Surmodics (SRDX) 10-Q 2002 Q1 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2001

OR

     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

Commission File Number 0-23837

SurModics, Inc.

(Exact name of registrant as specified in its Charter)

MINNESOTA
(State of incorporation) 41-1356149
(I.R.S. Employer Identification No.)

9924 West 74th Street
Eden Prairie, Minnesota 55344
(Address of principal executive offices)

Registrant’s telephone number, including area code: (952) 829-2700

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes     No    

The number of shares of the registrant’s Common Stock, $.05 par value per share, outstanding as of January 31, 2002 was 16,915,351.

TABLE OF CONTENTS

PART I — FINANCIAL INFORMATION
	Item 1. Financial Statements
		Condensed Balance Sheets
		Condensed Statements of Income
		Condensed Statements of Cash Flows
		Notes to Condensed Financial Statements
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PART II — OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities.
	Item 4. Submission of Matters to a Vote of Security Holders.
	Item 5. Other Information.
	Item 6. Exhibits and Reports on Form 8-K.
SIGNATURES
Purchase Agreement
Series C Preferred Purchase Agreement

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

SURMODICS, INC.
Condensed Balance Sheets
(In thousands, except share data)

					December 31,			September 30,
					2001			2001
					(Unaudited)
				ASSETS
Current Assets
	Cash & cash equivalents				$	2,035		$	9,044
	Short-term investments					3,770			5,796
	Accounts receivable, net					2,672			3,245
	Inventories					710			724
	Deferred tax asset					297			297
	Prepaids and other					766			877
			Total current assets			10,250			19,983
Property and equipment, net						15,032			7,672
Long-term investments						28,915			29,565
Deferred tax asset						646			646
Other assets, net						6,710			2,717
					$	61,553		$	60,583
				LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
	Accounts payable				$	621		$	553
	Accrued liabilities					1,154			1,672
	Deferred revenues					253			303
			Total current liabilities			2,028			2,528
Deferred revenue, less current portion						2,372			2,355
			Total liabilities			4,400			4,883
Commitments and Contingencies
Stockholders’ Equity
	Series A Preferred stock-
		$.05 par value, 450,000 shares authorized; no shares issued and outstanding				—			—
	Common stock-
		$.05 par value, 45,000,000 shares authorized; 16,786,106 and 16,760,501 shares issued and outstanding				839			838
	Additional paid-in capital					47,715			47,777
	Unearned compensation					(281	)		(376	)
	Accumulated other comprehensive income					284			275
	Retained earnings					8,596			7,186
			Total stockholders’ equity			57,153			55,700
					$	61,553		$	60,583

The accompanying notes are an integral part of these condensed balance sheets.

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SURMODICS, INC.
Condensed Statements of Income
(In thousands, except per share data)
(Unaudited)

			Three Months Ended
			December 31,
			2001			2000
						(As restated)
Revenue
	Royalties		$	2,735		$	2,058
	License fees			79			360
	Product sales			1,620			1,557
	Research and development			1,625			782
		Total revenues		6,059			4,757
Operating costs and expenses
	Product			565			608
	Research and development			2,430			1,775
	Sales and marketing			351			405
	General and administrative			894			713
		Total operating costs and expenses		4,240			3,501
Income from operations				1,819			1,256
Other income
	Investment income, net			419			631
	Gain on sale of investments			4			150
		Other income, net		423			781
Income before income taxes				2,242			2,037
Income tax provision				(832	)		(712	)
Income before cumulative effect of a change in accounting principle				1,410			1,325
Cumulative effect of a change in accounting principle, net of tax				—			1,705
Net income (loss)			$	1,410			($380	)
Basic net income per share before cumulative effect of a change in accounting principle			$	0.08		$	0.08
Cumulative effect of a change in accounting principle, net of tax				—			(0.10	)
Diluted net income (loss) per share			$	0.08			($0.02	)
Diluted net income per share before cumulative effect of a change in accounting principle			$	0.08		$	0.08
Cumulative effect of a change in accounting principle, net of tax				—			(0.10	)
Basic net income (loss) per share			$	0.08			($0.02	)
Weighted average shares outstanding
	Basic			16,780			16,590
	Dilutive effect of outstanding stock options			1,060			1,106
		Diluted		17,840			17,696

The accompanying notes are an integral part of these condensed financial statements.

