SURMODICS INC - Quarter Report: 2019 December (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended December 31, 2019

or

Commission File Number: 0-23837

Surmodics, Inc.

(Exact name of registrant as specified in its charter)

9924 West 74th Street, Eden Prairie, Minnesota 55344

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code:

(952) 500-7000

Securities registered pursuant to Section 12(b) of the Act:

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐ 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

The number of shares of the registrant’s Common Stock, $0.05 par value per share, as of February 4, 2020 was 13,590,159

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Unaudited Condensed Financial Statements

Surmodics, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

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

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Surmodics, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

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

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Surmodics, Inc. and Subsidiaries

Condensed Consolidated Statements of Comprehensive Income

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

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Surmodics, Inc. and Subsidiaries

Condensed Consolidated Statements of Stockholders’ Equity

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

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Surmodics, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

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

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Surmodics, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

Period Ended December 31, 2019

(Unaudited)

1. Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S.”) (“GAAP”) and, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, needed to fairly present the financial results of Surmodics, Inc. and subsidiaries (“Surmodics” or the “Company”) for the periods presented. These financial statements include amounts that are based on management’s best estimates and judgments. These estimates may be adjusted as more information becomes available, and any adjustment could be significant. The impact of any change in estimates is included in the determination of net income (loss) in the period in which the change in estimate is identified. The results of operations for the three months ended December 31, 2019 are not necessarily indicative of the results that may be expected for the entire 2020 fiscal year.

In accordance with the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”), the Company has omitted footnote disclosures that would substantially duplicate the disclosures contained in the audited consolidated financial statements of the Company. These unaudited condensed consolidated financial statements should be read together with the audited consolidated financial statements for the fiscal year ended September 30, 2019, and footnotes thereto included in the Company’s Annual Report on Form 10-K as filed with the SEC on December 3, 2019.

New Accounting Pronouncements

Recently Adopted

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) ASU 2016-02, Leases (“ASC Topic 842”). The update maintains two classifications of leases: finance leases, which replace capital leases, and operating leases. Lessees recognize a right-of-use asset and a lease liability on the consolidated balance sheets for those leases previously classified as operating leases under the previous guidance. The liability is equal to the present value of lease payments, while the asset is based on the liability, subject to adjustment, such as for direct costs.

Effective October 1, 2019, the Company adopted the new lease accounting standard using the optional transition method which allowed us to continue to apply the guidance under the lease standard in effect at the time in the comparative periods presented. In addition, the Company elected the package of practical expedients, including opting not to reassess whether any existing contracts contain a lease, historical lease classification as operating or finance leases, or initial direct costs. The Company has also elected the practical expedient to not separate the lease and non-lease components for all classes of underlying assets. The Company elected the short-term lease recognition exemption for all leases that qualified and has accordingly excluded short-term leases from the recognition of right-of-use assets and lease liabilities.

As a result of adoption of Accounting Standards Codification (“ASC”) Topic 842, we recorded operating lease right-of-use assets and corresponding operating lease liabilities of approximately $1.7 million and $2.9 million, respectively, as of October 1, 2019 with no impact on retained earnings. In addition, deferred rent liabilities related to escalating rent payments and tenant incentives totaling approximately $1.2 million were eliminated upon adoption, as these items are netted against right-of-use assets. The condensed consolidated balance sheets for reporting periods beginning on or after October 1, 2019 are presented under the new guidance, while prior period amounts are not adjusted and continue to be reported in accordance with previous guidance.

Not Yet Adopted

In June 2016, the FASB issued ASU No 2016-13, Financial Instruments – Credit Losses, Measurement of Credit Losses on Financial Statements. This ASU requires a financial asset (or a group of financial assets) measured at an amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to present the net carrying value at the amount expected to be collected on the financial asset. The accounting standard will be effective for the Company beginning in the first quarter of fiscal 2021 (October 1, 2020). Early adoption is permitted and the guidance will be applied using a modified retrospective approach. The Company is currently evaluating the impact that the adoption of this standard will have on the Company’s results of operations, cash flows and financial position.

No other new accounting pronouncement issued or effective has had, or is expected to have, a material impact on the Company’s condensed consolidated financial statements.

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2. Revenue

The following table presents our revenues disaggregated by product classification and by operating segment, excluding sales taxes collected and remitted to governmental authorities (in thousands, unaudited).

