Earnings Transcript for SRDX - Q3 Fiscal Year 2023

Operator: Welcome everyone to Surmodics Third Quarter of Fiscal Year 2023 Earnings Call. Please note that this call is being webcast. The webcast is accessible through the Investor Relations section of the Surmodics website at www.surmodics.com, where an audio replay will be archived for future reference. An earnings press release disclosing Surmodics quarterly results was issued earlier today and is available on the company's website as well. Before we begin, I would like to remind everyone that remarks and responses to your questions on today's call may contain 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 Surmodics forward-looking statements, resulting from certain risks and uncertainties, including those described in the company's SEC filings. Surmodics disclaims any duty to update or revise these forward-looking statements as a result of new information, future events, developments or otherwise. This call will also include references to non-GAAP measures because Surmodics believes they provide useful information for investors. Today's earnings release contains reconciliation tables to GAAP results. I would now like to turn the call over to Mr. Gary Maharaj, Surmodics' President and Chief Executive Officer. Please go ahead, sir.

Gary Maharaj: Thank you, operator and welcome, everyone, to our earnings call for the third quarter of fiscal year 2023. Let me begin with a quick overview of what we plan to cover on today's call. I'll begin my remarks with a brief overview of our quarterly revenue results and the key drivers of our performance, followed by a discussion of our recent operational progress and thoughts on our outlook for the remainder of the fiscal year. Tim will then discuss our third quarter financial performance in detail and review our fiscal 2023 guidance which we updated in our earnings press release today. We'll then open the call for questions. With that, let's get started with a review of our revenue performance. In the third quarter of fiscal 2023, we reported total revenue of $52.5 million, representing growth of 111% on a year-over-year basis. Our total revenue performance was driven by exceptionally strong growth in our Medical Device segment which increased 163% year-over-year, more than offsetting a 12% decrease in revenue from our in-Vitro Diagnostics or IVD segment. Our total revenue and medical device revenue growth benefited from the achievement of FDA premarket approval for our SurVeil drug-coated balloon. As a result of this achievement, we received $27 million of a milestone payment during the quarter from our commercial partner, Abbott, of which $24.6 million was recognized as revenue. I'll discuss this important accomplishment in further detail later in my remarks. I'm pleased to report that we delivered strong performance during the quarter on an underlying basis as well. Excluding the PMA milestone, we achieved total revenue growth of 12% year-over-year, driven by the Medical Device segment total revenue growth of 22% year-over-year. This impressive performance in our Medical Device segment was largely driven by product sales. The Medical Device segment product sales increased 38% year-over-year, fueled primarily by our sales of our pounds and supplying products, along with strength across our product portfolio, including sales of our performance coating reagents. In our IVD business, the year-over-year softness was driven primarily by decreased sales across our core product lines as we saw several customers taking steps to manage elevated inventory levels during the quarter. All in all, we were pleased with our revenue performance in the third quarter. Shifting to an update on our recent operational highlights. During the third quarter, our team made important progress with respect to each of our 3 key strategic objectives for fiscal 2023, while continuing to advance our pipeline of vascular intervention products towards commercialization. I'll start by discussing our recent progress with respect to each of these objectives which as a reminder are

