News Column

SURMODICS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 1, 2014

The following discussion and analysis provides information that we believe is useful in understanding our operating results, cash flows and financial condition. The discussion should be read in conjunction with both the unaudited condensed consolidated financial statements and related notes included in this Form 10-Q, and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2013. This discussion contains various "Forward-Looking Statements" within the meaning of the Private Securities Litigation Reform Act of 1995. We refer readers to the statement entitled "Forward-Looking Statements" located at the end of this Item 2.



Overview

SurModics is a leading provider of surface modification and in vitro diagnostic technologies to the healthcare industry. In fiscal 2014, our business performance continued to be driven by growth from our Medical Device hydrophilic coatings royalty revenue, product sales and contract coating services included in research and development revenue. Our In Vitro Diagnostics segment realized decreased demand in the first nine months of fiscal 2014 driven primarily by a shift in order patterns in the second quarter of fiscal 2014 by a few key customers who initiated inventory rebalancing programs, a slowdown in European sales, which continued throughout the third quarter, and recent increased competition related to our BioFx product offerings. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. For financial accounting and reporting purposes, we report our results for the two reportable segments as follows: (1) the Medical Device unit, which is comprised of surface modification coating technologies to improve access, deliverability, and predictable deployment of medical devices, as well as drug delivery coating technologies to provide site-specific drug delivery from the surface of a medical device, with end markets that include coronary, peripheral, and neurovascular, and urology, among others, and (2) the In Vitro Diagnostics unit, which consists of component products and technologies for diagnostic immunoassay and molecular tests and biomedical research applications, with products that include protein stabilization reagents, substrates, antigens and surface coatings. We made this determination based on how we manage our operations and the information provided to our chief operating decision maker who is our Chief Executive Officer. We derive our revenue from three primary sources: (1) royalties and license fees from licensing our proprietary surface modification and device drug delivery technologies and in vitro diagnostic formats to customers; the vast majority (typically in excess of 90%) of revenue in the "royalties and license fees" category is in the form of royalties; (2) the sale of reagent chemicals to licensees and the sale of stabilization products, antigens, substrates and surface coatings to the diagnostic and biomedical research markets; and (3) research and commercial development fees generated on customer projects. Revenue fluctuates from quarter to quarter depending on, among other factors: our customers' success in selling products incorporating our technologies; the timing of introductions of licensed products by our customers; the timing of introductions of products that compete with our customers' products; the number and activity level associated with customer development projects; the number and terms of new license agreements that are finalized; and the value of reagent chemicals and other products sold to customers. In our Medical Device business unit, we have licensed our Photolink® hydrophilic technology to a number of our customers for use in a variety of medical device surface applications. We have several U.S. and international issued patents and pending international patent applications protecting various aspects of these technologies, including compositions, methods of manufacture and methods of coating devices. The expiration dates for these patents and the anticipated expiration dates of the patent applications range from 2015 to 2033. These patents and patent applications represent distinct families, with each family generally covering a successive generation of the technology, including improvements that enhance coating performance, manufacturability, or other important features desired by our customers. Among these, an early generation of our Photolink® hydrophilic technology is protected by a family of patents that are expected to expire in November 2015 (in the U.S.) and October 2016 (in certain other countries). We estimate the royalty revenue associated with this early generation technology that has not yet converted, or that is not in the process of converting, to one of our advanced generation technologies will comprise approximately 18% of our anticipated fiscal 2014 revenue. A majority of the customer products utilizing this early generation technology (representing approximately 13% of our anticipated fiscal 2014 revenue) will continue to generate royalty revenue at a reduced royalty rate beyond the expiration of these patents. The royalty obligation for these customer products extends beyond the expiration of these patents because the license also includes rights to our know-how or other proprietary rights. Under these circumstances, the royalty obligation will continue at a reduced royalty rate for a specified number of years, as determined based on the specific terms and conditions of the applicable customer agreement, the date on which the customer's product was first sold, and other factors. In recent years, we have successfully converted a number of our customer's products utilizing this early generation technology to one of our advanced generation technologies. While we are actively seeking to convert our customers to one of our advanced generations of our hydrophilic coating technology, there can be no assurance that we will be successful in doing so, or that those customers that have converted, or will convert, will sell products utilizing our technology which will generate earned royalty revenue for us. 21



