I'm delighted with our Surmodics' team performance in the third quarter. We are on track to deliver an excellent fiscal 2016 and to achieve our key strategic objectives for this year. I want to thank all our employees around the world for their positive accomplishments in multiple areas.

Once again this was not an easy quarter by an measure given the ongoing effort required to integrate two acquisitions while currently driving core business performance and advancing major R&D programs including our drug-coated balloon platform. I have a lot to cover, so I will not repeat Andy's commentary except for areas of emphasis.

Our market leadership in vascular surface technology and the drug delivery technology. Creagh Medical's peripheral balloon technology and its manufacturing base and NorMedix's unique catheter platform technology create a winning combination and an exciting future for Surmodics.

We are making excellent progress in integrating Creagh Medical and NorMedix. In fact, during the third quarter we earned revenue from our first customer with a fully integrated Surmodics' Serene hydrophilic coatings and Creagh Medical's balloon technologies. We continue to head straight on all aspects of our strategic trifecta.

As you may recall from prior earnings calls, the first element in our trifecta is to transform Surmodics into whole products solutions provider medical devices via organic R&D and corporate development initiatives. We achieved major milestones here.

We have enrolled nine patients in Early Feasibility Study, EFS of our SurVeil drug-coated balloon, the clinicians love the device. Simply put, it performs well. We are pleased with the enrollment rate and in our fourth quarter, we hope to have completed the clinical enrollment.

Moreover on the M&A front, we've made excellent progress integrating in both Creagh Medical and NorMedix in a very short time. These two acquisitions dramatically accelerate our growth strategy to become a differentiated whole product solution provider for our medical device customers.

The second pillar of our trifecta is to continue to generate maximum revenue growth from our core medical device coatings and in vitro diagnostics businesses. We were able to drive significant growth in our medical device coatings business partly helped by catch-up royalty payment.

However, even excluding this revenue we still generated positive revenue growth in a year, where we're faced with patent expirations, as Andy noted. As we predicted, our IVD business had some difficult comparisons to high growth year-over-year quarters including this current quarter.

We continue to believe the long-term growth for IVD revenue will be in mid-single digits with a greater than 30% operating margin. Finally our fluid [ph] pillar is to continuously optimize investments required for the strategic transformation and the long-term value creation, with the short-term generation of earnings and I call this balance.

We continue to adapt our management focus of time and resources based on the continuously evolving opportunity landscape in front of us and the risks, so that we can maintain and maximize long-term shareholder value.

This is a critical element that really sets Surmodics apart and it is evident in our ability to invest in and accelerate our long-term strategy and these newly scoped opportunities while at the same time delivering profitable growth. Now these opportunities come to a clearer view, so do the investments required and their respective return profiles.

As we look to fiscal 2017, we'll continue to assess the situation depending on new information to create long-term profitable growth. Let's now move to the integration activities in Creagh Medical and NorMedix. These are proceeding right on schedule. In fact, we can even see more product opportunities that early [ph] imagined.

We've also rebranded our company while we're still called Surmodics, our friends at Creagh Medical in Ballinasloe, Ireland and NorMedix in Plymouth, Minnesota are now all simply Surmodics. I encourage you to visit our website and see our new logo. It's pretty cool.

We kept the Surmodics name since it has such major brand recognition with several hundred customers in the medical device and in vitro diagnostics space. In the future earnings call, I will be using Surmodics as a name versus Creagh Medical and NorMedix, since we're now one company with a common goal.

In the genre of less important, but still interesting information. Note that the M in Surmodics is no longer capitalized, since we're no longer just surface modification, but rather a company providing the entire best-in-class products solutions. While these are bold words, I'll let you tell me, why I've confidence in them.

We have already seen in our internal testing that our early designs of the PTA, peripheral balloon catheters that use our next generation proprietary coatings outperforms other devices in critical comparative challenge test.

Now there is still a lot more to do before we finalize and freeze these designs and file for regulatory approval, hopefully in early calendar 2017. I hesitated to share this with you prematurely on other hand, I'm quite excited about it.

