Back to Neutral on SurModics

We are reverting to a Neutral recommendation on SurModics Inc. ( SRDX - Analyst Report ) ) from Outperform as we believe that the stock is fairly valued at current levels. Our target price is $27.00. The stock carries a Zacks Rank #3 (Hold) in the short run.

Why the Downgrade?

In Jan 2013, SurModics came out with decent numbers for the first quarter of fiscal 2013 (ended Dec 31, 2012). The company’s first quarter fiscal 2013 adjusted earnings of 22 cents per share beat the Zacks Consensus Estimate by 4 cents, driven by higher revenues. Adjusted revenues climbed 18.1% year over year to $13.8 million. Increased sales of vitro diagnostics offerings and hydrophilic coatings were the primary reasons behind the year-over-year improvement.

We note that SurModics has taken a number of steps to improve efficiency following its disappointing performance in fiscal 2010. The company trimmed its workforce and made certain changes to its organizational structure.

Moreover, following the disappointing performance in fiscal 2010, SurModics revamped its board of directors and brought about a change at its helm, with the appointment of Gary R. Maharaj as the CEO.

We are positive on the sale of SurModics’ Pharmaceuticals unit in 2011 as this has allowed the company to focus on its core businesses.

However, since royalties are a major source of revenues at SurModics, any royalty-related setback will affect the top line. For example, Johnson & Johnson’s ( JNJ - Analyst Report ) decision to stop manufacturing Cypher and Cypher Select Plus sirolimus-eluting coronary stents, from which SurModics earned royalties, affected the latter’s top line. Setbacks of a similar nature will negatively impact SurModics’ stock price in the future.

While encouraged by the steps taken by the company to revive itself, we see limited upside potential for the stock from current levels and hence downgrade the stock to Neutral.

Other Stocks to Consider

Players in the Medical Devices market, of which SurModics is a part, such as Edwards Lifesciences Corporation ( EW - Analyst Report ) and CareFusion Corporation ( CFN - Snapshot Report ) are well placed and worth considering. Both these companies carry a Zacks Rank #2 (Buy).