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Overview of Research and Development Activities

We manage our customer-sponsored research and development ("R&D") programs based largely on the requirements of our customers. In this regard, our customers typically establish the various measures and metrics that are used to monitor a program's progress, including key deliverables, milestones, timelines, and an overall program budget. The customer is ultimately responsible for deciding whether to continue or terminate a program, and does so based on research results (relative to the above measures and metrics) and other factors, including their own strategic and/or business priorities. Customer R&D programs are mainly in our Medical Device segment. Our internal R&D activities are engaged in the exploration, discovery and application of technologies that solve meaningful problems in the diagnosis and treatment of disease. Our key R&D activities include efforts that support and expand our core offerings. These efforts include activities that support the development of our coating technologies that enhance drug-coated balloons. In the second quarter of fiscal 2013, we completed development activities and launched our next generation hydrophilic coating platform which is now commercially available under the tradename SereneTM (formerly referred to as Gen 5). We also launched in July 2013 a new in vitro diagnostic product, StabliZyme ® Protein-Free Stabilizer, which focuses on stabilizing biomolecule activity in assay tests. Additional planned activities include initiation of surface modification experiments that improve medical device performance and developing chemistries to support molecular diagnostic applications. For our internal R&D programs in our segments, we prioritize these programs based on a number of factors, including a program's strategic fit, commercial impact, potential competitive advantage, technical feasibility, and the amount of investment required. The measures and metrics used to monitor a program's progress vary based on the program, and typically include many of the same factors discussed above with respect to our customer R&D programs. We typically make decisions to continue or terminate a program based on research results (relative to the above measures and metrics) and other factors, including our own strategic and/or business priorities, and the amount of additional investment required. With respect to cost components, R&D expenses consist of labor, materials and overhead costs (for example, utilities, depreciation, and indirect labor) for both customer R&D and internal R&D programs. We manage our R&D organization in a flexible manner, balancing workloads/resources between customer R&D and internal R&D programs primarily based on the level of customer program activity. Therefore, costs incurred for customer R&D and internal R&D can shift as customer activity increases or decreases.



Critical Accounting Policies

Critical accounting policies are those policies that require the application of management's most challenging subjective or complex judgment, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Critical accounting policies involve judgments and uncertainties that are sufficiently likely to result in materially different results under different assumptions and conditions. For a detailed description of our critical accounting policies, see the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2013.



Results of Operations - Three and Nine Months Ended June 30

Revenue. Revenue during the third quarter of fiscal 2014 was $14.6 million, an increase of $0.4 million, or 2%, compared with the third quarter of fiscal 2013. Revenue during the first nine months of fiscal 2014 was $42.1 million, an increase of $0.3 million, compared with the same period of fiscal 2013. The increase in revenue, as detailed in the table below, is further explained in the narrative below. Three Months Ended June 30, % Nine Months Ended June 30, % (Dollars in thousands) 2014 2013 Change 2014 2013 Change Revenue Medical Device $ 10,821$ 10,591 2 % $ 31,852$ 30,857 3 % In Vitro Diagnostics 3,795 3,698 3 % 10,251 10,978 (7 )% Total Revenue $ 14,616$ 14,289 2 % $ 42,103$ 41,835 1 % Medical Device. Medical Device revenue was $10.8 million in the quarter ended June 30, 2014, an increase of 2% compared with $10.6 million for the same prior-year quarter. Medical Device revenue was $31.9 million in the first nine months of fiscal 2014, an increase of 3% compared with $30.9 million for the same prior-year period. The increase in the total revenue for both the three and nine months ended June 30, 2014 was attributable to higher royalty revenue ($0.1 million and $0.3 million, respectively), product 22