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SURMODICS, INC.
Condensed Statements of Cash Flows
(In thousands)
(Unaudited)

					Three Months Ended
					December 31,
					2001			2000
								(As restated)
Operating Activities
	Net income (loss)				$	1,410			($380	)
	Adjustments to reconcile net income to net cash provided by operating activities-
		Depreciation and amortization				441			361
		Gain on sale of investments				(4	)		(150	)
		Amortization of unearned compensation, net				32			27
		Change in deferred tax				—			655
		Cumulative effect of a change in accounting principle, net of tax				—			1,705
		Change in operating assets and liabilities:
			Accounts receivable			573			(329	)
			Inventories			14			(73	)
			Accounts payable and accrued liabilities			(218	)		(496	)
			Accrued income taxes			(232	)		—
			Deferred revenues			(33	)		39
			Prepaids and other			111			(128	)
				Net cash provided by operating activities		2,094			1,231
Investing Activities
	Purchases of property and equipment, net					(7,795	)		(470	)
	Purchases of available-for-sale investments					(6,959	)		(14,046	)
	Sales/maturities of available-for-sale investments					9,649			13,031
	Purchase of other assets					(4,000	)		—
				Net cash used in investing activities		(9,105	)		(1,485	)
Financing Activities
	Issuance of common stock					2			205
				Net decrease in cash and cash equivalents		(7,009	)		(49	)
Cash and Cash Equivalents
	Beginning of period					9,044			1,510
	End of period				$	2,035		$	1,461

The accompanying notes are an integral part of these condensed financial statements.

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SURMODICS, INC.
Notes to Condensed Financial Statements
(Unaudited)

(1) Basis of Presentation

         In the opinion of management, the accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles and reflect all adjustments, consisting solely of normal recurring adjustments, needed to fairly present the financial results for these interim periods. These financial statements include some amounts that are based on management’s best estimates and judgments. These estimates may be adjusted as more information becomes available, and any adjustment could be significant. The results of operations for the three months ended December 31, 2001 are not necessarily indicative of the results that may be expected for the entire fiscal year.

         According to the rules and regulations of the Securities and Exchange Commission, the Company has omitted footnote disclosures that would substantially duplicate the disclosures contained in the audited financial statements of the Company. Read together with the disclosures below, management believes the interim financial statements are presented fairly. However, these unaudited condensed financial statements should be read together with the financial statements for the year ended September 30, 2001 and footnotes thereto included in the Company’s form 10-K as filed with the Securities and Exchange Commission.

(2) Revenue Recognition

         Effective October 1, 2000, the Company adopted Staff Accounting Bulletin No. 101 (“SAB 101”) issued by the Securities and Exchange Commission in December 1999. Historically, the Company recognized initial license fees as revenue upon receipt, after a license agreement transferring the technology was executed and all significant obligations had been performed. SAB 101 requires that license and other up-front fees be recognized over the term of the agreement unless the fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process. The Company adopted SAB 101 in the fourth quarter of fiscal 2001, retroactive to October 1, 2000 by deferring license fee payments over the term of the agreement. The cumulative effect of this change to September 30, 2000, which was recorded in 2001, was $1,705,000 or $.10 per share, net of tax. The effect on the three months ended December 31, 2000 decreased income before cumulative effect of a change in accounting principle by $41,000. There was no impact on earnings per share compared to results previously reported.

(3) New Accounting Pronouncements

         In June 2001, the FASB issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (“SFAS No. 141”) and No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 141 supercedes Accounting Principles Board (“APB”) Opinion No. 16 and requires that all business combinations initiated after June 30, 2001 be accounted for by the purchase method. SFAS 141 also changes the requirements for recognizing intangible assets as assets apart from goodwill in business combinations accounted for by the purchase method for which the date of acquisition is July 1, 2001, or later. SFAS 142 addresses how intangible assets that are acquired individually or with a group of other assets (but not in a business combination) should be accounted for upon their acquisition. SurModics will adopt SFAS 141 and 142 on October 1, 2002, and management expects no material impact on its financial statements.