Contract Assets, Deferred Revenue and Remaining Performance Obligations

Contract asset balances consist of estimated sales-based royalties earned but not collected at each balance sheet date and are subject to timing fluctuations at the end of a given period. The Company’s deferred revenue, or contract liability, is primarily related to the upfront and milestone payments received pursuant to the collaborative license and commercialization agreement with Abbott (the “Abbott Agreement”) for the Company’s SurVeil™ drug-coated balloon product (“SurVeil DCB”) discussed in Note 3.

As of December 31, 2019, the estimated revenue expected to be recognized in future periods related to performance obligations that are unsatisfied for executed contracts with an original duration of one year or more totaled approximately $15.8 million. These remaining performance obligations relate to the Abbott Agreement (Note 3), exclude contingent milestone payments under the Abbott Agreement, and are expected to be recognized over the next six years as services, principally the TRANSCEND study, are completed.

3. Collaborative Arrangement

Under the Abbott Agreement, Abbott will have exclusive worldwide commercialization rights for the SurVeil DCB to treat the superficial femoral artery, which is currently being evaluated in a U.S. pivotal clinical trial. Separately, Abbott also received options to negotiate agreements for Surmodics' below-the-knee and arteriovenous (“AV”) fistula DCB products, which are currently in pre-clinical development and a first-in human clinical study, respectively. Surmodics is responsible for conducting all necessary clinical trials and other activities required to achieve U.S. and European Union regulatory clearances for the SurVeil DCB, including completion of the ongoing TRANSCEND clinical trial. Abbott and Surmodics participate on a joint development committee charged with providing guidance on the Company’s clinical and regulatory activities with regard to the SurVeil product.

To account for the Abbott Agreement, the Company applied the guidance in ASC Topic 808 (Collaborative Arrangements) as the parties are active participants and are exposed to significant risks and rewards dependent on commercial success of the collaborative activity.

The Company has received a $25 million upfront fee as well as a $10 million milestone under the Abbott Agreement and may receive up to $56 million of additional payments upon achievement of various clinical and regulatory milestones. For the three months ended December 2019 and 2018, the Company recognized revenue totaling $1.3 million and $2.4 million, respectively, from the Abbott arrangement, all of which was previously included in deferred revenue. As of December 31, 2019 and September 30, 2019, deferred revenue from the upfront and milestone payments received of $15.8 million and $17.1 million, respectively, is recorded in the condensed consolidated balance sheets. Upon the commercialization of the SurVeil DCB, Surmodics will be responsible for the manufacture and supply of clinical and commercial quantities of the product. Revenue from these product sales, including a per-unit transfer price and a share of net profits resulting from third-party sales by Abbott, will be recognized if and when these products are shipped and control is transferred to the customer.

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4. Fair Value Measurements

The accounting guidance on fair value measurements defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. The guidance is applicable for all financial assets and financial liabilities and for all nonfinancial assets and nonfinancial liabilities recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Fair value is defined as the exchange price that would be received from selling an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and also considers assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions and risk of nonperformance.

Fair Value Hierarchy

Accounting guidance on fair value measurements requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

Level 1 — Quoted (unadjusted) prices in active markets for identical assets or liabilities.

The Company did not have any Level 1 assets as of December 31, 2019 and September 30, 2019.

Level 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.

The Company’s Level 2 assets as of December 31, 2019 and September 30, 2019 consisted of money market funds, commercial paper instruments and corporate bonds.

Level 3 — Unobservable inputs to the valuation methodology that are supported by little or no market activity and that are significant to the measurement of the fair value of the assets or liabilities. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation.

The Level 3 liability as of September 30, 2019 consisted of contingent consideration obligations related to the fiscal 2016 acquisition of NorMedix, Inc. (“NorMedix”). Consideration owed to the sellers of NorMedix from revenue and value-creating milestones achieved through September 30, 2019 totaling $3.2 million was paid during the three months ended December 31, 2019, with $0.6 million and $2.6 million classified as cash flows used in operating and financing activities, respectively, on the condensed consolidated statements of cash flows.

In valuing Level 3 assets and liabilities, the Company is required to maximize the use of quoted market prices and minimize the use of unobservable inputs.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

In instances where the inputs used to measure fair value fall into different levels of the fair value hierarchy, the fair value measurement has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability.

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The following table presents information about the Company’s assets measured at fair value on a recurring basis as of December 31, 2019:

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2019:

Changes in the contingent consideration liabilities measured at fair value using Level 3 inputs were as follows : three months ended December 31, 2019 and 2018

There were no transfers of assets or liabilities between amounts measured using Level 1, Level 2, or Level 3 fair value measurements in fiscal 2020 and fiscal 2019.

