The following discussion and analysis of our financial condition, results of operations and trends for the future should be read together with "Selected Financial Data" and our audited consolidated financial statements and related notes appearing elsewhere in this report. Any discussion and analysis regarding trends in our future financial condition and results of operations are forward-looking statements that involve risks, uncertainties and assumptions, as more fully identified in "Forward-Looking Statements" and "Risk Factors." Our actual future financial condition and results of operations may differ materially from those anticipated in the forward-looking statements.

Overview

SurModics is a leading provider of drug delivery and surface modification technologies to the healthcare industry. In November 2008, we announced that we were changing our organizational structure so that we will now be organized into four clinically and market focused business units: Cardiovascular, Ophthalmology, In Vitro Technologies, and Brookwood Pharmaceuticals. We believe that this structure will improve the visibility, marketing and adoption of the Company's broad array of technologies within specific markets and help its customers in the medical device, pharmaceutical and life science industries solve unmet clinical needs. In addition, a new centralized research and development function has been formed to serve the needs of the Company's clinically and market focused business units. Brookwood Pharmaceuticals' research and development operations will remain unchanged. Because this change occurred in fiscal 2009 and is not useful in explaining our fiscal 2008 results, we will primarily describe our business below as it operated in fiscal 2008.

Until November 2008, the Company was organized into three operating segments composed of seven technology-centered and industry-focused business units. The "Drug Delivery" operating segment contains: (1) the Drug Delivery business unit, which was responsible for technologies dedicated to site-specific delivery of drugs; (2) the Ophthalmology business unit, which was dedicated to the advancement of treatments for eye diseases, such as age-related macular degeneration (AMD) and diabetic macular edema (DME), two of the leading causes of blindness; and (3) the Brookwood Pharmaceuticals unit, which provides proprietary polymer-based

technologies to companies developing improved pharmaceutical products. The "Hydrophilic and Other" operating segment consisted of three business units:
(1) the Hydrophilic Technologies business unit, which focused on enhancing medical devices with advanced lubricious coatings that facilitate their placement and maneuverability in the body; (2) the Regenerative Technologies business unit, which developed platforms intended to augment or replace tissue/organ function (e.g., cell encapsulation applications), or to modify medical devices to facilitate tissue/organ recovery through natural repair mechanisms (e.g., hemo/biocompatible or prohealing coatings); and (3) the Orthopedics business unit, which was committed to innovative solutions for orthopedics patients using proven SurModics technologies, and creating new technology solutions to existing patient care gaps in the orthopedics field. The "In Vitro" operating segment contains the In Vitro Technologies business unit, which includes our microarray slide products, our stabilization products, antigens and substrates for immunoassay diagnostic tests, our in vitro diagnostic format technology and our synthetic ECM cell culture products.

Revenue in each of our operating segments in fiscal 2008 is derived from three primary sources: (1) royalties and license fees from licensing our patented drug delivery and surface modification technologies and in vitro diagnostic formats to customers; the vast majority (typically in excess of 90%) of revenue in the "royalties and license fees" category is in the form of royalties; (2) the sale of polymers and reagent chemicals, stabilization products, antigens and substrates and microarray slides to the diagnostics and biomedical research industry; and (3) research and development fees generated on customer projects. Revenue should be expected to fluctuate from quarter to quarter depending on, among other factors: our customers' success in selling products incorporating our technologies; the timing of introductions of coated products by customers; the timing of introductions of products that compete with our customers' products; the number and activity level associated with customer development projects; the number and terms of new license agreements that are finalized; the value of reagent chemicals and other products sold to licensees; and the timing of future acquisitions we complete, if any.

For financial accounting and reporting purposes, we have treated our three operating segments as one reportable segment. We made this determination because a significant percentage of our employees provide support services (including research and development) to each operating segment; technology and products from each operating segment are marketed to the same or similar customers; each operating segment uses the same sales and marketing resources; and each operating segment operates in the same regulatory environment. We will be reviewing our segment reporting for fiscal 2009 as a result of the changes to our organizational structure in November 2008.

