Martek Biosciences Corporation F2Q08 (Qtr End 04/30/2008) Earnings Call Transcript

Martek Biosciences Corporation (MATK)

F2Q08 Earnings Call

June 4, 2008 4:45 pm ET

Executives

Steve Dubin - Chief Executive Officer

Peter L. Buzy - Chief Financial Officer

Analysts

Scott Van Winkle - Canaccord Adams

Dalton Chandler - Needham & Company

David Webber - Broadpoint Capital

Daniel Walker - Kalmar Investments

Presentation

Operator

Welcome everyone to the second quarter 2008 earnings conference call (Operator Instructions). It is now my pleasure to turn the conference over to Peter Buzy, Chief Financial Officer.

Peter Buzy

Welcome to Martek’s second quarter fiscal 2008 conference call. First I would like to start off with our Safe Harbor statement, and then I will 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 customer and third party suppliers, customer mix, product mix, customer demand, and 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 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 members’ 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

I think you can tell from our earnings release that we have had an extremely busy and productive quarter. The momentum from our solid start to 2008 continued into our second quarter with both record quarterly revenues and pre-tax income and our outlook for the second half of the year is for continued strong financial results.

We remain focused on growing our infant formula revenues to increasing penetration to international infant formula markets, expanding the use of DHA outside of infant formula, improving gross margins and profitability, and developing new products to support future growth.

Our strong financial results reflect the progress we are making in these areas and the ongoing execution of our business plan. Our core infant formula business has grown nicely so far this year, especially overseas and we are increasing our guidance growth for infant formula business to 9% to 11% from our previous guidance of 7% to 9% growth.

To help to continue the growth of our international infant formula market, in February we signed a multi-year license and supply group with Numico a wholly owned subsidiary of Danone, one of our larger infant formula customers and a leading international producer of infant formula products. Under this agreement we will be the sole source of ARA and microbial DHA to Numico.

We sold a record $8.3 million of non-infant formula nutritional products in the second quarter and are expecting even better non-infant formula sales in our third quarter.

During the second quarter seven new customers launched food and beverage products containing life'sDHA and one existing customer, WhiteWave Foods extended their products their offering by introducing two new flavors of Rachel’s Wickedly Delicious Yoghurt on the market.

The Rachel’s yoghurt line was first introduced into the US natural foods channel in the summer of 2007, is now the fastest growing yoghurt in the natural foods channel. Today WhiteWave announced that they are expanding the distribution of Rachel’s Yoghurt in some mainstream groceries in the US. Rachel’s expansion into mainstream grocery stores reflects the growing success in the marketplace of food products containing life’sDHA.

In addition to all this new activity in food and beverages, 40 supplements containing life’sDHA were launched during the second quarter and with these recent food, beverage, and supplement launches, we are rapidly approaching the 100 mark: that is 100 non-infant formula products that contain life’sDHA that have been launched over the past two years.

Consistent with previous guidance gross margin remained flat at 41.2% when compared to last quarter, but has increased by over 600 basis points from the second quarter of last year. Earnings per share grew to $0.28 primarily as a result of our 18% revenue growth and the improved gross margin.

We announced the introduction of a new protein free product form of life’sDHA in March. This new protein free powder contains no soy or milk proteins will be used in customer applications where allergens in labeling are concerns.

We continue to work on additional new products to support our future growth including lower cost delivery forms of DHA, DHA from other cost effective sources, DHA formulations for various nutritional applications, nutritional and neutroceutical products for microalgae and other nutrients and bioactive compounds from other microbial sources.

While speaking about potential future products, I want to take a minute to talk about our recently announced alliance with Dow AgroSciences. We formed the alliance for the purposes of developing a DHA-rich canola oil and it’s still in the very early research stage, but the alliance builds off of Martek’s previous efforts to incorporate DHA into a plant seed oil, have reinstituted Martek the leading producer of vegetarian DHA with Dow Agro’s world class R&D capabilities and proven track record of getting valuable tricks to market and plans. The alliance combines Martek’s proprietary library of omega-3gs from algae and associated microalgae fermentation knowledge and Do AgroSciences genie transformation expression in dermoplasm.