This proprietary coating goes beyond our generation wise [ph] technology that you know as Serene and will be retained by Surmodics for use on highly differentiated product solutions. I hope to be in a position during the fourth quarter earnings call to go into more detail.

We've made excellent headway in leveraging Creagh Medical facility in Ireland to begin the process of providing hydrophilic coatings to our non-US based customers in a simply world class production facility.

We have installed and validated our hydrophilic coating processes in Ireland and thanks to the combined US - Irish team effort we actually completed this slightly ahead of schedule. This is a major step, we can now serve our customers from both US and Irish base to better meet their needs.

We call more than 75% of our customers within 60 miles of the Creagh facility. We have also purchased the Creagh Medical facility, so that we can fully retain the value of our ongoing investment in infrastructure such as new clean rooms and manufacturing space for our product solutions.

These in similar initiatives will continue throughout fiscal 2017. At NorMedix, we've actually completed our assessment of the market needs for the potentially unique catheter and the first appropriate targets on schedule and as planned.

We have hired seasoned project leaders and engineers and have dedicated a product development team that's already working on this project.

Needless to say that, NorMedix is patented ultra-thin wall braided catheter platforms and its proprietary manufacturing processes, along with Surmodics' next generation coating platforms are being used in these application and we hope to change the standard of catheter performance.

As I stated before, our goal is obtain to at least one 510(k) clearance of unique catheter-based product per year starting in fiscal 2017. I mentioned our Surmodics SurVeil drug-coated balloon program clinical progress earlier. As I said, we hope to finish enrollment in our fourth quarter and complete the follow-up report by the end of December 2016.

We are of course continuing our discussions with the FDA we move to complete the study and refine our future clinical and regulatory strategy for the SurVeil DCB. We are also advancing our SurVeil drug-coated balloon program further load in the applications.

We have met our third quarter goal of having yet another dedicated drug delivery team project kicked off and focusing on 014 PTA drug-coated balloon platform for these applications. We are using Creagh Medical's balloon design and development expertise and their team for the device that will carry this unique [indiscernible] drug delivery technology.

Our longer term goals for Surmodics have not changed. Our objective is to generate consistent revenue growth in the mid-teens on a constant currency basis and EBITDA margins greater than 30%. We'll meet these goals by successful execution in the following three areas as you recall.

First, fully harness the potential for our drug delivery capabilities starting with a Surmodics SurVeil drug-coated balloon platform and then expanding to the other relevant anatomical targets. Second develop a well-stocked medical device R&D pipeline that leaves multiple differentiated product introductions and uptake by our customers.

Both Creagh Medical and NorMedix have given us a head start with their current portfolio of products. Together we have significantly more opportunities for R&D pipeline development especially in 510(k) type regulatory products which will offset intrinsically higher risk in our drug delivery platforms.

And third, we have to continue to develop and grow Surmodics' core medical device coatings and diagnostic reagents businesses. We continue to believe that, net of the patent expirations intrinsic growth of both of these businesses is in the mid-single digits with greater than 30% operating margins.

We have unique an exciting opportunities that we continue to refine. In our fourth quarter earnings call, I plan to lay out a high level products strategy and describe in more detail the types of opportunities investments and return as we believe, will continue to contribute to long-term value creation.

With three quarters under our belt, we're pleased at what we've accomplished and energized by our prospects. Operator, this concludes our prepared remarks. We'd now like to open the call to questions..

[Operator Instructions] our first question we'll take our first question from Ben Haynor. Please go ahead, your line is open..

Just to start off, can you talk a little bit more about the fully integrated Creagh and Surmodics technologies or product? I mean is that something that's on the market now, is it in development and maybe if you can discuss what the economics on something like that looks like?.

Sure. Creagh already had PTA balloons, but what we're doing is we're both modifying their designs and testing and putting in terms of the product targets our next generation coatings.

This is both Serene and then something we've called the Whiskey [ph] next generation coating that we have chosen not to commercialize in many areas, so that we can actually put it in our own proprietary products, so that's really the scoping of that. We want to start with the 014 and 018 peripheral balloon platforms.