In June 2007, we signed a collaborative research and license agreement with Merck & Co., Inc. ("Merck") to pursue the joint development and commercialization of the I-vation sustained drug delivery system with triamcinolone acetonide and other products that combine Merck proprietary drug compounds with the I-vation system for the treatment of serious retinal diseases. Under the terms of our agreement with Merck, we received an up-front license fee of $20 million and had the potential to receive up to an additional $288 million in fees and development milestones associated with the successful product development and attainment of appropriate U.S. and EU regulatory approvals for these new combination products.

In September 2008, Merck gave notice that it was terminating the collaborative research and license agreement, as well as the supply agreement entered into in June 2007, following a strategic review of Merck's business and product development portfolio. The termination is expected to be effective December 16, 2008. We anticipate that the revenue deferred under the accounting treatment required by Emerging Issues Task Force Issue (EITF) No. 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables," totaling $34.8 million as of September 30, 2008, will be recognized in the first quarter of fiscal 2009. In addition, we anticipate recognizing a $9 million milestone payment from Merck associated with the termination of the triamcinolone acetonide development program. This program terminated 30 days following the notice given in September 2008.

In July 2007, we acquired Brookwood Pharmaceuticals, Inc. ("Brookwood") by paying cash to Southern Research Institute, which owned the capital stock of Brookwood. Brookwood is a drug delivery company based in Birmingham, Alabama that provides its proprietary polymer-based technologies to companies developing improved pharmaceutical products. Brookwood is a wholly owned subsidiary of SurModics and is reported as part of our Drug Delivery operating segment. Our consolidated financial statements have included the operating results of Brookwood since the date of the acquisition.

In August 2007, we acquired all of the assets of BioFX Laboratories, Inc. ("BioFX") by paying cash to BioFX stockholders. Based in Owings Mills, Maryland, BioFX is a leading provider of innovative reagents and substrates for the biomedical research and medical diagnostic markets. BioFX is a wholly owned subsidiary of SurModics and is reported as part of our In Vitro operating segment. Our consolidated financial statements have included the operating results of BioFX since the date of the acquisition.

In November 2008, we acquired a portfolio of intellectual property and collaborative drug delivery projects from PR Pharmaceuticals, Inc., a drug delivery company specializing in injectable, biodegradable sustained release formulations. The proprietary technologies we acquired complement and enhance the existing portfolio of drug delivery capabilities available from SurModics and Brookwood by providing a broader toolkit for protein delivery and the ability to use smaller gauge needles for microparticle injections. In addition, the multiple customer development programs we assumed complemented the diversified portfolio of customer projects at Brookwood and we believe will further leverage the investment we are making in cGMP manufacturing facilities.

Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements is based in part on the application of significant accounting policies, many of which require management to make estimates and assumptions (see Note 2 to the consolidated financial statements). Actual results may differ from these estimates under different assumptions or conditions and could materially impact our results of operations. We believe the following are critical areas in the application of our accounting policies that currently affect our financial condition and results of operations.

Revenue recognition. In accordance with SEC Staff Accounting Bulletin (SAB) No. 104, "Revenue Recognition," revenue is recognized when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) shipment has occurred or delivery has occurred if the terms specify destination; (3) the sales price is fixed or determinable; and (4) collectability is reasonably assured. However, when there are additional performance requirements, revenue is recognized when such requirements have been satisfied. Royalty revenue is generated when a licensed customer sells products incorporating our technologies. Royalty revenue is recognized as our licensees report it to us, and payment is typically submitted concurrently with a quarterly report. Revenue related to a performance milestone is recognized upon achievement of the milestone and meeting specific revenue recognition criteria. We recognize initial license fees over the term of the related agreement. Minimum royalty fees are recognized in the period earned. Product sales to third parties are recognized at the time of shipment, provided that an order has been received, the price is fixed or determinable, collectability of the resulting receivable is reasonably assured and returns can be reasonably estimated. Our sales terms provide no right of return outside of our standard warranty policy. Payment terms are generally set at 30-45 days. Generally, revenue for research and development is recorded as performance progresses under the applicable contract. When we have revenue arrangements with multiple deliverables, we comply with EITF No. 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables," and recognize each element as it is earned.

