Martek Biosciences Corp., Q3 2008 Earnings Call Transcript

Martek Biosciences Corp. (MATK)

Q3 2008 Earnings Call Transcript

September 4, 2008 04:45 pm ET

Executives

Peter Buzy - CFO

Steve Dubin - CEO

Analysts

Dalton Chandler - Needham & Company

Suzanne Price - ThinkEquity

Scott Van Winkle - Canaccord Adams

Presentation

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Martek Biosciences Third Quarter Earnings Release Conference Call. During the presentation all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded Thursday, September 4th, 2008.

I would now like to turn the conference over to Mr. Peter Buzy, Chief Financial Officer. Please proceed, sir.

Peter Buzy

Great. Thank you, and welcome to Martek’s third quarter fiscal 2008 conference call. First I’d like to start the call 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 customers 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 numerous assumptions, which Martek cannot control and involve risks and uncertainties that could cause actual results to differ. These statements should be understood in light of the risk factors set forth in connection with the company’s filings with the Securities and Exchange Commission.

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

Steve Dubin

Thank you, Pete. Our third quarter was another solid quarter, one in which we recorded record quarterly pre-tax earnings for the second quarter in a row. Our outlook for the fourth quarter of 2008 is also looking strong. Accordingly, we are increasing our revenue and earnings guidance for the year as a whole.

As I have mentioned in previous calls, we remain focused on growing our infant formula revenues through increasing penetration in the international infant formula markets, expanding the use of DHA outside of the 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. In particular, our strong third quarter show – resulted primarily from growth in arachidonic acid and DHA sales to our infant formula customers and overall higher gross margins.

Our core infant formula business has grown by 16% year-to-date, driven mainly by growth overseas, and we are increasing our guidance for full year growth for our infant formula business to 12% to 13% from our previous guidance of 9% to 11%.

We had a disappointing quarter for non-infant formula DHA sales but are expecting better results for our fourth quarter, based on our significant orders to date and the increased number of new product launches planned by our food, beverage and supplement customers.

Our DHA sales for uses other than infant formula were impacted to some extent by some seasonal issues in our third quarter and are being affected somewhat by the challenging economic environment and that’s causing to delays by customers in launches and reduced marketing expenditures by some customers.

But despite the economy, our sales of DHA outside of formula are up 38% in the first three quarters of the year, and are expected to be up by close to 40% for the year as a whole. During the third quarter, we continue to expand distribution of our supplements, both in the U.S. and overseas, and we expect further expansion in months to come.

In the food and beverage areas we continue to broaden the type of food applications in which our life'sDHA can be added. And recent examples of these new types of food applications include Crisco cooking oils, Kellogg's longer life nutritional bars, Cabot dairy case cheeses, and some fresh baked goods that’s now in the Starbucks line. They are all great products and a great brand.

In addition, Abbott is now in the process of including our DHA in their entire line of PediaSure, the terrific complete beverage products from sugar. So, despite the current economy, interest in our DHA has never been stronger for food, beverage and supplement uses. And this should result in continued growth in these areas in 2009.

Gross margin increased to 41.5% in the quarter an increase 300 basis points over last year's third quarter and slightly higher than previously guided. This improvement in gross margin resulted from the increased utilization of our manufacturing facilities, DHA productivity gains and lower ARA cost we came about at a time of increased raw material and energy cost. We are expecting gross margins to be about the same in the fourth quarter, what we do expect further gains in 2009.

So as I said earlier we expect to finish 2008 with a strong fourth quarter, I believe that 2009 will leave than better as we continue to execute on our business plans to grow our infant formula business internationally as we work with customers to get more products containing our life’sDHA launch, making easier for them to do so, build our DHA brand, increase our margins, improve profitability, and continue to develop new product to support our future growth.

So Pete is going to give you some more detail on our third quarter financial results and our fourth quarter guidance and then we will open the floor to your questions.

Peter Buzy

Thank you, Steve. Martek reported another quarter of strong performance with earnings at record levels and improved gross margins. Product sales increased 12% as of third quarter of last year, strong growth in infant formula and non-infant formula market.

Lower operating expenses and higher gross margins offset the anticipated quarterly decline in revenue from the second quarter record level. And resulted in earnings of $0.28 per share maintaining the high level that was achieved in the last quarter.