Valuation Techniques

The valuation techniques used to measure the fair value of assets are as follows:

Cash equivalents — These assets are classified as Level 2 and are carried at historical cost which is a reasonable estimate of fair value because of the relatively short time between origination of the instrument and its expected realization.

Available-for-sale securities — Fair market values for these assets are based on quoted vendor prices and broker pricing in active markets underlying the securities where all significant inputs are observable. To ensure the accuracy of quoted vendor prices and broker pricing, the Company performs regular reviews of investment returns to industry benchmarks and sample tests of individual securities to validate quoted vendor prices with other available market data.

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5. Investments

Investments consisted principally of commercial paper and corporate bond securities and are classified as available-for-sale as of December 31, 2019 and September 30, 2019. These available-for-sale securities are reported at fair value with unrealized gains and losses, net of tax, excluded from the condensed consolidated statements of operations and reported in the condensed consolidated statements of comprehensive income as well as a separate component of stockholders’ equity in the condensed consolidated balance sheets, except for other-than-temporary impairments, which are reported as a charge to current earnings as they occur. A loss would be recognized when there is an other-than-temporary impairment in the fair value of any individual security classified as available-for-sale, with the associated net unrealized loss reclassified out of accumulated other comprehensive income with a corresponding adjustment to other income. This adjustment would result in a new cost basis for the investment. Interest earned on debt securities, including amortization of premiums and accretion of discounts, is included in investment income, net within other income. Realized gains and losses from the sales of debt securities, which are included in other income, are determined using the specific identification method. Investment purchases are accounted for on the date the trade is executed, which may not be the same as the date the transaction is cash settled.

The amortized cost, unrealized holding gains and losses, and fair value of available-for-sale securities were as follows:

6. Inventories

Inventories are principally stated at the lower of cost or market using the specific identification method and include direct labor, materials and overhead, with cost of product sales determined on a first-in, first-out basis. Inventories consisted of the following components:

7. Other Assets

Other assets consisted of the following:

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The Company has invested a total of $5.3 million in ViaCyte, Inc. (“ViaCyte”), a privately-held California-based biotechnology firm that is developing a unique treatment for diabetes using coated islet cells, the cells that produce insulin in the human body. The balance of the investment of $0.5 million, which is net of previously recorded other-than-temporary impairments of $4.8 million, is accounted for under the cost method and represents less than a 1% ownership interest. The Company does not exert significant influence over ViaCyte’s operating or financial activities.

The carrying value of each cost method investment is reviewed quarterly for changes in circumstances or the occurrence of events that suggest the Company’s investment may not be recoverable. The fair value of cost method investments is not adjusted if there are no identified events or changes in circumstances that may have a material effect on the fair value of the investment.

Other noncurrent assets include prepaid expenses related to our ongoing clinical trials and a receivable related to refundable Irish research and development tax credits.

8. Intangible Assets

Intangible assets consist principally of acquired patents and technology, customer lists and relationships, licenses and trademarks. The Company recorded amortization expense of $0.7 million for both the three months ended December 31, 2019 and 2018. 

Intangible assets consisted of the following:

Based on the intangible assets in service as of December 31, 2019, estimated amortization expense for the remainder of fiscal 2020 and each of the next five fiscal years is as follows (in thousands):

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Future amortization amounts presented above are estimates. Actual future amortization expense may be different as a result of future acquisitions, impairments, changes in amortization periods, foreign currency translation rates, or other factors.

9. Goodwill

Goodwill represents the excess of the cost of an acquired entity over the fair value assigned to the assets purchased and liabilities assumed in connection with a business acquisition. Goodwill is not amortized but is subject, at a minimum, to annual tests for impairment in accordance with accounting guidance for goodwill. The carrying amount of goodwill is evaluated annually, and between annual evaluations if events occur or circumstances change indicating that the carrying amount of goodwill may be impaired.

Goodwill as of December 31, 2019 and September 30, 2019 totaled $26.5 million and $26.2 million, respectively. Goodwill in the Medical Device reporting unit represents the gross value from the fiscal 2016 acquisitions of Creagh Medical Limited (“Creagh Medical”) and NorMedix. Goodwill in the In Vitro Diagnostics reporting unit represents the gross value from the acquisition of BioFX Laboratories, Inc. (“BioFX”) in fiscal 2007.

Goodwill was not impaired in either reporting unit based on the outcome of the fiscal 2019 annual impairment test, and there have been no events or circumstances that have occurred in the first three months of fiscal 2020 to indicate that goodwill has been impaired.