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(4) Operating Segments
       (dollars in thousands)

						Research &
		Licensing		Manufacturing		Development			Corporate			Consolidated
Three Months Ended December 31, 2001
Revenue:
	PhotoLink	$	2,300	$	1,167	$	1,440		$	—		$	4,907
	Diagnostic		514		—		—			—			514
	Stabilization & other		—		453		—			—			453
	Government		—		—		185			—			185
Total Revenue			2,814		1,620		1,625			—			6,059
Expenses			—		565		2,433			1,242			4,240
Operating income (loss)			2,814		1,055		(808	)		(1,242	)		1,819
Other income										423			423
Income tax provision										(832	)		(832	)
Net income												$	1,410
Three Months Ended December 31, 2000
Revenue:
	PhotoLink	$	1,786	$	723	$	709		$	—		$	3,218
	Diagnostic		632		—		—			—			632
	Stabilization & other		—		834		—			—			834
	Government		—		—		73			—			73
Total Revenue			2,493		1,557		782			—			4,757
Expenses			—		608		1,775			1,118			3,501
Operating income (loss)			2,493		949		(993	)		(1,118	)		1,256
Other income										781			781
Income tax provision										(712	)		(712	)
Income before cumulative effect of a change in accounting principle												$	1,325

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(5) Other Assets

         Included in other assets at December 31, 2001 was a $4.0 million equity investment in Novocell, Inc. On December 7, 2001, the Company announced an alliance with the privately held Irvine, California based biotech firm that is developing a potential cure for diabetes. The Company’s investment represents an ownership in Novocell of less than 15%.

(6) Comprehensive Income

         The components of comprehensive income for the three-month periods are as follows:

			Three months ended December 31,
			2001			2000
			(dollars in thousands)
Net income (loss)			$	1,410		$	(380	)
Other comprehensive income:
	Unrealized holding gains on available-for-sale securities arising during the period, net of tax			13			375
		Less reclassification adjustment for realized gains included in net income , net of tax		(4	)		(150	)
Other comprehensive income				9			225
Comprehensive income (loss)			$	1,419		$	(155	)

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

         SurModics, Inc. (the “Company”) develops, manufactures and markets innovative surface modification solutions to the medical device industry. The Company’s revenue is derived from the following sources: fees from licensing its patented technology to customers; royalties received from licensees; the sale of reagent chemicals to licensees, stabilization products to the diagnostic industry and coated glass slides to the genomics market; and research and development fees generated on projects for commercial customers and government grants. The Company markets its products through a direct sales force primarily in the United States and certain international markets.

Results of Operations

Three Months Ended December 31, 2001 and 2000

         Revenues.The Company’s revenues were $6.1 million for the first quarter of fiscal 2002, an increase of $1.3 million, or 27%, over the same period of fiscal 2001. The revenue components were as follows (in thousands):

								$ Increase			% Increase
				2001		2000		(Decrease)			(Decrease)
PhotoLink revenue:
	Royalties			$	2,221	$	1,426	$	795			56	%
	License fees				79		360		(281	)		(78	%)
	Reagent sales				1,167		723		444			61	%
	Commercial development				1,440		709		731			103	%
		Total PhotoLink revenue			4,907		3,218		1,689			52	%
Other revenue:
	Diagnostic royalties				514		632		(118	)		(19	%)
	Stabilization & other products				453		834		(381	)		(46	%)
	Government research				185		73		112			153	%
			Total revenue	$	6,059	$	4,757	$	1,302			27	%

         First quarter revenue growth was primarily the result of a 52% increase in PhotoLink revenue. Commercial development revenue increased 103% to over $1.4 million, a quarterly record. Most of this increase was due to the work on the drug delivery stent for Johnson & Johnson’s Cordis division. PhotoLink royalties were $2.2 million, a 56% increase, due mostly to increased sales of coated products by the Company’s licensees. Reagent chemical sales (those chemicals used by licensees in the coating process) increased 61% to nearly $1.2 million. A single client purchased more than half of the reagents sold during the first quarter.