Timothy Arens: Thank you, Gary. Unless noted, all references to third quarter results are on a GAAP and year-over-year basis. Total revenue for the third quarter of fiscal 2023 increased $27.6 million or 111% to $52.5 million. As Gary mentioned, our total revenue in the third quarter of this year included $24.6 million of revenue recognized from the $27 million milestone payment received for obtaining premarket approval of our SurVeil drug-coated balloon. Excluding the impact of this milestone payment, third quarter total revenue grew 12%. Product revenue increased $1.7 million or 13% to $15.7 million in the third quarter of fiscal 2023. The increase was driven by broad-based product sales growth in our Medical Device business which increased $2.6 million or 38%, driven primarily by increased sales of our Pounce arterial thrombectomy and supplying radial platforms as well as our performance coating reagents. IVD product revenue decreased $810,000 or 11% to $6.4 million. The decrease was driven primarily by several customers actively managing their inventory levels. The IVD industry is adapting to respond to multiple macroeconomic factors, including the decrease in demand for COVID testing products as well as stabilization and supply chains which are reducing the need for elevated safety stock. Royalty and license fee revenue increased $25.4 million or 288% to $34.2 million. Excluding $24.6 million of license fee revenue recognized in the third quarter of fiscal 2023 from the SurVeil PMA milestone payment, royalty and license fee revenue increased 8%. Royalty revenue from our Performance Coatings increased $450,000 or 6%. R&D services revenue increased $520,000 or 24% to $2.7 million. The increase was primarily due to higher customer demand for our Performance Coating Services in our Medical Device business which was impacted in the prior year period by our customer supply chain challenges. Moving down the P&L. Product gross margin in the third quarter of fiscal 2023 was 55.8% compared to 63.1% in the prior year period. The decline in product gross margin was driven by the adverse mix impact from increased device product sales which have lower product gross margins due to low production volumes during the scale-up phase following initial commercialization. R&D expense, including costs related to clinical and regulatory activities, decreased $1.7 million or 13% to $11.2 million in the third quarter of fiscal 2023. The decrease in R&D expense reflects the benefits from the spending reduction plan we implemented during the second quarter of 2023. SG&A expense was $12.9 million and was unchanged compared to the prior year period. Contingent consideration gain of $830,000 resulted from a noncash fair value adjustment to acquisition-related contingent consideration liabilities. Our Medical Device business reported operating income of $21.8 million compared to an operating loss of $7.3 million in the prior year period. The year-over-year change reflects the $24.6 million in license fee revenue recognized on the SurVeil PMA milestone payment in the third quarter along with disciplined expense management, broad-based revenue growth and the aforementioned contingent consideration gain. Our IVD business reported operating income of $2.9 million compared to $3.4 million in the prior year period. IVD operating income was 44% of IV revenue compared to 46% in the prior year period. Turning to income taxes, in the third quarter of fiscal 2023, we reported income tax expense of $13.3 million compared to an income tax benefit of $1.5 million in the prior year period. Given the magnitude of income taxes this quarter, I'd like to take a moment to outline the key drivers, starting with the $24.6 million in revenue recognized on the PMA milestone payment. In the third quarter, as a result of the milestone payment, we shifted from a taxable loss to a taxable income position, resulting in significant tax expense. Also contributing to our income tax expense was a recently effective IRS requirement to spread the deduction of U.S. R&D expense over a 5-year period. As a reminder, we are no longer recording tax benefits for deferred deductions or net operating losses as a result of having established a full valuation allowance against U.S. deferred tax assets at the end of fiscal 2022. GAAP net income in the third quarter of fiscal 2023 was $7.3 million or $0.52 per diluted share compared to a net loss of $5.7 million or a loss of $0.41 per diluted share in the prior year period. Non-GAAP net income in the third quarter of fiscal 2023 was $7.3 million or $0.52 per diluted share compared to non-GAAP net loss of $4.7 million or a loss of $0.34 per diluted share in the prior year period. Non-GAAP adjusted EBITDA in the third quarter of fiscal 2023 was $24.6 million compared to adjusted EBITDA loss of $3.1 million in the prior year period. Adjusted EBITDA includes adjustments for contingent consideration gain in the third quarter of fiscal 2023 and for stock-based compensation expense in both periods. Our earnings press release includes detailed reconciliations of GAAP to non-GAAP measures. Moving to the balance sheet, we began the third quarter of fiscal 2023 with $19.2 million in cash and $29.3 million in long-term debt. Cash provided by operations during the third quarter was $25.9 million, reflecting the $27 million PMA milestone payment from Abbott. Capital expenditures totaled $470,000. We ended the quarter with $44.6 million in cash and $29.4 million in long-term debt as of June 30, 2023. Long-term debt includes $5 million in borrowings on our $25 million revolving credit facility and $25 million in borrowings on our $100 million term loan facility. As of June 30, 2023, we had approximately $61 million in debt capital available, consisting of $50 million on our term loan availability and approximately $11 million of incremental availability on our revolving credit facility which is subject to borrowing base requirements. Turning now to fiscal 2023 guidance. We updated our fiscal 2023 revenue guidance today to reflect our performance in the third quarter as well as our revised expectations for the remainder of fiscal 2023. We now expect fiscal 2023 total revenue to range from $130 million to $132 million, representing an increase of 30% to 32% over the prior year. Excluding the estimated revenue recognized on the PMA milestone payment, we expect total revenue to range from $105 million to $107 million. This compares to our prior range of $103 million to $106 million or an increase of 3% to 6% over the prior year. We now expect fiscal 2023 GAAP diluted loss per share to range from a loss of $0.55 to a loss of $0.40 compared to our prior range of a loss of $2.30 to a loss of $2. Non-GAAP diluted loss per share in fiscal 2023 is expected to range from a loss of $0.29 to a loss of $0.14 compared to our prior range of a loss of $1.98 to a loss of $1.68. I'll now share a few additional considerations for modeling purposes. Our updated total revenue guidance reflects the following assumptions for the full fiscal year. Revenue for our 2 businesses, Medical Device and IVD is expected to be approximately 80% and 20% of revenue, respectively. Product revenue is expected to be approximately 46% of total revenue. Our guidance for product revenue does not include any sales of the SurVeil DCB product in our fourth quarter. Revenue associated with our legacy medical device performance coating offerings is expected to grow in the mid- to high single digits. IVD revenue is expected to decline in the low single digits. Abbott SurVeil license fee revenue is expected to range from $29.5 million to $30 million which includes approximately $25 million in revenue recognized in fiscal 2023 on the $27 million PMA milestone payment. This assumes fourth quarter revenue associated with the PMA milestone of $400,000. In the prior year, total Abbott SurVeil license fee revenue was $5.7 million. Our updated diluted loss per share guidance reflects the following full year assumptions

