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Executives

Peter Buzy - EVP of Finance and Administration, CFO and Treasurer

Steve Dubin - CEO

Analysts

Dalton Chandler - Needham & Co.

Scott Van Winkle - Canaccord Adams

David Webber - Broadpoint Capital

George Dai - MA Weatherbie & Company

Martek Biosciences Corp. (MATK) F1Q08 (Qtr End 01/31/08) Earnings Call March 5, 2008 4:45 PM ET

Operator

Welcome to the first quarter 2008 Earnings Call. (Operator Instructions)

It is now my pleasure to introduce Peter Buzy, Chief Financial Officer. Please go ahead, sir.

Peter Buzy

All right. Thank you, and good afternoon, and welcome to Martek's first quarter fiscal 2008 conference call. First, I'd like to start off the call with our Safe Harbor statement, and then I'll turn the call over to Steve Dubin, Martek's CEO.

Our call today will contain forward-looking statements concerning, among other things, expectations regarding production timing of customers and third-party suppliers, customer demand, product launches as well as Martek's revenue and profitability growth, cash flows from operations, inventory levels, and production and purchase costs, and specific revenue, gross margin, expense and income expectations future period, 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

Thanks, Pete. I think we're up to a very good start for fiscal 2008. We recorded both record quarterly revenues and pre-tax income in our first quarter, and the outlook for our second quarter is encouraging. We continue to focus on our four priorities, growing our infant formula revenues through increasing penetration in the international infant formula market, expanding the use of DHA outside of infant formula, improving gross margins and profitability, and developing new products to support our future growth. Our financial results reflect the progress we're making in these areas, and the ongoing successful execution of our business plan.

Although down slightly from our fourth quarter 2007, infant formula sales increased by almost 16% from the same quarter last year, first quarter last year, and a significant portion of that growth came from international markets. We also signed up a new infant formula licensee in South Korea in the first quarter, and hope to sign additional non-US licensees later in the year. Our sales of DHA outside of infant formula hit a record $7.3 million during the first quarter with the growth occurring in foods and beverages, pregnancy and nursing products, general supplements and fees.

During the quarter, two new customers launched food and beverage products containing life'sDHA, and one existing customer added to their line of products enhanced by our life'sDHA. There's also a launch of a new product in the pregnancy and nursing category. Already, in the early part of the second quarter, we see two new customers launch food products with our DHA and another existing customer expand its DHA product line.

All these new launches, and the launches to come, and the success of a number of products that we've seen launched by some of our larger customers should bode well for growth in the non-infant formula categories in coming quarters.

Gross margins grew at 41% in the first quarter, compared to 34% last year, and earnings per share grew at $0.26 as a result of our 18% growth in revenues, in combination with the improved gross margin.

We plan to continue executing our business plan to grow our infant formula business internationally, work with our customers to get more products that contain life'sDHA line and making easier for them to do so, further build our life's brand, increase our margins and improve profitability. As I said before, I feel really good about where we are today, where we're headed and about all the experienced, talented, hardworking people we have on board at Martek to help us get there.

So, Pete is going to talk to now with some details about our financial results, and after he is finished we'd be happy to entertain your questions.

Peter Buzy

Great. Thank you, Steve.

The first quarter reflected the best quarterly performance in Martek's history with record high revenues and earnings, and improved gross margins. During the quarter, we recognized our fourth consecutive quarter of record revenues. In line with expectations stated on our prior earnings call, we saw a decrease in infant formula revenue as a result of customer production timing, offset by an increase in non-infant formula revenues.

A $2 million decrease in infant formula was more than set off by revenue increases in the areas of food and beverage, pregnancy and nursing products, animal feeds and contract manufacturing. For the second quarter, we expect increases in infant formula, and non-infant formula revenue, while contract manufacturing revenue is expected to decrease, due to the semiannual timing of one of our customer's campaign.

We have seen growth in both domestic and international infant formula markets. And, although we cannot determine the exact region of the world where our oils will be used, we believe on average the proportion of international to domestic sales has increased slightly from a 40/60 split a year ago, to a 45/55 split this past quarter.

The quarter included expansion in international infant formula market by several customers, and we expect this trend to continue. Domestic market share is expected to increase in the future, very close to full conversion, with sales for private label brands and large retailers helping drive recent growth.