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sales ($0.4 million and $0.6 million, respectively) and R&D revenue ($0.3 million and $0.6 million, respectively). The increase in royalty revenue and product sales revenue resulted from continued growth in our hydrophilic coatings and drug delivery offerings. R&D revenue increased from increased hydrophilic contract coating services and customer development activities. Fiscal year 2013 third quarter and nine month results included license fee revenue of $0.5 million based on a customer achieving a milestone event in the third quarter. In addition, fiscal 2013 nine-month revenue included a $0.6 million one-time royalty catch-up payment. In Vitro Diagnostics. In Vitro Diagnostics revenue was $3.8 million in the quarter ended June 30, 2014, an increase of 3% compared with $3.7 million for the same prior-year quarter. In Vitro Diagnostics revenue was $10.3 million in the first nine months of fiscal 2014, a decrease of 7% compared with $11.0 million for the prior-year period. The $0.1 million increase for the third quarter was attributable to higher sales of micro-array slides ($0.3 million), antigens ($0.2 million) and BioFX branded products ($0.1 million) offset substantially by lower stabilization sales which declined $0.5 million. The $0.7 million decrease for the nine months was attributable to lower sales of stabilization products ($0.7 million), antigens ($0.3 million) and commercial R&D revenue ($0.1 million) offset partially by increases in micro-array slides ($0.4 million). The decline in the current year revenue was primarily driven by a shift in order patterns by a few key customers who initiated inventory rebalancing programs in the second fiscal quarter related to our stabilization and antigen product lines combined with a slowdown in sales in Europe, which continued throughout the third quarter, and recent increased competition related to our BioFx product offerings. The following is a summary of major costs and expenses as a percent of total revenue: Three Months Ended June 30, Nine Months Ended June 30, 2014 2013 2014 2013 % Total % Total % Total % Total (Dollars in thousands) Amount Revenue Amount Revenue Amount Revenue Amount Revenue Product costs $ 2,037 14 % $ 1,990 14 % $ 5,737 14 % $ 5,894 14 % Research and development 3,655 25 4,009 28 11,488 27 11,145 27 Selling, general and administrative 3,591 25 4,052 28 11,736 28 11,552



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Product costs. Product costs were $2.0 million and $5.7 million or 14% of total revenue in both the three and nine months ended June 30, 2014 compared with $2.0 million and $5.9 million or 14% in each of the respective prior-year periods. Product gross margins were 66% in both the three and nine months ended June 30, 2014 compared with 64% and 65% in the prior-year periods. The increase in product gross margins in the current year three-month and nine-month periods primarily reflected improved manufacturing leverage from higher production levels. Research and development expenses. R&D expenses were $3.7 million and $11.5 million in the third quarter and first nine months of fiscal 2014, respectively, or 25% and 27% of total revenue, respectively, compared with $4.0 million and $11.1 million or 28% and 27% in the respective prior-year periods. The fiscal 2014 third quarter decrease from fiscal 2013 was primarily the result of $0.3 million of lower compensation costs resulting from our September 2013 restructuring. The increase in expense in the fiscal 2014 nine-month period compared with fiscal 2013 was primarily a result of $1.2 million of higher spending for our drug-coated balloon development activities, offset partially by $0.5 million of lower compensation costs and $0.3 million of lower patent-related legal expenses. We expect R&D expenses to increase 2% to 5% for fiscal 2014 compared with fiscal 2013 as we continue to invest in our drug-coated balloon development program. This overall increase has declined from previous disclosures as the timing of certain expected drug coated balloon expenditures estimated for fiscal 2014 will not be incurred until fiscal 2015. Selling, general and administrative (SG&A) expenses. SG&A expenses were $3.6 million and $11.7 million in the third quarter and first nine months of fiscal 2014, respectively, or 25% and 28% of total revenue, compared with $4.1 million and $11.6 million or 28% of total revenue in both of the respective prior-year periods. The SG&A expense decrease of $0.5 million in the third quarter of fiscal 2014 resulted from $0.2 million in lower compensation costs and $0.1 million of lower professional services expenses covering legal, financial and strategic matters as well as $0.1 million of lower marketing expenses. The increase of $0.1 million for the nine months of fiscal 2014 included $1.4 million of higher compensation expense principally from $0.9 million in higher stock-based compensation expense as a result of accelerated vesting of Board of Director stock awards and the granting of a restricted stock award to the former Chairman of the Company's Board in recognition of his contributions to the Company during his years of service on the Board. A substantial amount of this increase was offset by $0.5 million in lower legal expenses as the prior-year period included higher SRI litigation costs, $0.3 million in lower consulting expenses as the prior-year period included higher costs associated with Medical Device and In Vitro Diagnostic business unit strategic activities and $0.2 million in lower professional services expenses. 23



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Other income, net. Major classifications of other income are as follows:

Three Months Ended Nine Months Ended June 30, June 30, (Dollars in thousands) 2014 2013 2014 2013 Investment income, net $ 42$ 60$ 194$ 187 Gain on sale of strategic investments 28 - 709 1,293 Other-than-temporary impairment of strategic investments - - - (129 ) Other investment capital gains - 2 125 167 Total other income $ 70$ 62$ 1,028$ 1,518



Other income was $0.1 million and $1.0 million in the three and nine months ended June 30, 2014, respectively, compared with $0.1 million and $1.5 million for the respective prior-year periods.

