J&J's Secret Weapon

What's the big secret? Why did last week's Wall Street Journal front-page spread on Johnson & Johnson's (NYSE: JNJ) breakthrough stent for heart patients barely include as an afterthought the words "the company that makes the polymer"? 

I would think the company whose technological advance enables the product would receive a little more love. Does ye olde Journal have a shortage of type?

Stent-orian
Here in Webland, we have no shortage of type -- or question marks. And here's one: Who cares about stents? A million people a year, that's who. You may have a stent, know someone who has, or have picked up the news on Vice President Cheney's stent. If not, here's a brief review. 

Each year, about one million heart patients undergo angioplasty, in which a cardiovascular surgeon inserts a balloon-tipped catheter into the groin (ouch). It reaches the heart arteries, unclogs vessels, and restores blood flow without surgery. Until 1994, according to reports, 4% to 7% of patients had acute closure of the vessels again within 24 hours, while 40% experienced restenosis, or reblockage, and needed a second procedure.

Starting in 1994, the numbers declined, and restenosis affected only 15% to 20% because Johnson & Johnson, Medtronic (NYSE: MDT), Boston Scientific (NYSE: BSX) and others introduced stents, ballpoint-pen spring-like devices (thanks to WSJ for the metaphor) aimed to reduce reclogging.

Enter the new stent. In human trials necessary to obtain FDA approval, Johnson & Johnson's Cordis division found that its advance prevents 70% to 95% of "redos." The nifty stent is drug-eluting, using a coating technology to deliver a drug that prevents scarring and reblocking. FDA approval is expected early in 2003. The company estimates that the new product's effectiveness and higher prices will double the stent market to $4 billion.  

Harrumph. The "company that provides the polymer," indeed!

And the secret name is...
That company is Minnesota-based SurModics (Nasdaq: SRDX), founded by CEO and Chairman Dale Olseth, age 71, former top exec of leading medical device maker Medtronic. SurModics's latest 10-K (from 2001; the 2002 was not filed by deadline for this column) tells the investor the company exists for one primary reason: to commercialize "its patented PhotoLink process through third-party licensing arrangements."

PhotoLink is a coating technology that, when applied to medical devices, enhances their performance through "lubricity, hemocompatibility, infection resistance, and drug incorporation." Those just happen to be the crucial problems with all medical devices implanted in the body.

Some products on the market or in development using PhotoLink:

• interventional cardiology catheters
• vascular stents
• interventional neurology catheters
• guide wires
• shunts
• cardiac rhythm devices
• urological devices
• microscopic space ships that cruise the circulatory system in search of preytlets 

Skip the last one, and it's still quite a list.

Challenges for the business
The business model is to sign licensees who will use PhotoLink in products, buy reagents for the coatings process from SurModics, and pay the company royalties (the rates are undisclosed) when the products are sold. The stent deal between SurModics and deep-pocket partner Johnson & Johnson validates the technology.

Near term, it's all about the Johnson & Johnson stent, but SurModics is signing other licenses that may lead to other products, too. Its SEC filings reveal that, in the first nine months of the fiscal year ending Sept. 30, it signed five new licensing agreements, versus six last year. Nevertheless, in the first nine months, two licensees accounted for 80% of its reagent sales. This includes Cordis' purchases for several years of human trials of the stent in the U.S. and abroad.

The company hasn't seen anything from genomics applications yet, though in July, former partner Motorola (NYSE: MOT) sold its unsuccessful SurModics-linked biochip (or microarray) business to life science company Amersham (NYSE: AHM). Almost all of the big companies that jumped at the microarray market in 2000 have retreated in pain, leaving Affymetrix (Nasdaq: AFFX) and Agilent (NYSE: A) to divide up the spoils -- not yet profitably, either.

Ultimately -- which can be near or very far away, since I have no facility in determining the competitive advantage period of any particular medical coating -- SurModics must develop the next advance or sell itself before its technology loses its edge.

So while we have a fascinating company with prospects for future growth, Foolish investors know that whether to invest is not only about a company's prospects, but about its valuation and potential to reward you, should its prospects become reality. To the extent you can estimate such a thing, is all its future growth currently reflected in the price?   

Quick and dirty valuation
The stock at Dec. 27 close sells for 68 times trailing-12-month earnings, and 43 times next year's. Revenues grew year over year for the last four quarters at 27%, 31%, 34%, and the most recent quarter's 28%, and for the last four years: 43%, 31%, 24%, and 30%. Earnings per share year over year grew in the last three quarters 9%, 22%, and 25%, with annual gains for the last two years of 14% and 53% (three quarters and two years because the comparison periods were unprofitable). Not bad.

SurModics predicts 25% revenue growth in 2003 and "higher net income growth," as hoped-for FDA approval brings U.S. revenues to join those already flowing from Europe. It's not unreasonable for the stock of a company whose earnings are growing at a 25% or higher rate to command a premium valuation in excess of growth rate, but be prepared: The slightest stumble could knock the stock down the stairs. 

But there's a catch. EPS, or net income, represents the financial health of the business through the eyes of a tax accountant. The true health of the business, to the extent visible, appears in cash flow from operations, especially free cash flow. Here, I have some concerns.

