Martek Biosciences Corporation F1Q09 Earnings Call Transcript

Martek Biosciences Corporation (MATK)

F1Q09 Earnings Call

March 4, 2009 4:45 pm ET

Executives

Steve Dubin - Chief Executive Officer

Peter L. Buzy - Chief Financial Officer

Analysts

Dalton Chandler - Needham & Co.

Tim Ramey - D.A. Davidson & Co.

Dietrich Bass - Canaccord Adams

Daniel Walker - Kalmar Investments

Presentation

Operator

Good morning ladies and gentlemen and welcome to the Martek Biosciences First Quarter Earnings Results Conference Call. (Operator Instructions) I would now like to turn the conference over to Mr. Peter Buzy, Chief Financial Officer. Please go ahead sir.

Peter Buzy

Thank you and good afternoon and welcome to Martek’s First Quarter Fiscal 2009 Conference Call. First I would like to start the call off with our Safe Harbor statement, and then I will turn the call over to Steve Dubin, Martek’s Chief Executive Officer.

Our call today will contain forward-looking statements concerning, among other things, expectations regarding production timing of customer and third party suppliers, customer mix, product mix, customer demand, product launches, patent matters and general economic conditions, as well as Martek’s revenue and profitability growth, cash flows from operations, inventory levels and production and purchase costs, specific revenue, gross margin, expense, and income expectations for future periods, as well as any forward-looking statements contained in the Safe Harbor section of today’s earnings release.

These statements are based upon numerous assumptions which Martek cannot control and involve risks and uncertainties that could cause actual results to differ. These statements should be understood in light of the risk factors set forth in connection with the company’s filings with the Securities and Exchange Commission.

With that, I’ll turn it over to Steve Dubin.

Steve Dubin

Thank you, Pete. Well in terms of our operating results, our first quarter demonstrated a solid start to fiscal 2009. Product sales were up 7% versus last years first quarter. Total revenue was by 5% over last year, even though our total manufacturing revenues dropped by nearly $1 billion as a result of our decision to start exiting our low margin contract manufacturing business.

Gross margins were up by over 100 basis points versus last year’s first quarter. The combination of increased revenues and gross margins resulted in record quarterly pre-tax earnings and a 12% increase in EPS over the first quarter of 2008. Despite the broad global economic situation, our outlook for the second quarter is also encouraging and I continue to believe that Martek is well positioned to deliver both moderate revenue and profit growth in 2009.

The strength of our core infant formula business, growing consumer awareness of the health benefits of DHA beyond infant formula, our ability to continue to execute on our business plan, our strong balance sheet with over $107 million in cash and cash equivalents and virtually no debt and our skilled and dedicated people, should put us in a good position to continue to grow in 2009.

Now Pete is going to provide you with some more detail on our financial results shortly, but first I want to take a few minutes to address Martek’s IP position for our infant formula products, the nature of our supply agreements with many of our infant formula customers, and our prospects for extending the sole source periods of those agreements. Because, we have recently been receiving numerous inquires from analysts and investors on these issues.

I understand some of the confusion and concern about these issues has arisen from certain comments made by one of our customers in some of their recent investor meetings. As stated in our disclosure documents, and as we have discussed before, Martek’s core infant formula patents expire between 2011 and 2014 in the US. In the US our mixed oils patent expires in December 2011, our DHA patents expire in March and April of 2012 and our arachidonic acid patent expires in August 2014.

In Europe our DHA patent expires in February 2011 and our arachidonic acid patent expires in January 2012.

In addition to Martek’s own patents, Martek is a licensee of a number of processes and composition of matter patents impacting both our arachidonic and DHA oils that run through March 2017 and additional pending patents that would extend certain protections even further. So while things can always change in the word of patents and as you know from our disclosure documents we’re involved in a number of proceedings involving our patents. We believe we have a mine field of patents that should give Martek a meaningful competitive advantage in the marketplace well beyond the expiration of some of our earlier core patents.

Our current agreements with our formula customers under which we are their exclusive supplier of DHA and arachidonic acid or in some cases just arachidonic acid, generally run for 10 to 15 years and generally provide for termination rights for our customers, in most cases, as of January 1, 2012.