Income from investments in fiscal 2014 remained relatively unchanged at approximately $0.1 million and $0.2 million, respectively, compared with the prior-year periods primarily from higher yields on our investments which were offset by lower investment balances as the result of our share repurchase activities in fiscal 2013 and 2014.



We recorded a gain of $0.7 million in the nine months ended June 30, 2014 associated with contingent clinical and sales milestone payments resulting from the fiscal 2013 sale of our ownership interest in Vessix Vascular, Inc. ("Vessix").

We recorded a gain of $1.3 million in the nine months ended June 30, 2013 associated with both the sale of our investment position in OctoPlus N.V. ("OctoPlus") and the sale of our ownership interest in Vessix.

In the nine months ended June 30, 2013, we recorded a $0.1 million other-than-temporary impairment loss related to our investment in ViaCyte, Inc.

In addition, in the nine months ended June 30, 2014 and 2013, we recognized $0.1 million and $0.2 million, respectively, in realized investment gains associated with our investment portfolio. Income tax provision. The reconciliation of the statutory U.S. federal tax rate of 35.0% and the Company's effective tax rate from continuing operations for the three and nine months ended June 30, 2014 and 2013 is as follows: Three Months Ended Nine Months Ended June 30, June 30, 2014 2013 2014 2013 Statutory U.S. federal income tax rate 35.0 % 35.0 % 35.0 % 35.0 % State income taxes, net of federal benefit 0.6 1.3 0.6 1.3 Gain on strategic investments - (2.2 ) (1.3 ) (1.7 ) Discrete item - capital loss carryback - - - (1.8 ) Discrete item - 2012 retroactive R&D federal tax credit - - - (1.0 ) Discrete item - state tax reserve release - - (1.7 ) (1.2 ) Discrete items - other (0.7 ) (5.7 ) - (1.4 ) Strategic investment (2.9 ) (2.3 ) (1.5 ) (2.7 ) Effective tax rate from continuing operations 32.0 % 26.1 % 31.1 % 26.5 % The difference between the U.S. federal statutory tax rate of 35.0% and the Company's effective tax rate reflects the impact of state income taxes, permanent tax items, valuation allowance changes for utilization of capital losses and discrete tax items. The income tax provision associated with continuing operations was $1.7 million and $4.4 million, respectively, for the three and nine months ended June 30, 2014 resulting in respective effective tax rates of 32.0% and 31.1%. The income tax provision associated with continuing operations was $1.1 million and $3.9 million for the three and nine months ended June 30, 2013, respectively, resulting in respective effective tax rates of 26.1% and 26.5%. The most significant variability in our effective tax rate is the result of changes in capital loss valuation allowances resulting from both gains on the sales of strategic investments or contingent milestone consideration payment and other-than-temporary impairment losses associated with certain strategic investments. We have historically recorded other-than-temporary impairment losses with no income tax effect as it has not been more likely than not that we would generate sufficient capital gains to realize these benefits. Consequently, the OctoPlus, Vessix and available-for-sale securities gains realized during fiscal 2014 or 2013 resulted in a reduction in capital loss carryforward valuation allowances resulting in no financial statement income tax effects associated with these capital gains. 24