We continue to lock in our infant formula licensees by signing a Sole Source Supply Agreement with Numico during the quarter, along with other supply agreement entered into over the past two years. We now have sole source commitments through at least 2011 with customers that comprise more than 70% of current infant formula revenues. We continue to seek long-term supply arrangements with certain other customers.

DHA and non-infant formula product is continuing to gain traction, with sequential quarterly growth of 20%, and growth from the first quarter of 2007 over 40%. We are very optimistic about the number of potential new products and customers for all of our non-infant formula applications, and expect continued year-over-year growth throughout the year.

We have made improvements in our gross margin for the fourth consecutive quarter, primarily as a result of better pricing on ARA purchases and enhancements in our production of DHA, which have lowered costs despite pressures from the Eurodollar exchange rate.

As compared to one year ago, gross margins have been increased over 700 basis points from the 34% reported in the first quarter of 2007. We expect gross margins in the second quarter to approximate the first quarter results, with slight improvements during the remainder of the year, primarily from productivity improvements expected from DHA.

As discussed in prior calls, changes in production costs have a delayed effect on gross margin, due to a near six months inventory levels and the application of FIFO inventory cost layers. So the Eurodollar exchange rate continues to be unfavorable to our ARA cost. The risk is shared with DSM under our amended arrangement with DSM, which reduced our currency risk by approximately one-half. A 5% increase in the Eurodollar rate would impact gross margins by approximately 25 basis points.

SG&A in the first quarter increased, and is expected to increase in subsequent quarters, with spending and marketing of public relation programs, an initiative to increase the knowledge of the benefits of DHA and arachidonic acid in the scientific and healthcare communities, as well as the general public. We have the ability to manage the spending rate of SG&A in response to projected success in the marketplace and financial performance.

R&D spending decreased in the first quarter from the prior quarter, primarily due to the timing of spending on clinical studies, but is expected to increase in the second quarter and subsequent quarters, with increased spending in the areas of product development for DHA application and product formulation, clinical studies to support the benefits of DHA and new product research.

Earnings growth for the company continues to be a major priority. EPS for the first quarter reached new levels, hitting $0.26, the highest ever reported, excluding the impact of one-time tax gains in certain prior quarters. On a pre-tax basis, income of $13.5 million was $1.4 million higher than the last quarter record levels, and was more than three times as high as the pre-tax income reported in the first quarter of last year.

As expected, cash from operations decreased in the first quarter relative to the fourth quarter, due to the timing of payments related to the purchases of ARA inventory, as well as the timing of annual incentive payment. Cash from operations of $15.1 million was generated in the first quarter, and should increase during the remaining quarters of 2008.

A portion of Martek's short-term investments are held in auction rate securities backed by student loans and guaranteed by the Department of Education. As discussed in our earnings release, there is currently a limited liquidity for these investments, and we have re-classed these securities as long-term investments. We have sufficient cash to cover working capital requirements and hold these investments until an opportunity for sale or redemption occurs.

Inventory decreased at the end of 2007 by nearly $2 million, primarily due to reductions in DHA inventory. As of the end of January, inventory was comprised of $65 million of ARA, $18 million of DHA for infant formula use, and near $18 million of DHA for non-infant formula applications, including food and beverage, nutritional supplements and animal feed, and finally $6 million of additional raw material and other inventory related to contract manufacturer.

While inventory levels will fluctuate quarter-to-quarter, primarily due to the timing of third-party ARA production, we expect to keep inventory levels near 2007 yearend levels, due to the long production cycle, reliance on third-party suppliers and the fact that we are the sole source DHA and ARA provider for most of our infant formula customers.

With increasing sales, our days outstanding in inventories have continued to decrease. For the second quarter of 2008, we expect increases in sales to infant formula and non-infant formula customers, partially offset by a near $1 million decrease in contract manufacturers. This is expected to result in total revenues of between $83 million to $88 million, including non-infant formula related nutritional product sales of between $7.4 million to $9 million.

Gross margin is expected to be relatively flat at 41% in the first quarter. We expect increases in SG&A and R&D, as marketing and research activities I previously mentioned are carried out. SG&A is expected to increase between $13.8 million and $14.3 million, and R&D increase to be between $6.5 million and $7 million.

Amortization is expected to be $1.9 million, and other operating expenses to be between $200,000 and $300,000. Net income is expected to be between $8 million and $8.7 million, and diluted EPS between $0.24 and $0.26, on weighted average shares outstanding of approximately $33.5 million.