Just as we did in 2006, when we first embarked on signing these multi-year sole source supply agreements, we plan on a look to go back to the market over the next two years to begin extending the sole source period of these agreements. In 2006 many skeptics said that we would not be able to sign up many companies under these sole source agreements and we created an agreement that ended up benefiting market and our formula customers. Since then we have signed such agreements with 17 customers, representing approximately 80% of our current sales to the infant formula market.

We are now in a position where we need to execute again, and extend the sole source period of these agreements beyond 2011 in a way that benefits both Martek and our customers. I think we have a compelling case to make to our customers for extending this period and that such an extension would be beneficial to both Martek and our customers.

Our market place advantages include the following: Martek’s post 2011 IP, which I just outlined and which in my view is not well understood by our customers. Martek’s reputation as a trusted supplier of high quality products in an environment where there are increasing concerns of our food quality and safety, particularly in the delicate infant formula market. Our dossier of regulatory approvals for our products for use in infant formula; our production capacity; the fact of the pivotal studies in infant development in DHA and ARA we’re doing with our oils; marking more than 15 years of experience in manufacturing DHA and arachidonic acid and the proprietary strains, knowledge and trade secrets developed over that time; and new technology that Martek is working on in the area of DHA production.

So while IP is very important in our industry, we continue to sign multi-year sole source agreements for our oils even in areas where we have limited or no IP as evidenced by the deal we announced earlier this week with the Rice Fields Corporation.

In addition to Rice Fields we have agreements with four other company’s operating solely or primarily in China and are working on a number of others and, again, we have really not any IP in China.

In summary, I, like all of you wish the global economy was in better shape, but it isn’t and we don’t have any control over it here at Martek. However, despite the economy, I feel good about your relative position, our prospects for growth this year, our future and our ability to extend out our infant formula franchise.

Pete is now going to go over some of the financial results and following his remarks we’ll open up the floor to your questions.

Peter Buzy

Thank you, Steve. Sales remained strong in the first quarter and combined with record gross margin and close management of expense growth, Martek produced record earnings for the quarter.

Revenues for the quarter were in line with our guidance. As previously discussed, infant formula revenues were slightly lower than the fourth quarter as a result of the timing of production campaigns by our infant formula licensee. Historically production timing by these customers fluctuates quarter-to-quarter and in the short term does not typically reflect changes in demand from end customers.

The split of shipments between domestic and international locations of our infant formula licensees remain near 50/50. Non infant formula revenue came in near the high end of our guidance with a slight increase over fourth quarter despite the challenging economic environment. Martek’s financial position remains very strong with cash increasing to $107 million near flat inventory levels versus the fourth quarter of last year and debt less than $500,000.00.

Gross margin of 42.4% for the quarter came in as anticipated. This is the highest gross margin every reported by Market and represents an increase of 110 basis points from the fourth quarter. These improvements came in as a result of new, lower cost production of DHA as well as product mix. We continue to expect additional improvements to gross margin in fiscal 2009.

As a percentage of revenue, R&D expenses remained consistent with the fourth quarter. Going forward, we expect R&D expenses to increase as a percentage of revenue in fiscal 2009 as a result of ongoing research aimed at the development of lower cost DHA sources, new products beyond our current offering, and the expansion of clinical studies.

SG&A as a percentage of revenue remained consistent with prior quarters in fiscal 2008. We expect SG&A as a percentage of revenue to remain near 2008 levels; however it may fluctuate from quarter to quarter due to the timing of marketing and TR campaigns.

Earnings per share were at the highest ever reported by Martek, excluding the impact in certain prior periods of non-recurring tax gains. The continued improvement of gross margin and close monitoring of expense growth were the key drivers in delivering record earnings.

As anticipated, cash from operations dropped from record levels produced in the fourth quarter of 2008.

Changes in working capital accounts of $14 million unfavorably affected cash from operations; however, these changes are timing related and will not necessarily impact full year’s cash flows.