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During the nine months ended June 30, 2013, we realized a 1.8% reduction in our effective tax rate as we recognized capital loss carrybacks as a result of the tax capital losses generated by the sale of certain of our strategic investments. During the nine months ended June 30, 2014 and 2013, the effective tax rate was reduced by 1.3% and 1.7% for net capital gains including the impact of a gain related to Vessix milestone contingent consideration payments and a gain on sale of our ownership interest in Vessix stock, respectively, for which there is tax expense recognized which has been offset by the reversal of a capital loss valuation allowance. We may receive an additional maximum of $3.4 million of future contingent payments through fiscal 2017 based on sales of Vessix products. These proceeds, if any, will generate capital gains which will result in reduction of the existing capital loss carryforward valuation allowance. Discontinued operations. The following is a summary of the operating results of SurModics Pharmaceuticals discontinued operations for the three and nine months ended June 30, 2014 and 2013: Three Months Nine Months Ended June 30, Ended June 30, (Dollars in thousands) 2014 2013 2014 2013 (Loss) income from discontinued operations $ (117 )$ 136$ (117 )$ 1,151 Income tax benefit (provision) 41 (183 )



41 (516 )

(Loss) income from discontinued operations, net of income taxes $ (76 )$ (47 )$ (76 )$ 635 (Loss) income from discontinued operations. The Company's discontinued operations gains and losses are recorded net of the income tax impact of these transactions. The Company recorded discontinued operations loss of $0.1 million in each of the three and nine-month periods ended June 30, 2014 associated with the resolution of the SRI litigation matter discussed in Footnote 17 to the financial statements included in this report. The Company recorded discontinued operations loss of less than $0.1 million and income of $0.6 million for the three and nine months ended June 30, 2013 related to this litigation matter. The loss in the three months ended June 30, 2013 reflects a $0.2 million pre-tax gain from the termination of recapturable job creation financial incentives provided by the State of Alabama offset by an income tax provision resulting from finalization of the fiscal 2012 federal and state income tax returns and adjustment of the recorded fiscal 2012 tax provision. The discontinued operations income of $0.6 million for the nine months ended June 30, 2013 is principally from a $1.2 million pre-tax gain from the settlement of recapturable job creation financial incentives provided by the City of Birmingham, Alabama. In this settlement, the Company paid $325,000 of $1.5 million of the recapturable financial incentives which were previously fully accrued by the Company as a discontinued operations liability.



Segment Operating Results

Operating income for each of our reportable segments was as follows:

Three Months Ended Nine Months Ended June 30, June 30, % (Dollars in thousands) 2014 2013 %Change 2014 2013 Change Operating income: Medical Device $ 5,855$ 5,223 12 % $ 16,466$ 15,848 4 % In Vitro Diagnostics 974 915 6 % 2,277 2,933 (22 )% Total segment operating income 6,829 6,138 18,743 18,781 Corporate (1,496 ) (1,900 ) (21 )% (5,601 ) (5,537 ) 1 % Total operating income from continuing operations $ 5,333$ 4,238 26 % $ 13,142$ 13,244 (1 )% Medical Device. Operating income was $5.9 million in the third quarter of fiscal 2014, compared with $5.2 million in the third quarter of fiscal 2013. Operating income was $16.5 million in the first nine months of fiscal 2014, compared with $15.8 million in the same period of fiscal 2013. The increase in operating income of $0.6 million in the three months ended June 30, 2014, compared with the prior-year period, resulted from the gross margin impact of $0.4 million of higher reagent product sales and $0.3 million of higher R&D revenue offset substantially by $0.5 million in lower royalty and license fee as the prior-year period included license fee revenue associated with a customer's milestone event. Direct operating expenses decreased $0.4 million in the three months ended June 30, 2014, compared with the prior-year period, with the majority of the decrease from $0.2 million in lower compensation costs following the September 2013 organizational changes and $0.1 million decrease in spending with the drug coated-balloon development program based on timing of activities in the program. Allocated corporate costs decreased $0.1 million in the three months ended June 30, 2014 when compared with the prior-year period. 25



