Executives
Steve Dubin – CEO
Peter Buzy - CFO
Analysts
Tim Ramey - D.A. Davidson & Co.
Chris Krueger - Northland Securities
Dalton Chandler - Needham
Pamela Bassett - Cantor Fitzgerald
Scott Van Winkle - Canaccord Adams
Nick Genova – B. Riley
Daniel Walker – Kalmar Investments
Martek Biosciences Corporation (MATK) Q4 2009 Earnings Call December 16, 2009 4:45 PM ET
Operator
Welcome to the Martek Biosciences fourth quarter 2009 earnings results conference call. (Operator Instructions) It is now my pleasure to turn the conference over to Mr. Peter Buzy, Chief Financial Officer; please go ahead sir.
Peter Buzy
Good afternoon and welcome to Martek’s fourth 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 customers and third party suppliers, customer demand, customer inventory levels including de-stocking, product launches, and general economic conditions, as well as cash flows from operations, inventory levels, production costs, purchase costs, and specific revenue, gross margin, expense, and income expectations for future periods, in addition to potential M&A activity and any forward-looking statements contained in the Safe Harbor section of today’s earnings release.
These statements are based upon numerous assumptions that 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 Peter, Martek turned in a solid 2009 financial performance despite the economy and we made significant progress in a number of fronts during the year. Sales of oil for infant formulas were most effected by the economy. Sales for use in infant formulas were down $15 million or 5% from 2008, the result of inventory de-stocking by retailers and our customers and a declining birth rate in the US.
International sales for oils for use in formula grew but at a slower than anticipated pace because some consumers when facing a tough economy opted for lower cost formulas that did not contain our DHA and ARA.
Sales of DHA outside of infant formula grew by a strong 27% despite the tough economy to close to $40 million for the year which is the reflection of the high quality of Martek’s products and the desire of consumers to improve their health and well-being even in times of economic uncertainty.
Each of our non-infant formula product categories increased in 2009. Sales for animal feeds applications increased by 50%, DHA for pregnancy and nursing applications increased by 49%, sales for supplements use increased by 17%, and food and beverage sales increased by 3%.
We also increased our gross margin by 200 basis points during the year and improved our EPS by 12% over the previous year. In addition a number of our 2009 accomplishments while having only minimal financial impact in 2009, should provide future financial benefits to us.
We signed 10 new infant formula agreements and began selling our oil to 13 new infant formula customers in 2009. We gained additional mass-market distribution for our supplements, grew our international presence, and gained additional [inaudible] regulatory approval for food and beverages.
Our pipeline of potential new food and beverage business became more robust and is expected to start flowing again in 2010. We signed up a number of new customers that are expected to launch new products over the next six months. For example in November of 2009 we entered into and agreement to provide our life'sDHA to a major Asia based food and beverage company.
This new agreement includes a purchase guarantee in excess of $10 million over the first 24 months following their initial product launch which is expected to take place in the first or second quarter of 2010.
We made progress along with our partners on new DHA delivery forms including gummies, emulsions, and powders that should enable more of our customers to incorporate our DHA into a wider variety of their products more easily.
The science behind the benefits of DHA consumption continue to grow stronger through the announced results of a number of studies including a Martek sponsored trial in healthy adults over the age of 55 who are experiencing memory complaints.
The study showed an improvement in learning and memory in the DHA consuming group. Significant progress was also made on our pipeline of new products and technologies. I believe that Martek is much more technology rich than the market appreciates. In order to give shareholders greater visibility into our capabilities we will soon unveil some of the exciting new products and technologies that have been generated from our microbial biotechnology platform and on which we have been quietly working over the past few years.
This same technology base or research engine that was responsible for our current DHA and ARA products, has been enhanced in recent years and has generated a significant pipeline of new opportunities.
We spoke about our new lower cost DHA brand for infant formulas that’s in development and we announced our collaboration with BP on bio fuels in August. We will be holding an analyst day in early February to tell you more about both of these opportunities, our research engine, and the other opportunities in our pipeline that I believe will help drive our future growth. We’ll be providing additional detail regarding date and location for the analyst day in the near future.
So despite the continuing challenges that is presented by the economy I’m looking forward to 2010. I expect growth in both revenues and profitability driven by growing consumer awareness of the health benefits of DHA consumption and the importance of DHA and ARA for infant development.
I’m also looking forward to seeing the opportunities currently in development start to have a commercial impact and accelerate our growth. I want to take one minute to talk about an item in the press release and that’s the reference to a potential M&A activity.
While we will not comment on any specific potential M&A activity beyond what is referenced in our press release I will repeat what we’ve said before and that is that we have an ongoing process in place to identify and assist various M&A opportunities that arise from time to time.
We will be opportunistic in assessing such opportunities and focus on additions that will allow Martek to capture greater value from our proprietary products to provide other synergies that increase value. The general criteria which we are seeking include companies with nutritional products that provide health benefits, are already or nearly commercialized and that have competitive advantages.
We’ve also been seeking companies that give Martek entry into new and relevant sales channels for our current and future products in order to accelerate our growth. In addition accretive opportunities are strongly preferred.