How's it really doing?
Trailing-12-month (TTM) free cash flow (FCF) is $0.01 a share, but even that single penny is misleading. Take out the stock option tax benefit, and it's (0.27) a share. Then excise the investment income and gain on sale of investments, and it's ($0.36) a share. That pulls the carpet out from under any valuation based on EPS.   

Let's match this up against the prior two years:

                        TTM 
                   to 6/30/02   2001    2000
Cash from ops 
 minus capex            $0.01   $0.32  $0.26
Minus tax benefit 
 from stock options     (0.27)  $0.24  $0.21
Minus investment income (0.36)  $0.13  $0.11
Growth rate              N/A       18%    --

This shows that free cash flow from the actual business of licensing, collecting royalties, selling reagents, and conducting collaborative research -- not tax benefits from stock options and investment income -- increased decently from 2000 to 2001 and then evaporated. Given that few investors squint behind EPS, EPS  can sustain a stock price for a long time. But sooner or later, a stock will sell at a reasonable multiple to the free cash flow produced by its business, not its stock options or investments. By this measure, SurModics stock could be heading for quite a fall, even if free cash flow were to resume.

Revenue guesses
How might that fall work? Let's posit some revenue and FCF scenarios. This is a highly artificial exercise, but it's quite sobering. I extrapolate management's view of the first year, 2003, of domestic Cordis stent royalties through 2008. There could be more revenues and better business from that or the non-Cordis side. Or things could be worse. The FDA could delay or deny approval -- unlikely, but it could happen.

Next, stir in 2% annual share dilution from stock options. Newly abstemious management dropped options to almost 0% in 2001 and to 0% in 2002, after truly shocking (or worse, but we are a family website) 14% and 18% net dilution of diluted shares from option grants in 1999 and 2000. I have no beef with options as a form of compensation -- management presumably knows what it takes to get the best people in low unemployment Minnesota to risk careers in new ventures -- as long as they are expensed and below roughly 5% a year for a newer, developing company, and 3% a year for an established one. Two percent may be far too low to account for the risk that management will return to its former ways, or too high if its conversion is permanent.

This example also assumes that revenues are converted to FCF at a 25% rate (free cash flow margin) -- high, but reasonable for a company with high margin license and royalty income. It also assumes that the company sells at a market cap-to-FCF ratio of 25. This is a conservative element in the model, because with 25% growth in FCF, you might reasonably expect the market to assign a higher multiple. For example, Medtronic's FCF growth lags its price-to-FCF multiple in the high 40s, but it has a history of consistently producing the stuff, though at levels that vary significantly from year to year.      

Beginning with a $498 million market cap as of  Dec. 27 close, this table shows what could happen if, at each point, the market brings the stock's valuation in line with free cash flow generation.

                               Year
                02   03    04   05   06   07   08
Rev.growth rate --   25%   25%  25%  25%  25%  25%
Revs.(mils.)   $30  $37   $46  $58  $72  $90 $113
Share dilution**      2%    2%   2%   2%   2%   2%
Adj. revs.(mils.)   $36   $44  $54  $67  $82 $100
FCF margin      --   25%   25%  25%  25%  25% 25%
FCF ($mils.)   $ 0  $ 9   $11  $14  $17  $20  $25
FCF multiple    --   25    25   25   25   25   25
Mkt.cap(mils.)$498 $227* $278 $340 $417 $510 $625
Total return        -55%  -46% -36% -23%  -8%  10%
CAGR***             -55%  -27% -14%  -6%  -2%   2%

*numbers rounded here; not on spreadsheet
**compounded annually
***compound annual growth rate

Under this guesstimate, the returns from today's level are all but nonexistent. It takes six years for the stock to return to current levels and provide a 10% total return and a 1.6% CAGR -- less than a money market account at today's rate -- balanced against the substantial risk for the next several years that the stock could be garroted in half.  

Not only that, but very few companies ever see growth, FCF production, and multiples like this -- outside of extreme bull markets -- unless they are both truly revolutionary and whoppingly successful. Yes, this entrepreneurial company could be that, and even exceed these estimates, but it may not, too. Each investor has to ask whether the potential for this company to succeed beyond 25%-a-year growth is worth the downside risk under this scenario -- especially taking into account the very real possibility of 4% to 6% annual returns from stocks, taken as an average over the next 10 years.    

Bottom line? A fascinating company refreshingly free from excessive management hype, whose products may yield many applications to benefit people, on top of license fees, royalties, and reagent sales, which benefit the company. However, as with many such companies, the stock at current levels is already priced for superior growth and doesn't offer any reward for the risks that the technology may be superseded or not find its way into other big-ticket products.

I'd be willing to take another look at half its Dec. 27 close of $28.89, absent negative business developments and with evidence that revenue growth will exceed these projections. What do you think? The Foolish Community is waiting in our SurModics and Rule Breaker-Companies discussion boards!

Updated portfolio returns below. As of Dec. 30 close, the port is .04% behind the S&P 500 for the year.

Have a most Foolish New Year's Eve, week, and New Year!