I think this agreement reaffirms how seriously we take our leadership position in the DHA market and our view of the long-term market potential for DHA.

Over the coming quarters we plan to continue executing our business plan in an effort to grow our infant formula business internationally, work with our customers to get more products that contain less DHA launched and on the market, help us to make it easier for them to make those launches, continue to build our brand of life’sDHA, increase our margins, improve profitability, and develop new products to support our future growth.

I look forward to taking your questions shortly, but first Peter Buzy will give you more details about our financial results.

Peter Buzy

Second quarter performance was once again the highest in Martek’s history with record revenue and earnings. During the quarter we recognized our fifth consecutive quarter of record revenues. The infant formula market provided the majority of growth between the second and first quarters of 2008 with an increase of over $8 million, plus sales to food and beverage customers provided increase of approximately $1.1 million, a sequential quarter increase of over 50%.

Contract manufacturing revenues decreased by $1.4 million, as the result of timing for certain production campaigns.

A portion of the $8 million increase in infant formula sales was due to production timing by our large infant formula customers, which is expected to lead to a decline in these sales in the third quarter. The sales increase reflects growth in both domestic and international infant formula markets and although we cannot determine the exact region of the world where oil will be used, we believe on average that the proportion of international to domestic sales has remained the same since the first quarter of approximately 45% to 55%.

Q2 included expansion in the international infant formula markets of several customers, which we believe provided over 10% growth and a run rate of sales as compared to a year ago. Accordingly, we have increased infant formula sales guidance for fiscal 2008 to 9% to 11% growth over fiscal 2007, which is an increase from our prior guidance of 7% to 9% annual growth.

We now have sole source commitments through at least 2011 with customers that comprise more than 70% of our infant formula revenues.

DHA in non-infant formula and nutritional products is continuing to gain traction with sequential quarter growth of 12% and growth from the second quarter of 2007 of 56%. This was primarily attributable to sales in the food and beverage market, which were driven by increases in sales to our largest customers, as well as eight new launches.

Excluding food other non-infant formula applications decreased slightly on a sequential quarter basis due to the failed timing of a relatively small number of customers, but increased 22% as compared to the same period last year. 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 through out the year.

Gross margin remained relatively flat as compared to the first quarter, but continued to increase year-over-year and has resulted in a greater than 600 basis point increase over the second quarter of the prior year, due to cost decreases in both DHA and arachidonic acid ARA. DHA costs have decreased as a result of production enhancements, even with higher utility cost and raw material cost increases over the prior year. Our production efficiencies and overall cost structure provides a low incremental cost of production which has allowed us to improve gross profit margins.

Better pricing on ARA has offset pressure from the dollar/euro exchange rate. Though the euro/dollar exchange rate continues to unfavorably impact ARA costs, the risk is shared with DSM under our amended agreement with DSM which reduced our currency risk by approximately ½. A 5% increase in the dollar/euro rate would impact gross margins by approximately 25 basis points.

Although third quarter gross margin is expected to be flat compared to the second quarter, we anticipate slight improvements in the fourth quarter and in sequential quarters due to production improvements for both DHA and arachidonic acid, as well as the mix of our sales. On an overall basis, over the next several quarters we continue to anticipate gross margin improvement due to improvements in production mix, slightly higher volume, and continued improvements in processes.

SG&A as a percentage of revenue remained consistent with the first quarter at approximately 15.7%. This is higher than the fiscal 2007 average of 14.6% due to continued investment in new personnel required to support growth, expansion of marketing efforts designed to increase sales in both infant formula and non-infant formula markets, as well as the projected increases in a variable component of company wide compensation resulting from Martek’s improved overall financial performance.