With that I’m going to hand it over to Peter, he’s going to talk to you about some of the details on our financial results, and when he’s finished we’ll be happy to answer your questions.
Peter Buzy
Thank you Steve, in the fourth quarter Martek improved upon record non infant formula sales, gross margins and earnings achieved earlier this year and met the guidance provided on our third quarter conference call.
Infant formula revenue increased $7 million from the third quarter as a result of a declining impact of inventory de-stocking as discussed on last quarter’s call. For the year infant formula decreased by $15 million from the prior year primarily as a result of estimated de-stocking of between $12 and $14 million and the impact of a slight decline in US birth rates.
Non-infant formula sales slightly exceeded the record levels reported in the third quarter continuing a trend of increases for the fifth consecutive quarter and providing growth of 26% for the year over 2008 levels. The annual growth was driven by increases in sales of capsules and oils for pregnancy and nursing and general nutrition, as well as products for animal feeds.
Sales to the food and beverage industry increased only slightly over the past year. While there have been many small product launches during the recent fiscal year a number of large product launches were delayed as a result of economic conditions.
We have many customer projects in the pipeline including some larger launches expected for the first half of 2010. In addition we are developing new delivery forms of DHA that could widen the applications for our product some of which are expected to be available in 2010. As a result of these factors we are expecting improved food and beverage sales over this next few quarters.
Contract manufacturing and other revenues were approximately $5.7 million, and included revenues associated with the joint development arrangement with BP for work on microbial oils for advance bio fuels. As we have previously indicated we are phasing out of the majority of our lower margin contract manufacturing activities.
Following the completion of the current shikimic acid campaign which is a precursor of an anti-viral drug for the treatment of influenza revenues in this area are expected to decline throughout the second half of 2010.
Gross margins of 43.8% was slightly higher than our third quarter and improved throughout the year as a result of both yield improvements and the production of DHA and lower ARA costs. Product gross margins are expected to continue to improve in the coming quarters.
R&D expenses of $6.9 million increased slightly from the third quarter. On a percentage of revenue basis the 8.2% seen in the fourth quarter represents and increase from early 2009 and 2008. We expect an upward trend in R&D spending in the coming quarters as we invest in application development of lower cost DHA sources, new high value products beyond our current offerings, and the expansion of clinical studies designed to further support the benefits of our DHA.
SG&A expenses of $12.6 million increased $1.32 million from the third quarter. But in gross dollars and as a percentage of revenue were the second lowest quarter amount reported this year and are lower than any reported quarter in 2008. This trend is the result of continued cost containment measures employed in response to challenging economic conditions including a reduction in company wide incentive compensation expense.
We expect SG&A expenses as a percentage of revenue to continue to remain relatively flat in the near-term. However cost may fluctuate from quarter to quarter due to the timing of marketing and PR campaigns. Earnings per share of $0.33 were in line with our guidance and matched the record high reported in the second quarter of fiscal 2009.
Continued high non infant formula sales, strength in gross margins, and close cost control spending were the key drivers in delivering these results. Martek’s financial position remains solid with cash and short-term investments increasing to $148 million with minimal debt, actually less than $500,000.
cash flow from operations of $26 million for the fourth quarter benefited from a $9 million decrease in inventory from the third quarter. This was expected due to the timing of ARA shipments from DSM which are typically lower in the fourth quarter as a result of summer plant shutdowns at DSMs. We expect total inventory to increase to between $119 to $123 million by the end of the first quarter primarily as a result of timing of ARA shipments.
As of the end of October inventory was comprised of $72 million of arachidonic acid ARA, $24 million of DHA for infant formula use, $12 million of DHA for non infant formula applications including food and beverage, nutritional supplements and animal feeds, and then finally $8 million of raw materials and certain inventory related to contract manufacturing.
Cash from operations for the year totaled approximately $66 million, and we expect cash from operations in the first quarter to be between $12 and $15 million. Going forward in fiscal 2010 we expect a return to growth in infant formula revenues over 2009 as a result of continuing growth in international markets which are expected to more than offset the impact of declining birth rates or any additional de-stocking of inventory by our customers.
We continue to expect quarter to quarter fluctuations as a result of production timing of campaigns by our infant formula licensees. For the first quarter we expect revenue to be between $85 million and $89 million with infant formula sales of between $67 and $71 million.
We expect non infant formula nutritional revenue of between $10 and $11 million, non nutritional revenues of approximately $900,000, and contract manufacturing and other revenues of between $5 and $6 million. Contract manufacturing is expected to continue to be high in the first quarter as a result of the shikimic acid campaign.
This estimate also includes revenue related to the BP bio fuels agreement which are expected to be approximately $1 million in our first quarter. Gross margins is expected to be approximately between 43.5% and 44.5%. During the first quarter we expect to incur costs related to a due diligence opportunity which to date totals approximately $1 million or $0.02 per share.
No agreement to date has been reached and there’s no assurance that the company will complete any acquisitions in the near-term. Including this expense net income is expected to be between $8.9 million and $10 million and diluted earnings per share between $0.27 and $0.30 on weighted average shares of approximately 33.4 million.
