SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
Annual Report Pursuant to Section 13 or 15(d) of
The Securities Exchange Act of 1934
For the fiscal year ended September 30, 1999
Commission file number 0-23837
SURMODICS, INC.
(Name of Small Business Issuer in its Charter)
Minnesota 41-1356149
(State or Other Jurisdiction of (IRS Employer Identification Number)
Incorporation or Organization)
9924 West 74th Street
Eden Prairie, Minnesota 55344
(Address of Principal Executive Offices; Zip Code)
Issuer's telephone number Including Area Code: (612) 829-2700
Securities registered Under Section 12(b) of the Act: None
Securities registered Under Section 12(g) of the Act: Common Stock
Check whether the Issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 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.
X Yes ____ No
Check if no disclosure of delinquent filers pursuant to Item 405 of Regulation
S-B is contained in this form, and no disclosure will be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB. [ X ]
The issuer's revenues for the fiscal year ended September 30, 1999 were
$13,493,540.
The aggregate market value of the Issuer's Common Stock held by non-affiliates
(persons other than officers, directors or holders of more than 5% of the
outstanding stock) as of December 15, 1999, was approximately $137.7 million
(based on the closing sale price of the Issuer's Common Stock on such date).
Shares of Common Stock outstanding on December 15, 1999: 7,736,674
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Annual Report to Shareholders for the fiscal year
ended September 30, 1999 are incorporated into Part II of this Form 10-KSB.
Portions of the Registrant's Proxy Statement for its 1999 Annual Meeting of
Shareholders are incorporated by reference into Part III of this Form 10-KSB.
Transitional Small Business Disclosure Format (check one): Yes No X
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PART I
ITEM 1. DESCRIPTION OF BUSINESS
General
SurModics, Inc. ("SurModics" or the "Company") is a leading provider of
surface modification solutions to the medical device industry. The Company's
primary focus is the commercialization of its patented PhotoLink process through
third-party licensing arrangements. PhotoLink is a versatile, easily applied,
light-activated coating technology that modifies medical device surfaces by
creating covalent bonds between those surfaces and a variety of chemical agents.
Through the PhotoLink process, these chemical agents can impart many
performance-enhancing characteristics, such as lubricity, hemocompatibility,
infection resistance and drug delivery, onto the surface of a medical device
without materially changing the dimensions or physical properties of the device.
The Company believes that medical device manufacturers who utilize the Company's
technology are able to significantly improve the performance of their products
and, in many cases, differentiate their products in a highly competitive
marketplace.
The Company focuses on providing high value-added surface modification
solutions to a variety of medical device markets and product categories.
Examples of products in the market or under development that incorporate the
PhotoLink technology include interventional cardiology catheters, vascular
stents, interventional neurology catheters, guide wires and shunts, cardiac
rhythm management devices, and urological and gynecological devices. The surface
properties created by the PhotoLink technology have greatly reduced treatment
times in catheter-based vascular procedures and have shown the potential to
enhance the long-term performance of implantable devices by improving infection
resistance and promoting host cell attachment, growth and subsequent tissue
integration. During fiscal 1999, the Company introduced its first coated
product: 3D-Link Activated Slides. This product is a coated glass slide used by
the genomics market to orient DNA strands for analysis. The Company believes
further opportunities exist to commercialize its PhotoLink technology both in
the genomics market and other market applications.
The Company has commercialized its PhotoLink technology through
licensing arrangements with medical device manufacturers who apply the PhotoLink
coatings to their own products. The Company believes this approach allows it to
focus its resources on further development of its technology and expansion of
its licensing activities, while leveraging the established manufacturing, sales
and marketing capabilities of its licensees. Revenues from these arrangements
include initial license fees, development revenue, minimum royalties, and earned
royalties based on a percentage of licensees' product sales. In addition to
licensing its PhotoLink technology, the Company also licenses certain diagnostic
technology to Abbott Laboratories for use with rapid point-of-care diagnostic
tests, such as pregnancy and strep tests. The Company also manufactures and
sells the chemical reagents used in the PhotoLink process, and offers a line of
stabilization products used to extend the shelf life of immunoassay diagnostic
tests.
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The Company was organized as a Minnesota corporation in June 1979 and
changed its name from BSI Corporation to SurModics, Inc. in June 1997.
Markets and Need for Surface Modification
Recent trends in healthcare toward improved patient outcomes and
reduced total costs have resulted in intense competition for the development of
medical devices that demonstrate superior product performance, reduced procedure
times, improved outcomes and overall cost effectiveness. Medical device
manufacturers have attempted to address these competitive pressures by
developing innovative medical devices manufactured from a wide variety of
synthetic materials, including many new, expensive and exotic materials. In an
effort to further differentiate their products through improved product
performance, a growing number of medical device manufacturers are turning to the
emerging field of surface modification technology. Surface modification
technology enables device manufacturers to provide medical devices with desired
surface characteristics including improved lubricity, hemocompatability and
infection resistance, as well as the ability to deliver drugs and promote cell
growth and tissue integration.
Although it is an emerging field, surface modification technology has
been used to improve medical devices in many different industry segments. The
table below identifies several of these market segments and the surface
properties the Company believes are desired by each segment.
Market Segment Served Desired Surface Property and
Examples of Applications
Interventional cardiology Lubricity: catheters, guide wires
and vascular access Hemocompatability: vascular stents, catheters,
guide wires
Therapeutic drug delivery and release: vascular
stents,catheters
Infection resistance: catheters, implantable
ports
Cardiac rhythm management Lubricity: pacemaker and defibrillator leads,
electrophysiology devices
Hemocompatability: electrophysiology devices
Cardiothoracic surgery Infection resistance: heart valves
Hemocompatability: minimally invasive bypass
devices, vascular grafts, ventricular
assist devices
Cell growth and tissue integration: heart
valves, vascular grafts
Interventional neurology Lubricity: catheters, guide wires
and neurosurgery Infection resistance: catheters, shunts
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Urology and gynecology Lubricity: urinary catheters, incontinence
devices, ureteral stents, fertility devices
Infection resistance: urinary catheters,
incontinence devices, ureteral stents,
fertility devices, penile implants
Orthopedics Cell growth and tissue integration: bone
regeneration
In addition to the above-identified market segments, the Company
believes that one of the next areas of growth for surface modification
technology will be the genomics market. SurModics recently launched its 3D-Link
Activated Slides which provide lower background levels and more consistent
results for reproducible microarrays used in DNA analysis to screen for new
drugs, to sequence unknown portions of the human genome, or to search for signs
of viruses. The Company believes the slides will benefit from surface
modification technology to provide biomolecule immobilization and wettability
properties.
The PhotoLink Solution
PhotoLink is a versatile, easily applied, light-activated coating
technology that modifies medical device surfaces by creating covalent bonds
between those surfaces and a variety of chemical agents. The PhotoLink solution
to surface modification involves the utilization of proprietary, light sensitive
(photochemical) reagents. These reagents can consist of advanced polymers or
active biomolecules having desired surface characteristics and an attached
light-reactive chemical compound (photogroup). When the reagent is exposed to a
direct light source, typically ultraviolet, a photochemical reaction creates a
covalent bond between the photogroup and the surface of the medical device,
thereby imparting the desired property to the surface. A covalent bond is a very
strong chemical bond which results from the sharing of electrons between carbon
molecules of the substrate and the applied coating.
SurModics' proprietary PhotoLink reagents work on most polymer-based
(e.g., plastic) substrates, biological substrates (latex rubber, cellulose,
tissue and natural fibers), and metal and glass substrates. Metal and glass
substrates generally require pretreating with polymers to make a carbon-molecule
available for bonding prior to the application of the PhotoLink reagents. The
reagents are easily applied to a clean material surface by dipping, spraying,
roll coating, ink jetting or brushing. SurModics continues to develop
proprietary photochemical reagents providing new product features while
expanding the number and type of substrates on which the reagents can be
applied.
The Company believes that its proprietary PhotoLink process provides
its licensees with a number of benefits.
o Flexibility. PhotoLink coatings can be applied to many different kinds
of surfaces and can immobilize a variety of chemical, pharmaceutical
and biological agents, which allows licensees to be innovative in the
design of their products without significantly changing the dimensions
or physical properties of the devise.
o Variety of Surface Properties. The PhotoLink process can be tailored to
provide SurModics' licensees with the ability to improve the
performance of their devices by choosing the specific coating
properties desired for particular applications. The PhotoLink
technology also provides the medical device manufacturer with the
ability to combine multiple surface-enhancing characteristics on the
same device.
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o Ease of Use. The PhotoLink coating process is a relatively simple
process that does not require expensive special equipment or the use of
hazardous materials and does not subject the coated products to harsh
chemical, pressure or temperature conditions. Further, PhotoLink
coatings are compatible with all the generally accepted sterilization
processes, so the surface attributes are not lost when the medical
device is sterilized prior to usage.
Surface Properties
SurModics' PhotoLink process has been used by manufacturers of
pacemaker leads, drug infusion catheters, laser and balloon angioplasty
catheters, urinary drainage catheters, vascular closure devices, wound drains,
guide wires, stent delivery catheters, angiography catheters, ureteral stents
and hydrocephalic shunts, among other devices. The PhotoLink process can be used
to provide medical device manufacturers with the following surface properties to
improve product performance:
o Lubricity. Low friction or lubricious coatings reduce the force and
time required for insertion, navigation and removal of devices in
vascular, neurological and urogenital applications. Lubricity also
reduces tissue irritation and damage caused by products such as
catheters, guide wires and endoscopy devices. Based on Company and
licensee testing, when compared to uncoated surfaces, the PhotoLink
process has reduced the friction on surfaces by as much as 85% to 95%,
depending on the substrate being coated.
o Hemocompatibility. Hemocompatible coatings help reduce adverse
reactions that may be created when a device is inserted into the body
and comes in contact with blood. Heparin has been used for decades as
an injectable drug to reduce blood clotting in patients. SurModics can
immobilize heparin on the surface of blood-contacting medical devices
thereby inhibiting blood clotting on the device surface, minimizing
patient risk and enhancing the performance of the device. PhotoLink
heparin coatings have been shown in Company and licensee testing to
reduce blood clotting by greater than 90% compared to uncoated
surfaces.
o Infection Resistance. Antimicrobial coatings are advantageous for most
implantable medical devices where risk of infection is a concern.
PhotoLink technology can apply passive coatings which significantly
reduce bacterial adhesion to the device or active coatings
incorporating antimicrobial agents which kill bacteria around the
device. Testing by the Company has demonstrated that a PhotoLink
coating can reduce the adherence of microorganisms to biomaterial
surfaces by 97% to over 99% depending on the base material of the
device. In addition, when compared to uncoated products, the PhotoLink
process has been shown to increase the uptake of antimicrobial agents
applied to the device just prior to implantation and prolong the
release of these agents.
