Martek Biosciences: Worth Revisiting

In 2004, when Martek Biosciences (MATK) (21.70 --> $721mm market cap) was a high-flying growth stock, I had the opportunity to meet with the CFO. While what they did sounded real interesting, I walked out of that meeting wishing that I worked at a place that could short stocks. Long story short, the company was way overly optimistic regarding the prospects for continued growth. Since then, they have been in my almost permanent "penalty box", but a recent appearance on a few of my screens convinced me to spend some time refreshing myself. I am glad that I overcame a bias of permanently labeling a company or management team, and I believe I have uncovered a pretty decent growth story. Here is what I like:

• Recession resistant
• Healthcare name with zero Obama exposure
• Strong Financials and FCF generation
• Valuation bordering on deep value despite growth potential
• The chart looks good
• DHA play is very timely

For those not familiar with Martek, they are all about DHA, the amino acid that has been proven to offer cardiovascular and cognitive benefits. I personally can testify to the cardiovascular side, though I get mine through fish oil. Martek uses a biotech process to create DHA from algae, offering the benefits of avoidance of both mercury exposure and a fishy taste. The major catalyst for the company's growth earlier this decade was the rapid adoption by the oligopolistic baby formula industry of Martek's DHA. Back in 2004, the company was very excited about the opportunity to add it to other types of food, but I correctly expected that this would be a much more challenging endeavor. The company not only failed to gain traction quickly, but they also paid the price for relying upon an Italian sole-source supplier of a critical ingredient when their power failed at about the same time as a fire destroyed a warehouse in New Jersey as well as several capacity issues. The stock fell from its peak of 70 or so in 2003 to a recent March low of 15 before rebounding to 23 or so.

Despite taking much longer to break into the functional food business than they had expected, the company has gained traction and has its DHA in many products, including dairy products like yogurt, milk, and soymilk, juices, and baked goods. Baby formula related sales still remain the vast majority of revenue, but supplements and additives are growing rapidly. Expanding international penetration is another growth driver. While the recent reset shows that the company isn't recession-proof, I do believe that it is resistant. The set back was due to inventory destocking at formula manufacturer customers. Nevertheless, sales should be flat in 2009 with EPS slightly higher.

Healthcare valuations are generally attractive these days, but everyone is afraid of reimbursement risk as we revamp the delivery system. I am on the lookout for names in the sector that aren't subject to that risk, as they might command a premium for the generally non-cyclical elements due to investor fears about the other companies subject to that risk.

MATK used to consume cash, but now it spits it out faster than its formula additives run through babies. In FY08, it generated $55mm after producing $36mm of NI, $29mm of D&A and just $10mm of CapEx. The past several years have seen a dramatic dropoff compared to the massive spending prior to 2005. The balance sheet is very strong, with Total Liabilities of just $57mm, cash of $118mm, Net PPE of $260mm and Equity of $613mm.

Valuation strikes me as very fair if not downright cheap. On the one hand, the stock trades at 16X forward EPS, less than 1/2 the 5yr median. On the other hand, despite having such a strong balance sheet, it trades at just 1.2X book value (1.4X tangible book value). The FCF yield is almost 10%! As you can see in the chart below (click to enlarge), it is cheap on EV/Sales and EV/EBITDA as well:

As I look at the chart, I like what I see. While I think that it should hold 20, I see very strong support at 18. When they reported in early June and shared very disappointing guidance, the stock traded down on very high volume very briefly violating the 20 level and has sense traded much better than the market as it has consolidated. To the upside, I see the obvious resistance at 22.50, a bigger hurdle at 25 but then nothing until 28. As you can see in the chart below, playing for 28 with hopefully risking a drop just to 20 can be supported. 20 was support in 2006 and twice in 2007, while 28 was resistance earlier this year, support in early 2008 and resistance exactly 2 years ago.

I would be remiss if I didn't mention an extremely timely catalyst, as the company is hosting a call on Monday 7/13 to discuss some new research on DHA for Alzheimer's. While I hope that we don't see a 'buy the rumor sell the news' reaction and certainly don't expect a buy the news reaction, the bigger picture is that there are some likely boosts ahead for demand for DHA. So many supplement stories over the years have been just hype, but DHA appears to have a lot of clinical support.

While I like the story and added it to a charitable foundation I manage for my parents (see my disclosure) as well as to my Top 20 Model Portfolio (as part of a massive Small-cap Healthcare skew), I have my concerns. First, I prefer to bet on good management teams, and this is one that I can say only that I hoped that they learned from their prior mistakes and aggressive promotion. Second, there are some patent issues in a few years, though I don't expect that there are any binary events. For the story to work, the company needs to see continued traction in food supplements. I mentioned technical resistance at 28, and valuation issues won't impede that goal at all. In fact, I believe that very conservatively the stock gets there over the course of a year. All it has to do is be on track to hit the consensus number for FY10 of 1.45 and achieve a 18 multiple of likely earnings of 1.58 in the year ending 7/31/09 (assuming 1.64 or 13% growth for FY11).

As one who always appreciates a potential contrarian play, I took satisfaction in how quickly several of my clients rejected the idea without even hearing anything but the symbol. That was pretty much my initial reaction too. If these guys can keep generating FCF and improving their margins, investors should take notice in what will most likely remain a market starved for growth. Short-interest plunged at the lows in March but still remains high at about 14% of shares outstanding.

Some big institutional sales in Q1 certainly pressured the stock, with Friess selling its entire 1mm+ share postion (5%) and Fidelity and Putnam selling another combined 4%, with a lot of it going to the shorts in retrospect. I look forward to seeing the Q2 data in coming days.

One final piece of advice: Whether or not you like the stock, you should learn more about DHA. I have been a big fan of DHA while not being a fan of Martek - we'll see if owning the stock is as healthy for the portfolio as their products are for the body.

Disclosure: Long MATK

Comments

[Gretchen Va...:]

Hi
Nice overview. I'm a nutrition scientist and feel compelled to let you know.........DHA is a Fatty Acid, not an amino acid. :)

DHA is highly unique, is required in the body (brain, eyes, heart, sperm store highest amounts) and must come through diet. Sources are fish, fish oil and algae (what Martek supplies).

There is no substitute for this fat - much different than vegetable oils, animal fats - DHA is essential in human nutrition.

Amino acids are what comprise protein. Fatty acids are fats, which combine to make bigger fat molecules, like triglyercides, cell membranes, etc.

Gretchen Vannice, MS, RD
Omega-3 Dietitian
Portland, OR

Jul 17 12:48 PM

[Alan Brochs...:]

Thanks for that correction!


On Jul 17 12:48 PM Gretchen Vannice, MS, RD wrote:

> Hi
> Nice overview. I'm a nutrition scientist and feel compelled to let
> you know.........DHA is a Fatty Acid, not an amino acid. :)
>
> DHA is highly unique, is required in the body (brain, eyes, heart,
> sperm store highest amounts) and must come through diet. Sources
> are fish, fish oil and algae (what Martek supplies).
>
> There is no substitute for this fat - much different than vegetable
> oils, animal fats - DHA is essential in human nutrition.
>
> Amino acids are what comprise protein. Fatty acids are fats, which
> combine to make bigger fat molecules, like triglyercides, cell membranes,
> etc.
>
> Gretchen Vannice, MS, RD
> Omega-3 Dietitian
> Portland, OR

Jul 17 04:11 PM