Costs related to products delivered are recognized in the period revenue is recognized except for services related to the Merck agreement, which are recognized as incurred. Customer advances are accounted for as a liability until all criteria for revenue recognition have been met.

Valuation of long-lived assets. We periodically evaluate whether events and circumstances have occurred that may affect the estimated useful life or the recoverability of the remaining balance of long-lived assets, such as property and equipment. If such events or circumstances were to indicate that the carrying amount of these assets would not be recoverable, we would estimate the future cash flows expected to result from the use of the assets and their eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) or other measure of fair value were less than the carrying amount of the assets, we would recognize an impairment charge.

Goodwill. Goodwill represents the excess of the cost of the acquired entities over the fair value assigned to the assets purchased and liabilities assumed in connection with the Company's acquisitions. Goodwill is not amortized but is subject, at a minimum, to annual tests for impairment in accordance with Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." Under certain situations, interim

impairment tests may be required if events occur or circumstances change indicating that the carrying amount of goodwill may be impaired.

Evaluating goodwill for impairment involves the determination of the fair value of our reporting units in which we have recorded goodwill. A reporting unit is a component of an operating segment for which discrete financial information is available and reviewed by management on a regular basis. SurModics has determined that its reporting units are its Brookwood business unit, a component of the Drug Delivery operating segment, and the In Vitro operating segment.

We performed our annual impairment test of goodwill in the fourth quarter of fiscal 2008 and did not record an impairment charge. In evaluating whether goodwill was impaired, we compared the fair value of reporting units to which goodwill is assigned to their carrying value (step one of the impairment test). In calculating fair value, we used a valuation technique based on multiples of revenue and book value for comparable companies since the technique is consistent with the objective of measuring fair value. The comparison companies selected have operations comparable to each of the SurModics reporting units for which indefinite-lived assets were being evaluated.

Investments. Investments consist principally of U.S. government and government agency obligations and mortgage-backed securities and are classified as available-for-sale or held-to-maturity at September 30, 2008. Our investment policy calls for no more than 5% of investments be held in any one credit issue, excluding U.S. government and government agency obligations. Available-for-sale investments are reported at fair value with unrealized gains and losses net of tax 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 in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Our evaluation of the available-for-sale investments resulted in loss recognition of $4.3 million related to our investment in OctoPlus N.V. (included in Other Assets in the Consolidated Balance Sheet) in fiscal 2008, as we determined the loss to be an other-than-temporary impairment based on a significant decline in the stock price. The impairment of the OctoPlus N.V. investment has resulted in a new cost basis. Investments which management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. If there is an other-than-temporary impairment in the fair value of any individual security classified as held-to-maturity, the Company will write down the security to fair value with a corresponding adjustment to other income
(loss). Interest on debt securities, including amortization of premiums and accretion of discounts, is included in other income (loss). Realized gains and losses from the sales of debt securities, which are included in other income
(loss), are determined using the specific identification method.

Income tax accruals and valuation allowances. When preparing the Consolidated Financial Statements, we are required to estimate the income taxes in each of the jurisdictions in which we operate. This process involves estimating the actual current tax obligations based on expected income, statutory tax rates and tax planning opportunities in the various jurisdictions. In the event there is a significant unusual or one-time item recognized in the results of operations, the tax attributable to that item would be separately calculated and recorded in the period the unusual or one-time item occurred. Tax law requires certain items to be included in our tax return at different times than the items are reflected in our results of operations. As a result, the annual effective tax rate reflected in our results of operations is different than that reported on our tax return (i.e., our cash tax rate). Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some are temporary differences that will reverse over time, such as depreciation expense on capital assets. These temporary differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheets. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax return in future years for which we have already recorded the expense in our Consolidated Statements of Income. We must assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance against those deferred tax assets. Deferred tax liabilities generally represent items for which we have already taken a deduction in our tax return, but we have not yet recognized the items as expense in our results of operations. Significant judgment is required in evaluating our tax positions, and in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We had total deferred tax assets in excess of total deferred tax liabilities of $12.2 million as of September 30, 2008 and $7.0 million as of September 30, 2007, including valuation allowances of $3.4 million as of September 30, 2008 and $1.8 million as