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o Drug Delivery. PhotoLink technology can be used to create reservoirs to
entrap drugs on the surface of medical devices. These drugs can then be
released from the surface on a controlled basis by tailoring the
polymers, by adjusting the extent of crosslinking, or by using a
barrier coating to control diffusion. For example, SurModics has
developed a PhotoLink coating that would allow a coronary stent
manufacturer to incorporate a drug onto the surface of a stent which
would be released over time to reduce the incidence of restenosis (the
re-narrowing of the artery).
o Wettability. PhotoLink hydrophilic coatings have been shown in tests by
the Company and its licensees to accelerate liquid flow rates on
normally hydrophobic (water repelling) materials by 75%. Rapid
point-of-care diagnostic tests, such as home monitoring or physician
monitoring of glucose levels in diabetics, are currently done by
pricking a patient's finger and carefully placing a drop of blood onto
a polymer strip which is then inserted into a blood glucose reader. The
Company believes that the time it takes for the blood to flow up the
strip to provide the patient with a readout can be dramatically reduced
and the consistency can be greatly improved with PhotoLink technology.
o Cell Growth, Tissue Integration and Other Tissue Engineering. Studies
have shown that attachment of extracellular matrix proteins and
peptides onto surfaces of implantable medical devices improves host
cell attachment, growth and subsequent tissue integration. PhotoLink
technology has been used to coat biomedical devices with photoreactive
collagens and other proteins upon which cells normally grow within the
body. Company studies have shown that biomedical devices (such as
vascular grafts and ocular implants) coated with such proteins, have
improved attachment, growth of cells and acceptance by surrounding
tissues. In addition, the Company is also using its PhotoLink
technology to produce three-dimensional scaffolds to promote bone
regeneration.
o Biomolecule Immobilization. During a DNA gene analysis, typically
hundreds of different probes need to be placed in a pattern on a
surface, called a DNA microarray. These microarrays are used by the
pharmaceutical industry to screen for new drugs, by genome mappers to
sequence unknown portions of the human genome, or by diagnostic
companies to search a patient sample for disease causing bacteria or
viruses. However, DNA does not readily adhere to most surfaces that are
important for DNA assays. The Company has demonstrated a versatile
method for the immobilization of DNA on various surfaces and introduced
a coated slide during fiscal 1999.
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Current Licensing Arrangements
The Company has commercialized its PhotoLink technology through
licensing arrangements with medical device manufacturers who apply the PhotoLink
coatings to their own products in their own facility. The Company believes this
approach allows it to focus its resources on further developing its technology
and expanding its licensing activities, while leveraging the established
manufacturing, sales and marketing capabilities of its licensees for the
marketing of the specific medical device utilizing the PhotoLink technology. The
Company's licensing agreements are designed to allow manufacturers to
incorporate the PhotoLink process into their own manufacturing processes so they
can control production and quality without the need to send product outside
their facility.
The licensing process begins with the medical device manufacturer
specifying the surface characteristics it desires. Because each surface is
unique, the Company routinely conducts a feasibility study at no charge to the
customer to qualify each new potential product application. Once the feasibility
has been proven, the customer typically funds further development by SurModics
to optimize the coating formulation to meet the customer's technical needs. A
license agreement is then executed granting the licensee the rights to use the
technology. SurModics' technical personnel are then available to provide
services in the transfer of the PhotoLink technology into the licensee's
manufacturing process. Such services can include further coating optimization,
process control and trouble shooting which are billable to the licensee. The
Company also manufactures and sells the chemical reagents used by all licensees
in the PhotoLink process, thus creating another source of revenue.
The term of a license agreement is generally for a period of 15 years
or the life of SurModics' patents, whichever is longer, although an agreement
may be terminated for any reason upon prior written notice, typically required
at least 90 days before termination. The worldwide license can be either
exclusive or nonexclusive for a particular medical device, but over 80% of the
Company's licensed applications are nonexclusive. SurModics requires the payment
of a non-refundable license fee which has historically ranged from $25,000 to
$750,000 and quarterly "earned" royalties of 2% to 6% on the sales of products
incorporating SurModics' technology. The amount of license fees and the royalty
rate are based on whether the arrangement is exclusive or nonexclusive, the
perceived value of the PhotoLink application to the device and the size of the
potential market. Certain nonrefundable license and research and development
fees are recoverable by the licensees as offsets against a percentage of future
earned royalties. Most of SurModics' agreements also incorporate a minimum
royalty to be paid by the licensee while the medical devices are developed,
tested and commercialized. In most cases, payment of these minimum royalties
will not commence until several months after the execution of an agreement for a
particular application. On a quarterly basis a client will pay the greater of
earned or minimum royalties to SurModics
Other Products
Stabilization Products
Although the primary focus of the Company is the development and
marketing of its PhotoLink technology, the Company also markets stabilization
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products for use by manufacturers of immunoassay diagnostic tests. SurModics'
StabilCoat and StabilZyme Stabilizers are designed to maintain the activity of
biological components of the immunoassays, resulting in a longer shelf life.
These products offer SurModics' customers the benefit of product differentiation
and improvement while providing the ultimate end users the benefit of a faster
test with fewer steps and fewer errors. In fiscal 1999, SurModics generated $2.3
million of revenue from its stabilization products.
Diagnostic Formats
The Company also licenses a format for in vitro diagnostic tests
developed during the early years of the Company. This format has found broad
application in the expanding area of rapid point-of-care diagnostic testing,
such as pregnancy and strep tests, and generated $2.8 million of royalty revenue
for the Company in fiscal 1999 pursuant to a license agreement with Abbott
Laboratories. Although this revenue is expected to grow in the future with the
increased sales of licensed products, limited additional SurModics-funded
research and development is being undertaken in this area.
Industrial Applications
While it is not the Company's primary focus, the Company occasionally
pursues industrial applications for its PhotoLink technology. The Company only
pursues those applications that are perceived to be high value applications in a
market that is not considered to be price sensitive. To date, revenue associated
with industrial applications has been immaterial and is not expected to be
significant in the foreseeable future.
Research and Development
SurModics' research and development department supports the sales and
marketing staff in performing feasibility studies, providing technical
assistance to potential licensees, optimizing the coating methodologies for
specific licensee applications, assisting in training licensees and integrating
the Company's technology and know-how into licensee manufacturing processes. In
addition, the research and development department works to enhance and expand
the PhotoLink technology through the development of new reagents and new
applications.
As medical devices become more sophisticated and complex, the Company
believes the need for optimized surface properties will grow. The Company
intends to continue its development efforts to expand its PhotoLink technology
to provide additional optimized surface properties to meet these needs. The
Company's technical strategy is to target selected coating characteristics for
further development, in order to facilitate and shorten the license cycle. The
Company has begun to perform research into applications for future products both
on its own and in conjunction with some of its licensees. Some of the research
and development projects currently being worked on include coatings for
site-specific drug release, bone and cartilage repair, enhanced tissue growth,
long-term blood compatibility and DNA immobilization methods. In addition to
expanding the number of medical applications that may use PhotoLink technology,
the Company is working on improving the coating process for metals, developing a
process for coating the interior diameter of medical devices, expanding the
portfolio of PhotoLink reagents, and developing additional proprietary products
in which PhotoLink reagents serve as the end product. An example of this is the
3D-Link Activated Slide.
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The technical staff of the Company consists of 61 employees, including
eleven with Ph.D. degrees, seven with Masters degrees and 40 with Bachelor
degrees, with expertise in chemistry, biomedical engineering, biology,
microbiology, cell biology and biochemistry. The technical staff is organized
into five areas of specialization: hydrophilicity, microbiology,
hemocompatibility, biochemistry and tissue engineering. In addition, a chemistry
group supports the synthesis of new reagents needed by the other five groups.
In fiscal 1998 and 1999, the Company's research and development
expenses were $4.5 million and $5.2 million, respectively. The Company's
research and development efforts are often funded by commercial licensees and
government agencies. Such research and development revenues were approximately
$2.0 million in both years.
Since its founding, the Company has actively participated in the
federal government's Small Business Innovative Research ("SBIR") program to fund
development efforts. Since 1979, 141 research contracts resulting in revenues of
over $25.0 million have been awarded to SurModics, primarily under the SBIR
program. Grant proposals are generally directed toward the commercial strategies
of the Company. The Company retains commercial rights to discoveries and
technologies resulting from the research and development efforts funded by these
grants. Where possible, licensees' products or substrates are used when
performing research under the grant; thus the results are often directly
applicable to SurModics' licensees. Grant funding has also allowed SurModics to
maintain a larger and more technologically diverse employee base than would
otherwise be possible.
Patents and Proprietary Rights
The Company has taken steps intended to protect certain PhotoLink
related inventions through a series of patents covering a variety of coating
methods, reagents and formulations, as well as particular medical device
applications, based on or employing the Company's proprietary photoreactive
chemistry. The patents related to the PhotoLink technology include 16 issued
U.S. patents, twelve pending U.S. patent applications, 30 issued foreign
patents, and 40 pending foreign patent applications. The Company generally files
international patent applications in parallel with its U.S. applications. The
Company generally files national or regional applications in Australia, Canada,
Europe, Japan, and Mexico. In addition to the patents related to the PhotoLink
technology, SurModics has seven issued U.S. patents, one pending U.S. patent
application, 19 issued foreign patents and four pending foreign patent
applications related to its diagnostic technology. There can be no assurance
that any of the pending patent applications will be allowed.
The Company also relies heavily upon trade secrets and unpatented
proprietary technology. The Company seeks to maintain the confidentiality of
such information by requiring employees, consultants and other parties to sign
confidentiality agreements and by limiting access by parties outside the Company
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to such information. The Company also does not divulge the detailed chemical
structure of its reagent chemical to anyone, including clients. There can be no
assurance, however, that these measures will prevent the unauthorized disclosure
or use of this information or that others will not be able to independently
develop such information. Additionally, there can be no assurance that any
agreements regarding confidentiality and non-disclosure will not be breached,
or, in the event of any breach, that adequate remedies would be available to the
Company.
Marketing and Sales
The Company markets its PhotoLink technology throughout the world using
a direct sales force consisting of three licensing managers who focus on
specific markets such as cardiology, neurology, urology and orthopedic products.
This specialization fosters an in-depth knowledge of the issues faced by
SurModics' licensees within these markets such as technology changes,
biomaterial changes and the regulatory environment.
Because the sales cycle can take several months from feasibility
demonstration to the execution of a license agreement, the Company focuses its
sales efforts on potential licensees with established market positions rather
than those with only development stage products which may never come to market.
Generally, the PhotoLink technology is licensed on a nonexclusive basis to
medical device manufacturers for use on specific products. This strategy enables
the Company to license the PhotoLink technology to multiple licensees in the
same market. SurModics also targets selling new applications to existing
licensees. The Company believes the sales cycle is much faster in these
situations because the licensee is already familiar with the technology and the
general terms of the license have already been negotiated.
As part of its marketing strategy, the Company publishes technical
literature on each surface capability of the PhotoLink technology (i.e.,
lubricity, hemocompatibility, etc.). In addition, the Company participates at
major trade shows and technical meetings, advertises in trade journals and
through its website, and conducts direct mailings to appropriate target markets.
The Company also offers ongoing customer service and technical support
throughout a licensee's relationship with SurModics. This service and support
begins with a coating feasibility study at no charge to the licensee and also
includes additional services such as assistance in the transfer of the
technology to the licensee, further coating optimization, process control and
trouble shooting, and assistance with FDA submissions for coated product
approval. Certain of these services are billable to the client.