Accounts receivable was the largest of these factors which routinely fluctuates quarter to quarter due to the unevenness of customer ordering patterns within a quarter.

Shipments to customers during the fourth quarter were fairly evenly distributed throughout the quarter which resulted in a low DSO of 41 days.

During the first quarter shipments were heaviest towards the end of the quarter due to the aforementioned timing of our customer’s production campaigns of supplemented infant formula, which resulted in higher than average DSO of between 51 to 52 days and an increase in receivables by near $9 million.

Martek’s DSO typically average between 43 and 48 days, but may be higher or lower than this range in any given quarter. A $4 million increase to inventory, as well as the pay out of annual incentive compensation, also impacted cash from operations during the quarter.

We expect that cash from operations will be relatively flat in the second quarter, as compared to the first quarter, due to the timing of shipments of ARA from DSM as well as expectations that receivables will likely remain at similar levels due to the timing of shipments in the second quarter. We also expect that cash from operations will be higher in the second half of the year, as was the case in fiscal 2008.

Inventory increased slightly, as expected, due to an increase in the production of DHA for both infant formula and non-infant formula applications. The increase was planned to keep inventory levels in line with sales, and in the case of non-infant formula with the expectation of further product launches.

Inventory is expected to increase further in the second quarter to approximately in the range of $112 to $116 million primarily due to the timing of shipments of ARA from DSM which are higher leading up to the planned annual summer shutdown following a similar pattern as in 2008.

As of January inventory was comprised of $15 million of arachidonic acid; $20 million of DHA for infant formula use; $16 million of DHA for non infant formula applications including food and beverage, nutritional supplements, animals feed, and finally $8 million of raw materials in inventory related to contract manufacturing.

For the second quarter we expect revenue to be between $87 to $92 million, an increase over the first quarter. We expect infant formula sales of $76 to $80 million; non infant formula nutritional revenue of between $7 and $9 million; non nutritional revenue of approximately $1.2 million and contract manufacturing revenue of between $2 and $2.5 million as we continue to wind down our contract manufacturing activities.

Gross margin is expected to be approximately $42.5 and it is anticipated to increase during the remainder of fiscal 2009 primarily as a result of lower ARA costs and a decrease in the average cost of inventory for DHA for non infant formula applications due to continued efficiencies and increased production levels.

Net income is expected to be between $8.9 and $10.3 million and diluted EPS to be between $0.27 and $0.31 on weighted average shares of approximately $33.5 million.

In summary, the core business is sound and we anticipate moderate growth in both revenues and profitability over 2008 with profitability growing at a faster rate than revenues primarily due to continued improvements in gross profit margins. Earnings continue to be a priority and we can adjust spending levels in response to the projected success in the marketplace and financial performance of the company. And finally, although the economic conditions are impacting the rate of new product launches for non infant formula products, we continue to anticipate fiscal 2009 growth in all of our product categories.

Before I open the call for questions, I want to state that we will not be able to answer any specific questions regarding our customers, their products, and/or their product launches due to confidentiality agreements. We can, however, address questions regarding the sales of our oils for use in these products and related trends and expectations.

With that we will open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Dalton Chandler with Needham & Co.

Dalton Chandler - Needham & Co.

Can you break out the depreciation and amortization from the cash flow accounts?

Steve Dubin

The depreciation number is about $5.5 million and the amortization number is $5.6 million.

Dalton Chandler - Needham & Co.

With regard to market conditions, I believe you said last quarter that in a touch economy you are seeing fewer product launches by your customers, but you hadn’t seen any reduction in terms of their development processes. Could you give us an update on how that may have changed in the last quarter?

Steve Dubin

Yes. I think that is generally still true. I don’t necessarily think the development processes are taking longer, but they are taking a longer time to launch because companies are just more reluctant to launch in a tough market. Also some of the types of products they’re working on today are some of the longer shelf life things that may take a little bit longer.

The number of projects continues to grow and we see no diminishment in the interest from customers on adding DHA to their products.

Dalton Chandler - Needham & Co.