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The increase in operating income of $0.6 million for the nine months ended June 30, 2014, compared with the prior-year period, resulted from the gross margin impact from $0.6 million of higher reagent product sales and $0.6 million of higher R&D revenue offset partially by $0.2 million of lower royalty and license fee revenue as the prior-year period included the customer milestone event referenced previously. Offsetting the increased revenue was higher direct operating expenses of $0.4 million principally from $1.2 million of additional expenses associated with the drug-coated balloon development program offset by $0.4 million of lower compensation costs. Allocated corporate costs were $4.0 million and $4.1 million in the nine months ended June 30, 2014 and 2013, respectively. In Vitro Diagnostics. Operating income was $1.0 million in the third quarter of fiscal 2014, compared with $0.9 million in the third quarter of fiscal 2013. Operating income was $2.3 million in the first nine months of fiscal 2014, compared with $2.9 million in the same period of fiscal 2013. The increase in operating income of $0.1 million in the three months ended June 30, 2014 was a result of the gross margin impact from $0.6 million of higher microarray slides, antigen and BioFX branded product sales offset by $0.5 million of lower stabilization product sales. Product gross margins were 62.2% and 60.1% for the three months ended June 30, 2014 and 2013, respectively. Direct operating expenses increased $0.1 million in the three months ended June 30, 2014 compared with the prior-year period resulting from $0.2 million in fees for professional services offset by lower spending in several other expenses. Allocated corporate costs remained relatively unchanged in both periods. The decrease in operating income of $0.7 million in the nine months ended June 30, 2014 was a result of the gross margin impact of $1.1 million of lower stabilization, antigens, reagents and BioFX branded product sales offset partially by $0.4 million in higher revenue from microarray slides. Product gross margins were 61.9% and 61.2% for the nine months ended June 30, 2014 and 2013, respectively. Direct operating expenses increased $0.3 million in the nine months ended June 30, 2014 compared with the prior-year period principally from $0.3 million in increased fees for professional services. Allocated corporate costs decreased by $0.1 million in the nine months ended June 30, 2014, compared with the comparable prior-year period. Corporate. The Corporate category includes expenses for administrative corporate functions, such as executive, corporate accounting, legal, human resources and Board of Directors related fees and expenses, which have not been fully allocated to the Medical Device and In Vitro Diagnostics segments. Corporate also includes expenses, such as litigation, which are not specific to a segment and thus not allocated to our operating segments. The unallocated Corporate expense operating loss was $1.5 million and $1.9 million in the three months ended June 30, 2014 and 2013, respectively, and $5.6 million and $5.5 million in the nine months ended June 30, 2014 and 2013, respectively. Share-based compensation expenses decreased $0.1 million and increased $1.0 million in the three and nine months ended June 30, 2014, compared with the comparable prior-year periods. The increase in the nine-month expense was primarily from $0.9 million in additional expense related to the accelerated vesting of Board of Director stock awards and granting of an award to the former Chairman of the Company's Board in recognition of his contributions to the Company during his years of service on the Board. Other compensation costs increased $0.2 million in the nine months ended June 30, 2014 resulting from increased headcount, annual salaries effective October 1, 2013 and our insurance premiums. Legal expenses decreased $0.4 million in the nine months ended June 30, 2014 as the prior-year period included higher expenses related to the SRI litigation. In fiscal 2014 we were reimbursed by SRI for a substantial portion of our legal expenses pursuant to an agreement reached in the fourth quarter of fiscal 2013.



Liquidity and Capital Resources

As of June 30, 2014, we had working capital of $46.7 million, an increase of $16.9 million from September 30, 2013. Our cash, cash equivalents and available-for-sale securities totaled $57.1 million at June 30, 2014, a decrease of $1.0 million from $58.1 million at September 30, 2013, principally resulting from share repurchases of $12.5 million and capital expenditures of $1.2 million in the first nine months of fiscal 2014 offset by cash generated by continuing operations of $12.5 million. Our investments consist principally of U.S. government and government agency obligations, asset-backed securities, mortgage-backed securities and investment grade, interest-bearing corporate and municipal debt securities with varying maturity dates, the majority of which are five years or less. The Company's investment policy excludes ownership of collateralized mortgage obligations, mortgage-backed derivatives and other derivative securities without prior written approval of the Board of Directors. The Company's investment policy requires that no more than 5% of investments be held in any one credit or issue, excluding U.S. government and government agency obligations. The primary investment objective of the portfolio is to provide for the safety of principal and appropriate liquidity while generating an above benchmark ("Merrill Lynch 1-3 Year Government-Corporate Index") total rate of return on a pre-tax basis. Management plans to continue to direct its investment advisors to manage the Company's securities investments primarily for the safety of principal for the foreseeable future as it continues to assess other investment opportunities and uses of its cash and securities investments, including those described below. 26