Competition
Competition in the medical device industry has resulted in an increase
in competition in the surface modification market. The Company's PhotoLink
technology competes with technologies developed by Carmeda (a division of Norsk
Hydro, Inc.), Specialty Coatings Systems, Spire Corporation and STS Biopolymers
Inc., among others. In addition, many medical device manufacturers have
developed or are engaged in efforts to develop surface modification technologies
for use on their own products. Most competitors marketing surface modification
to the outside marketplace are divisions of organizations with businesses in
addition to surface modification. Overall, the Company believes the worldwide
market is very fragmented with no competitor marketing to third parties having
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more than a 10% market share. Some of the Company's existing and potential
competitors (especially medical device manufacturers pursuing coating solutions
through their own research and development efforts) have substantially greater
financial, technical and marketing resources than the Company.
SurModics attempts to differentiate itself from its competition by
providing what it believes is a high value-added solution to surface
modification. The Company believes that the primary factors customers consider
in choosing a particular surface modification technology are performance, ease
of manufacturing, ability to produce multiple properties from a single process,
compliance with manufacturing regulations, customer service and pricing. The
Company believes that its PhotoLink process competes favorably with respect to
these factors, enabling it to charge a premium price. The Company believes that
the cost and time required to obtain the necessary regulatory approvals
significantly reduces the likelihood of a manufacturer changing the coating
process it uses once a device has been approved for sale.
Because a significant portion of the Company's revenue is dependent on
the receipt of royalties based on sales of medical devices incorporating
PhotoLink coatings, the Company is also affected by competition within the
markets for such devices. The Company believes that the intense competition
within the medical device markets creates opportunities for the Company's
coating technology as medical device manufacturers seek to differentiate their
products through new enhancements or to remain competitive with enhancements
offered by other manufacturers. Because the Company seeks to license its
technology on a non-exclusive basis, the Company may further benefit from
competition within the medical device markets by offering its PhotoLink
technology to multiple competing manufacturers of a device. However, competition
in the medical device markets could also have an adverse effect on the Company.
While the Company seeks to license its products to established manufacturers, in
certain cases the Company's licensees may compete directly with larger, dominant
manufacturers with extensive product lines and greater sales, marketing and
distribution capabilities. The Company also is unable to control other factors
that may impact commercialization of PhotoLink-coated devices, such as the
marketing and sales efforts of its licensees or competitive pricing pressures
within the particular device market. There can be no assurance that products
coated with the PhotoLink technology will be successfully commercialized by the
Company's licensees or that such licensees will otherwise be able to effectively
compete.
The primary competition for SurModics' stabilization products is its
customers' internally developed formulations. The consolidation of the
diagnostic industry increases the availability of internally developed
stabilizers to the market. There are several direct competitors that have
recently emerged, of which Pierce Medical Products, Inc. and Medix, Inc. are the
two largest. The Company believes that quick market penetration is the best
strategy for addressing these threats. As in the coating market, the Company
also believes that once its stabilization products are accepted in an
FDA-approved diagnostic test, the likelihood of change is reduced because of the
cost and time required to qualify a new component. SurModics' marketing strategy
for its stabilization products is to develop a strong market presence by
offering superior product performance and technical service.
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Manufacturing
In accordance with its licensing strategy, the Company does not perform
the actual coating of its licensees' medical devices, nor does it manufacture
any of these devices. The Company has, however, adopted a strategy of developing
and manufacturing the reagents itself, allowing it to maintain the quality of
the reagents and their proprietary nature, while providing an additional source
of revenue. PhotoLink reagents are specialty photoreactive chemicals that are
prepared using a proprietary formula in small batch processes (as contrasted
with commodity chemicals prepared by large continuous methods). Generally, all
PhotoLink reagents share a similar production process: a water soluble polymer
is synthesized in a glass reactor; reactive photochemical groups are attached to
the polymer; the solution is purified and freeze-dried, thus removing the water
and creating a solid; and the PhotoLink reagents are packaged in standard
quantities in light- and moisture-proof packaging. The reagents are sold dry,
requiring the licensee, in most cases, to simply add water or a water and
isopropyl alcohol mix before application. The Company has developed proprietary
testing and quality assurance standards for manufacturing the reagents and does
not disclose the reagent formulas or manufacturing methods. Although licensees
may purchase the requisite chemical reagents from any source, all have elected
to purchase them from the Company.
The Company also manufactures its stabilization products. These
products are a group of sterile-filtered liquids that generally share a
three-step production process. A standard recipe of chemicals is mixed in high
purity water, these liquids are sterile-filtered into specific container sizes
under aseptic conditions, and the resultant finished goods are bottled and
labeled.
The Company maintains multiple sources of supply for the key raw
materials used to manufacture reagents and stabilization products. The Company
does, however, purchase some raw materials from single sources, but it believes
that additional sources of supply are readily available.
Although not required to follow Good Manufacturing Practice quality
procedures, SurModics does follow such procedures in part to respond to requests
of licensees to establish compliance with their criteria. The Company has not
yet sought ISO 9001 certification but may do so in the future.
Government Regulation
Although PhotoLink technology itself is not directly regulated by the
FDA, the medical devices incorporating this technology are subject to FDA
regulation. The burden of demonstrating safety and efficacy of such medical
devices, the ultimate criteria applied by the FDA, rests with the Company's
licensees (the medical device manufacturers). Medical products incorporating the
PhotoLink technology may generally be marketed only after 510(k) or PMA
applications have been submitted and approved by the FDA, which process can take
anywhere from six months for a 510(k) application, to two or three years for a
PMA application. These applications are prepared by the manufacturer and contain
results of extensive laboratory toxicity, mutagenicity and clinical evaluations
on animals and humans conducted by the manufacturer.
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The Company maintains confidential Device Master Files at the FDA
regarding the nature, chemical structure and biocompatibility of the PhotoLink
reagents. Although the Company's licensees do not have access to these files,
the licensees may, with the permission of the Company, reference these files in
any medical device submission to the FDA. This process allows the FDA to
understand in confidence the details of the PhotoLink technology without the
Company having to share this highly confidential information with its licensees.
Recent U.S. legislation allows device manufacturers, prior to obtaining
FDA approval to market a medical device in the U.S., to manufacture the device
in the U.S. and export it for sale in international markets, which generally
allows SurModics to realize earned royalties sooner. However, sales of medical
devices outside the U.S. are subject to international requirements that vary
from country to country. The time required to obtain approval for sale
internationally may be longer or shorter than that required by the FDA.
Employees
As of December 1, 1999, SurModics had 102 full-time and 4 part-time
employees of whom 74 were engaged in development or manufacturing positions,
with the remainder in marketing, quality or administrative positions. Of
SurModics' employees, 11 hold Ph.D. degrees and 15 hold Masters degrees. The
Company is not a party to any collective bargaining agreements and believes that
its employee relations are good.
Management believes that the future success of the Company will depend
in part on its ability to attract and retain qualified technical, management and
marketing personnel. Such experienced personnel are in high demand, and the
Company must compete for their services with other firms which may be able to
offer more favorable benefits.
ITEM 2. DESCRIPTION OF PROPERTY
In May 1999, SurModics purchased the land and building it currently
occupies in Eden Prairie, Minnesota for approximately $3.2 million. The purchase
of the building was internally funded and remains unencumbered. The building has
approximately 64,000 square feet of space. The Company occupies approximately
48,000 square feet and rents the remaining 16,000 square feet to two tenants. In
August 1999, the Company began approximately $1.0 million of construction to
convert 12,000 square feet of space previously leased by two tenants to
additional laboratory space and office space. When construction is completed in
December 1999, there will be approximately 17,000 square feet of office space,
23,000 square feet of laboratory space and 8,000 square feet of manufacturing
space. Approximately 6,000 square feet of the manufacturing space is a
HEPA-filtered, highly controlled environment, but not certified as a "clean
room" under FDA standards. The Company believes that projected capacity of the
manufacturing area is adequate to service the needs of its licensees for the
foreseeable future.
12
<PAGE>
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to nor is any of its property subject to any
material pending legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during
the fourth quarter of fiscal 1999.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) Use of Proceeds for the period ending September 30, 1999.
(1) Effective Date: March 3, 1998
SEC File Number: 333-43217
(2) Offering Date: March 3, 1998
(4)(i) The offering has terminated; all securities registered
were sold.
(4)(ii) Managing Underwriter: John G. Kinnard and Company,
Incorporated
(4)(iii) Title of Securities: Common Stock
(4)(iv) Amount Registered: 2,300,000
Aggregate Offering Price: $17,250,000
Amount Sold: 2,300,000
Aggregate Offering Price Sold: $17,250,000
(4)(v) Underwriting Discounts and
Commissions $ 1,293,750
Other Expenses $ 435,148
Total Expenses $ 1,728,898
All the above items represented direct or indirect payments to others.
(4)(vi) Net Offering Proceeds $15,521,102
(4)(vii) Use of Net Offering Proceeds:
Research and development $ 1,066,000
Sales and marketing $ 825,000
Building and equipment upgrades $ 5,046,000
Patent protection $ 111,000
Working capital and general
corporate purposes $ 666,000
Administration $ 62,000
Money market funds $ 7,745,102
All the above items represented direct or indirect payments
to others.
13
<PAGE>
(b) The information required by Item 5 relating to the Company's Common
Stock and other shareholder matters is incorporated herein by reference to the
section entitled "Stock Listing and Price History" which appears in the
Company's 1999 Annual Report to Shareholders.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS
The Section entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations" in the 1999 Annual Report to Shareholders
is incorporated herein by reference.
ITEM 7. FINANCIAL STATEMENTS
The balance sheets as of September 30, 1999 and 1998 and the statements
of operations, stockholders' equity and cash flows for each of the three years
in the period ended September 30, 1999 together with the Report of Independent
Public Accountants contained on pages 14 through 24 of the Company's Annual
Report to Shareholders for the year ended September 30, 1999 are incorporated
herein by reference.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
The names, ages and positions of the Company's executive officers are
as follows:
Name Age Position
- ---- --- --------
Dale R. Olseth ............ 69 Chairman and Chief Executive Officer
James C. Powell ........... 50 President and Chief Operating Officer
Stephen C. Hathaway ....... 44 Vice President and Chief Financial Officer
Patrick E. Guire, Ph.D. ... 63 Senior Vice President of Research and
Chief Scientific Officer
Walter H. Diers, Jr........ 48 Vice President of Corporate Development
Marie J. Versen ........... 38 Vice President of Quality Management and
Regulatory Compliance
14
<PAGE>
Dale R. Olseth joined the Company in 1986 as its President, Chief
Executive Officer and a director of the Company and has served as Chairman since
1988. Mr. Olseth also serves on the Board of Directors of The Toro Company and
Graco Inc. He served as Chairman or President and Chief Executive Officer of
Medtronic, Inc. from 1976 to 1986. From 1971 to 1976, Mr. Olseth served as
President and Chief Executive Officer of Tonka Corporation. Mr. Olseth received
a B.B.A. degree from the University of Minnesota in 1952 and an M.B.A. degree
from Dartmouth College in 1956.
James C. Powell joined the Company in 1987. He became Vice President of
Technical Operations in 1992 and was elected President and Chief Operating
Officer in 1998. He was employed at Precision-Cosmet Company, Inc., a
manufacturer of contact and intraocular lenses, from 1978 until he joined
SurModics. Mr. Powell received a B.S. degree in wood sciences from Texas A&M
University in 1972 and an M.S. degree in polymer science in 1975 from the
University of Washington.