Operator: [Operator Instructions] One moment, please, while we poll for questions. Our first question is from Brooks O'Neil with Lake Street Capital Markets, please go ahead.

Brooks O'Neil: Good morning, since I have about 10 questions, I'm going to have to queue up multiple times here but I'll try to follow your guidance. The first question I have is, how do you think the FDA declaration that there is no negative effect from paclitaxel to impact the ultimate success of SurVeil?

Gary Maharaj: It's quite positive actually. If you look at the potential for growth of paclitaxel devices, it's not quite penetrated and it's been strained because of this 2019 labor warning that's now been removed. And one of the restraints was the marketing and commercial programs to drive market adoption were basically stunted by the FDA's label warning. And so now I believe all companies can get back into demonstrating what paclitaxel can do as an anti-restenotic drug on both stents and drug-coated balloons in the distal peripheral vasculature. So, I think it's going to help drive the market. What it means to us and I know Tim is closer to some of this market data but it is about $1 billion potential for this 0.5 million procedures per year. But for us, in particular, with Abbott as a commercial partner, we have the trifecta, I believe and that momentum. So the timing is great. We have a technically superior product. And we have a clinical trial, the only clinical trial that a pivotal worldwide trial that demonstrates that technical superiority. This unwinding of the label warning will allow for the market growth opportunity to get back into full ball and then we have the commercial strength of Abbott Vascular. They are really well known for their ability to move the market in terms of drug-eluting devices. So that trifecta, we believe, it's going to give us a multiplicative impact as we grow. Now we'll stay tuned and we'll tell you more about that and what that means for fiscal '24. But the trade winds are blowing favorably because of it.

Timothy Arens: Gary, I would just add for Brooks and other benefits. We have heard from several physicians that there are still hospitals and accounts that have restricted the use of paclitaxel devices. So obviously, with the FDA changing its position, those restrictions should be lifted and should have a greater opportunity in terms of addressing the need to treat patients who are suffering from peripheral vascular disease with the drug coated balloon. So we'll be looking closely to the data on this over the following for the next couple of quarters. So stay tuned.

Brooks O'Neil: Great. At the risk of being accused of achieving, I'm going to combine questions 2 and 3 and just ask you, can you tell us the key steps and timing that you need to take to prepare for Abbott's launch of the product? And then can you help us begin to think about the impact of SurVeil on Surmodics results in fiscal '24?