         Diagnostic royalty revenue declined 19% as payments from certain sub-licensees were not received prior to quarter end. Stabilization and other product revenue fell 46%. Most of this decrease is attributed to slower sales of genomics slides to Motorola. Slide sales are expected to bounce-back to historical levels in the second quarter.

         SurModics signed one new PhotoLink license agreement during the first quarter of fiscal 2002. Prorata income from the new license fee and for previously executed license fees combined for total license fee revenue of $79,000. Historically, the Company recognized license fee revenue upon

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execution of the license. Effective October 1, 2000, the Company now defers up-front license payments and recognizes revenue over the term of the agreement. The Company has license agreements with 51 companies covering over 100 different product applications.

         Overall, management expects revenue growth to be in the 20% to 25% range in the second quarter. Once again, this growth should be led by increases in Photolink revenue.

         Product costs.The Company’s product costs were $565,000 for the first quarter of fiscal 2002, a decrease of $43,000, or 7%, over the same period of fiscal 2001. Overall product margins increased to 65% in the first quarter of fiscal 2002 from 61% in the same period of fiscal 2001, since higher margin reagent product sales constituted a greater percentage of total product sales. The Company expects that product margins will be in the 62% to 63% range for the balance of the fiscal year.

         Research and development expenses.Research and development expenses were $2.4 million for the first quarter of fiscal 2002, an increase of $655,000, or 37%, over the same period of fiscal 2001. The increase was primarily due to compensation and benefits associated with technical personnel added by the Company over the last year and higher patent fees, depreciation and facilities costs. The Company expects that the growth of research and development expenses will slow to produce an overall increase of 18% to 20% over fiscal 2001.

         Sales and marketing expenses.Sales and marketing expenses were $351,000 for the first quarter of fiscal 2002, a $54,000 or 13% decrease from the same period of fiscal 2001. Most of the difference was due to a decrease in business travel and a reduction in promotional expenses. Sales and marketing expenses in fiscal 2000 are expected to be fairly flat with last year.

         General and administrative expenses.General and administrative expenses were $894,000 for the first quarter of fiscal 2002, an increase of $181,000, or 25%, over the same period of fiscal 2001. The increase was the result of additional facilities costs associated with property recently acquired for expansion, legal fees and higher compensation and benefit costs. The Company expects that general and administrative expenses will show a similar percent increase over the rest of the year due to added facility costs.

         Income from operations.The Company’s income from operations was $1.8 million for the first quarter of fiscal 2002, an increase of $563,000, or 45%, over the same period of fiscal 2001.

         Other income, net.The Company’s other income was $423,000 for the first quarter of fiscal 2002, a decrease of $358,000, or 46%, over the same period of fiscal 2001. The decrease in investment income was a result of lower investment yields and a nearly 15% decrease in cash and investment balances from last year’s first quarter. In addition, in fiscal 2001, the Company sold and reinvested a portion of its bond portfolio to take advantage of a tax capital loss carryforward, generating realized gains of $150,000. The Company expects that other income will remain at a similar level for the remainder of fiscal 2002.

         Income tax expense.The Company’s income tax provision was $832,000 (an effective tax rate of 37%) for the first quarter of fiscal 2002 versus $712,000 (an effective rate of 35%) in the same period of fiscal 2001. The increase in the effective rate was due to the recognition of the capital loss carryforwards in fiscal 2001.

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Liquidity and Capital Resources

         As of December 31, 2001, the Company had working capital of $8.2 million and cash, cash equivalents and investments totaling $34.7 million. The Company’s investments principally consist of U.S. government and government agency obligations and investment grade, interest-bearing corporate debt securities with varying maturity dates, the majority of which are five years or less. The Company generated positive cash flows from operating activities of $2.1 million in the first three months, which was an increase of 70% from the same period of last year, primarily due to the increase in net income.