Changes in the carrying amount of goodwill by segment were as follows:

10. Accrued Liabilities

Accrued liabilities consisted of the following:

11. Stock-based Compensation

The Company has stock-based compensation plans under which it grants stock options, restricted stock awards, performance share awards, restricted stock units and deferred stock units. Accounting guidance requires all share-based payments to be recognized as an operating expense, based on their fair values, over the requisite service period.

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The Company’s stock-based compensation expenses were allocated to the following expense categories:

As of December 31, 2019, approximately $10.5 million of total unrecognized compensation costs related to non-vested awards is expected to be recognized over a weighted average period of approximately 2.7 years.

Stock Option Awards

The Company uses the Black-Scholes option pricing model to determine the weighted average grant date fair value of stock options granted. The weighted average per share fair values of stock options granted during the three months ended December 31, 2019 and 2018 were $14.38 and $18.30, respectively.

The risk-free interest rate assumption was based on the U.S. Treasury’s rates for U.S. Treasury zero-coupon bonds with maturities similar to those of the expected term of the awards. The expected life of options granted was determined based on the Company’s experience. Expected volatility was based on the Company’s stock price movement over a period approximating the expected term. Based on management’s judgment, dividend yields were expected to be 0.0% for the expected life of the options. The Company also estimated forfeitures of options granted, which were based on historical experience.

Non-qualified stock options are granted at fair market value on the date of grant. Non-qualified stock options expire in seven years upon termination of employment or service as a Board member. With respect to members of our Board, non-qualified stock options generally become exercisable on a pro-rata basis within the one-year period following the date of grant. With respect to our employees, non-qualified stock options generally become exercisable with respect to 25% of the shares on each of the first four anniversaries following the grant date. The stock-based compensation table above includes stock option expenses recognized related to these awards, which totaled $0.6 million and $0.5 million for the three months ended December 31, 2019 and 2018.

The total pre-tax intrinsic value of options exercised during the three months ended December 31, 2019 and 2018 was $0.2 million and less than $0.1 million, respectively. The intrinsic value represents the difference between the Company’s common stock fair market value on the date of exercise and the option’s exercise price.

Restricted Stock Awards

The Company has entered into restricted stock agreements with certain key employees, covering the issuance of common stock (“Restricted Stock”). Under accounting guidance, these shares are considered to be non-vested shares. The Restricted Stock is released to the key employees if they are employed by the Company at the end of the vesting period. Restricted Stock vesting periods range from one to three years. During the three months ended December 31, 2019 and 2018, the Company awarded 54,694 and 42,248 Restricted Stock shares, respectively, to certain key employees and officers. Forfeiture of 4,099 and 507 Restricted Stock shares occurred during the three months ended December 31, 2019 and 2018, respectively. As of December 31, 2019 and September 30, 2019, 99,500 and 90,409 Restricted Stock shares were outstanding, respectively. Compensation expense has been recognized for the estimated fair value of the common shares, net of estimated forfeitures, and is being charged to operating expenses over the vesting term. The stock-based compensation expense table includes Restricted Stock expenses recognized related to these awards, which totaled $0.5 million and $0.4 million for the three months ended December 31, 2019 and 2018, respectively.

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Performance Share Awards

The Company has entered into performance share agreements with certain key employees covering the issuance of common stock (“Performance Shares”). Performance Shares vest upon the achievement of all or a portion of certain performance objectives (which may include financial or project objectives), which must be achieved during the performance period. The Organization and Compensation Committee of the Board of Directors (the “Committee”) approves the performance objectives used for our executive compensation programs, which objectives were cumulative revenue and cumulative earnings before interest, income taxes, depreciation and amortization (“EBITDA”) for the three-year performance periods for awards granted in fiscal 2017 (2017 – 2019). The fiscal 2017 awards also included performance objectives related to achievement of the Company’s strategic initiatives. Awards granted in fiscal 2017 were finalized in the three months ended December 31, 2019 and resulted in the issuance of 67,653 shares, with a value of $2.8 million, based on the performance objectives relative to actual results achieved during the performance period. The per share compensation cost for each award was fixed on the grant date. The stock-based compensation expense table includes Performance Shares expense recognized related to these awards, which totaled $0.2 million for the three months ended December 31, 2018. Performance Shares expense recognized in the three months ended December 31, 2019 was insignificant as all Performances Shares were vested as of September 30, 2019.

The fair values of the Performance Shares, at target, were $1.2 million for awards granted in fiscal 2017. There have been no Performance Share awards granted subsequent to fiscal 2017.