Gary Maharaj: Sure and Tim is really connected to our operational. So I'll turn part of that over to him pre-commercial activities with Abbott. But really, the first thing was to secure materials and we're in good shape. It might have increased some inventory balances a little much, especially paclitaxel is not inexpensive drug to acquire. But on the raw materials and supply chain side, we're secure and we're prepared for whatever Abbott has in their plans. The second thing you've heard me talk about a cold start of a diesel engine in winter. And so we have started that up. We have been able to retain most of the team members despite the reduction in force we had earlier this year and then we've hired some more people so that we have the ability for future scale here as well. So that's been going well. It takes a while to fulfil these orders that I'll pass it on to Tim.

Timothy Arens: Thank you, Gary. Well said. Brooks, I think the key takeaway for us is that we will be prepared. We have the people, materials and equipment to support Abbott's commercial launch. Notably, our manufacturing team has built thousands and thousands of SurVeil units over the years to satisfy our clinical, regulatory and development efforts. So we've got a lot of experience. We have the experienced team here. They've been in place for years and we've actually have restarted and have done test manufacturing runs just to ensure that we're ready. And there is still work to be done more on the administrative front but we're waiting for the [indiscernible] and then we'll start manufacturing products. And the second thought was, what do we expect, I guess, I'll ask you to stay tuned. We have not yet received the final appeal. But what we have discussed in the past, we had talked, I think, previously that Abbott had shared perspective in terms of their forecast. They've done so again. We like what we're seeing. We'll have more to say on this topic probably as early as Q4.

Operator: Thank you. Our next question comes from the line of Michael Matson with Needham & Company. Please go ahead.

Michael Matson: Thanks, just a few more on SurVeil. So I guess just starting with the DCB market, can you remind us where pricing is, I'm not asking where Abbott is going to price their product but I seem to remember that the DCB is really launched were kind of in the $1,200 range, I'm remembering correctly but I think it's come down quite a bit. Do you have a feel for where just kind of the typical pricing is these days?

Timothy Arens: It's a great question, Mike. And what I can tell you is looking at the IMS data, industry data, these are sales into hospital accounts. We still see list prices around $1,400 to $1,500 per device. As you can imagine, every manufacturer is probably having some discount relative to their products. So I can't really speak to what the ultimate pricing is but the list price has remained constant over the last several years.

Michael Matson: Okay. And then can you just remind us about what you've said about the economics of the Abbott deal. I know you haven't given specific numbers but it's kind of convoluted, I guess, in the way that it works from what I remember. And then would it be crazy to assume that Surmodics might be capturing roughly 50% of the kind of end market price in terms of value that you're getting?

Timothy Arens: So I'll walk through great question. I appreciate the question. I know this is a topic on many people's minds. The economics really, I think probably the best way to describe it is that Surmodics will receive 2 revenue streams. The first revenue stream will be for the product shift to Abbott and we call it a transfer price and we'll recognize that revenue at the moment the product is shipped out of our docs. And then the second piece is what we call profit sharing. And the profit sharing, obviously, there's a formula, it works somewhat like this. I think we've articulated this a bit in the past but Abbott will back out the transfer price and they'll have a gross margin. I think we can appreciate how to get to gross margin. They also can deduct what I would consider a typical multinational strategic sales and selling expense percentage from the revenue. And so then basically what remains is what we call the profit pool and we've characterized this in the past that it's not quite 50-50 but it's close. And so I would say in terms of thinking about what percentage of the revenue on the sale price of SurVeil, the 50% might be high but I think we've highlighted in the past that from a whole product solutions or a partnered product solutions perspective, Surmodics is approaching that 50% level. We'll talk more about this, I'm sure, as we kind of get past the initial commercialization but it is very attractive.

Michael Matson: Okay. And then when you report your fourth, I understand you're not including any kind of survey revenue in your guidance now. But when you report your fourth quarter, is it safe to assume that you're going to factor something into the '24 guidance, some assumption around SurVeil revenue, continue revenue guidance and earnings guidance?

Timothy Arens: Another great question. Yes, that is the expectation. Gary and I will have more color and context to provide on SurVeil, probably during our November earnings call.

Michael Matson: Okay. Got it. All right. And then just unrelated to devices or SurVeil on the IVD business, just the decline is a little concerning, I guess, is I mean, how long do you think this is going to last? Is this kind of going to be like a 4-quarter kind of a step down that last 12 months and then you kind of lap it and it starts to grow again or something like that?