We expect the average for fiscal 2008 to be near 16%. We have the ability to manage the spending rate of SG&A in response to the success in the market place and the financial performance of the company.

R&D as a percentage of revenue was 7.5%. We expect this percentage to be approximately 8% for the year due to the timing of spending on clinical studies and outside services. Martek’s R&D efforts continue to focus on developing new food and beverage applications for life’sDHA, broadening the scientific evidence supporting the benefits of life’sDHA throughout life and improving in manufacturing processes and developing new products to expand our marketing offerings.

Earnings continue to hit new highs. EPS for the second quarter was $0.28 and is the highest ever reported, excluding the impact of one-time tax gains in certain prior quarters and reflects an 87% increase over the same period a year ago.

As expected, cash from operations increased in the second quarter, reaching $13.6 million, $39 million year-to-date, and we expect cash from operations to be higher on average for the remaining two quarters of fiscal 2008, assisted by lower inventory expenditures due to the timing of ARA production.

Inventory increased at the end of the first quarter by approximately $4 million, due primarily to increases in ARA as the result of timing of production campaigns partially offset by reductions in DHA inventory for both infant formula and food applications. As of the end of April our inventory is comprised of $72 million of ARA, approximately $17 million of DHA for infant formula use and $17 million of DHA for non-infant formula applications, including food and beverage, supplements, and animal feed. Then finally, $7 million of raw materials and other inventory related to contract manufacturer.

The increase in ARA inventory was due to the timing of our third party producer and will fluctuate quarter-to-quarter. We expect inventory by the end of the year to be below 2007 year- end levels due to the timing of ARA and the decreased production in the second half of the year. With the increase in sales our day sales of inventory should continue to decrease as well.

As previously discussed on our first quarter earnings call, for the third quarter of 2008 we expect decreases in sales to the infant formula market as a result of the timing of customer production runs and related order timing that caused an increase in the second quarter sales that was higher than our estimated run rate. We now, however, expect that the decrease in the quarter will be less than previously stated.

We previously stated with a run rate of sales of infant formula products of approximately $71 to $73. Any revenues reported in our second quarter over this amount would potentially reduce our third quarter sales.

We now expect that even with a high Q2, our second quarter infant formula revenues of $78.4 million, our third and fourth quarter infant formula related sales will remain near the previously stated run rate or higher. Specifically, we expect these sales to be between $71 and $73 million in our third quarter.

We also expect increases in nearly every category of non-infant formula sales totaling $9 to $10 million in our third quarter as well and contract manufacturing revenue is expected to be between $3.5 and $4 million, for total revenue of $85 to $88 million in our third quarter.

Gross margin is expected to be near 41%, relatively flat with the second quarters margin percentage, but slight improvements expected in the fourth quarters. We expect increases in SG&A and R&D as the result of marketing and research activities, I have previously mentioned, are carried out.

SG&A is expected to increase to be between $14.3 and $14.6 million and R&D is expected to increase between $6.9 and $7.2 million. Amortization is expected to be approximately $2 million and other operating expenses between $200 and $300,000.

Net income is expected to be between $7.6 million and $8.3 million and dilutes EPS for the quarter between $0.23 and $0.25 on weighted shares of approximately $33.4 million. For the year we expect to achieve revenue of between $344 and $350 million which equates to growth of approximately 12% to 14% over fiscal 2007 with growth in all major product markets. Net income is expected to be between $33.6 and $35 million with EPS of between $1.01 and $1.05.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Scott Van Winkle - Canaccord Adams.

Scott Van Winkle - Canaccord Adams

Let’s look at the gross margin. Pete, I don’t know what I should do, but I don’t know relative to how your sales came out through the quarter, what was the impact from currency? We know the math, 5% is 25 basis points, but how much was your average currency? I’m wondering what the gross margin improvement was on a normalized currency basis.

Peter Buzy

The dollar impact in the quarter was fairly minimal. I think on a year-over-year basis it is probably several hundred thousand dollars, but the sequential amount in the quarter was fairly small.