Infant formula sales were higher than expected and came in at $75 million, $2 million to $4 million higher than our prior expectation of $71 million to $73 million, while we did experience the expected decline from our second quarter with certain customers, due to production timing. Orders from other customers, particularly in international markets was higher than anticipated and offset a portion of the decrease.

Sales in food and beverage markets increased 32% and other nutritional markets including pregnancy and nursing and supplements in animal feeds increased 4% over the third quarter of prior year.

Sales to the non-infant formula markets declined from the second quarter and were lower than our previous guidance primarily due to unevenness in order balance resulting to some degree from seasonality of customer products as well as delays in the lots of certain new customer offerings due in parts to the challenging economic environment. We expect a return to growth in the fourth quarter in these markets.

Year-over-year we expect food and beverage related sales to grow between 95% and 105% over fiscal 2007 and sales for pregnancy and nursing applications, supplements and animal feeds to grow in the mid-20% range over 2007.

Contact manufacturing revenue increased by $2.1 million, as a result of higher demand from one customer, as well as, the timings of the production campaign.

Gross margins increased 30 basis points over the second quarter of 2008, and 300 basis points over the third quarter of 2007, excluding a one-time gain of 250 basis points, and a third quarter of 2007, related to a prior-period DSM purchases, gross margins actually increased 550 basis points over the third quarter of 2007. These improvements were due to the lower cost in both DHA and ARA. DHA costs has decreased as a result of enhancements in our production facilities and increases in plant utilization, which has offset increases in the utility costs and raw materials over the prior year. Better pricing on ARA during fiscal 2008 has offset pressure from the euro-dollar exchange rate. We expect these higher gross margins to continue to the fourth quarter with additional improvements in fiscal 2009.

SG&A as a percentage of revenue was slightly lower than that of the second quarter at approximately 15.3%. This is higher than the fiscal 2007 average of 14.6% due to continued investments in new personnel required for growth, expansion for marketing efforts to try to increase sales in both infant formula and non-infant formula markets, as well, as projected increases in the variable components of company-wide compensation resulting from Martek’s improved overall financial performance.

We expect the average for fiscal 2008 to be approximately 15.5%. We continue to have the ability to manage spending rate of SG&A in response to the projected success in the market place and the financial performance of our company.

R&D as a percentage of revenue was 7.1%, slightly lower than the second quarter. We expect this percentage to be near 7.5% for the year due to the timing of spending on clinical studies and outside services which will increase in our fourth quarter. R&D efforts continue to focus on development of new food and beverage applications for life’sDHA, broadening the scientific evidence supporting the benefits of life’sDHA throughout life, improving manufacturing processes and developing new products to expand our marketing offerings.

Earnings were higher than our previous guidance of $0.23 to $0.25 per share, and held at a record level set in our second quarter. EPS for the second and third quarters was $0.28 each or the highest ever reported, excluding the impact of one-time tax gains in certain prior quarters. Q3 EPS reflects a 47% over the same quarter one year ago.

Cash from operations remained very strong at $23 million in the third quarter and at $62 million year-to-date. We expect cash from operations to increase by between $5 million to $10 million in our fourth quarter, assisted by lower inventory levels due to the timing of ARA production and related purchases from DSM.

Inventory for the quarter increased slightly compared to second quarter to a total of $130 million, or an increase of about $600,000. As of the end of July, our inventories comprised of $73 million of ARA, $16 million of DHA for infant formula use, $17 million of DHA for non-infant formula applications, including food and beverage, supplement and animal feed. Then finally $7 million of raw material and inventory associated with our contract manufacture. We expect inventory by the end of the year, so by the end of the fourth quarter to be at levels comparable or below beginning of the year, which was at $109 million. That is primarily due to the timing of ARA purchases from DSL. With increasing sales, our day sales of inventory should continue to decrease as well.

For the fourth quarter revenue is expected to be higher than that what we included in our previous annual guidance, and we expect a quarterly increase in sales in both infant formula and non-infant formula markets. Specifically we expect infant formula sales to be between $74 million and $77 million, non-infant formula nutritional revenues to be between $8 million and $9.5 million, non-nutritional revenues to be approximately $1 million, and then finally, contract manufacturing revenues to be between $3 million and $3.5 million. This results in total expected revenue for the fourth quarter of between $87 million and $91 million.