On a pro forma basis excluding the impact of these due diligence costs EPS is expected to be between $0.29 and $0.32. In summary the core business remains sound and we anticipate moderate growth in revenues and profitability in 2010 primarily driven from gross profit margins and ongoing expense containment. With inventory de-stocking expected to be substantially behind us, we expect a return to growth in the infant formula markets in 2010.
Although economic conditions are impacting the rate of new product launches for non infant formula products we anticipate 2010 growth from current customers and new launches and new customers. Earnings growth continues to be a priority and we can adjust spending levels in response to the demand of the marketplace and financial performance of the company.
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, the status of infant formula contract discussions, their products, or product launches due to confidentiality arrangements. We can however address questions regarding the sales of our oils for use in these products and related trends and expectations.
We will not provide any additional comments on any specific M&A activity referenced in our press release beyond what has already been said on this call. We will now open up the call for questions.
Question-and-Answer Session
Operator
(Operator Instructions) Your first question comes from the line of Tim Ramey - D.A. Davidson & Co.
Tim Ramey - D.A. Davidson & Co.
Just curious about the outlook for infant formula just as a category, I think you expressed confidence that there would be growth in it for the full year driven by growth in international and Asian markets, what do you think that North America will do and is North America still roughly about 50% of your sales.
Steve Dubin
I think its just about, yes, about 50/50 US and international actually so I think the, right now the data suggests that the infant formula market in the US is down in the mid single-digit range from a year ago. We have seen some recent, and birth rates are down if you look at the March data which is the most recent data, I think somewhere between 3% and 4%. You’ve got some [inaudible] issues so I guess, totals were down, and economic issues, and I guess there’s some, we’re hearing there’s some increase in breast feeding so that probably counts for the difference between the birth rate and the market.
But we are seeing some anecdotal evidence that suggests that things could be improving some, for instance diaper sales have been increasing in the last 30 days so we’re looking at everything but so far if you looked at the total mix we feel pretty good in saying that we think the market overall for us will improve during the year.
Tim Ramey - D.A. Davidson & Co.
And I know this is totally unfair, because last year you did qualify your sales forecast, I’ll put that right out front, you said if the economy is lousy our sales forecast is qualified but you did forecast moderate growth I think was the term and we ended up with a small decline, do you think you understand those category dynamics or the economic dynamics enough so that your confidence level is higher in this year’s forecast.
Steve Dubin
Well I think that the big change, the big impact was the de-stocking issue that impacted those numbers. So and I think I don’t know that anybody fully predicted the extent of the economic situation how it would impact exactly every segment. So I think the crystal ball is clearer this year than it was last year but I would not say its perfectly clear. A lot of turmoil in my opinion.
Operator
Your next question comes from the line of Chris Krueger - Northland Securities
Chris Krueger - Northland Securities
Following up on that last question on infant formula can you, I know its about a 50/50 mix between US and international can you give us an idea of what the growth rate ranges are for US versus international.
Steve Dubin
The US is actually down right now, its been down over the last 12 months and we estimated in the mid single-digits. So international though—
Peter Buzy
If you strip out the de-stocking the 2009 growth rate was in the low to mid single-digits. Looking out into 2010 we believe it will be in the high single, somewhere probably between 7% and 10%.
Chris Krueger - Northland Securities
Looking at your food and beverage pipeline right now, you indicated that its better than it has been just looking at that right now versus one year ago, is it a pretty significant improvement.
Steve Dubin
Yes, I think the numbers are holding up very well but I think the quality and maturity of the pipeline has improved. So what happens, the average product, its hard to believe but it takes about two years to get to market. So because of the progress we’ve made in some of our application work and just because our customers have been working with the products for some period of time, everything is closer to the end of the pipeline. I think because we’re feeling some greater degree of optimism from our customers they’re today talking about new launches whereas last year we weren’t getting a lot of positive feedback in that regard.
And I think you should expect some announcements over the coming months and I think again this one product that we talked about, or one customer that we talked about is a pretty significant deal. Unfortunately we can’t announce the specifics today, we will as soon as we can because most of our customers don’t like to say anything specific until they’re right about to launch for competitive reasons.
But to get a $10 million plus guarantee for a two year period is good and if you divide that by two, that’s a pretty big increase for our food and beverage business by itself. We’re feeling, I think it would be even better if the economy was better, I think that the food and beverage business would do a bit better than we think it will but I do seen an improvement over last year.
Chris Krueger - Northland Securities
And on that large customer you went over it pretty quickly, essentially we should expect to see an announcement in the coming months.
Steve Dubin
Probably right before they launch which again will be in the first or second calendar quarter of next year.
Chris Krueger - Northland Securities
I know you can’t talk too specifically about your large infant formula customers and what’s going to happen next in a couple of years but when you talk about a new DHA product that’s cheaper to make and potentially they could use that, is there a whole FDA process that they would have to go through and you would have to go through to qualify that or could you just walk us through that.
Steve Dubin
Yes there is an FDA process and you can’t do it over night. So right now we’re projecting it to be available or be on the market somewhere in the 2012 to 2013 timeframe. But we have to do a lot of testing before the customers will even start to test and then they have to do their thing so there’s a fairly rigorous process involved.
Chris Krueger - Northland Securities
Are you in your stage of doing some of that testing right now.