Okay and then to your comments on the IP position and extending your supply agreements. Can you tell us first of all, just the timing of how you expect to approach your customers and then the process that you go through in those negotiations?

Steve Dubin

Based upon our experience last time it’s a long process. We’ll probably start going some time later this year and we kind of have to almost take it a couple at a time, because you can’t negotiate in circles with all of these agreements. It is kind of a methodical process. It doesn’t happen quickly, but we’ve done it once before and we’ll go through it again. Like I said, I think we have a great case to make and we’ll provide, I think, a great package for both Martek and the customer.

Dalton Chandler - Needham & Co.

Do you need to go back to all 17 of those customers before the end of 2011?

Steve Dubin

Well I think we probably will ultimately, but we will obviously start with the bigger ones first because the bigger ones have a disproportionate share of the business.

Dalton Chandler - Needham & Co.

Okay, thanks a lot.

Operator

Your next question comes from Tim Ramey - D.A. Davidson & Co.

Tim Ramey - D.A. Davidson & Co.

The gross margin gains have been impressive and some of that is capacity utilization, I think you referenced that today. Is there anything else impacting that as we look out to the next 24 months or so, currency issues or anything else that you would bring up there?

Peter Buzy

I think these are capacity utilization. It is also just some production efficiencies. It is not just volumes going through this, it’s the factories were getting better either in the biology or in the downstream processing. We do have some impact from foreign currency, none at all in our revenues, but in a component of our cost of sales. A portion of the DSM purchases are denominated in euros. That will track down during the year. We have locked in a fairly significant portion of this year’s activities with specific hedges. Year-over-year we have maybe $1.5 million of savings in 2009 compared to 2008, but I think as we exit 2009 there is some additional savings in currency. It is not a huge amount, but it’s moving in the right direction.

Steve Dubin

And we continue to make productivity improvements too; so over the years we should continue to get better. That is the nice thing about working with fermentation products. On the negative side we’re subject to the same commodity price fluctuations as anybody else is, but they are a relatively small part of the cost of producing our goods.

Peter Buzy

The other piece is product mix and there is a little bit of difference between some of the infant formula companies. The bigger piece of this is, long term, as we grow our non infant formula business the margins for that business will be better than the infant formula margins. Again, as that part of the business grows that will also start to more significantly impact the margins in a positive direction.

Tim Ramey - D.A. Davidson & Co.

Great and on the microencapsulation process that you licensed to General Mills, I assume you still have the ability to license that to other food manufacturers, or was that an exclusive deal with them?

Steve Dubin

This is something that we licensed from them, so it is actually their technology that just happens to marry up very well with some of our technology. There are some unique things we can do with our product that make their process extremely useful in certain food applications.

Operator

Your next question comes from Dietrich Bass from Canaccord Adams.

Dietrich Bass - Canaccord Adams

You mentioned the Rice Field and Prodigy brand in China that you announced a couple days ago. I was wondering how big is that brand and have you seen any incremental volume coming from Asia? Also, could you give us more color on how much business is going to China?

Steve Dubin

I think the Rice Field company is relatively small, but we actually do a lot of business in Asia, both through the multi-nationals and through those four or five companies that I mentioned that we have that are either primarily China based or marketing in China. We have a number of things in the hopper that will hopefully increase that base.

In general, I think we’re still seeing some increases from Asia in general. We keep reading that the rate of growth could be slowing a little bit, but in our orders we haven’t seen too many changes. In the current environment, I will tell you, it is kind of week to week in terms of what you see. So far, though, things are holding together and all we can do is follow our customer’s public pronouncements and track their orders.

My gut sense is there could be some weakening in the growth rate in Asia, but that things are still holding together pretty well.

Dietrich Bass - Canaccord Adams

Okay thank you that is helpful.

You have a good amount of cash on the balance sheet. I am just wondering what your current thoughts are on cash utilization?

Peter Buzy

Right now in this marketplace, we think having cash is a good thing and having that liquidity is a bit positive for the company. Most likely we will probably make some level of decision of what to do with the cash of, let’s say, probably by the end of the year, maybe out three or four quarters. But, in this environment we think increasing the cash level right now is positive and prudent for the company.