The high end of our revenue guidance of $88 million for the second quarter reflects a significant increase from the first quarter sales, primarily from infant formula customers. Our high end sales guidance for the second quarter is based on what we currently believe to be our customers' production schedules. Should the high end Q2 sales be achieved, it would likely result in lower infant formula sales in the third quarter of fiscal 2008.

We continued to anticipate an increase in non-infant formula nutritional revenues in the third quarter as compared to the second quarter. However, if such timing issues occur in our infant formula business, Martek's overall revenues and earnings in the third quarter of fiscal 2008 will be lower than the second quarter.

Based upon estimated current run rate of sales for infant formula products of $71 million to $73 million, any revenues reported in excess of that amount could potentially reduce our Q3 sales. We estimate our company-wide run rate for the second quarter to be in $84 million to $85 million range.

Despite the anticipated quarter-to-quarter fluctuations, we project the annual growth of our core infant formula business and related sales in 2008 compared to 2007 to be between 7% and 9%, which is slightly higher than previously estimated, with a significant portion of the growth coming from the expansion of international markets.

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

With that, we'll open it for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from the line of Dalton Chandler with Needham & Co. Please go ahead, sir.

Dalton Chandler - Needham & Co.

Hi. Good afternoon and congratulations on a nice quarter.

Peter Buzy

Thanks.

Dalton Chandler - Needham & Co.

First, just with regard to the international business and the success there, is this your existing customers taking more share or is it driven more by signing up new customers?

Steve Dubin

I'd say primarily it is existing customers. We signed up some smaller infant formula companies last year, I think five or six. We've done one so far this year. And they are starting to make a difference, these companies. And I think every time they get the competition going, and even if it's started by the smaller companies, everybody kind of gets going. So I think most of the volume is attributable to the success of the larger companies.

Dalton Chandler - Needham & Co.

Okay. And then on your guidance for where food and beverage might be going for the year, I think a year ago you had 49 new product launches. Is there some number like that that's underlying your assumptions for this year?

Steve Dubin

I think last year might have been 29-ish or something like that. But maybe cumulatively, I think, at the end of the year we had 35 or something like that. I think we've not really been giving too much guidance in terms of numbers of launches, but I don't think the number will go down, let's put it that way.

So I think the volume of interest and activities continues to go up. We're seeing so many different types of launches it's kind of hard to even know how to count some of these things any more. A lot of our customers who are broadening their product lines, those types of things you will see as we go forward in this year. So I think the activity, both in the food and beverage area and the supplement area, is very encouraging.

Dalton Chandler - Needham & Co.

Okay. And then just on the gross margin, I think last quarter you had guided that by the end of the fiscal year you'd be in the 41% to 43% range. And you are already in the low end of that range now, so is there an update you could give us there on expectations for the year-end?

Steve Dubin

Dalton, I think right now we're still comfortable with that range and the second quarter margin should be fairly comparable to the first quarter. And then we do anticipate some incremental improvement. It effectively will be in Q3 and Q4.

Dalton Chandler - Needham & Co.

Okay. All right. Thanks a lot.

Steve Dubin

Thanks.

Operator

(Operator Instructions)

We have a question coming from the line of Scott Van Winkle from Canaccord Adams. Please go ahead, sir.

Scott Van Winkle - Canaccord Adams

Hi, guys. Congratulations as well. First, in the food and beverage side, has there been any change to your new innovation on your ability to deliver product, or applications, or anything new on the food and beverage development side?

Steve Dubin

We've done a lot of things. I don't think we've really announced them, although maybe we will in the future. But we have a new protein-free powder version that's out. They say a lot of people are concerned with the proteins as being potential allergens. We have some new emulsion products that we have in customer testing.

So we're always working to make it easier for the customer to incorporate the products. At the end of the day that will speed the time to commercial launch. The problem is every customer has a unique set of circumstances. We haven't discovered a universal application that fits all the needs, but we're kind of checking them down one at a time.

Scott Van Winkle - Canaccord Adams

Okay. In any of those application or changes, do you want to differentiate a position relative to your traditional fish oil competition?

Steve Dubin

Well, I wouldn't say any one of those is a magic bullet type of applications. But I think if you look at the totality of what we're doing we stack up very well today against anybody. And we're working on some more magic bullet type applications for the future.

Scott Van Winkle - Canaccord Adams

And Pete, at the end you mentioned 7% to 9% revenue growth guidance. You were talking infant only?

Peter Buzy

Yeah. Scott, that is our core infant formula revenues.