1999 Employee Stock Purchase Plan

Under the amended 1999 Employee Stock Purchase Plan (“Stock Purchase Plan”), the Company is authorized to issue up to 600,000 shares of common stock. All full-time and part-time U.S. employees can choose to have up to 10% of their annual compensation withheld, with a limit of $25,000, to purchase the Company’s common stock at purchase prices defined within the provisions of the Stock Purchase Plan. As of December 31, 2019 and September 30, 2019, there was less than $0.1 million of employee contributions included in accrued liabilities in the condensed consolidated balance sheets. Stock compensation expense recognized related to the Stock Purchase Plan for the three months ended December 31, 2019 and 2018 totaled less than $0.1 million in each respective period. The stock-based compensation table includes the Stock Purchase Plan expenses.

Restricted Stock and Deferred Stock Units

During the three months ended December 31, 2019 and 2018, the Company awarded 8,032 and 6,206 restricted stock units (“RSUs”), respectively, to non-employee directors and certain key employees in foreign jurisdictions. RSU awards are not considered issued or outstanding common stock of the Company until they vest. As of December 31, 2019 and September 30, 2019, outstanding, unvested RSUs totaled 62,113 and 62,242, respectively. Compensation expense has been recognized for the estimated fair value of the common shares and is being charged to operating expenses over the vesting term. The estimated fair value of the RSUs was calculated based on the closing market price of Surmodics’ common stock on the grant date. The stock-based compensation table includes RSU expenses recognized related to these awards, which totaled $0.2 million and $0.1 million for the three months ended December 31, 2019 and 2018, respectively.

Directors may elect to receive their annual fees for services to the Board in deferred stock units (“DSUs”). Directors may elect this option quarterly. During the three months ended December 31, 2019 and 2018, 823 and 751 units, respectively, were issued with a total fair value of less than $0.1 million in each period. As of December 31, 2019 and September 30, 2018, outstanding, fully vested DSUs totaled 30,552 and 29,729, respectively. Stock-based compensation expense related to DSU awards totaled less than $0.1 million for both the three months ended December 31, 2019 and 2018.

12. Net Income Per Share Data

Basic net income per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period. The Company’s potentially dilutive common shares are those that result from dilutive common stock options, non-vested stock relating to restricted stock awards, restricted stock units and deferred stock units, as well as performance shares in years prior to fiscal 2020. Options to purchase shares of common stock as well as unvested restricted stock and performance stock units are considered to be potentially dilutive common shares.

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The calculation of weighted average diluted shares outstanding excludes outstanding stock options associated with the right to purchase 0.1 million shares of common stock for both the three months ended December 31, 2019 and 2018, as their inclusion would have had an antidilutive effect on diluted net income per share for those periods.

The following table sets forth the denominator for the computation of basic and diluted net income per share (in thousands):

The Company’s Board of Directors has authorized the repurchase of up to $25.3 million of the Company’s outstanding common stock. This authorization does not have an expiration date.

13. Income Taxes

For interim income tax reporting, the Company estimates its annual effective tax rate and applies it to year-to-date pretax (loss) income, excluding unusual or infrequently occurring discrete items. Tax jurisdictions with losses for which tax benefits cannot be realized are excluded. The Company recorded income tax benefit of $0.3 million and $0.2 million for the three months ended December 31, 2019 and 2018, respectively. 

The effective income tax rate for the three months ended December 31, 2019 and 2018 differs from the U.S. federal statutory tax rate of 21% primarily due to the favorable impacts of the U.S. federal research and development tax credits in both periods, as well as stock award activity in the three-month period and operating results of our Irish subsidiary, where tax benefit is offset by a valuation allowance. The effective income tax rate for the three months ended December 31, 2019 and 2018 was impacted by discrete tax benefits of $0.2 million and $0.5 million, respectively, related to share awards vested, expired, cancelled and exercised during the periods. 

The total amount of unrecognized tax benefits, excluding interest and penalties that, if recognized, would affect the effective tax rate is $2.7 million and $2.1 million as of December 31, 2019 and September 30, 2019, respectively. Interest and penalties related to unrecognized tax benefits are recorded in the income tax (benefit) provision.

The Company files income tax returns, including returns for its subsidiaries, in the U.S. federal jurisdiction and in various state jurisdictions as well as several non-U.S. jurisdictions. Uncertain tax positions are related to tax years that remain subject to examination. U.S. income tax returns for years prior to fiscal 2015 are no longer subject to examination by federal tax authorities. For tax returns for state and local jurisdictions, the Company is no longer subject to examination for tax years generally before fiscal 2009. For tax returns for non-U.S. jurisdictions, the Company is no longer subject to income tax examination for years prior to 2014. Additionally, the Company has been indemnified of liability for any taxes relating to Creagh Medical and NorMedix for periods prior to their respective acquisition dates, pursuant to the terms of the related share purchase agreements. As of December 31, 2019 and September 30, 2019, there were no undistributed earnings in foreign subsidiaries.