Stephen C. Hathaway joined the Company as its Vice President and Chief
Financial Officer in September 1996. Prior to joining SurModics, he served as
Director of Finance for Ceridian Employer Services, Ceridian Corporation from
1995 to 1996. Prior to that, Mr. Hathaway was Vice President - Finance &
Operations for Wilson Learning Corporation from 1988 to 1995. He also spent ten
years with Arthur Andersen LLP. Mr. Hathaway received a B.S. degree in
accounting in 1977 from Miami University and became a Certified Public
Accountant in 1980.
Patrick E. Guire, Ph.D. is a co-founder of the Company and has served
as Senior Vice President of Research and Chief Scientific Officer and a director
since 1980. Dr. Guire is responsible for the research affairs of the Company.
Prior to founding SurModics, Dr. Guire was employed by Kallestad Laboratories,
Inc. as a senior scientist from 1978 to 1979 and was a researcher at the Midwest
Research Institute, Inc. in Kansas City, Missouri from 1972 to 1978. He received
a B.S. degree in Chemistry from the University of Arkansas, Fayetteville in 1958
and a Ph.D. in biochemistry from the University of Illinois in 1963.
Walter H. Diers, Jr. joined the Company in 1988 and currently serves as
Vice President of Corporate Development. He served as a consultant to several
small, high technology companies from 1984 until he joined SurModics. Prior to
that, he was the Controller of the Laserdyne division of Data Card Corporation.
Mr. Diers received a B.S. degree in economics and a B.S. degree in business in
1977 and an M.B.A. degree in finance in 1979 from the University of Minnesota.
15
<PAGE>
Marie J. Versen joined the Company in 1987, and in 1996 became its Vice
President of Quality Management and Regulatory Compliance. She was previously
employed at Precision-Cosmet Company, Inc. from 1983 to 1986. Ms. Versen
received a B.S. degree in chemical engineering from the University of Minnesota
in 1983.
The executive officers of the Company are elected by and serve at the discretion
of the Board of Directors.
The information required by Item 9 relating to directors and compliance
with Section 16(a) is incorporated herein by reference to the sections entitled
"Election of Directors" and "Section 16(a) Beneficial Ownership Reporting
Compliance" which appear in the Company's definitive proxy statement for its
1999 Annual Meeting of Shareholders.
ITEM 10. EXECUTIVE COMPENSATION
The information required by Item 10 is incorporated herein by reference
to the section entitled "Executive Compensation" which appears in the Company's
definitive Proxy Statement for its 1999 Annual Meeting of Shareholders.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 11 is incorporated herein by reference
to the section entitled "Shareholdings of Principal Shareholders and Management"
which appears in the Company's definitive Proxy Statement for its 1999 Annual
Meeting of Shareholders.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 12 is incorporated herein by reference
to the section entitled "Certain Transactions" in the Company's definitive Proxy
Statement for its 1999 Annual Meeting of Shareholders.
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits. See "Exhibit Index" on the page following signatures.
(b) Reports on Form 8-K. No reports on Form 8-K were filed
during the fourth quarter ended September 30, 1999.
16
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities
Exchange Act of 1934, the Registrant has caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized.
SURMODICS, INC.
("Registrant")
Dated: December 22, 1999 By: /s/ Dale R. Olseth
Dale R. Olseth
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of
1934, this Report has been signed by the following persons on behalf of the
Registrant, in the capacities, and on the dates, indicated.
(Power of Attorney)
Each person whose signature appears below constitutes and appoints DALE
R. OLSETH and STEPHEN C. HATHAWAY as his true and lawful attorneys-in-fact and
agents, each acting alone, with full power of substitution and resubstitution,
for him and in his name, place and stead, in any and all capacities, to sign any
or all amendments to this Annual Report on Form 10-KSB and to file the same,
with all exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents, each acting alone, full power and authority to do and perform each and
every act and thing requisite and necessary to be done in and about the
premises, as fully to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all said attorneys-in-fact and agents,
each acting alone, or his substitute or substitutes, may lawfully do or cause to
be done by virtue thereof.
Signature Title Date
/s/ Dale R. Olseth Chairman, Chief Executive Officer December 22, 1999
Dale R. Olseth and Director (Chief Executive
Officer)
/s/ Stephen C. Hathaway Vice President and Chief Financial December 22, 1999
Stephen C. Hathaway Officer (Chief Financial and
Accounting Officer)
- ------------------------- Director December __, 1999
Donald S. Fredrickson, M.D.
17
<PAGE>
- ------------------------ Director December __, 1999
James J. Grierson
/s/ Patrick E. Guire Director December 22, 1999
Patrick E. Guire
/s/ Kenneth H. Keller Director December 22, 1999
Kenneth H. Keller
/s/ David A. Koch Director December 22, 1999
David A. Koch
/s/ Kendrick B. Melrose Director December 22, 1999
Kendrick B. Melrose
18
<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
EXHIBIT INDEX TO FORM 10-KSB
For the Fiscal Year Ended September 30, 1999
SURMODICS, INC.
Exhibit
3.1 Restated Articles of Incorporation, as amended--incorporated by
reference to Exhibit 3.1 to the Company's Quarterly Report on Form
10-QSB for the quarter ended March 31, 1998, SEC. File No. 0-23837
3.2 Bylaws, as amended to date--incorporated by reference to Exhibit 3.1 to
the Company's Quarterly Report on Form 10-QSB for the quarter ended
December 31, 1998, SEC. File No. 0-23837.
10.1* Company's Incentive 1987 Stock Option Plan, including specimen of
Incentive Stock Option Agreement--incorporated by reference to Exhibit
10.2 to the Company's Registration Statement on form SB-2, Reg. No.
333-43217
10.2* Company's Incentive 1997 Stock Option Plan, including specimen of
Incentive Stock Option Agreement--incorporated by reference to Exhibit
10.3 to the Company's Registration Statement on form SB-2, Reg. No.
333-43217
10.3* Form of Restricted Stock Agreement--incorporated by reference to
Exhibit 10.4 to the Company's Registration Statement on form SB-2, Reg.
No. 333-43217
10.4* Form of Non-qualified Stock Option Agreement--incorporated by reference
to Exhibit 10.5 to the Company's Registration Statement on form SB-2,
Reg. No. 333-43217
10.5 Form of License Agreement--incorporated by reference to Exhibit 10.6 to
the Company's Registration Statement on form SB-2, Reg. No. 333-43217
10.6 License Agreement with Abbott Laboratories dated November 20, 1990, as
amended--incorporated by reference to Exhibit 10.7 to the Company's
Registration Statement on form SB-2, Reg. No. 333-43217
10.7 Purchase and Sale Agreement dated March 31, 1999 between the Company
and Prairie View Jack Ltd.--incorporated by reference to Exhibit 10.1
to the Company's Quarterly Report on Form 10-QSB for the quarter ended
March 31, 1999, SEC. File No. 0-23837.
i
<PAGE>
10.8* SurModics, Inc. Executive Income Continuation Plan--incorporated by
reference to Exhibit 10 to the Company's Quarterly Report on Form
10-QSB for the quarter ended June 30, 1999, SEC. File No. 0-23837.
13 Portions of Annual Report to Shareholders for the fiscal year ended
September 30, 1999 incorporated by reference in this Form 10-KSB
23 Consent of Arthur Andersen LLP
24 Power of Attorney (included on signature page of this Form 10-KSB).
27 Financial Data Schedule
- ----------------
*Management contract or compensatory plan or arrangement
ii
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
General
SurModics is a leading provider of surface modification solutions to
medical device manufacturers. The Company's revenues are derived from four
primary sources: fees from licensing its patented technology to customers;
royalties received from licensees; the sale of photo-reactive chemical compounds
to licensees and stabilization products to the diagnostics industry; and
research and development fees generated on projects for commercial customers and
government grants. In March 1998, the Company completed an initial public
offering ("IPO") of 2.3 million shares of Common Stock which generated proceeds
of approximately $15.5 million, net of related offering expenses.
SurModics' royalty-based economic model once again drove strong
financial performance in fiscal 1999. Total revenues increased 38% to $13.5
million in fiscal 1999 from $9.8 million in fiscal 1998. The overall revenue
growth was led by an 84% increase in PhotoLink-related revenue to a record $7.6
million in fiscal 1999. The Company is continuing to see significant increases
in the usage of the PhotoLink technology as shown by the growth in royalty
revenue and reagent sales. PhotoLink royalties increased 77% to $3.9 million and
reagent sales, those chemicals used by licensees in the PhotoLink coating
process, increased 136% to $1.9 million. These revenue gains resulted in net
income of $4.4 million, or $.54 per diluted share, compared to $1.6 million, or
$.24 per diluted share, in fiscal 1998.
Results of Operations
Years Ended September 30, 1999 and 1998
Revenues. The Company's revenues were $13.5 million in fiscal 1999, an
increase of 38% over fiscal 1998. The revenue components were as follows:
<TABLE>
<CAPTION>
(Dollars in thousands) Fiscal 1999 Fiscal 1998 Increase %Increase
----------- ----------- (Decrease) (Decrease)
---------- ----------
<S> <C> <C> <C> <C>
PhotoLink revenue:
Royalties $3,912 $2,205 $1,707 77%
License fees 645 222 423 191%
Reagent sales 1,876 794 1,082 136%
Commercial development 1,122 891 231 26%
----- --- ---
Total PhotoLink revenue 7,555 4,112 3,443 84%
Diagnostic royalties 2,758 2,578 180 7%
Stabilization products 2,261 2,004 257 13%
Government research 920 1,085 (165) (15%)
--- ----- -----
Total revenues $13,494 $9,779 $3,715 38%
======= ====== ====== ===
</TABLE>
The revenue growth in fiscal 1999 was mainly due to the 84% increase in
PhotoLink revenue between years. PhotoLink royalty revenue increased 77% due to
the introduction of six additional coated products as well as increases in the
sales of previously introduced coated products by licensees. Two of these new
products are already generating meaningful royalties to the Company. SurModics'
clients now have 43 PhotoLink-coated products on the market. Reagent sales
increased 136% due to increased production of PhotoLink-coated devices by these
1
<PAGE>
clients. A single customer purchased 57% of the reagents sold during fiscal 1999
up from 12% in fiscal 1998. It is expected that the reagent purchases by this
customer will decrease in the last half of fiscal 2000. During fiscal 1999,
SurModics signed 14 new license agreements, compared to three new agreements in
fiscal 1998, resulting in a 191% increase in license fees. Three new license
agreements were signed in fiscal 1998. The Company now has license agreements
with 44 companies covering over 100 product applications. Increased
customer-funded development projects resulted in a 26% increase in commercial
development revenue. Approximately 75% of the commercial development revenue
resulted from work on projects for two customers. One of these customers
accounted for 50% of the commercial development revenue in fiscal 1998.
The growth of the non-PhotoLink revenues was more moderate in fiscal
1999. The diagnostic royalties grew 7% between years due to increased product
sales by the licensee. Sales of stabilization chemicals grew 13% between years
as a result of increased market penetration. Finally, revenue from government
grants decreased 15% between years, as the Company has begun to internally-fund
more of its research and development projects rather than relying on these
grants.
Product costs. The Company's product costs were $1.5 million for fiscal
1999, an increase of $300,000, or 27%, over fiscal 1998. Overall product margins
increased to 63% in fiscal 1999 from 57% in fiscal 1998. The margin improvement
was primarily due to cost efficiencies realized in the production of reagent
chemicals as a result of increased production volumes. The margins on
stabilization product sales remained relatively flat between years.