Now there's a lot of work to be done. We came out very nicely in some of the initial challenge testing. Our hope is to actually freeze those designs by the end of this calendar year and apply for regulatory approvals in the first quarter of calendar 2017 or second fiscal quarter..

And specifically for this first customer, it's really an early feasibility optimization process we're going through and the regulatory processes underway.

So we don't expect this product to have material impact on a business but it is the first product that's fully integrating the old inquiry [ph] Surmodics technology with the Irish Surmodics technology..

Okay, so that makes sense and so if I'm hearing you right, you're not sharing your Whiskey [ph]..

The Whiskey [ph] is going to be used in applications where we, don't foresee the long-term future ever commercializing. Some non-vascular applications potentially structure heart [ph] type applications, but it is where we're not going to have a proprietary product in the contemplatable future, we're prepared to.

It so outperforms anything out there, that we prefer to keep that as you know for home consumption, that's why we call it the Whiskey [ph]. Thanks to our Irish team..

Excellent and then on the DCB from now that you have a the study more than halfway enrolled, are you seeing any additional interest incoming from potential strategic licensers?.

Always. As we continue to generate clinical data, the interest is there and first of all, the clinical in my opinion from what I've seen is going very well. The anecdotal feedback from the principal investigators I think we - I didn't share this last time, but since you reminded to publish some clinical trials at gov [ph] Dr.

Gary and [indiscernible] Dr. Ravish Sachar, at Rex Hospital on Raleigh, North Carolina and our National TI, Dr. Chris Matsko [ph], in Kingsboro, Tennessee. The device in their hand works.

Now certainly there is data and endpoints and statistics and a whole lot, even it's only 15 patients, there's a whole lot of data collection follow primary safety endpoint. So that will take some time to crank, but we are very satisfied and we are actually matching the enrollment create [ph] off the other enrolled clinical in this area.

Remember we only have three sites..

That's great and if you could remind me, what you expect in terms of the first data coming out is that going to be six months data, is it going to be one year data, how do you look? How's that going to come out?.

I'll tell you. Our primary end point is the 30-day safety follow-up and this is in our, what we go from the FDA, it's a 30-day safety follow-up. We're looking at the blood levels of the drug. We're looking certainly, how the patients are doing any adverse events.

We intend to a do a six-month do both duplex ultrasound angiographic follow-up in the patients, however those are not the primary endpoints. The 30 days really where we're looking at and as you know these patients have followed up to, I believe three years to five years in any case..

And so, how quickly can we see the data once the trials wrapped up?.

Once we finish the enrollment and the last patient is out for 30 days that's when the, that segment of the study the data analysis really begins and that I have been told, even though it's just a few patients still takes a couple months and we're hands off after that, those are the both angiographic and duplex call labs and clinical evaluation committee.

So what I hope is by the end of this calendar year December, we will actually have the report. I'd certainly like to have it in hand before the fourth quarter earnings call, but I believe that's very optimistic..

Okay and then lastly from me. You mentioned that your customers burn off the inventory for the product that were manufactured [indiscernible] coating prior to the patent expirations.

Do you have any idea of how much is left out there to burn off or don't you have that information?.

Well that's really Ben, customer specific and if I take you back to our initial guidance, where we expected there to be at $3 million to $4 million impact from the expiration of our third generation coating technology in fiscal 2016.

You know, I would say that's more in the $1.5 million to $2.5 million range at this point as our customers did have in general more inventory in the channel at the time of expiration the patent than we initially anticipated..

Okay, that's all I had gentlemen. Thank you very much..

Thanks, Ben..

Thank you. [Operator Instructions] at this time, we have no further questions. I'll turn the conference back to management for closing comments or remarks..

Well, thank you. To reiterate we are pleased with recent acquisitions, the progress of our integration efforts and our financial performance year-to-date in fiscal 2016. We've increased our guidance and are on track to accelerate our strategy to delivering whole production solutions to our customers.

I look forward to speaking with you on our fourth quarter earnings call. Thanks everyone..

Thank you that does conclude today's conference. You may disconnect at any time and have a great day..