14. Segment Information

The Company’s management evaluates performance and allocates resources based on reported results for two reportable segments, as follows: (1) the Medical Device unit, which designs, develops and manufactures interventional medical devices, primarily for the peripheral vascular market; surface modification coating technologies to improve access, deliverability, and predictable deployment of medical devices; as well as drug-delivery coating technologies to provide site-specific drug-delivery from the surface of a medical device, with end markets that include coronary, peripheral, neuro-vascular and urology, among others, and (2) the In Vitro Diagnostics unit, which consists of component products and technologies for diagnostic test kits and biomedical research applications, with products that include protein stabilization reagents, substrates, antigens and surface coatings.

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Segment revenue, operating (loss) income, and depreciation and amortization, were as follows:

The Corporate category includes expenses that are not fully allocated to Medical Device and In Vitro Diagnostics segments. These Corporate costs are related to functions, such as executive management, corporate accounting, legal, human resources and Board of Directors. Corporate may also include expenses which are not specific to a segment and thus not allocated to the operating segments.

Asset information by operating segment is not presented because the Company does not provide its chief operating decision maker assets by operating segment, as the data is not readily available or significant to the decision-making process.

15. Leases

The Company leases facilities for research, office, manufacturing and warehousing. The Company determines whether a contract is a lease or contains a lease at inception date. Upon commencement, the Company recognizes a right-of-use asset and lease liability based on the net present value of the future minimum lease payments over the lease term at the commencement date. The unamortized balance of leasehold improvement incentives in the form of tenant allowances represents the primary difference between the balance of the right-of-use assets and operating lease liabilities. As the Company’s leases typically do not provide an implicit rate, the Company’s lease liabilities are measured on a discounted basis using the Company's incremental borrowing rate. Lease terms used in the recognition of right-of-use assets and lease liabilities include only options to extend the lease that are reasonably certain to be exercised. The condensed consolidated balance sheets do not include recognized assets or liabilities for leases that, at the commencement date, have a term of twelve months or less and do not include an option to purchase the underlying asset that is reasonably certain to be exercised. The Company recognizes such leases in the condensed consolidated statements of income on a straight-line basis over the lease term.

The Company’s leases include one or more options to renew and extend the lease term at the Company’s discretion. These renewal options are not included in our right-of-use assets and lease liabilities as they are not reasonably certain of exercise. We regularly evaluate the renewal options and when they are reasonably certain of exercise, we include the renewal period in our lease term.

The Company's operating lease cost for the three months ended December 31, 2019 was $0.1 million. Cash paid for operating lease liabilities approximated operating lease cost for the three months ended December 31, 2019.

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Operating lease right-of-use assets and operating lease liabilities were as follows:

As of December 31, 2019, operating lease maturities for the remainder of fiscal 2020 and each of the next five fiscal years are as follows (in thousands):

As of December 31, 2019, the weighted average remaining lease term for operating leases was 8.2 years and the weighted average discount rate used to determine operating lease liabilities was 4.6%.

16. Commitments and Contingencies

Litigation. From time to time, the Company may become involved in various legal actions involving its operations, products and technologies, including intellectual property and employment disputes. The outcomes of these legal actions are not within the Company’s complete control and may not be known for prolonged periods of time. In some actions, the claimants seek damages as well as other relief, including injunctions barring the sale of products that are the subject of the lawsuit, which if granted, could require significant expenditures or result in lost revenue. The Company records a liability in the condensed consolidated financial statements for these actions when a loss is known or considered probable and the amount can be reasonably estimated. If the reasonable estimate of a known or probable loss is a range, and no amount within the range is a better estimate, the minimum amount of the range is accrued. If a loss is possible but not known or probable, and can be reasonably estimated, the estimated loss or range of loss is disclosed. In most cases, significant judgment is required to estimate the amount and timing of a loss to be recorded. 

InnoCore Technologies BV. In March 2006, the Company entered into a license agreement whereby the Company obtained an exclusive license to a drug delivery coating for licensed products within the vascular field which included peripheral, coronary and neurovascular biodurable stent products. The license requires an annual minimum payment of 200,000 euros (equivalent to $224,000 using a euro to US dollar exchange rate of $1.1215 to the Euro as of December 31, 2019) until the last patent expires, which is currently estimated to be September 2027. The total minimum future payments associated with this license are approximately $1.8 million as of December 31, 2019. The license is currently utilized by one of the Company’s drug delivery customers.