Scott Van Winkle - Canaccord Adams

On the commodity side, what kind of commodities do you guys have exposure to? I would assume it is like natural gas and some basic inputs, but is there anything of significance that we should watch?

Peter Buzy

The commodities that we have are natural gas and then a glucose source. Between the two we are probably looking at somewhere between 20% and 30% of our cost structure. The nice thing about the business model, we have a fairly fixed cost structure, but the year-over-year increases, we are seeing small amounts or a small decrease in our profit margin because of that.

Steve Dubin

I think so far our productivity improvements and our volume improvements have more than offset the input cost increases and again I think, because of the way the inventory works out, we will be flat for another quarter, but we do see gains in the fourth quarter. We should do even better next year than we’ve done this year, so we’re still optimistic about the marks in improvement.

Scott Van Winkle - Canaccord Adams

Then moving over to the infant formula side: the strong sales in the second quarter above your expectations. The timing shift from customer orders, it sounds like since the mix US international was the same Q1 to Q2 that we saw the same type of issue or same type of relationship between US and international on kind of the buy-ahead or building some volume going into the summer months, is that fair? I always assumed that it was usually the European customers that maybe were a little heavier buyers in Q2 as they shut down in Q3 or is that in the US as well?

Peter Buzy

Yes, in general we are seeing that almost across the boarder. A little bit higher buying, but I don’t think we have a distinction at all between the European customers or US customers here. IF you get a plant shut down in the third quarter, which most of our customers have, you will have some quarter-to-quarter fluctuation.

Scott Van Winkle - Canaccord Adams

Moving over to the food side, what’s been the most successful product category? Obviously you can’t talk about individual customers, but is there one product category that’s been the most successful at this point that we should really be watching to kind of drive consumer acceptance?

Steve Dubin

I think this area has obviously been big for us and dairy and beverages I guess are the big ones so far. A lot of the other categories are new; the press has just come out. There are some new categories that have come out and are coming out, so as I said before, you will see continuing broadening of the types of foods that life’sDHA appears in, but I think pretty much everything that’s launched, when we did our customer testing, about 75% of the products that are launched have met or beat our customers expectations, which is well above the industry average. It’s pretty much across the board in terms of application.

Scott Van Winkle - Canaccord Adams

Steve, what was that you said 75% of customers did what? I missed that.

Steve Dubin

The launch of the DHA included products has met or exceeded the expectations of customers 75% of the time. In a typical new product launch, they probably would be satisfied about 25% of the time, to give you a perspective.

Scott Van Winkle - Canaccord Adams

Looking forward, you probably still have a large pipeline of new food deals. Are there any new product categories that are going to shock us or just kind of be new that are coming out where we are seeing the next level of DHA and omega 3 and general penetration?

Steve Dubin

I don’t know what would shock you or not shock you but I think that there will be some ones that you may not have thought, off the top of your head may be the best way to put it.

Scott Van Winkle - Canaccord Adams

Moving over to the supplement side, the last couple of years have been great and the pregnant nursing supplements, the last 24 months where has the biggest piece of that growth come from? Has it come from DHA being sold separately or has it been the inclusion of your DHA into a broader prenatal vitamin?

Steve Dubin

For the most part today there are two kinds of presentations in the pregnant nursing area, either it’s a stand-alone DHA produce or it’s a low two-pack combination of let’s say a bottle of multivitamins and a bottle of DHA, those are kind of the two forms. In the future you may see some physical combinations of products, but to date that really hasn’t been the case.

Scott Van Winkle - Canaccord Adams

Have both of them been equally successful?

Steve Dubin

I think so.

Peter Buzy

One thing that has held this year as compared to last year is we are working with customers that have sales force at the doctors’ offices and that’s really helping to educate the masses that are out there getting the doctors to sell this at the OBGYN level.

Scott Van Winkle - Canaccord Adams

You guys have seen no impact from that study that came out or opinion piece that came out a few months ago about DHA and relative to breastfeeding? I don’t know the best way to term it.