of September 30, 2007. The valuation allowances related to impairment losses on investments and were recorded because the Company does not currently foresee future capital gains within the allowable carry-forward and carry-back periods to offset these capital losses when they are recognized. As such, no tax benefit has been recorded in the Consolidated Statements of Income.

The Company adopted the provisions of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109," on October 1, 2007. The new standard defines the threshold for recognizing the benefits of tax return positions in the financial statements as "more-likely-than-not" to be sustained by the taxing authorities based solely on the technical merits of the position. If the recognition threshold is met, the tax benefit is measured and recognized as the largest amount of tax benefit that, in our judgment, is greater than 50 percent likely to be realized. The total gross amount of unrecognized tax benefits as of September 30, 2008 was $1.5 million, excluding accrued interest and penalties. $1.3 million of these tax benefits would affect our effective tax rate if recognized. Interest and penalties recorded for uncertain tax positions are included in our income tax provision. As of September 30, 2008, $0.4 million of interest and penalties was accrued, excluding the tax benefits of deductible interest. Fiscal years 2005, 2006 and 2007 remain subject to examination by federal tax authorities. Tax returns for state and local jurisdictions for fiscal years 2003 through 2007 remain subject to examination by state and local tax authorities. In the event that we have determined not to file tax returns with a particular state or local jurisdiction, all years remain subject to examination by the tax authorities. The ultimate outcome of tax matters may differ from our estimates and assumptions. Unfavorable settlement of any particular issue would require the use of cash and could result in increased income tax expense. Favorable resolution could result in reduced income tax expense. Within the next 12 months, we do not expect that our unrecognized tax benefits will change significantly. See Note 5 to the Consolidated Financial Statements for further information regarding the impact of adopting this new standard as well as changes in unrecognized tax benefits during fiscal 2008.

Results of Operations

                    Years Ended September 30, 2008 and 2007


                                   Fiscal       Fiscal
         (Dollars in thousands)     2008         2007       Increase       % Change

         Revenue:
         Drug Delivery            $ 43,938     $ 26,488     $  17,450             66 %
         Hydrophilic and Other      31,864       26,493         5,371             20 %
         In Vitro                   21,249       20,183         1,066              5 %

         Total revenue            $ 97,051     $ 73,164     $  23,887             33 %

Revenue. Fiscal 2008 revenue was $97.1 million, an increase of $23.9 million or 33% from fiscal 2007. We experienced growth in all three operating segments, as detailed in the table above and further explained in the narrative below.

Drug Delivery. Revenue in the Drug Delivery segment increased 66% to $43.9 million in fiscal 2008. The increase in total revenue reflects a significant increase in research and development fees, which was partially offset by an 8% decrease in royalties and license fees related to drug delivery and ophthalmology projects. Brookwood contributed $20.6 million and $2.4 million in revenue for fiscal 2008 and 2007, respectively. Fiscal 2007 results included Brookwood for only two months, as the acquisition closed on July 31, 2007.

Drug Delivery derives a substantial portion of its revenue from royalties and license fees and product sales attributable to Cordis Corporation, a subsidiary of Johnson & Johnson, on its CYPHER® Sirolimus-eluting Coronary Stent. The CYPHER® stent incorporates a proprietary SurModics polymer coating that delivers a therapeutic drug designed to reduce the occurrence of restenosis in coronary artery lesions.