Steve Dubin
Yes we can make it, we’ve made it in fairly large [fermenter] size and we’ve done a number of the early tox studies already and its looking pretty good.
Operator
Your next question comes from the line of Dalton Chandler - Needham
Dalton Chandler - Needham
I just wanted to ask about the guidance for the infant formula for the first quarter does this reflect some ongoing de-stocking.
Peter Buzy
We do believe that there are some amounts of let’s say carry over de-stocking that we’re seeing in our first quarter, not large numbers, but some amounts.
Dalton Chandler - Needham
And do you think this will be the last quarter that we’ll see that.
Peter Buzy
I can’t tell you that we know for certain but we have seen that number move down fairly significantly and I would anticipate that between the first quarter and second quarter hopefully it will be behind us.
Steve Dubin
I think as we mentioned I think things are a little more clearer than they were but in this environment its hard to say anything with absolute certainly but the feedback we’re getting is that we think most of it is about done.
Dalton Chandler - Needham
And then just with regard to all the new product launches you’ve talked about can you just give us maybe a sense of the magnitude of what you expect in 2010 versus 2009 for food and beverages.
Steve Dubin
I think food and beverages, maybe I’ll put it this way, I think food and beverages will go to, from the slowest growing to maybe the fastest growing of the categories, maybe that puts it in perspective.
Dalton Chandler - Needham
Any update on publication of the Midas study.
Steve Dubin
We don’t have any update at this moment. Its in the review stage and it’s a painful process but we do expect publication some time in the next three to six months.
Operator
Your next question comes from the line of Pamela Bassett - Cantor Fitzgerald
Pamela Bassett - Cantor Fitzgerald
Congratulations on the progress. It sounds like there’s an awful lot going on and I couldn’t help noticing the press release, one of the non infant formula product launches lists dark chocolate and cupcakes with DHA. And I’m wondering if that product, in that product have you used any new formulation technologies or is that straight DHA.
Steve Dubin
I’d have to check on that one and get back to you. I’m not sure what form that was, if that was a powder or just the straight oil. I’m just not positive on it.
Pamela Bassett - Cantor Fitzgerald
Because is the first time I’ve, are there other baked goods on the market currently with—
Steve Dubin
There are some bread products on the market, there’s I don’t know if you consider tortillas a baked good or not, but there are a few. And we’re working on this powder technology that we think will make it even more accessible to baked products. That’s one of the primary targets for this new powder technology.
But they’re not using that new powder technology in that product, that I know because we haven’t commercialized it yet.
Pamela Bassett - Cantor Fitzgerald
So there’s no change during the baking process of the bio availability—
Steve Dubin
Its amazing that its not. We’ve done some tests even on some of the cooking oils that are out and the DHA amount per serving holds relatively stable.
Pamela Bassett - Cantor Fitzgerald
So using the new powder formulation technology that you mentioned will impart what types of opportunities in the baked goods.
Steve Dubin
Well I think what it will do, it makes it easier to work with our product and I think it will allow for some longer shelf live type bake products. So breads for instance maybe have a shelf life of a week or two, so the current product, they’re actually fairly well. But if you’re going to put something at room temperature for a month or two, you have a greater degree of difficulty.
So you can do it under certain circumstances. This just makes it easier and more turn key for the customer.
Pamela Bassett - Cantor Fitzgerald
And will that technology or maybe a few of the other ones that sound like they’ve progressed significantly in development be usable for say powdered box goods like cake mixes or cereals perhaps, will it open up new product categories.
Steve Dubin
We hope so and that, and I think we announced the deal what was it January or February of this year when we were doing this joint development thing with General Mills and it was for the purpose of developing these powders for those types of applications. So that’s certainly our goal. Whether that would be the initial spot or it would be more of the fresher type baked goods I don’t know yet.
But we’ll probably, our hope is to start commercializing that powder kind of like a pellet thing actually later in 2010.
Pamela Bassett - Cantor Fitzgerald
And when you say pellet I remember that deal being around micro encapsulation technology.
Steve Dubin
Yes, its basically it’s a micro encapsulation type technology and it comes out, its like a pellet type powder kind of thing.
Pamela Bassett - Cantor Fitzgerald
And there was what looks like a very important study that you mentioned in the press release that was published in December showing the benefit of DHA in lowering progression, decrease in progression to AMD and I wonder how you’re going to use that information to help position—
Steve Dubin
That’s the same question I’ve been asking. It was an interesting study because I think there are some studies going on with combinations of fish oils and other vitamins on macular degeneration and this was an interesting observation in that it basically said that the data in terms of improvement was correlated to DHA and not some of these other fatty acids.
So we’re looking hot and heavy right now in terms of how to kind of make some progress in that. I don’t have anything to report today but its high on our radar screen.
Pamela Bassett - Cantor Fitzgerald
And there was some other publications you mentioned in the press release as well, should we be thinking about Martek moving towards some prescription products in these areas.
Steve Dubin
I think in the cognitive arena its certainly based upon that Midas study and the NIH study and we held the next [for panels] I think we said we told you we were going to do and we are looking at some ways to move the ball forward on that. We’re not a pharmaceutical company. We can’t be a pharmaceutical company and I think what we’d like to do with this and some of the other technologies that we’ll be talking to you about in early February for the things that are not in our sweet spot nutritional core sweet spot, we’ll partner those things.