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On November 4, 2013, we entered into a three-year $20.0 million secured revolving credit facility. Borrowings under the credit facility, if any, will bear interest at a benchmark rate plus an applicable margin based on the Company's leverage ratio. No borrowings have been made on the credit facility and the Company is in compliance with all covenants, including a maximum leverage ratio and a minimum EBITDA amount. The following table depicts our cash flows provided by operating activities from continuing operations: Nine Months Ended June 30, (Dollars in thousands) 2014 2013 Net income $ 9,687$ 11,481 Loss (income) from discontinued operations 76 (635 ) Depreciation and amortization 2,054 2,174 Stock-based compensation 3,043 1,983 Deferred tax (98 ) 34 Net other operating activities (1,287 ) (1,079 ) Net change in other operating assets and liabilities (1,009 )



(2,054 )

Net cash provided by operating activities from continuing operations $ 12,466$ 11,904 Operating Activities. We generated cash flows from operating activities from continuing operations of $12.5 million and $11.9 million for the first nine months ended June 30, 2014 and 2013, respectively. The fiscal 2014 nine-month period increase compared with fiscal year 2013 reflected incremental cash generation of $0.9 million from accrued income taxes, accounts payable and accrued liability balances, $0.2 million from a reduction in prepaids and other assets and $0.1 million from a decrease in inventory partially offset by usage of cash flow of $0.2 million from accounts receivable and $0.5 million from adjustments to net income as noted in the table above. Investing Activities. We invested $1.2 million in property and equipment in the first nine months of fiscal 2014, compared with $1.4 million in the prior-year period, primarily as a result of higher spending on building improvements in the 2013 period. We have invested $0.6 million in building improvements and $0.6 million in laboratory and production equipment in the nine months of fiscal 2014. We anticipate spending an additional $1.0 million to $1.3 million on building improvements and equipment purchases for the remainder of fiscal 2014 which would result in a full year increase when compared with our fiscal 2013 investment of $1.9 million. Our sales of available-for-sale securities less the amounts reinvested in securities also provided cash of $25.3 million. We received cash of $0.7 million (contingent milestone payments associated with the sale of our ownership interest in Vessix Vascular) and $2.3 million (sale of shares of Vessix Vascular and OctoPlus) in the first nine months of fiscal 2014 and 2013, respectively. In the first nine months of fiscal 2014 and 2013, we invested cash associated with our discontinued operations of $0.2 million and $0.1 million, respectively. Financing Activities. We used cash related to our financing activities of $12.9 million and $10.3 million in the first nine months of fiscal 2014 and 2013, respectively. In July 2013, our Board of Directors authorized the repurchase of up to $20.0 million of the Company's outstanding common stock through open-market purchases, private transactions, block trades, accelerated share repurchase transactions, tender offers, or by any combination of such methods. During the first nine months of fiscal 2014, we repurchased 485,577 shares of common stock for $11.5 million at an average price of $23.77 per share. As of June 30, 2014, there was no remaining amount available for future share repurchases under the July 2013 repurchase authorization. We also used cash of $1.1 million in the first nine months of fiscal 2014 to purchase common stock to pay employee taxes resulting principally from issuance of common shares associated with our fiscal year 2011-2013 performance share program. In fiscal 2013, we used cash totaling $10.3 million to repurchase 405,290 shares at an average price of $25.47 under a repurchase authorization approved by our board of directors in January 2013. We believe that our existing cash, cash equivalents and available-for-sale securities, which totaled $57.1 million as of June 30, 2014, together with cash flow from operations and our credit facility, will provide liquidity sufficient to meet the below-stated needs and fund our operations for the remainder of fiscal 2014. There can be no assurance, however, that SurModics' business will continue to generate cash flows at current levels, and disruptions in financial markets may negatively impact our ability to access capital in a timely manner and on attractive terms. Our anticipated liquidity needs for the remainder of fiscal 2014 may include, but are not limited to, the following: general capital expenditures in the range of $1.0 million to $1.3 million and obligations remaining after the Pharma Sale, including indemnification obligations of $2.5 million to Evonik related to contingent consideration payments from the acquisition of assets from PR Pharmaceuticals in November 2008. Discontinued Operations. Our Pharmaceuticals discontinued operation used cash in operating activities of $0.2 million and $0.1 million in the first nine months of fiscal 2014 and 2013, respectively. Cash used in discontinued operations in fiscal 2014 related to payments made in connection with the resolution of the SRI litigation matter discussed in Footnote 17 to the financial statements included in this report, and payments of certain accounts payable 27