The decrease in Drug Delivery royalties and license fees principally reflects a 19% decrease in royalty revenue from Cordis as a result of lower CYPHER® sales, partially offset by an increase in royalties and license fees from ophthalmology customers, as well as an increase in research and development fees from drug delivery and ophthalmology customers. We received $11 million in license fees from Merck in association with the collaborative

research and license agreement we signed in fiscal 2007. However, we recognized as revenue only a small portion of these fees, as well as the initial $20 million license fee from Merck paid in fiscal 2007, as we are amortizing these amounts over the estimated economic life of the technology we licensed to Merck. Fiscal 2008 sales of reagent chemicals (chemicals that we manufacture and sell to licensees for coating their medical devices) to Cordis decreased significantly compared with the prior year.

The CYPHER® stent, from which we derive a substantial amount of our Drug Delivery revenue, faces continuing competition from drug-eluting stents manufactured by Boston Scientific, Medtronic and Abbott. These stents compete directly with the CYPHER® stent both domestically and internationally. The Company also receives a royalty on the Medtronic Endeavor® drug-eluting stent, but the associated royalty revenue is reflected in the Hydrophilic and Other segment. In addition to competition among the various players, the total size of the drug-eluting stent market has decreased significantly in the past two years as a result of concerns about product safety, mostly related to potential clotting associated with stents. Therefore, future royalty and reagent sales revenue could decrease due to lower CYPHER® stent sales as a result of the overall market contraction and the ongoing and expected future competition. We anticipate that quarterly royalty revenue from the CYPHER® stent may be volatile throughout fiscal 2009 and beyond as the various marketers of drug-eluting stents continue competing in the marketplace and as others enter the marketplace.

The inclusion of Brookwood, which contributed to Drug Delivery revenue for only two months in fiscal 2007, impacted the overall revenue and revenue mix in fiscal 2008, as a substantial majority of Brookwood's revenue is comprised of research and development fees. Our research and development revenue increased 344% to $22.0 million in fiscal 2008 and it constituted a majority of total Drug Delivery revenue.

In September 2008, following a strategic review of its business and product development portfolio, Merck gave notice that it was terminating the collaborative research and license agreement as well as the supply agreement entered into in June 2007. The termination is expected to be effective December 16, 2008. We anticipate that the revenue deferred under the accounting treatment required by Emerging Issues Task Force Issue No. 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables," totaling $34.8 million as of September 30, 2008, will be recognized in the first quarter of fiscal 2009. In addition, we anticipate recognizing a $9 million milestone payment from Merck associated with the termination of the triamcinolone acetonide development program. This program terminated 30 days following the notice given in September 2008.

Hydrophilic and Other. Hydrophilic and Other revenue increased 20% to $31.9 million, primarily as a result of 21% growth in royalties and license fees and 60% growth in research and development fees. In contrast to our Drug Delivery segment, where a significant percentage of revenue is attributable to Cordis, there are several dozen licensees and an even larger number of coated products generating royalties in our Hydrophilic and Other segment. The growth in royalties principally reflects increased sales of coated products already on the market, and to a lesser extent newly introduced licensed products.

In Vitro. Revenue in the In Vitro segment increased 5% to $21.2 million. The increase was mainly attributable to increased product sales, principally as a result of the addition of $4.6 million of BioFX products sold during the year as compared with BioFX product sales of $0.5 million in fiscal 2007. Operating results of BioFX have been included in the Company's consolidated financial statements since August 14, 2007. The product sales increase was substantially offset by a 27% decrease in royalties and license fees. Royalties and license fees likely will decrease in fiscal 2009. In Vitro derives a significant percentage of its revenue from GE Healthcare and Abbott Laboratories. Royalty revenue generated under our diagnostic format patent license agreement with Abbott Laboratories (the "Abbott Agreement") is expected to cease following the expiration of the licensed patents in December 2008. Consistent with our revenue recognition practices, royalty revenue is recognized as licensees report it to us, which typically occurs one quarter following the sales of the licensee's products. Accordingly, we expect royalties generated under the Abbott Agreement . . .