We’ll create some value and partner those like we did on bio fuels. So we’d be looking to advance the ball enough so that we could get a partner interest if we decide to move forward in that area.
Pamela Bassett - Cantor Fitzgerald
And I couldn’t hear all of your answer regarding potential launches of, from the new strains, I heard projecting 2012 through—
Steve Dubin
I think the question was when, or the answer was when would it be on the market and what kind of regulatory process we have to take it through to get there, and it’s a rigorous regulatory process because we’re talking about infant formula and thinking about the first time we took our oils through it was very painful because these types of oils were never put into infant formula before so we don’t have, I don’t think we have to deal with that issue anymore.
Its going to be more on the safety of the product itself so we kind of had two issues to deal with the first time around, one is the product safe and two was why should this stuff be in infant formula in the first place. Its in infant formula I think that’s established today so I think when we get through all the tests and the customers get through their tests you’re talking about a market launch sometime in the 2012 2013 timeframe.
Pamela Bassett - Cantor Fitzgerald
And is this going to look more like some sort of bio equivalent kind of review from the agency.
Steve Dubin
I think its probably going to be a little more than that. Only because its coming from a different strain of algae so they’re extra cautious. And I think from a product perspective and we haven’t sorted out the exact regulatory path yet, but I think we’re planning to proceed with the full range of tests and as I said a lot of those early toxicity tests are already under way and in fact the early tests have already come back and come out very well.
So I think things are looking good for that product but unfortunately you can’t put it out over night.
Pamela Bassett - Cantor Fitzgerald
Is it a new CMC submission.
Steve Dubin
What’s a CMC.
Pamela Bassett - Cantor Fitzgerald
That looks at the manufacturing process.
Steve Dubin
That will be part of the filing but if it follows the same path as the last one, its not a drug, it’s a food so you’ll have to submit the manufacturing process but they really don’t grade it, it’s the same type of process as we’re currently using.
Operator
Your next question comes from the line of Scott Van Winkle - Canaccord Adams
Scott Van Winkle - Canaccord Adams
In regard to that million dollars of due diligence you expect to see in the January quarter have you ever done anything to that extent in the past.
Steve Dubin
Well we have done to that extent in the past but it resulted in deals, we bought [inaudible] and we bought OmegaTech so we have bought a couple of companies in our history so I don’t know if that answers your question or not.
Scott Van Winkle - Canaccord Adams
I was just wondering if two things, one that seemed like a large dollar amount and then two if there had been other things along the way that you had kind of gone this far on that we never saw hit the P&L, maybe it was diminimous our something of that nature.
Peter Buzy
There have been ongoing costs each quarter, this opportunity we’re looking at now we’ve done a much deeper dive and the existing purchase accounting rules require us to expense these costs, kind of pay as we go.
Scott Van Winkle - Canaccord Adams
And so you have a million of revenue I believe I saw coming in the next quarter related to BP, what do the economics look like, are we going to see a million dollars of costs on the R&D line, how should we think about the offsets on the cost side relative to the revenue.
Steve Dubin
It’s a little bit positive revenue versus costs but it’s fairly close, it’s a little better than a wash but not a lot better I would say.
Peter Buzy
And the reason we’re doing that deal is it’s a very long-term deal, there’s work we’re doing in the initial term of the arrangement but we’re really doing this really for potential piece of the upside and so far so good as far as how that process is looking.
Steve Dubin
The commercialization timeframe for this, and we again remind everybody we have a piece of the action on the upside here which is very important and the original commercialization timeframe was five years when we signed the deal, so its now four years and eight months or whatever it is, but we’re making pretty good progress and we hope to tell you more at this February session.
Scott Van Winkle - Canaccord Adams
And I apologize, I misheard parts of the conference call, but you talked about the new food customer in the second quarter was that an existing customer and a new product, or a new customer altogether.
Steve Dubin
New customer.
Peter Buzy
New customer for an arrangement that was entered into in November, 2009.
Steve Dubin
And the launch will be in calendar first or second quarter I want to clarify that.
Scott Van Winkle - Canaccord Adams
And has there been any product categories in the food side that have kind of consistently been more successful than others, you seem to have a lot of success in soy milk and maybe a juice like that pomegranate juice, I’m wondering if there is a, if you’ve kind of come to an area where you say, you know what we do real well in these beverages focused on kids, or we do real well in these types of items. Have you gotten to that point yet.
Steve Dubin
Well I think there’s a couple of generic categories that we like but I think those categories hopefully and a lot of the categories that we like are based around ease of application, ease of formulating whatever you want to call it, so I expect that those categories will broaden over time.
Scott Van Winkle - Canaccord Adams
And when we look at the pregnant lactating opportunity should we tie that to the formula, obviously de-stocking is maybe not the same but obviously there’s going to be correlation with the birth rate certainly and should we just assume that they follow the same trajectory.
Steve Dubin
Well we had a really good year, a strong year in the pregnant and nursing supplement area and I think the market is smaller in that category right now than it is for infant formula but the category has been growing because the science has been getting better and I think, so I think the growth rate in that area will outstrip the formula growth rate at least for the next couple of years.