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Clinical Trials. The Company has engaged clinical trial clinical research organization (“CRO”) consultants to assist with the administration of its ongoing clinical trials. The Company has executed separate contracts with two CROs for services rendered in connection with the TRANSCEND pivotal clinical trial for the SurVeil DCB, including pass-through expenses paid by the CROs, of up to $26 million in the aggregate. As of December 31, 2019, an estimated $11.9 million remains to be paid on these contracts, which may vary depending on actual pass-through expenses incurred to execute the trial. The Company estimates that the total cost of the TRANSCEND clinical trial will be in the range of $35 million to $40 million from inception to completion. In the event the Company were to terminate any trial, it may incur certain financial penalties which would become payable to the CRO for costs to wind down the terminated trial.

Asset Acquisitions. In July 2019, the Company acquired certain intellectual property assets supporting ongoing development of the Company’s medical device pipeline. As a result of this acquisition, the Company made an upfront, nonrefundable payment of $0.8 million. In addition, the Company is obligated to pay up to $1.3 million of additional consideration upon achievement of certain strategic milestones within a contingency period ending in 2022, of which $0.2 million is guaranteed to be paid in fiscal 2021.

In May 2018, the Company acquired certain intellectual property assets of Embolitech, LLC (the “Embolitech Transaction”). As part of the Embolitech Transaction, the Company paid the sellers $5.0 million during fiscal 2018. Additionally, the Company is obligated to pay $3.5 million in several installments beginning in fiscal 2020 and ending in fiscal 2024. These payments may be accelerated upon the occurrence of certain sales and regulatory milestones. An additional $2.0 million payment is contingent upon the achievement of certain regulatory milestones within a contingency period ending in 2033.

As of December 31, 2019, $1.2 million and $2.1 million, respectively, is included in other accrued and other long-term liabilities on the condensed consolidated balance sheets related to the Embolitech Transaction. As of September 30, 2019, $1.0 million and $2.1 million is included in other accrued liabilities and other long-term liabilities, respectively, on the consolidated balance sheets related to the Embolitech Transaction.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis provides information management believes is useful in understanding the operating results, cash flows and financial condition of Surmodics, Inc. and subsidiaries (referred to as “Surmodics,” the “Company,” “we,” “us,” “our” and other like terms). The discussion should be read in conjunction with both the unaudited condensed consolidated financial statements and related notes included in this Form 10-Q and our audited consolidated financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations, each included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2019. This discussion contains various “Forward-Looking Statements” within the meaning of the Private Securities Litigation Reform Act of 1995. We refer readers to the statement entitled “Forward-Looking Statements” located at the end of this Item 2.

Overview

Surmodics is a leading provider of medical device and in vitro diagnostic technologies to the healthcare industry, with the mission of improving the detection and treatment of disease. Our revenue performance continues to be driven by growth in our Medical Device and In Vitro Diagnostics (“IVD”) product offerings. We remain committed to developing medical device products and platforms leveraging the technologies and manufacturing capabilities in our Medical Device business unit for the treatment of peripheral arterial disease (“PAD”) and other vascular diseases. Our primary focus has been the continued development of our drug-coated balloon (“DCB”) platform, our radial access device platform, and our thrombectomy device platform.

Product Development

Our business model for our whole-product solutions strategy is to design, develop and manufacture highly differentiated products that incorporate our proprietary catheter, balloon, thrombectomy and/or surface modification coating technologies to improve patient outcomes and reduce procedure costs, while maintaining patient safety. We are focused on developing devices that consider the needs of various care settings ranging from hospitals to alternate care facilities, in order to provide improved care and address unmet needs in the treatment of PAD and other vascular diseases. Our strategy has been built on our investment in proprietary device technologies, as well as state-of-the-art medical device design, development and manufacturing capabilities. Over the past several years, we have made investments to enhance our clinical and regulatory capabilities, and in fiscal 2020, we intend to make additional investments to obtain clinical data, reduce the time from product development to commercialization, and drive clinician engagement with our products after approval to optimize adoption.

Below is a brief summary of our pipeline of medical device products under development and recently commercialized, grouped by product family.

Drug-coated balloons

Radial access

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Thrombectomy

Specialty catheters

For more information regarding our product development and commercialization strategy, see Part I, Item 1 of our Annual Report on Form 10-K for the fiscal year ended September 30, 2019.