Peter Buzy

Could you repeat that question Scott?

Scott Van Winkle - Canaccord Adams

The piece that came out a few months ago from a breastfeeding…

Peter Buzy

The cornucopia thing?

Scott Van Winkle - Canaccord Adams

Yes, has that had any impact on customers or sales or anything?

Steve Dubin

We haven’t seen any, if you see the numbers the sales have been increasing. We talk to our former customers constantly and I think when there are some articles written and a little bit of buzz in the media there are a few questions, but we haven’t had really anything in the last couple of months.

If you ask the FDA or if you ask the customers, you analyze the data and you look at the facts. Our DHA has been on the market for a very long time, since 1994 and your preemie babies in Europe for term formulas, really since 1996 overseas and since 2002 in the United States and we just don’t see any problems. We haven’t seen a factual problem in terms of the effects that this group was citing and we really haven’t seen much concern expressed by the consumer.

Scott Van Winkle - Canaccord Adams

The relationship with Symbiosis, I assume that’s just in the past now the new Dow AgroSciences deal?

Steve Dubin

Symbiosis has some continuing interest in certain outcomes based upon the final terms for our deal which is between us and them, but they are not at this point in time involved in the actual work.

Operator

Your next question comes from Dalton Chandler - Needham & Co.

Dalton Chandler - Needham & Company

I wanted to come back a little bit to the growth in the formula products; I have a couple of questions there. One, you went through a period of sort of slow growth, in the last three quarters you’ve seen accelerating growth, which I assume you’re mostly attributing to international. Did something change there with your partners or with their emphasis on the DHA enhanced product?

Steve Dubin

I think there are a number of things going on. I can’t tell you we know everything that’s going on with our [indiscernible] members, we try to stay informed, but because we get along with their competitors they don’t tell us everything; but I think that the customers have been watching, especially products in Europe for instance and people are wanting the same thing everybody else wants.

There has been some success in Asia. The economies are growing there. There is an overall growth in formula usage in Asia that’s growing at a double-digit type rate, so we’re kind of started along with that. I think we’ve done a number of things in terms of signing up smaller licensees that have added several million dollars to our top line and have also created a competitive environment in these geographies in which they launch their products.

So, it’s a combination of maybe luck from the big growth in the Asian market and also some of the hard work we’ve put in to kind of create a competition in certain markets by signing up some of these smaller players.

Dalton Chandler - Needham & Company

I know you don’t give precise numbers on your domestic versus international mix, but you haven’t really changed your estimate for a few quarters which implies the US still also has strong growth. Could you maybe reconcile that?

Steve Dubin

I think there’s growth in the US because, and I don’t have the exact numbers at my fingertips, maybe Pete Buzy can jump in where I say the wrong thing, but the average last year was probably something under 90% and the average this year will be something in the 95% range maybe. Therefore, there is growth this year and there will be growth next year, because if we added 100% you’re still going to have growth from whatever the average was this year.

In addition, I think that there’s still some potential for future growth in the United States and I don’t know whether we, at the end of the day classify these as formulas or as foods, but as some of these companies move into these top reprise [ph] for the next age group, so I think there’s still a potential for growth in the United States even as we approach 100% in the core infant formula business.

Dalton Chandler - Needham & Company

I know Pete, you touched on the gross margin a little bit already, but if you look at the revenue from last quarter versus this quarter and then what you’re forecasting for next quarter, there is a lot of variation between those three, but your gross margin, you’re expecting to stay about flat in percentage terms. What is driving that flatness in gross margin while your revenue is moving around?

Peter Buzy

One big piece of our margin is the arachidonic acid cost and in general we have a price from DSM which has lasted most of the year. There is some FICO [ph] layer intact of that, but that does effectively lock a big piece of the gross margin. The other component that will impact margin relates to product mix and we do think as we move into the future quarters we’ll be selling more just stand-alone DHA that we have better margins on. Then finally, to a much lesser extent, some of the contract manufacturing impacts overall margin.