Operator
Your next question comes from the line of Nick Genova – B. Riley
Nick Genova – B. Riley
Kind of a curiosity question on the animal feed side just because its an interesting opportunity at least in my view are you putting a lot of effort into that or does that just drive itself.
Steve Dubin
What we did a few years ago we kind of formed little groups within Martek that are responsible for the various areas and we have a group I think of three or four people that are just focused on animal feeds. And so its still a relatively small part of the business but we like it, its got a good margin for us. its easy in some respects in that we sell it in a dry biomass form so formulates is not an issue, so the biggest issue in that field is cost.
So and its our lowest cost product, you don’t have to do anything to it but like I said the margins are very respectable. It’s a good business and we’re pushing it and we’ve made a lot of progress in it and we’re dealing with one of the top distributors in that area, [Novis] and so we think there’s a big opportunity there. We really didn’t get in it until about a year ago or year and a half or two years ago or something, so I think we made a lot of progress in a short period of time.
Nick Genova – B. Riley
And what is your sense of the opportunity there because as you said it is kind of small right now, is there a lot of scientific data on that side that shows some sort of benefit or is that something you are pushing or is it, what drives that and how big can the market be.
Steve Dubin
I think there’s three different drivers, one is the desire for producing DHA enhanced meats and milks and things like that and eggs and so for instance there are eggs on the market and there have been for quite some time actually using our product and other people’s products, so DHA enhanced eggs, you’ve probably seen them in the supermarket.
There is DHA enrichment for aquaculture and so part of that is aquaculture and what happens is if your farm raising salmon or other types of fish, they do not get any DHA because all the algae that’s usually present in their diet is not there so today fishmeal is the primary source of giving DHA to farm raised fish although we’re starting to make some inroads there.
The third thing is for animal health itself. For companion animals there’s some studies that show that you get better behavior in kittens and puppies and then for other types of animals, again it’s a, you get some of the data suggests and again I think some of this data has to still be improved but yet you have more live birth things like that so its an economic issue for the farmer.
It proves the economics of raising the animal.
Nick Genova – B. Riley
And then jumping over to the food and beverage side, you mentioned a couple of new classes of formulations now, you mentioned the powders, and one or two other ones, at this point, maybe I can ask two questions, how does it work does the customer come to you or do you go out to a customer and say we’d like to get this in your product and if they say yes then you go out and develop the formulations or are you constantly developing the formulations and if that’s the case at this point how flexible is your formulation technology at this point. What percent of the class of products could you be into at this point.
Steve Dubin
I don’t know the answer percentage of class, but in terms of how we do it we try to figure out where the market is. So for instance the reason we’re trying to get gummies out is because we think there’s a fairly decent sized market for kids. Some of the emulsions we know that we’ve been very successful in some refrigerated juice beverages and our current customers and other customers have said when can you help us get a shelf stable beverage product out because most of the world doesn’t drink refrigerated beverages so that’s a big market both intuitively and just from the feedback from our customers.
Things like the powders I think if you can get it into things like cereals and other long shelf life things that kids eat that’s a pretty good thing to put it in. So we look at categories again that are, early on we looked at categories that we could formulate into such as refrigerated beverages. We went there first because that was easier to work with and trying to get into a cereal we know, we tried that, and we didn’t make much progress with the technology that we had at that time.
So our first learning was go where you can formulate where its easy for the customer. We knew where the demand side was but we couldn’t satisfy all those things. what we’ve been trying to do ever since then is fill in the gap on the formulation or application side to be able to stretch the utility of the product to fulfill some of the demand for the product categories that our customers are coming to us with.
Nick Genova – B. Riley
And is that when the two year lead time so to speak starts because I know that whole industry takes a while to get into a product, but you have the gummy technology now, before that turns into revenue does that start the two year time.
Steve Dubin
We hope the gummy technology will turn into revenue this year. We’ve been working on it for a while. But again not in every case its just our technology in fact the specific gummy technology is a third party that we’ve been working with. We hope that both the gummies and the powders will be commercialized this year and we think we have a good shot on the emulsions this year. those will all help greatly.
Operator
Your next question comes from the line of Daniel Walker – Kalmar Investments
Daniel Walker – Kalmar Investments
It is nice to know where everybody is calling from, hopefully its not never never land. When you talk about gummies are you talking about chewable vitamins.
Steve Dubin
What happened in the vitamin world is that, I know our kids used to take the Flintstone tablet type vitamins, but today its all gummies, like Gummy Bear kind of convections, that’s what we’re talking about, the Gummy Bear consistency type of product.
Daniel Walker – Kalmar Investments
Talking about the Asian development for a moment, is what this particular company has in mind is it in any way analogous to something you’ve already done either in the US or Europe.
Steve Dubin
Its not a new product category if that’s the question.
Daniel Walker – Kalmar Investments
Would this have been competitive with fish oil.
Steve Dubin
I think everything we do is competitive with fish oil to some extent.
Daniel Walker – Kalmar Investments
Can you describe a reason why they opted for algal DHA rather than fish oil.