Research and development expense. Research and development expense was
$5.2 million for fiscal 1999, an increase of $700,000, or 16%, over fiscal 1998.
Most of this increase was due to compensation and benefit expenses associated
with the additional technical personnel hired by the Company during the year. In
addition, the Company incurred additional expense on project management training
for its technical personnel and increased legal expense related to the filing of
new patents. These cost increases were offset by a reduction in the amount of
research performed at external laboratories on government grants.
Sales and marketing expense. Sales and marketing expense was $1.8
million for fiscal 1999, an increase of $400,000, or 25%, over fiscal 1998. This
increase was primarily due to compensation and benefit expenses associated with
additional sales and marketing personnel hired during the year, increased
incentive compensation associated with the sales growth and increased
promotional spending. These cost increases were offset by a reduction in market
research costs. An external market study performed last year was not repeated
this year.
General and administrative expense. General and administrative expense
was $2.5 million for fiscal 1999, an increase of $800,000, or 50%, over fiscal
1998. The increase was primarily due to compensation and benefit costs
associated with additional personnel hired during the year, increased expenses
associated with being a public company for the full year (such as investor
relations costs, Nasdaq fees, and other external reporting expenses) and
expenses associated with the shareholder rights plan adopted in fiscal 1999. In
addition, a portion of the overall increase was from expenses associated with
the Company president, who was appointed in the fourth quarter of 1998. The
growth in general and administrative expenses is expected to slow considerably
next year.
Other income, net. The Company's net other income was $1.2 million for
fiscal 1999, an increase of $400,000 or 59%, over fiscal 1998. The increase in
interest income was due to earnings generated on the investments resulting from
the $15.5 million of IPO proceeds received in March 1998. The level of
investments also increased due to the $4.4 million of cash provided by operating
activities in fiscal 1999.
Benefit from income taxes. The Company's net income was benefited by a
positive income tax adjustment. During fiscal 1999, management concluded that
the Company would generate sufficient taxable income in the future to utilize
all of the previously unrecognized tax net operating loss ("NOL") carryforwards
2
<PAGE>
prior to their expiration. Therefore, during fiscal 1999, the Company reversed a
$2.5 million valuation allowance related to these NOL carryforwards.
Years Ended September 30, 1998 and 1997
Revenues. The Company's revenues were $9.8 million in fiscal 1998, an
increase of 29% over fiscal 1997. The revenue components were as follows:
<TABLE>
<CAPTION>
(Dollars in thousands) Fiscal 1998 Fiscal 1997 Increase % Increase
----------- ----------- (Decrease) (Decrease)
---------- ----------
<S> <C> <C> <C> <C>
PhotoLink revenue:
Royalties $2,205 $1,448 $757 52%
License fees 222 540 (318) (59%)
Reagent sales 794 494 300 61%
Commercial development 891 742 149 20%
--- --- ---
Total PhotoLink revenue 4,112 3,224 888 28%
Diagnostic royalties 2,578 1,465 1,113 76%
Stabilization products 2,004 1,665 339 20%
Government research 1,085 1,228 (143) (12%)
----- ----- -----
Total revenues $9,779 $7,582 $2,197 29%
====== ====== ====== ===
</TABLE>
The fiscal 1998 revenue growth was primarily due to an increase in
royalty revenue received from licensed clients. The 52% growth in PhotoLink
royalties was due to increases in the minimum royalty payments from certain
clients, the introduction of 10 additional coated products by the Company's
licensees, and increased earned royalties from greater market penetration of
previously released coated products sold by licensees. The sales of reagent
chemicals increased 61%, as a result of growing production of PhotoLink-coated
devices by SurModics' customers. Commercial development revenue increased 20%
between years due to more customer-funded development projects related to
PhotoLink coatings. Half of this revenue was generated on projects for a single
customer. License revenue decreased due to the completion of fewer new license
agreements during the year. Three new license agreements were signed in fiscal
1998, compared to ten in fiscal 1997.
The 76% increase in diagnostic royalties was due primarily to the
impact of two events in fiscal 1998: a product acquisition by a licensee and the
issuance of a new patent to SurModics, both of which resulted in more of the
licensee's sales being subject to royalties. The 20% increase in stabilization
product sales was the result of greater market penetration due to the Company's
sales and marketing efforts.
Product costs. The Company's product costs were $1.2 million for fiscal
1998, a decrease of $200,000, or 17%, from fiscal 1997. Overall product margins
increased to 57% in fiscal 1998 from 34% in fiscal 1997. The margin improvement
was due to various manufacturing efficiencies achieved during the year as a
result of increased production volumes. The most significant factors were: the
transfer of stabilization production to a new manufacturing space which
increased efficiency; a change to a less costly raw material formulation for the
production of some stabilization products; and the increased market demand for
some of the Company's products that allowed the Company to establish separate
teams for stabilization and reagent production.
3
<PAGE>
Research and development expense. Research and development expense was
$4.5 million for fiscal 1998, an increase of $900,000, or 26%, over fiscal 1997.
Most of this increase was due to compensation, benefit, and general business
expenses associated with the additional technical personnel hired by the Company
during the year. In addition, the Company incurred additional depreciation
expense associated with the build-out of additional laboratory space. These cost
increases were offset by a reduction in the amount of research performed at
external laboratories on government grants.
Sales and marketing expense. Sales and marketing expense was $1.4
million for fiscal 1998, an increase of $300,000, or 29%, over fiscal 1997. This
increase was primarily due to compensation, benefit, and travel expenses
associated with additional sales and marketing personnel hired during the year
and the cost of an external market study performed on potential genomics product
applications.
General and administrative expense. General and administrative expense
was $1.7 million for fiscal 1998, an increase of $300,000, or 20%, over fiscal
1997. The increase was primarily due to the cost of a new directors' and
officers' liability insurance policy that was entered into at the time of the
IPO; new expenses associated with being a public company (such as investor
relations costs, Nasdaq fees and other external reporting expenses); and
additional expenses associated with certain consulting projects.
Other income, net. The Company's net other income was $700,000 for
fiscal 1998, an increase of $500,000, or 247%, over fiscal 1997. The increase in
interest income was due to the earnings generated on the additional investments
resulting from the $15.5 million of proceeds received from the IPO in March.
Net Operating Loss Carryforwards
As of September 30, 1999, the Company had a NOL carryforward of
approximately $5.6 million, which expires in varying amounts through 2014. The
Company also has $400,000 of capital loss carryforwards at September 30, 1999,
which expire in 2001. A valuation allowance of $149,000 has been established due
to the uncertainty of realization of the capital loss carryforwards.
Year 2000 Compliance
The Company has evaluated and tested its information technology
infrastructure for Year 2000 compliance. The Company has an internal technical
infrastructure comprised of client server networks and desktop microcomputers.
The applications which run on these computers are primarily purchased software
without any significant customized programming. Over the last few years, the
Company has routinely upgraded most of its computer hardware, software and
telecommunications systems. As a result of its evaluation, the Company does not
anticipate any problems related to Year 2000 compliance with its information
technology infrastructure.
The Company has also evaluated and tested its non-information
technology systems with regard to Year 2000 compliance, including contacting
significant raw material suppliers. This is especially important related to
embedded technology such as microcontrollers contained in various lab equipment,
and raw material suppliers who support the Company's manufacturing process.
Based upon information currently available, the Company does not anticipate any
material disruption in its operations as a result of any failure by either
non-information technology equipment or one of its suppliers to be in
compliance. Compliance should not be an issue with the Company's products, since
they are not date-sensitive.
Costs associated with Year 2000 compliance are expensed as incurred. To
date, those costs have not been material. Based upon currently available
information, the Company does not expect that the costs of addressing any
further Year 2000 issues will have a material impact on the Company's financial
condition or results of operations.
4
<PAGE>
Although the Company believes it has addressed all Year 2000 issues,
there are risks if the Company's evaluation has not been complete. The most
severe risk is business interruption. Specific examples of situations that could
cause business interruption include, among others, (i) computer hardware or
application software processing errors or failures; (ii) failure of lab or
manufacturing equipment; (iii) outside suppliers who may not be Year 2000
compliant. Depending on the extent and duration of the business interruption
resulting from non-compliant Year 2000 systems, such interruption could have a
material adverse effect on the Company's financial condition and results of
operations.
Liquidity and Capital Resources
As of September 30, 1999, the Company had working capital of
approximately $5.8 million and cash, cash equivalents and investments totaling
approximately $21.8 million. The Company generated positive cash flows from
operating activities of approximately $4.4 million in fiscal 1999, $2.1 million
in fiscal 1998 and $0.5 million in fiscal 1997. The increase in cash flow in
fiscal 1999 was primarily due to the increased net income generated during the
year.
The significant increase in investing activities over the last two
years was primarily due to the activity in the Company's available-for-sale
investment portfolio as managed by an independent investment manager. 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 three years or less. A
10% increase in interest rates would result in an approximate $150,000 decrease
in the fair value of the Company's available-for-sale securities as of September
30, 1999, but no material impact on the results of operations or cash flows.
SurModics' does not use derivative instruments in its investment portfolio.
The increase in purchases of property and equipment in fiscal 1999 was
primarily due to the Company's purchase of the land and building it currently
occupies (which includes additional space for expansion) for approximately $3.2
million. The most significant financing activity over the last three years was
the completion of the initial public offering of 2.3 million shares of Common
Stock in March 1998, which generated net proceeds to the Company of
approximately $15.5 million net of related offering expenses. The exercise of
stock options generated an additional $1.3 million of cash during fiscal 1999.
As of September 30, 1999, 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.
Forward-Looking Statements
Certain statements contained in this Annual Report and other written
and oral statements made from time to time by the Company do not relate strictly
to historical or current facts. As such, they are considered "forward-looking
statements" which provide current expectations or forecasts of future events.
These forward-looking statements are made pursuant to the safe harbor provisions
of the Private Securities Reform Act of 1995. Such statements can be identified
by the use of terminology such as "anticipate," "believe," "estimate," "expect,"
"intend," "may," "could," "possible," "plan," "project," "will," "forecast" and
similar words or expressions. The Company's forward-looking statements generally
relate to its growth strategy, financial results, product development programs,
sales efforts, and Year 2000 compliance. One must carefully consider
forward-looking statements and understand that such statements involve a variety
of risks and uncertainties, known and unknown, and may be affected by inaccurate
assumptions. Consequently, no forward-looking statement can be guaranteed and
actual results may vary materially. The Company undertakes no obligation to
update any forward-looking statement.
5
<PAGE>
Although it is not possible to create a comprehensive list of all
factors that may cause actual results to differ from the Company's
forward-looking statements, such factors include, among others, (i) the trend of
consolidation in the medical device industry, resulting in more significant,
complex and long-term contracts than in the past and potentially greater pricing
pressures; (ii) the Company's ability to attract new licensees and to enter into
agreements for additional product applications with existing licensees, and the
willingness of potential customers to sign license agreements under the terms
offered by the Company; (iii) the success of existing licensees in selling
products incorporating SurModics' technology and the timing of new product
introductions by licensees; (iv) 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 FDA marketing
clearances, which may result in lost market opportunities or postpone or
preclude product commercialization by licensees; (v) efficacy or safety concerns
with respect to products marketed by SurModics and its licensees, whether
scientifically justified or not, that may lead to product recalls, withdrawals
or declining sales; (vi) the development of new products or technologies by
competitors, technological obsolescence and other changes in competitive
factors; (vii) the Company's ability to successfully respond to Year 2000
issues, which depends, in part, on the availability of personnel, the Company's
ability to identify and resolve issues, both foreseen and unforeseen, and the
readiness of third parties to resolve their issues; and (viii) economic factors
over which the Company has no control, including changes in inflation and
consumer confidence. Investors are advised to consult any further disclosures by
the Company on this subject in its filings with the Securities and Exchange
Commission.