Gary Maharaj: Tim and I will after the ACC meeting with Joe, our President of that business last week. And if you look, Mike, I don't think you track IVD industry but it's been whipsawed around and the idea was whipsawed around because of COVID. Now we are a smoothing function on that because we had quite a few reagents and stuff in COVID. And so we didn't get it sold around as much. And 12% is not as much as a lot of the rest of the industry saw. So what we've heard is that the industry hopes to lap that comparable. We don't have enough detailed analysis to know specifically for IVD business, how that lapping is going to work. But we do understand that there were a lot of customers who had geared up for a lot of reagents with high expectations and they just have to work through that inventory. Tim, I know you have some color as well.

Timothy Arens: Yes. Thank you, Gary. Mike, I think it's really important to recognize that our IVD business has gone through kind of a soft period here over the last several quarters. If you consider and contemplate the guidance that we provided and the percentage of our revenue that's being generated by IVD, you'll come to the conclusion that IVD is going to be returning to growth in our fourth quarter. We're starting to see some of the customers who have delayed or slowed their purchases. We're seeing some of those come back online. I think we feel pretty confident that this is not going to persist much longer. That's not to say that there could still be some general softness on the business but we like where we sit today and we'll have more to say about these macro impacts here in a couple of months.

Michael Matson: Okay, got it. So do you feel like you're kind of already several quarters into the slowdown [indiscernible].

Timothy Arens: Yes and again, the entire industry in these types of regions have gone through this in a bigger fashion.

Operator: Our next question comes from the line of Michael Petusky with Barrington Research. Please go ahead.

Michael Petusky: So Tim, I guess I wanted to ask on the initial stocking order, you will be able to recognize revenues in Q4 from that initial stocking order. It sounds like you just said that correct?

Timothy Arens: No, that is incorrect. The stocking order. So Mike, just to be clear, let's rewind a bit. We will not recognize revenue on the stocking order until the product leaves our dock. And so you can infer from my comments here that we do not anticipate that we'll be shipping product before the end of September. Just to be clear, the receipt of an Abbott to manufacture SurVeil is a distinct part of the process. Another distinct part of the process is when Abbott wants to receive the product shipment. So Abbott has to decide when they want to receive the shipment. And as you can imagine, it probably has something to do with when they're thinking about the launch. I will also just let folks know, there's 20-some SKUs. And so it's yet to be determined are we shipping all the SKUs simultaneously? Or does Abbott want to receive certain SKUs. So we'll have a lot more. It's exciting but we're in a position here of having received the PMA and working with Abbott's commercialization and we'll have a lot more information over the coming quarters and months.

Gary Maharaj: And remember, the initial stocking order, we have up to 120 days and we might use all of that to produce that product available to be shipped. So it takes us a couple of months. So up to 4 months to actually cool the engine and make sure we can deliver that product when they need.

Michael Petusky: And then, just shifting real quick on the side of [indiscernible], you sort of laid out that, hey, the progress we've made, the $1 million revenue each of the past two quarters, we've made with a small sales team, a fraction of the size of some competitors out there, given that you now have some breathing room in terms of cash and likely over the next 12 months or so cash generation, I mean, does it make sense to look towards expanding that team and for really putting some muscle to that effort?

Gary Maharaj: Yes. I'm glad you picked up on that. And the reason I said it is a lot of investors that says, we have no idea of the scale of this percentages don't mean a whole lot. So I wanted to at least let a little bit out that these products are generating over $1 million per quarter and we expect that to grow. There are a couple of things. One, we do have to remain disciplined in our allocation of capital. That being said, as these products get more traction of value analysis committees and up to and including group contracts when you have those needs that are pent up from customers, we're going to strategically increase the size of where the territories where we can have territory managers. Right now, we're constrained. But as we look into what we're doing in fiscal '24, we'll strategically do it. I want to stop short of saying we're going hog-wild and just adding dozens of territory managers. We have a very, very sharp small team now. And what we're looking for are really a player or hungry who can really do justice to the quality and call of these products. And you've heard me wax poetic where I go to conferences and people say these products have had not been created at the end. And so not a single product in our vascular interventions portfolio exists outside of Surmodics. And that's a very important thing. So to answer your question, we'll have a little more color in Q4 but it's a strategic dosing and adding high-caliber sales people, not necessarily doubling the sales force in the next 3 months. There's a limit to how much we can reasonably staff support with the high quality of service that our current sales team does as well. So we'll add us to you but can't get over the cash barrel too much.