Steve Dubin
I think because our stuff in a number of applications is easier to formulate with so you’ll get a greater shelf stability. I think they valued the brand that we created. I think those are the two main drivers.
Peter Buzy
And the resume that we built for our oils, we’ve been in now almost 50 million babies throughout the world and that’s helping significantly with some of these larger deals as well.
Daniel Walker – Kalmar Investments
One presumes though that this is an Asian domiciled player that is not taking something that either they or someone else has done in the US or Europe and that’s why the focus is on Asia.
Peter Buzy
Right now we really cannot drill down I think at that level.
Daniel Walker – Kalmar Investments
If we were to move forward on regulatory expense as you have to possibly do trials related to the new strain of DHA would you imagine that that would be meaningful enough to notice within your income statement.
Peter Buzy
We’ve said that our Martek R&D as a percentage of revenue will start to trend up a little bit. At the same time I think we’re saying we expect revenues and earnings to improve in 2010 versus 2009. but that will be part of where we’re spending money into 2010 in connection with the regulatory safety approval process.
Daniel Walker – Kalmar Investments
It doesn’t sound like though the need to do trials will be material enough in let’s say the 2010, 2011, 2012 timeframe to support the new IF product to where it costs millions and millions of dollars per annum.
Steve Dubin
No, we’re talking maybe a couple a million a year for that kind of thing.
Daniel Walker – Kalmar Investments
Help us better understand what you believe the implications for the WIC change might be.
Steve Dubin
Well that’s a great question and one where we don’t have perfect clarity. We get conflicting answers depending on who we talk to. So far what we’re gleaning is that the impact hasn’t been that significant. So we kind of [inaudible] at a worst case of about a 5% impact on the volume in the US but I don’t, we really haven’t seen that at this point in time.
We can’t necessarily de-convolute the various reasons for the 7% or 5% or whatever the percentage change is, decrease in the US market between birth rates and WIC and other things. So I can’t give an exact answer to that question but it could have some impact but it hasn’t been so far significant.
Daniel Walker – Kalmar Investments
To a different topic your supplement business which appears to have been largely driven by pregnancy and animal feed grew a lot this past year, it sounds like the over the counter supplements was the number that you described as being up 17%, is that the right number.
Peter Buzy
Correct.
Daniel Walker – Kalmar Investments
Does that reflect all the, that 17% number does that reflect all the present initiatives or do you think that understates what’s at work.
Steve Dubin
Well I think that what we still haven’t done on the general supplements, we think there’s a big opportunity internationally because we really have just scratched the surface so I think there’s plenty of room for growth both in the US based upon things like the Midas study once that becomes published, and based upon the other data that’s coming out, and based upon growing our markets internationally.
Daniel Walker – Kalmar Investments
If you were to take that same category general supplements how would that portion of the business increased in the prior fiscal year.
Steve Dubin
I should have had that data with me but I don’t have it.
Peter Buzy
I think it’s a smaller number, we don’t have that exact number with us.
Daniel Walker – Kalmar Investments
Would it be a fair statement though that having gained distribution in the drug chains and some of the mass merchants which presuming the sell in and some of the sell through is reflected in that 17% number that the turnover off the shelf is not like hot potatoes and it probably needs the type of topicality that a memory trial or new insights related to vision or cardiac health would draw it.
Steve Dubin
I think that’s a fair statement and some of the mass market distribution by the way helped to cover our pregnant nursing products so we got a lot of distribution for both of those types of products and in fact most of the general supplement mass market distribution was really later in the year. You’re competing on a shelf that’s crowded and it’s a constant bombardment that’s necessary for consumers because there’s always something new and hot and great but I think again, the benefits that have come out for DHA Omega-3 fatty acids have been pretty consistent over the last five or 10 years and its just, if people are doing more and more things, looking at finding more and more benefits so we think the ability to kind of refresh the message is there based upon the signs.
Daniel Walker – Kalmar Investments
Your non IF business in the year just closed was $39 million, it was $31 million in the year before, how would you provide some frame of reference for fiscal 2010.
Steve Dubin
Let me just say this, I’ll be disappointed if we don’t have a similar growth rate in 2010.
Daniel Walker – Kalmar Investments
Which would take the number up to something close to 50 at a minimum.
Steve Dubin
We think there are great prospects there and certainly this deal that we mentioned is going to help that and again I think the science is good, we’ll be hopefully marketing our Midas product in a big way so we think we’re going to have a good year in the non infant formula area.
Daniel Walker – Kalmar Investments
Final thought which relates to inventory as you now have stockpiled inventory for quite a while to comfort customers and as you possibly look at this ongoing need to discuss the extension of long-term deals related to instant formula contracts out a couple of years, how will that effect your personal inventory management.
Steve Dubin
I don’t think its going to impact it this year.
Peter Buzy
It is a factor in that our customers to the extent that their sole source arrangement needs some level of comfort that we have back up inventory, we’re keeping in two or three different locations, it has been a critical component in connection with our overall arrangements with our big customers.
Steve Dubin
Having lived through the shortages that we did in the 2004 2005 timeframe, I really don’t want to go back there again and the alternative use of that money if you put it in a money market account, you’re not getting any value there so the insurance that this is providing, it has made a huge difference to the company and the way we can operate and the costs that we save on shipping and all kinds of other things. I certainly sleep better at night with a little more rather than a little less.