Operator

Your next question comes from Daniel Walker with Kalmar Investments.

Daniel Walker - Kalmar Investments

If one were to look at your gross margin, the cost of products sales margin, if we were to exclude the effect of contract manufacturing appears to be up over 250 basis points year-over-year and about 170 basis points sequentially. And yet you went from making money in contract manufacturing in Q4 to losing money in Q1. Do you have any comments that you would choose to color those statements with?

Peter Buzy

We have made a decision to phase out the contract manufacturing business. That business in general, if we were making high single digit gross margins, we’re doing very well. As we phase that out there are some overhead allocations and a few other things, so most likely it is going to be very close to break even. I think the big piece here, really what drove the margin improvement, is the gross margin on product sales and we do anticipate that will continue to improve for the remainder of the year.

Daniel Walker - Kalmar Investments

If a year from now you are out of contract manufacturing will there be some cost that is run through that revenue line that will show up in your total cost of goods that will then be represented in product sales cost of goods?

Peter Buzy

There will be some, but it’s primarily hedged now and most of the people that are working on the contract manufacturing right now will be phasing in and start working in the nutritional side of our manufacturing. So that will absorb really substantially all of that headcount.

Daniel Walker - Kalmar Investments

Do you have any operating expense that is presently supporting the contract work that will go away?

Peter Buzy

Some amount and you know some of that is engineering support and other things. We do think on balance there really should not be a big swing either in overall margins or bottom line from the phasing out of that work.

Daniel Walker - Kalmar Investments

But as you phase out there is unlikely to be a positive spread in that business?

Peter Buzy

Yes. If it is positive it will be a very low margin.

Daniel Walker - Kalmar Investments

All right, could you supplement us on what’s going on, on the supplement front, be it pregnancy or other?

Steve Dubin

Yes it’s going pretty well. I mean I think the data is good. KB the largest seller of omega 3’s in that market, as you know, pulled everything off the market. I think that presents an opportunity for some of our customers to substitute our products for the KB products. We’ll have to wait another quarter or two to see how that goes, but we think that enhances our prospects for growth in that area.

Daniel Walker - Kalmar Investments

What type of ammunition and momentum are you seeing from some of your more recent supporters in that area, the drug store companies and the mass merchants?

Steve Dubin

So far everybody is please with things. I mean assuming you mean the expectations; we have a really good network of advocates that go out there and talk about our products, so, so far so good.

Daniel Walker - Kalmar Investments

Is there either more that you can do or people that are more laser focused who you can get behind that might allow that business line to grow faster?

Steve Dubin

Yes, we have a couple things we’re working on for later in the year that hopefully will enhance that. But, it’s not like an instant thing, because consumers get bombarded with so many messages and use that to keep hammering away at it and you keep tally of this basic come out and keep the people having product placements on TV and things like that. It is repetition and trying to explain that to the consumer out there that they’re getting real value for the money that they’re spending on these products.

Daniel Walker - Kalmar Investments

Pete was your earlier point about gross margin that you would expect in the back half of the fiscal, that gross margin is higher than it is in the first half?

Peter Buzy

Yes, that’s right.

Daniel Walker - Kalmar Investments

How about you give us a comment or two, if you would, on international infant formula. Should one draw the conclusion that the domestic market was flattish and that your growth came from overseas?

Peter Buzy

Yes, I think year-over-year we had maybe some slight growth in the US and that our average penetration rate last year was probably 96% or 97% and now it’s 99%. The market continues to expand overseas and all of our big customers are taking advantage of that growth, so we do see that driving most of our growth in 2009.

Daniel Walker - Kalmar Investments

That’s all I have for the moment, thank you.

Operator

Sir, there are no further questions at this time.

Steve Dubin

We appreciate your attention today. We are excited about where we are. We have a lot of good things that we’re working on. Like I said, I feel good about where we stand in light of everything, although I think we’d be doing a lot better if it wasn’t for the global situation. But, I like where we are. We hope to bring you continued good news throughout the end of the year and we look forward to talking to you next quarter.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation.

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