Operator

Your next question comes from David Webber - Broadpoint Capital.

David Webber - Broadpoint Capital

Steve, I was interested in your statistic about the percentage of product launches that have met or exceeded customers’ expectations. Do you have a similar statistic for the percentage of projects, prototype work done by potential customers that end up becoming products?

Steve Dubin

Well I’m sure we have and I don’t know what the number is.

Peter Buzy

One of the difficulties right now of giving that is there is almost a two year lead time between introduction to the product and launching, and we’re pretty early in the overall process, I think, to have a good handle on that number.

Steve Dubin

I can say that the interest continues to build in a number of projects, although I don’t want to start talking specific numbers any more on that, but the number of projects is still growing and it’s both in the food and beverages and supplements area. One of the things that I should say, one of our goals this year internally with the company is to have some increased distribution for the supplements.

The preemie nursing supplements are actually pretty well distributed today, I mean much better than they were a year ago. The general supplements are still hard to find and it’s always kind of bugged us when somebody does work on our ad and we have to send them to our website, which is fine, but it makes it hard for people.

I think you’re going seeing a lot of improvement on the distribution side as we move forward in the year and early next year and that should help our revenue growth too.

David Webber - Broadpoint Capital

Can you give us any sense of how you will accomplish that?

Steve Dubin

I think it’s a combination of dealing with some of the name brand players out and some of the larger commercial outlets.

Operator

Your last question comes from Daniel Walker - Kalmar Investments.

Daniel Walker - Kalmar Investments

Could you talk about why Dow would be the preferred partner as you work to include something in a plant based product, versus some other partner?

Steve Dubin

I think there are a number of reasons. It goes from who owns what patents in terms of getting into the marketplace and getting into plants.

There are certain other potential players that are doing things competitively to us and Dow was very interested. The chemistry between the two companies was very good. We’ve been kind of working together for almost a year before we signed the actual agreement. We had a courtship and had a chance to see if it would work, but they were interested in us, we were interested in them. There was some, I believe, some people who had worked together in previous jobs, so people knew each other, and it just worked out well.

Daniel Walker - Kalmar Investments

On another topic, did I hear you say that there were 40 either supplements or nutritional products introduced in the quarter?

Steve Dubin

Four in the quarter: if I said 40, that was a mistake, it was four.

Daniel Walker - Kalmar Investments

On the bread front, can you talk about the way that your product is treated, whether it’s microencapsulated or some other way of dealing with the DHA to make it work in bread?

Steve Dubin

I believe that these products are not microencapsulated. I’m not sure; I’d have to check on that.

Daniel Walker - Kalmar Investments

The partners that you’re working with, is this there first entrée into using DHA or an omega 3 in their products, or had they used a different source?

Peter Buzy

Well I can tell you they have minimally tested every source, but I believe this is their first actual market launch with the DHA source.

Daniel Walker - Kalmar Investments

You offered the prohibition that you wouldn’t talk about a partner, but has Rachel’s been solely offered in health food stores and organic stores to this point?

Steve Dubin

It has been the natural product in whole foods and things like that. Yes, by the way, Dan I’m sorry it’s really a terrific product. It looks good, it tastes great, and if you go in and look at it and try it you’ll see why we’re so excited about that product.

Daniel Walker - Kalmar Investments

Do you have reason to believe that the distribution you’ll gain in traditional stores will be enabled in some way versus someone else that might have such ambition, but doesn’t have the access to do it?

Steve Dubin

Rachel’s is part of Dean which is different area’s of the country, so I would imagine that if anybody can get distribution, Dean’s can.

Steve Dubin

Thanks very much for the questions we got. We’re really excited to hear about what’s been happening. There has been a lot of action in the past quarter. I think there’ll be a lot of things going on in the next quarter. We just keep moving the ball forward and look forward to talking to you next quarter.

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