Operator: Our next question comes from the line of Jim Sidoti with Sidoti & Company. Please go ahead.

James Sidoti: Gary, how many sales folks does Abbott have that will focus on SurVeil?

Gary Maharaj: I don't know the answer but it's the Abbott vascular sales force, Tim I don't want to guess. It's going to be 100.

Timothy Arens: I remember, Jim, when we think the agreement with Abbott, we had all that information and data honest I have not looked at that.

Gary Maharaj: Well, what's changes the acquisition of CSI who had several hundred but those were coronary and peripheral.

Timothy Arens: So it's large and I would say it's probably, as you think through large Medtech competitors in the space, I would say Abbott's size of their sales force is probably well on the dartboard with everyone.

Gary Maharaj: Yes. And look, what I like about the setup. So I would say, Brooks, the question is clearly matches any of the large strategics. And with the acquisition of CSI, I expect that what's nice about it is, at least in my opinion, I'm not speaking on behalf of Abbott here but in my opinion, Abbott has an incredible stent in [indiscernible] I mean you need a trifecta for this vessel, right? You need a sense, you need atherectomy to prepare the vessel and you need a drug-coated balloon. And what I'm excited about is as the Vascular division has all 3 in the arsenal now and they are formidable sales and marketing organization. So we feel really good about that.

James Sidoti: And how do you feel about your capacity? Do you think you need to add to ramp up to Abbott's demand? Or do you think that you have enough folks and equipment on hand to meet Abbott's demand?

Gary Maharaj: Tim and our operations team have been really carefully monitoring that. As I said, we put the better raw materials component, I don't want any ups there. But Tim, if you're on to chat, I mean we have multiple ships we can go to and stuff.

Timothy Arens: That's right. I think I've addressed this. We're ready, Jim. I think we're ready to support Abbott's commercialization and what their needs are, what we expect there needs to be over the next 12-plus months, not only from an equipment perspective but also from a personnel perspective and raw materials perspective. We're looking forward to the possibility of the future where we're going to be constrained and we have to think differently about people and equipment and space. But I think at least for the next 12-plus months, we should be in good shape. And keep in mind one thing, I may have said in the past but we have proprietary manufacturing technology. I don't know if anybody else has but I know we have it which where we use robotic automation to coat the drugs on these devices. These are not trivial low tech components. So in all of the time, we had a mind to when we do have to manufacture these are robotically controlled machines that actually coat the drug on the product. So those manufacturing cells have a lot of scale potential.

James Sidoti: All right. And then, Tim, can you just talk a little bit about taxes. Why are you going to get the refund in the fourth quarter? Is the $3 million payment, is that all you need to pay on the milestone payment? And when do you think you'll be in a position where you'll be paying cash taxes? Do you think that will happen in fiscal 2024 fiscal 2025?

Timothy Arens: I'll hold off on the second part of your question, James. We still need to do the work to think through fiscal '24 and create our plan and we'll have a lot more to say about guidance in November. But yes, you're right, the tax bill, the cash tax payment that will be into the IRS, I believe at September 15 will be approximately $3 million. And it's for the entire business but obviously driven by the SurVeil milestone payment. It is a little wacky that we have a huge tax expense here in Q3 and then we're going to revert to a tax benefit in the fourth quarter. That's because we're back in an operating loss position. And you can do the guidance and you will recognize that we will be in an operating loss position. We'll have a tax benefit. That's probably going to put us in a position where it's going to be were you don't see it very often but we're going to be in a position where I expect that we'll even have a favorable and positive on GAAP EPS and non-GAAP EPS. But if you combine the two and the IRS and from a tax perspective, you don't smooth this stuff. But if you combine Q3 and Q4, you actually have about of the $4 million tax expense. And unfortunately, it just makes it really lumpy and that's probably the best way to describe it. We'll get through the lumpiness here and we'll have about a $3 million tax payment, as I mentioned. So cash is really the thing we're paying attention to here.

Operator: Thank you, ladies and gentlemen. As there are no further questions, that concludes our conference for today. Thank you for your participation. You may now disconnect your lines.