Photolink^TM Fourth-Generation Patents

Our fourth-generation PhotoLink hydrophilic technology is protected by a family of patents that expired in the first quarter of fiscal 2020 in all countries where patent coverage existed for this technology. The Medical Device business royalty revenue associated with our fourth-generation hydrophilic coating technology was approximately 21% of our fiscal 2019 revenue. Of the license agreements using our early-generation technologies, most continue to generate royalty revenue, at a reduced royalty rate, beyond patent expiration. The remainder of our royalty revenues are derived from our other coatings that are protected by a number of patents that extend to at least fiscal 2035.

Critical Accounting Policies and Significant Estimates

Critical accounting policies are those policies that require the application of management’s most challenging, subjective or complex judgment, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. Critical accounting policies involve judgments and uncertainties that are sufficiently likely to result in materially different results under different assumptions and conditions. For the three months ended December 31, 2019, there were no significant changes in our critical accounting policies. For a detailed description of our other critical accounting policies and significant estimates, see Management’s Discussion and Analysis of Financial Condition and Results of Operations under Item 7 in our Annual Report on Form 10-K for the fiscal year ended September 30, 2019.

Results of Operations

Three Months Ended December 31, 2019 and 2018

Revenue. Revenue for the first quarter of fiscal 2020 was $22.6 million, an increase of $0.4 million, or 1.7%, as compared with the first quarter of fiscal 2019. The following is a summary of each operating segment’s revenue.

Medical Device. Medical Device revenue was $17.4 million in the first quarter of fiscal 2020 and was essentially flat as compared with the first quarter of fiscal 2019. Product sales increased 5.1%, or $0.2 million, for the first quarter of fiscal 2020 as compared with the prior-year quarter, with growth in coatings reagents partially offset by weakness in legacy balloon catheter products. Research, development and other revenue was level with the prior year period. Royalties and license fee revenue was essentially flat as compared with the prior-year first quarter. Impacting royalty revenue in the first quarter of fiscal 2020 was a $0.7 million one-

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time catchup payment for previously under-reported hydrophilic coating royalty revenue, as well as growth in royalties from our hydrophilic coatings customers. These increases were offset by a $1.1 million planned decrease in license fee revenue from the Abbott Agreement due to reduced TRANSCEND clinical trial spending subsequent to full trial enrollment in the fourth quarter of fiscal 2019. As expected, the aforementioned patent expiration for our fourth-generation hydrophilic coating had an insignificant revenue impact in the first quarter of fiscal 2020. For the full fiscal 2020, the revenue impact of this expiration is expected to range from $5.0 to $5.5 million.

In Vitro Diagnostics. In Vitro Diagnostics revenue increased 4.6% to $5.2 million in the first quarter of fiscal 2020 as compared with $5.0 million for the first quarter of fiscal 2019, primarily due to growth in sales of our microarray slides.

Major costs and expenses as a percentage of total revenue were as follows:

Product costs. Product gross margin (defined as product sales less related product costs) was 67.9% and 63.9% of product sales for the first quarter of fiscal 2020 and 2019, respectively. Current-quarter product gross margin was favorably impacted by product mix in our Medical Device business.

Research and development (R&D) expenses. R&D expenses increased $0.7 million to 54% of revenue in the first quarter of fiscal 2020, as compared with 52% of revenue for the same prior-year period. This increase is due to investment in our medical device pipeline, with personnel investments in quality, technical, regulatory, and proprietary product development. Partially offsetting these increases was planned lower TRANSCEND clinical trial spending with the progression from active enrollment in fiscal 2019 to patient follow up in fiscal 2020. For the full fiscal 2020, R&D expenses are anticipated to be the mid-to-high fifties as a percent of revenue.

Selling, general and administrative (SG&A) expenses. SG&A expenses increased $1.0 million to 31% of revenue in the first quarter of fiscal 2020, as compared with 27% of revenue for the same prior-year period. Contributing to the increase in SG&A expense during the quarter were increased investments to support product pipeline development and preparation for product market evaluations. For the full fiscal 2020, SG&A expenses are expected to be in the low-to-mid thirties as a percent of revenue.

Acquired intangible asset amortization. As part of our fiscal 2016 acquisitions in our Medical Device business, we acquired certain intangible assets which are being amortized over periods ranging from 4 to 14 years. In addition, we own certain intangible assets related to the BioFx acquisition in fiscal 2007. We recognized $0.6 million in amortization expense related to these acquisitions in the three months ended December 31, 2019 and 2018.

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