The Business

Biocompatibles is a world leader in technology for “Combination Products” – medical products that combine the functionality of a medical device, like an orthopaedic spinal implant or a coronary pacemaker, with the ancillary therapeutic action of a drug, like a bone growth factor or an anti-inflammatory steroid. The growth in the global market for drug eluting coronary stents, from $1.6bn in 2003 to $5.1bn in 2006 was a significant factor in the growth of the wider market for Combination Products whose sales are estimated to reach $10bn in 2009.

We have two businesses – Biocompatibles in Farnham (UK) and CellMed in Alzenau (Germany). Both divisions use bead technology to deliver a therapeutic agent – Farnham delivers established chemical formulations and CellMed delivers novel biological formulations, including stem cell-based therapies. Many drugs are limited by toxicity or related delivery problems and Biocompatibles’ core technology has been developed specifically to overcome these challenges.

Each business uses a proprietary polymer system for bead production and both businesses have first-generation bead products that do not contain any drug – Bead Block and the Phycomer Bead, respectively.

The Board has decided that the Company should, in the next two or three years, focus its management resource and its capital on two parallel goals - establishing a strong package of clinical trial results and maintaining our commercialisation momentum.

We have established distribution agreements with Terumo, a leading supplier of products for interventional medicine, headquartered in Japan; with Rita Medical Systems whose acquisition by Angiodynamics, another leading supplier of products for interventional medicine and headquartered in New York State, was announced in December; and with SciClone Pharmaceuticals, the leading supplier of imported branded pharmaceutical products in China, headquartered in California. These distribution agreements have an average of three years to run and as they expire, we will be reviewing our distribution strategy with an emphasis on demonstrating value for shareholders.

The Vision

Our Vision for Biocompatibles as a whole is the development of a high margin, high growth business based on a range of valuable drug device combination products.

The vision of the Biocompatibles business based in Farnham is the creation and leadership of a market for Drug-Eluting Beads and the recognition of our products as a Gold Standard treatment for HCC and mCRC.

CellMed’s vision is to be first to market with an engineered stem cell product.

Each of the 2007 Goals is a milestone on the way to the realisation of these ambitions.

The Technology

Biocompatibles has a portfolio of granted patents around three biomedical polymer systems – the NFil Technology™ licensed from the Biocure affiliate of Novartis’ Ciba Vision subsidiary, which is used in the Drug-Eluting Beads programme; the CellMed technology, CellBeads®, which is required for the encapsulation of the biological agents delivered in the CellMed programmes; and the PC Technology™ that was the Group’s original platform and which is used for Medtronic's Endeavor® drug-eluting stent and Dideco, amongst other leading medical device companies.

During the course of the year, a transaction to out-license certain PC technology patents for commercialisation by Seal Sands Chemicals Ltd was completed. Seal Sands is a subsidiary of Vertellus Specialties Inc., a specialty chemical organisation. The licence covered the use of PC technology for application to medical devices and excluded the fields of cardiovascular stents, soft contact lenses, embolisation and drug delivery to tumours. An upfront payment of £1.5m was received with the potential for an additional £2m of deferred consideration as well as a share of milestones and royalties secured by Seal Sands from new licenses. This transaction is consistent with the Board’s focus on proprietary products in general and the Drug-Eluting Bead programmes in particular.

The Group’s intellectual property assets comprise our people and their expertise and know-how, the patent portfolio and the trial data published in scientific journals. The progress made last year in relation to the Group’s technology is described in the Operational Review.

Building Value

Biocompatibles’ financial profile is being transformed by the growth in sales and gross margin; but the Group is not yet profitable and the most commonly accepted measure of business success is therefore not available to investors or other stakeholders. This imposes an obligation on the Board and management to be very specific about how the value of the Group is to be increased and risk is to be managed.

There are three ways in which this issue is addressed. First, the Group lays out a vision in the medium-term which is described above, along with annual goals. The Board anticipates that the vision should create value for shareholders. Shareholders can monitor progress in the annual and interim reports. Second, management undertakes the discipline of providing financial guidance to investors and the rest of the financial community on the level of sales and cash consumption. This guidance appears in the Financial Review. Again, shareholders can monitor delivery against these targets. Third, the Board and management review whether there are specific opportunities for accelerating the delivery of value to shareholders. This approach was taken in 2002 with the sale of the cardiovascular stent and contact lens businesses, and the subsequent return to shareholders of £123m of capital. These kinds of strategic initiatives are available with high growth product lines with the potential for significant and sustainable profitability at the gross margin level. The focus of our operational activities is on building such product lines.

Acquisition and Business Development Activity

The Board monitors a short list of acquisition and in-licensing opportunities, which are typically companies that would strengthen the competitiveness of our bead product lines.

Corporate Governance

The Directors place a high priority on maintaining high standards of corporate governance and rigorous management systems, and the Company is in compliance with the Combined Code on Corporate Governance, published in June 2006. Biocompatibles’ quality management system incorporates a number of relevant provisions from the Code (and the Turnbull Guidance), including those relating to risk management and internal control. The internal control risk review ensures that, as the Group and its technology evolves, its approach to risk keeps pace. The Company’s continued accreditation to the ISO 9001-2000 quality standard represents independent verification of the Company’s compliance with some of the key elements of corporate governance.

Since 2001, the Company has also held both the FTSE4Good and Investor in People accreditations. The FTSE4Good status symbolises a commitment to high standards of corporate and social responsibility, and Investor in People recognises the Group’s dedication to employee development.

Memorandum and Articles of Association

Management of Risk

The Biocompatibles’ share price is more volatile than the average share on the London stock market, not least because the Company is part of a volatile sector – of small/mid size healthcare technology companies. The Directors take the view that the Company’s investors are aware of this “sector risk” and that they are looking for the exceptional returns that can be achieved when healthcare technology is successfully commercialised. The Directors therefore focus their review of risk on the issues that can cause a delay to ultimate success as well as on those that can cause failure. For further details of the Group’s risk assessment and mitigation plan see the Corporate Governance Report. The principal risks and uncertainties the Group faces are set out in the Directors’ Report.

Outlook

The Group recognises that regular updates on the progress being made with existing and new product programmes are important. The Group made nine such announcements in 2006 and the Board has identified nine priority news flow items to mark the progress of the Group in 2007 and these are identified in the Operational Review.

The strong results of the clinical trials in HCC, the promising data on mCRC, the commitment, capability and product commercialization record of our distribution partners and the enthusiasm, generally, of physicians who now regularly use Biocompatibles’ Bead products provide the Directors with confidence that Biocompatibles’ products can deliver growth for the Company, development opportunities for our people, benefit to patients and value for our shareholders.

Managing the kind of leading edge development programmes that Biocompatibles is undertaking requires exceptional technology, certainly, but also dedicated and expert employees. Before I accepted Biocompatibles’ invitation to join the Board, I conducted a personal review of the Company and its reputation – from a variety of angles. I was impressed with what I heard and have been subsequently pleased to find a quality of person – both in Germany and in the UK - that exceeds the earlier favourable impressions. On behalf of the Board I express my sincere appreciation of their effort and of their achievements.

The technology and know-how in both Farnham and Alzenau is very promising and the progress with the core managed programmes has been good; but the creation of shareholder value is the fundamental goal and this is where the Board and all our people are firmly focused.