6
<PAGE>
SurModics, Inc.
Financial Statements as of
September 30, 1999 and 1998
Together With Report of
Independent Public Accountants
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To SurModics, Inc.:
We have audited the accompanying balance sheets of SurModics, Inc. (a Minnesota
corporation) as of September 30, 1999 and 1998, and the related statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended September 30, 1999. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of SurModics, Inc. as of September
30, 1999 and 1998, and the results of its operations and its cash flows for each
of the three years in the period ended September 30, 1999, in conformity with
generally accepted accounting principles.
/s/ ARTHUR ANDERSEN LLP
Minneapolis, Minnesota,
October 27, 1999
<PAGE>
SurModics, Inc.
Balance Sheets
As of September 30
<TABLE>
<CAPTION>
1999 1998
-------------- ------------
<S> <C> <C>
ASSETS
Current Assets
Cash and cash equivalents $1,975,188 $1,343,561
Short-term investments 3,947,273 3,526,493
Accounts receivable, net of allowance of $40,000 and $35,000 1,433,328 1,056,710
Inventories, net 458,888 379,946
Prepaids and other 259,403 255,456
-------------- ------------
Total current assets 8,074,080 6,562,166
Property and Equipment, net 5,275,165 1,239,548
Long-Term Investments 15,916,538 16,248,914
Deferred Tax Asset 2,465,000 --
Other Assets, net 227,504 254,361
-------------- ------------
$31,958,287 $24,304,989
============== ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable $710,363 $304,706
Accrued liabilities-
Compensation 783,271 615,264
Other 477,351 334,904
Deferred revenues 268,283 227,725
-------------- ------------
Total current liabilities 2,239,268 1,482,599
Deferred Revenues, less current portion -- 124,231
-------------- ------------
Total liabilities 2,239,268 1,606,830
Commitments and Contingencies (Note 6)
Stockholders' Equity
Series A preferred stock- $.05 par value, 150,000 shares
authorized no shares issued and outstanding -- --
Common stock- $.05 par value, 15,000,000 shares authorized
7,701,921 and 7,214,085 shares issued and outstanding 385,096 360,704
Additional paid-in capital 32,008,996 28,934,732
Unearned compensation (267,157) (170,335)
Stock purchase notes receivable (58,273) (182,273)
Accumulated other comprehensive income (loss) (186,502) 278,244
Accumulated deficit (2,163,141) (6,522,913)
-------------- ------------
Total stockholders' equity 29,719,019 22,698,159
-------------- ------------
$31,958,287 $24,304,989
============== ============
</TABLE>
The accompanying notes are an integral part of these balance sheets.
<PAGE>
SurModics, Inc.
Statements of Operations
For the Years Ended September 30
<TABLE>
<CAPTION>
1999 1998 1997
---------- ----------- ----------
<S> <C> <C> <C>
Revenues
Royalties $6,670,153 $4,782,626 $2,913,119
License fees 645,000 222,500 540,000
Product sales 4,135,970 2,797,647 2,158,572
Research and development 2,042,417 1,975,888 1,970,174
---------- ----------- ----------
Total revenues 13,493,540 9,778,661 7,581,865
---------- ----------- ----------
Operating Costs and Expenses
Product 1,510,582 1,193,178 1,431,675
Research and development 5,247,647 4,521,689 3,597,061
Sales and marketing 1,768,578 1,419,028 1,098,316
General and administrative 2,547,716 1,696,741 1,417,524
---------- ----------- ----------
Total operating costs and expenses 11,074,523 8,830,636 7,544,576
---------- ----------- ----------
Income from Operations 2,419,017 948,025 37,289
---------- ----------- ----------
Other Income
Investment income and other, net 1,068,861 698,193 209,204
Gain on sale of investments 88,599 27,634 --
---------- ----------- ----------
Other income, net 1,157,460 725,827 209,204
---------- ----------- ----------
Net Income Before Income Taxes 3,576,477 1,673,852 246,493
Provision for (benefit from) Income Taxes (783,295) 37,220 10,820
---------- ----------- ----------
Net Income $4,359,772 $1,636,632 $ 235,673
========== =========== ==========
Net Income per Share
$.59 $.26 $.05
Basic $.54 $.24 $.04
Diluted
Weighted Average Shares Outstanding
Basic 7,354,013 6,224,362 4,853,558
Dilutive effect of outstanding stock options 688,064 574,271 531,780
------- ------- -------
Diluted 8,042,077 6,798,633 5,385,338
</TABLE>
The accompanying notes are an integral part of these financial statements.
<PAGE>
SurModics, Inc.
Statements of Stockholders' Equity
For the Years Ended September 30, 1999, 1998 and 1997
<TABLE>
<CAPTION>
Convertible Voting
Preferred Stock Common Stock
--------------------- -------------------- Additional
Shares Amount Shares Amount Paid-In Capital
---------- -------- --------- ------ ---------------
<S> <C> <C> <C> <C> <C>
Balance, September 30, 1996 376,828 $18,841 3,311,480 $165,576 $13,093,961
Components of comprehensive income:
Net income - - - - -
Change in unrealized gain on available-for-sale securities - - - - -
Total comprehensive income
Common stock options exercised - - 45,388 2,268 179,904
Restricted stock granted - - 44,000 2,200 217,800
Amortization of unearned compensation - - - - -
-------- -------- --------- -------- -----------
Balance, September 30, 1997 376,828 18,841 3,400,868 170,044 13,491,665
Components of comprehensive income:
Net income - - - - -
Change in unrealized gain on available-for-sale securities - - - - -
Total comprehensive income
Common stock options exercised - - 25,905 1,296 111,988
Conversion of preferred stock to common stock (376,828) (18,841) 1,507,312 75,364 (56,523)
Issuance of common stock - - 2,300,000 115,000 15,406,102
Restricted stock activity - - (20,000) (1,000) (18,500)
Net loan activity - - - - -
Amortization of unearned compensation - - - - -
-------- -------- --------- -------- -----------
Balance, September 30, 1998 - - 7,214,085 360,704 28,934,732
Components of comprehensive income:
Net income - - - - -
Change in unrealized gain on available-for-sale securities - - - - -
Total comprehensive income
Common stock options exercised, net - - 482,777 24,139 1,309,787
Tax benefit from exercise of stock options - - - - 1,650,000
Restricted stock activity - - 8,500 425 170,305
Net loan activity - - (3,441) (172) (55,828)
Amortization of unearned compensation - - - - -
-------- -------- --------- -------- -----------
Balance, September 30, 1999 - $ - 7,701,921 $385,096 $32,008,996
======== ======== ========= ======== ===========
</TABLE>
<PAGE>
SurModics, Inc.
Statements of Stockholders' Equity
For the Years Ended September 30, 1999, 1998 and 1997
(continued)
<TABLE>
<CAPTION>
Stock Accumulated
Purchase Other Total
Unearned Notes Comprehensive Accumulated Stockholders'
Compensation Receivable Income(Loss) Deficit Equity
------------ ---------- ------------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Balance, September 30, 1996 $(142,720) $ - $ - $(8,395,218) $4,740,440
Components of comprehensive income:
Net income - - - 235,673 235,673
Change in unrealized gain on available-for-sale securities - - - - -
---------
Total comprehensive income 235,673
---------
Common stock options exercised - (160,000) 22,172
Restricted stock granted (220,000) - - - -
Amortization of unearned compensation 103,720 - - - 103,720
--------- -------- -------- ----------- ---------
Balance, September 30, 1997 (259,000) (160,000) - (8,159,545) 5,102,005
Components of comprehensive income:
Net income - - - 1,636,632 1,636,632
Change in unrealized gain on available-for-sale securities - - 278,244 - 278,244
---------
Total comprehensive income 1,914,877
---------
Common stock options exercised - - - - 113,284
Conversion of preferred stock to common stock - - - - -
Issuance of common stock - - - - 15,521,102
Restricted stock activity 19,500 - - - -
Net loan activity - (22,273) - - (22,273)
Amortization of unearned compensation 69,165 - - - 69,165
--------- -------- -------- ----------- ---------
Balance, September 30, 1998 (170,335) (182,273) 278,244 (6,522,913) 22,698,159
Components of comprehensive income:
Net income - - - 4,359,772 4,359,772
Change in unrealized gain on available-for-sale securities - - (464,746) - (464,746)
Total comprehensive income 3,895,026
Common stock options exercised, net - - - - 1,333,926
Tax benefit from exercise of stock options - - - - 1,650,000
Restricted stock activity (170,730) - - - -
Net loan activity - 124,000 - - 68,000
Amortization of unearned compensation 73,908 - - - 73,908
--------- -------- -------- ----------- ---------
Balance, September 30, 1999 $(267,157) $(58,273) $(186,502) $(2,163,141) $29,719,019
========= ======== ======== =========== =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
<PAGE>
SurModics, Inc.
Statements of Cash Flows
For the Years Ended September 30
<TABLE>
<CAPTION>
1999 1998 1997
----------- ----------- ----------
<S> <C> <C> <C>
Operating Activities
Net income $ 4,359,772 $ 1,636,632 $ 235,673
Adjustments to reconcile net income to net cash provided by
operating activities-
Depreciation and amortization 708,937 617,536 460,039
Gain on sale of investments (88,599) (27,634) -
Amortization of unearned compensation, net 73,908 69,165 103,720
Change in deferred rent (30,481) (17,742) (11,104)
Change in deferred tax (815,000) - -
Change in assets and liabilities:
Accounts receivable (376,618) (134,244) (294,647)
Inventories (78,942) (115,938) (3,240)
Accounts payable and accrued liabilities 716,111 481,739 446,729
Deferred revenue (53,192) (205,418) (393,416)
Prepaids and other (3,947) (181,332) (12,701)
----------- ----------- ---------
Net cash provided by operating activities 4,411,949 2,122,764 531,053
----------- ----------- ---------
Investing Activities
Purchases of property and equipment, net (4,720,703) (775,402) (298,388)
Purchases of available-for-sale investments (24,436,386) (33,595,043) (3,923,184)
Sales/maturities of available-for-sale investments 23,971,835 17,455,608 2,425,000
Repayment (issuance) of stock purchase notes receivable 68,000 (22,273) -
Other 3,006 31,897 (277,935)
----------- ----------- ---------
Net cash used in investing activities (5,114,248) (16,905,213) (2,074,507)
----------- ----------- ---------
Financing Activities
Issuance of common stock, net of offering costs 1,333,926 15,634,386 22,172
----------- ----------- ---------
Net cash provided by financing activities 1,333,926 15,634,386 22,172
----------- ----------- ---------
Net increase (decrease) in cash and cash equivalents 631,627 851,937 (1,521,282)
Cash and Cash Equivalents
Beginning of year 1,343,561 491,624 2,012,906
----------- ----------- ---------
End of year $ 1,975,188 $ 1,343,561 $ 491,624
=========== =========== =========
Supplemental Cash Flow Information
Interest paid $ - $ - $ 1,700
Non-cash investing and financing activity--
Issuance of stock purchase notes receivable from exercised stock $ - $ - $ 160,000
options
Tax benefit from exercise of stock options $ 1,650,000 $ - $ -
=========== =========== =========
The accompanying notes are an integral part of these financial statements.