Scott Van Winkle - Canaccord Adams

Okay. And, I apologize; I think I missed the part where you talked about the international percentage of formula revenue. Did you say that it went up to what percent?

Peter Buzy

Previously we were running about 60/40. Now the international component is about 45% of our infant formula sales.

Scott Van Winkle - Canaccord Adams

Okay. Any update on new research or anything of that nature? I know you had a couple of mentions in the press release. Is there any new study coming out that we should know about?

Peter Buzy

I don't know of anything at the moment, but there is always stuff in the pipeline. You just don't know what the results are going to be if they come out. But I think everything we can probably talk about we've talked about at this stage.

Scott Van Winkle - Canaccord Adams

Okay. And Pete, on your comments about the currency, I didn't know you had negotiated a little less risk on the euro dollar. Are there any collars on that or stats? It's pretty unprecedented the type of weakness we've seen in the US dollar.

Peter Buzy

There is not. And just a recap, a year ago about half of Martek's purchases were denominated in euros. Last summer the new deal basically reduced that to about a quarter of Martek's purchases. So, with that I think we're really able to effectively protect on the currency downsize.

Scott Van Winkle - Canaccord Adams

They moved the manufacturing to New Jersey, or more of the manufacturing in Jersey, or just gave you some price security?

Peter Buzy

Under the new amendment, we gave them more flexibility to do whatever they want. As long as the currency we paid for was fixed, we kind of didn't care. But I think it is probably roughly 50/50 right now.

Scott Van Winkle - Canaccord Adams

Okay. And back on the food, my last question. Obviously, you are tracking your customer's products and all successfully, I know that couple of them had been more successful. Is there any way that's really kind of taken off? It seems like with these ingredients when they break into the market here, you kind of need that one leader to go out there and show the consumer that you've got to have this product. Is there anyone, anything out there that seems to be developing into that big product, the big validation product?

Steve Dubin

I think one of the products that gives us maybe more encouragement, that has done very well, is Minute Maid Berry Pomegranate Juice. It's just been going terrifically well. I think it's the category leader right now for being on the market for a very short period of time. The Horizon Organic Milk I know is doing very well.

So those are both very encouraging products, not only because of products themselves, but I think these are big companies and we have a very good relationship with the companies. And I think the success in the marketplace makes companies want to do other things. And that's why you are seeing this kind of incremental product launch even within current customers.

Scott Van Winkle - Canaccord Adams

And the last question is on the long-term license agreements. I think you mentioned 70% of revenue in those agreements run through at least 2011. I assume that most of those are running longer. Is that accurate? I just thought that 2011 was little bit of a shorter date than I anticipated.

Peter Buzy

For the most part the agreements go beyond 2011. There are some options for the customer to back out of the exclusive arrangement after 2007.

Scott Van Winkle - Canaccord Adams

Okay. Great thank you.

Steve Dubin

And these lay on top of our license agreement. So we have this whole labyrinth of agreements at this point in time. But the exclusive supply period to date, as in general could expire at the end of 2011.

Scott Van Winkle - Canaccord Adams

So Steve, when we consider your agreements relative to pattern expiration, we can look at whichever is longer between the license agreement and the supply agreement?

Steve Dubin

The reason we went back into so many supply agreements is because a number of the license agreements did not have supply provisions. So they're long-term license agreements that customers could basically opt out within a short period of time. Now on the patents, if you look at -- really I always direct people to the 10-Ks and 10-Qs because they are so complicated in detail, the pictures lay out much clear there -- but in general, the patents infant formula side expire in the 2012 to 2014 time period.

So anyway, I think that's a pretty good summary.

Scott Van Winkle - Canaccord Adams

Great. Thank you.

Operator

(Operator Instructions)

We have a question coming from the line of David Webber from Broadpoint Capital. Please go ahead, sir.

David Webber - Broadpoint Capital

Okay. Thanks. Congratulations on the quarter. Most of the questions I had have been asked, but I just want to ask if you have any sense in your dealing with customers as to whether the average DHA content might be rising over time?

Steve Dubin

It's hard to give you an absolute on that. I think some of the products that have been coming out have a little bit higher levels. I think the Minute Maid Berry Pomegranate Juice has 50 milligrams. We always thought the average would be about 32, and I think in general that is still true. But I think there is a slight tendency towards higher amounts. My gut tells me that the science will support even higher levels in the future based upon the data that I have seen today.