         On October 1, 2001, the Company purchased a 135,000 square foot facility on 27 acres of land in Bloomington, Minnesota for approximately $7.1 million through a wholly-owned subsidiary entity. The Company intends to gradually move a portion of its operations into this facility, before completely occupying the facility in 2003. Prior to acquiring the Bloomington facility, the Company acquired real property for approximately $2.5 million through another wholly-owned subsidiary entity. The Company now intends to sell this property and expand into the Bloomington location. The Company continues to own and occupy its current facility in Eden Prairie, Minnesota.

         On December 7, 2001, the Company announced an alliance with privately held Novocell, Inc. an Irvine, California based biotech firm that is developing a potential cure for diabetes. The Company’s investment of $4.0 million represents less than 15% ownership of Novocell.

         As of December 31, 2001, the Company had no debt, nor did it have any credit agreements. The Company believes that its existing capital resources will be adequate to fund the Company’s operations into the foreseeable future.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

         SurModics’ investment policy requires investments with high credit quality issuers and limits the amount of credit exposure to any one issuer. The Company’s investments principally consist of U.S. government and government agency obligations and investment-grade, interest-bearing corporate debt securities with varying maturity dates, the majority of which are five years or less. Because of the credit criteria of the Company’s investment policies, the primary market risk associated with these investments is interest rate risk. SurModics does not use derivative financial instruments to manage interest rate risk or to speculate on future changes in interest rates. A 10% increase in interest rates would result in an approximate $165,000 decrease in the fair value of the Company’s available-for-sale securities as of December 31, 2001, but no material impact on the results of operations or cash flows. Management believes that a reasonable change in raw material prices would not have a material impact on future earnings or cash flows because the Company’s inventory exposure is not material. Also, the Company’s foreign currency exposure is not significant.

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Forward Looking Statements

         The statements contained in this quarterly report relating to future revenue growth and expense levels are based on current expectations and involve a number of risks and uncertainties. These statements are forward looking and are made pursuant to the safe harbor provisions of the Private Securities Reform Act of 1995. The following factors could cause royalty revenue to materially and adversely differ from that anticipated: the ability of the Company’s licensees to successfully gain regulatory approval for, market and sell products incorporating the Company’s technology; the amount and timing of resources devoted by the Company’s licensees to market and sell products incorporating the Company’s technology; the Company’s ability to attract new licensees and to enter into agreements for additional applications with existing licensees; the Company’s ability to maintain a competitive position in the development of technologies and products in its areas of focus; and business and general economic conditions. Investors should consider these risks and other risks identified in the Company’s filings with the SEC when making investment decisions. Shareholders and other readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. SurModics undertakes no obligation to update publicly or revise any forward-looking statements.

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PART II — OTHER INFORMATION

Item 1. Legal Proceedings

                       None.

Item 2. Changes in Securities and Use of Proceeds

                       None.

Item 3. Defaults Upon Senior Securities.

                       None.

Item 4. Submission of Matters to a Vote of Security Holders.

(a)	The Company held its Annual Meeting of Shareholders on January 28, 2002.
(b)	Proxies were solicited pursuant to Regulation 14A under the Securities Act of 1934. The shareholders voted on two matters: (i) to set the number of directors at eight (8) and (ii) to elect Class III directors. The shareholders approved both matters by the following votes:

			Votes		Votes		Broker
	Votes For		Against		Abstained		Non-Votes
(i)    Set the number of directors at eight (8)		13,701,083		13,454		12,916		—

				Votes		Broker
		Votes For		Withheld		Non-Votes
(ii)   Elect Class III directors
	Dale R. Olseth		12,266,526		1,460,927		—
	Kenneth H. Keller		11,315,825		2,411,628		—
	David A. Koch		13,708,276		19,177		—

Item 5. Other Information.

                       None.

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Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits –

10.1	Purchase agreement by and between Seagate Technology, LLC and DRB#10, LLC (a wholly-owned subsidiary entity of the Company)
10.2	Series C Preferred Purchase Agreement between Novocell, Inc. and the Company dated December 10, 2001

(b) Reports on Form 8-K — None

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SIGNATURES

         Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	SurModics, Inc.
February 13, 2002	By:	/s/ Stephen C. Hathaway
		Stephen C. Hathaway Vice President & CFO (Principal Financial Officer)

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