</TABLE>
<PAGE>
SurModics, Inc.
Notes to Financial Statements
1. Description
SurModics, Inc. (the Company) develops, manufactures and markets innovative
surface modification solutions to the medical device industry. The Company also
produces and markets a line of proprietary biomolecule stabilization products.
Its revenues are derived from the following: fees from licensing its patented
technology to customers; royalties received from licensees; the sale of
photoreactive chemical compounds to licensees and stabilization products to the
diagnostic industry; 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 some
international markets.
In March 1998, the Company completed an initial public offering of 2.3 million
shares of Common Stock, generating net proceeds to the Company of approximately
$15.5 million net of offering expenses.
2. Summary of Significant Accounting Policies
Cash and Cash Equivalents
Cash and cash equivalents consist principally of money market instruments with
original maturities of three months or less and are stated at cost which
approximates fair value.
Investments
Investments consist principally of U.S. government and government agency
obligations and corporate debt securities and are classified as
available-for-sale as of September 30, 1999 and 1998. Available-for-sale
investments are reported at fair value with unrealized gains and losses excluded
from operations and reported as a separate component of stockholders' equity,
except for other-than-temporary impairments, which are reported as a charge to
current operations and result in a new cost basis for the investment.
The amortized cost, unrealized holding gains and losses, and fair value of
investments as of September 30, 1999 and 1998 were as follows:
<TABLE>
<CAPTION>
September 30, 1999
------------------------------------------------------------------------
Amortized Cost Unrealized Unrealized Fair Value
Gains Losses
----------------- ------------------ ----------------- -----------------
<S> <C> <C> <C> <C>
U.S. government obligations $10,422,826 $225 $(133,645) $10,289,406
Corporate bonds 3,457,977 - (4,521) 3,453,455
Mortgage-backed securities 2,682,899 2,742 (28,455) 2,657,186
Asset-backed securities 2,309,677 447 (7,854) 2,302,271
Municipal bonds 1,176,934 726 (16,167) 1,161,493
----------------- ------------------ ----------------- -----------------
Total $20,050,313 $4,140 $(190,642) $19,863,811
================= ================== ================= =================
</TABLE>
<TABLE>
<CAPTION>
September 30, 1998
------------------------------------------------------------------------
Amortized Cost Unrealized Unrealized Fair Value
Gains Losses
----------------- ------------------ ----------------- -----------------
<S> <C> <C> <C> <C>
U.S. government obligations $12,178,480 $243,326 $ - $12,421,806
Corporate bonds 5,638,397 5,755 (724) 5,643,428
Mortgage-backed securities 1,286,413 28,784 (3,071) 1,312,126
Municipal bonds 200,000 4,174 - 204,174
Other debt securities 193,873 - - 193,873
----------------- ------------------ ----------------- -----------------
Total $19,497,163 $282,039 $(3,795) $19,775,407
================= ================== ================= =================
</TABLE>
The amortized cost and fair value of investments by contractual maturity at
September 30, 1999, were as follows:
Amortized Cost Fair Value
------------------ -----------------
Debt securities due within:
One year $3,947,273 $3,947,273
One to five years 14,534,234 14,356,330
Five years or more 1,568,806 1,560,208
------------------ -----------------
Total $20,050,313 $19,863,811
================== =================
Inventories
Inventories are stated at the lower of cost or market using the specific
identification method and include direct labor, materials and overhead.
Inventories consisted of the following components as of September 30:
1999 1998
--------- ----------
Raw materials $179,205 $107,522
Finished products 279,683 272,424
--------- ----------
Total $458,888 $379,946
========= ==========
Property and Equipment
Property and equipment are stated at cost and are depreciated using the
straight-line method over three to twenty years, the estimated useful lives of
the assets. Upon completion, construction-in-progress will begin depreciation
over the estimated useful lives of the assets.
1999 1998
------------- ---------------
Laboratory fixtures and equipment $3,009,379 $2,313,236
Office furniture and equipment 1,383,197 1,002,210
Building and improvements 4,532,713 1,323,387
Construction-in-progress 408,362 --
Less-Accumulated depreciation and amortization (4,058,486) (3,399,285)
-----------------------------
Property and equipment, net $5,275,165 $1,239,548
=============================
Other Assets
Other assets consist principally of patents, which are amortized over 7 to 12
years. Accumulated amortization was $64,000 and $40,000 as of September 30, 1999
and 1998, respectively.
Revenue Recognition
Royalties are recognized as third-party licensees report sales of the licensed
product or as minimum royalties become due. Initial nonrefundable license fees
<PAGE>
are recognized as revenue upon execution of the license agreement. Certain
nonrefundable license and research and development fees are recoverable by the
licensees as offsets against a percentage of future earned royalties.
Revenues on product sales are recognized as products are shipped and for
research and development as performance progresses under the applicable
contract.
Cash received prior to performance is recorded as deferred revenues in the
accompanying balance sheets.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Ultimate results could differ from those estimates.
Reclassification
Certain 1998 and 1997 amounts in the accompanying financial statements have been
reclassified to conform to the 1999 presentation. These reclassifications had no
effect on previously reported net income or stockholders' equity.
New Accounting Pronouncements
SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities,"
establishes accounting and reporting standards requiring that every derivative
instrument (including certain derivative instruments embedded in other
contracts) be recorded in the balance sheet as either an asset or liability
measured at its fair value. Based on its current operations, the Company
anticipates that the adoption of SFAS No. 133 in fiscal 2002 will have not have
a significant impact on its financial statements.
3. Stockholders' Equity
Authorized Shares
The authorized capital stock of the Company consists of 20,000,000 shares of
capital stock, $.05 per share par value, of which 15,000,000 shares are Common
Stock, 150,000 are Series A Preferred Stock and 4,850,000 shares are
undesignated. The Series A Preferred Stock was designated by board action in
conjunction with a Shareholder Rights Plan and has certain preferential voting,
liquidation and dividend rights as follows:
a. Each share of Series A Preferred Stock is entitled to 100 votes on all
matters submitted to a vote of the stockholders of the Company.
b. In the event of liquidation of the Company, the holders of these shares
are entitled to receive the greater of $100 per share or 100 times the
per share amount to be distributed to holders of shares of Common
Stock.
c. Preferred stockholders are entitled to receive a quarterly dividend of
the greater of $1.00 per share or 100 times the per share amount of any
dividend declared on the Common Stock.
Shareholder Rights Plan
In April 1999, the Company adopted a Shareholder Rights Plan (the "Rights
Plan"). Under the Rights Plan, the Board of Directors declared a dividend to
stockholders of record on April 5, 1999 of one preferred stock purchase right
<PAGE>
(the "Rights") for each outstanding share of Common Stock. Each right entitles
the holder to purchase one one-hundredth of a share of Series A Preferred Stock
from the Company. The Rights issued under the plan will only become exercisable
by stockholders, other than a potential acquirer, following an acquisition by
the acquirer (without prior approval of the Company's board of directors) of 15%
or more of the Company's Common Stock, or the announcement of a tender offer for
15% or more of the Common Stock. The Rights will expire in April 2009.
Restricted Stock Awards
The Company has entered into restricted stock agreements with certain key
employees, covering the issuance of Common Stock (the Restricted Stock). The
Restricted Stock will be released to the key employees if they are employed by
the Company at the end of a five-year waiting period. Unearned compensation has
been recognized for the estimated fair value of the applicable common shares,
reflected as a reduction of stockholders' equity, and is being charged to
operations over the five-year waiting period.
Transactions in restricted stock were as follows:
Outstanding at September 30, 1996 82,400
Granted 44,000
--------
Outstanding at September 30, 1997 126,400
Granted 4,000
Canceled (24,000)
Exercised (42,400)
--------
Outstanding at September 30, 1998 64,000
Granted 12,500
Canceled (4,000)
--------
Outstanding at September 30, 1999 72,500
========
Stock Purchase Notes Receivable
The Company established a loan program during fiscal 1997 to assist employees in
purchasing shares of the Company's stock. The loans are collateralized by the
employees' purchased shares and require annual interest payments at a rate equal
to prime at the date of issuance (8.5%) with principal and any unpaid interest
due at the earlier of five years after the date of issuance or three months
after termination of employment. The loans may be repaid in either cash or
mature shares held by the employee. No further loans are being granted under
this program.
4. Stock-Based Compensation Plan
Under the Company's 1997 Incentive Stock Option Plan (the Plan), 600,000 shares
of Common Stock were reserved for issuance to employees and officers. The Plan
requires that the option price per share must be at least 100% of the fair
market value of the Common Stock on the date of the grant of the option or 110%
with respect to optionees who own more than 10% of the total combined voting
power of all classes of stock. Options expire in five to seven years or upon
termination of employment and are exercisable at a rate of 20% per year from the
date of grant or 20% per year commencing one year after the date of grant. In
addition, options representing a total of 195,350 shares remain outstanding from
the Company's 1987 Incentive Stock Option Plan which was replaced by the 1997
Plan.
Under the Company's Nonqualified Stock Option Plan, 972,240 shares of Common
Stock were reserved for issuance to outside directors, employees and officers.
<PAGE>
The options are granted at fair market value. Options expire in five to ten
years and are exercisable at a rate of 20% per year from the date of grant or
20% per year commencing two years after the date of grant.
As of September 30, 1999, there were 420,380 additional shares available for
grant under the stock plans. Information regarding stock options under all plans
is summarized as follows:
<TABLE>
<CAPTION>
1999 1998 1997
------------------------- ------------------------ -----------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Options Shares Price Shares Price Shares Price
---------- -------- ----------- ---------- --------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Outstanding, beginning
of year 1,269,640 $4.86 1,204,800 $4.60 1,163,600 $4.52
Granted 183,700 15.73 137,300 6.98 157,400 5.00
Exercised (541,030) 4.16 (26,220) 4.47 (45,388) 4.01
Canceled (38,020) 5.82 (46,240) 4.78 (70,812) 4.51
------------ ------ ---------- ------ --------- ------
Outstanding, end of
year 874,290 $7.53 1,269,640 $4.86 1,204,800 $4.60
============ ====== ========== ====== ========= ======
Exercisable, end of
year 439,410 $5.18 757,860 $4.49 589,320 $4.42
============ ====== ========== ====== ========= ======
Weighted average
fair value of
options granted $11.47 $4.91 $3.30
====== ===== =====
</TABLE>
The options outstanding at September 30, 1999 have exercise prices ranging
between $5.00 and $16.75, with a weighted average exercise price of $7.53 and a
weighted average remaining contractual life of 5.33 years.
The fair value of each option is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1999, 1998 and 1997, respectively: risk-free
interest rates of 6.01%, 5.00% and 6.24%; expected lives of 7.3, 6.4 and 5.6
years; and expected volatility of 71%, 73% and 73%.