David Webber - Broadpoint Capital

Okay. And are you able at this point to give us any update on how enrollment is going in the MIDAS trial, and if we should expect that to be completed some time in the next 12 months?

Steve Dubin

I believe it was probably three quarters in a row. I could be off a little bit on that. I think we're expecting enrollment gets complete within the next three or four months and the study to complete early next year some time.

David Webber - Broadpoint Capital

Okay. Thanks. And then, Peter, a question for you on SG&A. You mentioned in your comment that you can control that relative to other financial performance. Is your intent to keep that at about 16% of revenue, as recently?

Peter Buzy

I think that's probably a reasonable range. Again, I think we are very cognizant on two things; growing the company, then also growing bottom line. I think that is a reasonable range

David Webber - Broadpoint Capital

Okay. And then you commented on what we should expect for contract manufacturing revenues in the second fiscal quarter, should we expect it to continue to trend down over the course of the year?

Peter Buzy

I'll tell you right now the Q2 level of somewhere around $3million is probably reasonable for the rest of the year.

David Webber - Broadpoint Capital

Okay. Very well. Thanks very much.

Steve Dubin

Thanks, David. Just getting back to your question of level for one second- interestingly, the international levels are actually a little higher than the US levels. I know in Australia their expert bodies recommend a very high level of DHA daily. I think there is a Boost Juice there which is kind of equivalent to Jamba Juice which you see here. One of their drinks has 700 milligrams of DHA per serving. So internationally, we're actually getting some pretty interesting levels

David Webber - Broadpoint Capital

Great. Thanks a lot

Operator

Our next question is coming from the line of George Dai from MA Weatherbie & Company. Please go ahead, sir.

George Dai - MA Weatherbie & Company

Hi. Good afternoon, gentlemen, and congratulations on a good quarter.

Steve Dubin

Thanks, George.

George Dai - MA Weatherbie & Company

I have one question regarding the gross margin guidance. According to my calculation, it seems that the non-tolling revenue gross margin was around 43.8%. And I guess with the increased volume of infant formulas as well as other products and the increased efficiency, should this gross margin gradually trend up for the remainder of the year?

Steve Dubin

I think, George, we've said in the last call, and earlier that we think we should be able to exit the year somewhere between 41% and 43%. It's going to be a combination of higher volumes and just improved efficiency at the plants. The Q2 number is going to be fairly similar with Q1, and we did have a nice sequential increase in the first quarter. But we are still targeting to exit the year between 41% and 43%.

George Dai - MA Weatherbie & Company

Great. I understand there could be some quarter-to-quarter fluctuation, but generally speaking it should be trending up, right?

Steve Dubin

That's right. I think Q2 may be flat, which I think is again a healthy increase, and then you should see a trend on a quarterly basis for the remainder of the year.

George Dai - MA Weatherbie & Company

Okay. Now Q2, according to my calculation, if I assume similar gross margin on the non-tolling revenue and lower gross margin on the tolling revenue, it seems that the blended is actually 1 percentage point higher than your guidance. Am I doing my math wrong?

Steve Dubin

I think our guidance is approximately 41%. We have not given that level of accuracy in our guidance number. And if we do a better job in the tolling and run the plants well, then hopefully we will be a little bit better than 41%.

Peter Buzy

Part of the problem is, George, that the tolling is kind of hard to predict because if you have a bad batch or an off batch that throws off the whole margin. But in general, I think if you look at the tolling margins compared to last year, there's been a dramatic turnaround.

George Dai - MA Weatherbie & Company

Right. I understand there is some lumpiness, but we should expect that tolling gross margin should be generally higher than last year as you guys improve the operation. Correct?

Steve Dubin

Yeah. What we did purposely last year is we probably went from making between 10 and 12 products to 3 or 4. And if we can do that I think, so far that's worked as far as improving margin.

George Dai - MA Weatherbie & Company

I see. Okay. Thank you.

Peter Buzy

Thanks George.

Operator

Mr. Buzy, I'll turn it back to you for closing remarks. There are no further questions registered at this time.

Peter Buzy

Well, I appreciate your attendance today at our conference call. We are very excited here about things and how the market is shaping up and all the new products in the pipeline. And we hope to talk with you again in about 90 days with mortgage news. Thanks very much.

Operator

Ladies and gentlemen, this does conclude the conference call for today. We thank you all for your participation and ask that you please disconnect your lines. Have a great evening, everyone.

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