Daniel Walker – Kalmar Investments
I don’t know if you want to use this platform but there’s been some surmising about the possibility of competition in your infant formula DHA business, can you talk at a high level or more detailed if you like about some of the regulatory and possible economic hurdles that competition might face based on my understanding if your infant formula business is just under $300 million and approximately a third of that is DHA, we’re talking about $100 million of revenue that would be subject to competition. Could you address that.
Steve Dubin
Well I think, look as we’ve disclosed in our SEC filings there are a number of companies out there that are producing products that [couldn’t really] be competitive. There’s fish oil out there that can already be included in infant formula product. And you know a lot of our growth over the last year has actually been in territories by the way where we have no patent.
So I think that’s important to keep in mind, why, because we have a reputation, we have a high quality product, we’ve been in the most sensitive population for a long time now with no problems. We still have even post 2011, its not like we don’t have any IP anymore. We have some IP, we’ve licensed some IP in from DMSs. We have regulatory approvals throughout the world.
It’s a country by country battle often times to get these regulatory approvals. We have the production capacity, the pivotal studies that shows the benefits in babies were done with our oils. We’ve been doing this for 15 years. We have new strains and new products on the way. We believe we’re on the leading edge of innovation in the area.
And if you take all that into consideration I think we have a fairly good picture to show the people. So look at the end of the day our customers want a cheaper price, we want a higher price, so the battle will be fought on that basis. We’ve been there before and we’ll go through it and we’re also working on lowering our costs so that we’ll be in a better competitive position.
Daniel Walker – Kalmar Investments
You have a huge plant though in South Carolina and you have a plant in Kentucky which you’re not using presently what would it require for someone to make DHA in terms of capital investment let alone the type of expense and time investment necessary.
Steve Dubin
Well I guess between us and the DSM, for DHA or for—
Daniel Walker – Kalmar Investments
I’m more focused, you put in well over $100 million into your facility in South Carolina—
Steve Dubin
All in, what we put in and DMS has put in, you’re talking about $300 million. I’m not saying somebody else will spend as much but that’s the actual number that the two companies spent to kind of get our capacity where it is today.
Peter Buzy
And the DHA fermentation process is a very difficult process in that it requires a very, very high level of sterility, a high level of stainless steel and equipment and generally you just do not see existing large scale fermentation out there that could manufacture Martek’s DHA.
Daniel Walker – Kalmar Investments
Do you have some reason to think though that the dollars spent today would go a heck of a lot further than the way you spent money way back then based on supposed yields and other methodologies that may be obsolesce.
Peter Buzy
If Martek had to reproduce our facility today could we make it cheaper, I think probably the answer is absolutely we could construct it cheaper. At the same time there are fairly significant barriers as far as any other company scaling other algalable DHA strains to be able to try to reproduce the productivity that Martek has in the fermentation and then there are significant downstream processing technologies or really know how that we have that would also be fairly difficult to reproduce.
Daniel Walker – Kalmar Investments
And if somebody had existing fermentation capital today would there be any hurdles in recommitting that to this from an FTA oversight standpoint.
Steve Dubin
I know from an FTA issue its more of a, for the DHA anyway you can’t make it just any old, it has to be very high quality because the organism, it’s a long fermentation process and if its not perfect you get contaminations that overrun the DHA organism so its not as easy to do as some might think,
But again if I look at the combination of patents of quality of technology, I think again we have a good case to present to customers and we feel comfortable with that.
Operator
Your final question is a follow-up from the line of Tim Ramey - D.A. Davidson & Co.
Tim Ramey - D.A. Davidson & Co.
I was just kind of circling back on the inventory question a couple of minutes ago, despite your probable unwillingness to comment, its generally accepted wisdom that the price of these algal oils will go down and if so aren’t we taking an awful lot of risk to an inventory write-down here by keeping these high levels of inventory.
Steve Dubin
We only have six months of inventory and I don’t think we’re going to have any write-down in the next six months or any price decrease. We have our contracts locked through the end of 2011.
Peter Buzy
And the margins on a go forward basis, our product margin has really, I think we had in Q4 and we’re predicting in Q1, are in the 45% range.
Tim Ramey - D.A. Davidson & Co.
So but I mean are you implying that you probably won’t sign a contract with someone until 2011. I mean I assume that you would be prudent to be working on that today. You could announce a new contract with any one of your major customers any moment, could you not.
Steve Dubin
We could, but I think that makes an inventory write-down even less likely so I see zero risk of an inventory write-down or as near zero as you can possibly predict.
Well I appreciate, it was actually a quite interesting call, we had really good questions and we really enjoy answering those kinds of questions. So thanks for listening today and I look forward to analyst day in February, hope you can make it. I think you’ll really see a lot of interesting things we’ve been working on and again, it will talk a lot about the future of the company and accelerating the growth of the company and I look forward to talking to you the next quarter because I think we’ll have a few more things to tell you that I think you’ll be interested in.
So again we’re looking forward to 2010 and starting to make things happen and we will talk to you in three months. Thank you.
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