The Company accounts for the options under APB Opinion No. 25, under which no
compensation cost has been recognized. Had compensation cost for the options
been determined consistent with SFAS No. 123, "Accounting for Stock-Based
Compensation," the Company's net income would have been the following pro forma
amounts for the years ended September 30:
1999 1998 1997
---- ---- ----
Net income:
As reported $4,359,772 $1,636,632 $235,673
Pro forma $4,119,529 $1,506,492 $155,541
Net income per share:
As reported $.54 $.24 $.04
Pro forma $.51 $.22 $.03
Because the SFAS No. 123 method of accounting has not been applied to options
granted prior to October 1, 1995, the resulting pro forma information may not be
representative of that to be expected in future periods.
<PAGE>
5. Income Taxes
The Company utilizes the liability method to account for income taxes. Deferred
taxes are based on the estimated future tax effects of differences between the
financial statement and tax bases of assets and liabilities given the provisions
of the enacted tax laws. Reserves are established on the basis of expected
ability to utilize the deferred assets. During fiscal 1999, management concluded
that the Company would generate sufficient taxable income in the future to
utilize all of the previously unrecognized tax net operating loss ("NOL")
carryforwards attributable to ordinary income prior to their expiration.
The deferred income tax provision (benefit) reflects the net change during the
year in deferred tax assets and liabilities. Income taxes in the accompanying
statements of operations for the years ended September 30 were as follows:
<TABLE>
<CAPTION>
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
Current provision:
Federal $ - $33,477 $ 356
State and foreign 16,705 3,743 10,464
---------- ------- ------
Total current provision 16,705 37,220 10,820
Deferred benefit:
Federal (735,000) - -
State (65,000) - -
---------- ------ ------
Total deferred benefit (800,000) - -
---------- ------ ------
Total provision (benefit) $ (783,295) $37,220 $10,820
========== ======= ======
</TABLE>
The reconciliation of the difference between amounts calculated at the statutory
federal tax rate and the Company's effective tax rate was as follows:
<TABLE>
<CAPTION>
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
Amount at statutory federal income tax rate: $1,323,000 $ 621,000 $ 93,000
Change due to:
Reversal of tax valuation allowance (2,466,000) - -
Utilization of net operating losses - (619,000) (91,000)
Rate difference for deferred tax assets 180,000 - -
Other 179,705 35,220 8,820
---------- --------- --------
Income tax provision (benefit) $ (783,295) $ 37,220 $ 10,820
========== ========= ========
</TABLE>
<PAGE>
The components of deferred income taxes consisted of the following as of
September 30:
1999 1998
Net operating loss carryforwards $2,048,000 $1,875,000
Capital loss carryforwards 149,000 197,000
Depreciation 265,000 247,000
Other 152,000 296,000
---------- ----------
Total deferred tax assets 2,614,000 2,615,000
Less- valuation allowance (149,000) (2,615,000)
---------- ----------
Net deferred tax assets $2,465,000 $ -
========== ==========
These deferred tax assets result from differences in the recognition of
transactions for income tax and financial reporting purposes. The Company's NOL
carryforwards of approximately $5.6 million at September 30, 1999 expire in
varying amounts through 2014. The Company also has $400,000 of capital loss
carryforwards at September 30, 1999, which expire in 2001, on which a 100%
valuation allowance has been established.
6. Commitments and Contingencies
Government Contracts
Under provisions contained in the government research contracts, representatives
of the government agencies have the right to access and review the Company's
underlying records of contract costs. The government retains the right to reject
expenses considered unallowable under the terms of the contract. The Defense
Contract Audit Agency has reviewed the contracts through 1989. In the opinion of
management, future amounts due, if any, with respect to open contract years will
not have a material impact on the financial position or results of operations of
the Company.
Construction Commitments
The Company has entered into agreements with certain contractors for the
construction of additional laboratory and office space totaling approximately
$1.0 million, of which $408,000 was recorded in construction-in-progress as of
September 30, 1999. This construction is expected to be completed in the first
quarter of fiscal 2000.
7. Defined Contribution Plan
The Company has a 401(k) retirement and savings plan for the benefit of
qualified employees. Under the plan, qualified employees may elect to defer up
to 20% of their compensation, subject to a maximum limit determined by the
Internal Revenue Service. Beginning October 1, 1998, the Company matched 50
percent of each dollar of the first six percent of the tax deferral elected by
each employee. In prior years, the Company made discretionary contributions to
the plan subject to the approval of the Board of Directors. Company
contributions totaling $122,000, $117,000 and $86,000 have been charged to
operations for the years ended September 30, 1999, 1998 and 1997, respectively.
8. Operating Segments (Dollars in thousands)
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.
<PAGE>
The Company manages its business on the basis of three business segments:
licensing, manufacturing, and research and development. The licensing segment
includes all license fees and royalty revenues generated from the transfer of
the Company's technology. No expenses are allocated to the licensing segment.
The manufacturing segment includes revenue from the sale of PhotoLink reagents,
stabilization products and DNA slides. The expenses include all production
costs, including analytical costs to verify quality of the finished products and
certain technical support. The research and development segment includes the
revenue generated from development projects for commercial customers and
research revenues received from government grants. The expenses include all
costs of the Company's technical personnel. Corporate includes all
administrative, sales and marketing costs of the Company. These costs, along
with interest income and income taxes, are not allocated to the other business
segments. The Company's assets are not reviewed by business segment. The
accounting policies for segment reporting are the same as for the Company as a
whole (see Note 2).
<TABLE>
<CAPTION>
Research &
Licensing Manufacturing development Corporate Consolidated
------------ ---------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C> <C>
Year Ended September 30, 1999
Revenues:
PhotoLink $4,557 $1,876 $1,122 $ - $7,555
Diagnostic 2,758 - - - 2,758
Stabilization - 2,261 - - 2,261
Government - - 920 - 920
------------ ---------------- --------------- --------------- ---------------
Total Revenues 7,315 4,137 2,042 - 13,494
Expenses - 1,511 5,248 4,316 11,075
------------ ---------------- --------------- --------------- ---------------
Operating income (loss) 7,315 2,626 (3,206) (4,316) 2,419
Other income 1,158 1,158
Income tax benefit 783 783
Net income $4,360
==============
Year Ended September 30, 1998
Revenues:
PhotoLink $2,427 $794 $891 $ - $4,112
Diagnostic 2,578 - - - 2,578
Stabilization - 2,004 - - 2,004
Government - - 1,085 - 1,085
------------ ---------------- --------------- --------------- ---------------
Total Revenues 5,005 2,798 1,976 - 9,779
Expenses - 1,193 4,522 3,116 8,831
------------ ---------------- --------------- --------------- ---------------
Operating income (loss) 5,005 1,605 (2,546) (3,116) 948
Other income 726 726
Income tax expense (37) (37)
--------------
Net income $1,637
==============
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Year Ended September 30, 1997
<S> <C> <C> <C> <C> <C>
Revenues:
PhotoLink $1,988 $494 $742 $- $3,224
Diagnostic 1,465 - - - 1,465
Stabilization - 1,665 - - 1,665
Government - - 1,228 - 1,228
------------ ---------------- --------------- --------------- ---------------
Total Revenues 3,453 2,159 1,970 - 7,582
Expenses - 1,432 3,597 2,516 7,545
------------ ---------------- --------------- --------------- ---------------
Operating income (loss) 3,453 727 (1,627) (2,516) 37
Other income 209 209
Income tax expense (10) (10)
---------------
Net income $236
===============
</TABLE>
Major Customers
Revenues from customers that exceed 10% of total revenues were as follows for
the years ended September 30:
1999 1998 1997
---- ---- ----
U.S. government agencies 7% 11% 16%
Company A 20% 26% 21%
Company B 12% 2% --
Revenues from U.S. Government agencies are derived from the Research and
development segment. Revenues from Company A are derived from the Licensing and
royalties segment. Revenues from Company B are derived from all three revenue
segments.
Geographic Revenue
Geographic revenues were as follows for the years ended September 30:
1999 1998 1997
---- ---- ----
Domestic 87% 90% 93%
Foreign 13% 10% 7%
9. Quarterly Financial Data (Unaudited, in thousands except per share data)
<TABLE>
<CAPTION>
First Quarter Second Quarter Third Quarter Fourth Quarter
Fiscal 1999
- -----------
<S> <C> <C> <C> <C>
Revenues $2,639 $3,308 $3,685 $3,862
Income from operations 265 591 755 808
Net income 925 1,105 1,214 1,117
Net income per share:
Basic .13 .15 .16 .15
Diluted .12 .14 .15 .14
Fiscal 1998
- -----------
Revenues $1,909 $2,579 $2,672 $2,619
Income from operations 101 288 330 229
Net income 151 376 566 544
Net income per share:
Basic .03 .07 .08 .08
Diluted .03 .06 .07 .07
</TABLE>
<PAGE>
STOCK LISTING AND PRICE HISTORY
Surmodics' stock is traded on the Nasdaq National Market under the symbol
"SRDX." On March 4, 1998, the Company completed its initial public offering of
Common Stock at a price of $7.50 per share. The following table sets forth the
range of high and low closing sale prices for the Company's Common Stock, as
reported by Nasdaq:
FISCAL QUARTER ENDED HIGH LOW
- ------------------------------------------------------------------------------
September 30, 1999......................... $ 18 3/4 $ 14 1/8
June 30, 1999............................... $ 16 3/4 $ 12 3/4
March 31, 1999.............................. $ 14 1/2 $ 9 7/8
December 31, 1998........................... $ 15 1/2 $ 6 1/2
September 30, 1998.......................... $ 14 1/8 $ 7 3/16
June 30, 1998............................... $ 11 3/4 $ 8 1/4
March 31, 1998.............................. $ 9 $ 7 3/4
December 31, 1997........................... N/A N/A
According to the records of the Company's transfer agent, as of November 29,
1999, the Company had 227 holders of record of the Company's Common Stock
(excluding beneficial owners of shares registered in nominee or street name).
The Company has never paid any cash dividends on its Common Stock and does not
anticipate doing so in the foreseeable future.
EXHIBIT 23
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our
report incorporated by reference in this Form 10-KSB, into the Company's
previously filed Registration Statements-File Nos. 333-64171, 333-64173 and
333-79741.
/s/ ARTHUR ANDERSEN LLP
Minneapolis, Minnesota,
December 21, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<CURRENCY> U.S. Dollars
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> SEP-30-1999
<PERIOD-START> OCT-01-1998
<PERIOD-END> SEP-30-1999
<EXCHANGE-RATE> 1
<CASH> 1,975
<SECURITIES> 3,947
<RECEIVABLES> 1,473
<ALLOWANCES> 40
<INVENTORY> 459
<CURRENT-ASSETS> 8,074
<PP&E> 9,333
<DEPRECIATION> 4,058
<TOTAL-ASSETS> 31,958
<CURRENT-LIABILITIES> 2,239
<BONDS> 0
0
0
<COMMON> 385
<OTHER-SE> 29,334
<TOTAL-LIABILITY-AND-EQUITY> 31,958
<SALES> 4,136
<TOTAL-REVENUES> 13,494
<CGS> 1,511
<TOTAL-COSTS> 11,075
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 3,576
<INCOME-TAX> (783)
<INCOME-CONTINUING> 4,360
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,360
<EPS-BASIC> .59
<EPS-DILUTED> .59
</TABLE>