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balances. Cash used in discontinued operations in fiscal 2013 related to payments to settle the City of Birmingham job incentive obligation and other accrued liability payments partially offset by cash received from remaining accounts receivable balances. Cash generated by financing activities of $0.2 million and $0.1 million in the first nine months of fiscal 2014 and 2013, respectively, related to transfers of cash from the continuing operations of SurModics and consisted of cash used for the matters previously mentioned. Customer Concentrations. Our licensed technologies provide royalty revenue, which represents the largest revenue stream to the Company. We have licenses with a diverse base of customers and certain customers have multiple products using our technology. Medtronic, Inc. ("Medtronic") was our largest customer comprising 19% of total revenue for fiscal 2013 and remains at this level for the first nine months of fiscal 2014. Medtronic has several separately licensed products that generate royalty revenue for SurModics, none of which represented more than 7% of SurModics' total revenue. No other individual customer using licensed technology constitutes more than 10% of SurModics' total revenue.



Off-Balance Sheet Arrangements

As of June 30, 2014, the Company did not have any off-balance sheet arrangements with any unconsolidated entities.

Forward-Looking Statements

This Quarterly Report on Form 10-Q, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 2, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include expectations concerning our growth strategy, including our ability to sign new license agreements, broaden our hydrophilic coatings royalty revenue and convert our customers using early generation technology to one of our advanced generation technologies, product development programs, various milestone achievements, research and development expenses, increased legal expenses within selling, general and administrative expenses, future cash flow and sources of funding, short-term liquidity requirements, future property and equipment investment levels, the impact of potential lawsuits or claims, and the impact of Medtronic, as well as other significant customers, including new diagnostic kit customers. Without limiting the foregoing, words or phrases such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "intend," "may," "plan," "possible," "project," "will" and similar terminology, generally identify forward-looking statements. Forward-looking statements may also represent challenging goals for us. These statements, which represent the Company's expectations or beliefs concerning various future events, are based on current expectations that involve a number of risks and uncertainties that could cause actual results to differ materially from those of such forward-looking statements. We caution that undue reliance should not be placed on such forward-looking statements, which speak only as of the date made. Some of the factors which could cause results to differ from those expressed in any forward-looking statement are set forth under "Risk Factors" in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended September 30, 2013. We disclaim any intent or obligation to update publicly these forward-looking statements, whether because of new information, future events or otherwise. Although it is not possible to create a comprehensive list of all factors that may cause actual results to differ from our forward-looking statements, such factors include, among others:



• our reliance on a small number of significant customers, which causes our

financial results and stock price to be subject to factors affecting those

significant customers and their products, the timing of market

introduction of their or competing products, product safety or efficacy

concerns and intellectual property litigation could adversely affect our

growth strategy and the royalty revenue we derive; • general economic conditions which are beyond our control, such as the impact of recession, business investment and changes in consumer confidence;



• a decrease in our available cash or the value of our investment holdings

could impact short-term liquidity requirements and expected capital and

other expenditures;



• the difficulties and uncertainties associated with the lengthy and costly

new product development and foreign and domestic regulatory approval

processes, such as delays, difficulties or failures in achieving

acceptable clinical results or obtaining foreign or U.S. Food and Drug

Administration marketing clearances or approvals, which may result in lost

market opportunities or postpone or preclude product commercialization by

licensees; • the development of new products or technologies by competitors,



technological obsolescence and other changes in competitive factors as

well as our ability to perform successfully certain product development

activities, the related R&D expense impact and governmental and regulatory

compliance activities which we have not previously undertaken in any significant manner;



• our ability to successfully convert our customers from an early generation

of our Photolink® hydrophilic technology protected by a family of patents expected to expire in November 2015 (in the U.S.) and October 2016 (in



certain other countries) to one of our advanced generation technologies;

and



• other factors described in "Risk Factors" and other sections of SurModics'

Annual Report on Form 10-K for the fiscal year ended September 30, 2013, which you are encouraged to read carefully. 28



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Many of these factors are outside the control and knowledge of us, and could result in increased volatility in period-to-period results. Investors are advised not to place undue reliance upon our forward-looking statements and to consult any further disclosures by us on this subject in its filings with the SEC.


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