Gross margin is expected to be near 41.5%, which is consistent with the third quarter. Net income is expected to be between $8 million and $9 million, and diluted EPS between $0.24 and $0.27 on weighted shares of approximately $33.5 million. We are raising our revenue and earnings guidance for the year. We expect to achieve revenue of between $349 million and $353 million, which equates to growth of approximately -- of between 14% and 15% over fiscal 2007, with growth in all major product categories.

Net income is expected to be between $35.2 million and $36.2 million, with EPS of $1.06 to $1.09. This reflects a near 65% increase over fiscal 2007, after adjusting for the non-recurring tax gains recorded last year.

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

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is from the line of Dalton Chandler with Needham & Company. Please proceed with your question.

Dalton Chandler - Needham & Company

Good afternoon. I was wondering if you could expand a little bit on the comments you made in your press release, and I think a little bit in your prepared remarks, about the impact of the economic environment. Are you seeing this in particular product lines or is it particular geographies?

Steve Dubin

I think companies are a little more hesitant to put out new products in this environment. They are still doing it, and I think things have been pushed back a little bit, but as I said we expect some of this to pick back up in the fourth quarter. So I think consumers are switching to some extent from brands to non-brands. And it's not the best environment to introduce new products. But that won't last for forever, and even in the face of that, I think we are growing pretty well.

Peter Buzy

Just to follow-up on that. I don't think we are seeing any of that in our core infant formula business. As matter of fact, the growth is accelerating internationally. So is impacting kind of new applications here.

Steve Dubin

It's impacting in some of the non-infant formula segments.

Dalton Chandler - Needham & Company

Okay. So it just customers are rolling out new product more slowly, or that product is already on the shelf is selling more slowly, or may be a combination of the two?

Steve Dubin

I haven't seen the products on the shelves necessarily selling more slowly but it's more of the delay from new product launches because they don’t want to do it in the face of bad situation and have a product failure. So I think that's impacting us. But that being said, as I said, the interest from outside and the amount of increase in projects is at the highest level ever in the history of company. So, we see no change really in the outlook and demand for the product. But you could have -- it would be better if it wasn’t the current economic situation, but it is what it is and despite like I said they are growing a pretty well.

Dalton Chandler - Needham & Company

Okay. I think usually you give us some estimate of the break out of infant formula cell between domestic and OUS?

Peter Buzy

Right now, for over the last two quarters it's trending, give or take about 55% U.S. and corresponding 45% international.

Dalton Chandler - Needham & Company

Okay. And as last question you probably have fair amount of cash these days, any thoughts on what you are going to do with that?

Peter Buzy

I think Martek really has never had surplus cash and this environment do think that is a good thing. The company has looked at alternative for the cash, and we are still considering different alternatives for the future, but right now I think building some additional cash on our balance sheet is smart move. In quarter we also paid off probably a few months earlier, I think remaining or $8 or $9 million of debt.

Dalton Chandler - Needham & Company

Okay. Thanks very much.

Operator

Our next question is from the line of Suzanne Price with ThinkEquity. Please proceed with your question.

Suzanne Price - ThinkEquity

Hi, guys. Congratulations on a good quarter. Just wondering if you seen any push back on the price of the product especially from food companies who are seeing their own ingredient cost go up a lot in every other area?

Steve Dubin

We haven't seen any.

Suzanne Price - ThinkEquity

Okay. That's good to know.

Peter Buzy

For most products the cost to put our product in a food ingredient or food product it is near attending per serving. So is not a huge incremental cost to add our oil to products.

Steve Dubin

I think, again if you are in a situation where consumers, at least, some portions of consumers are downshifting, so to say, on their food purchases I mean no one wants at any cost. But really no one said as we want to pay penny per serve, we want to pay $0.07 per penny. I think the companies that are really believers in this, and it just a matter of timing and launches and their own internal budget concerns that are impacting thing, but it's -- I don’t look there is a long term thing at all. Again, there are new product launches scheduled in the fourth quarter. Our orders to date in this quarter are the highest they've ever been to this stage in the quarter in the non-infant formula area. So in general we're feeling really good about things.

Suzanne Price - ThinkEquity

Great, thanks.

Operator

And our next question is from line of Scott Van Winkle with Canaccord Adams. Please proceed with your question.

Scott Van Winkle - Canaccord Adams

Hey guys, Congrats, another good quarter. The DSOs, if you mentioned this. I apologize, did you mention why DSOs were up sequentially?

Peter Buzy

We did not, and it is the timing of the ordering pattern during the quarter. Sales were the back end of our second quarter because of some of the lumpiness of large orders from customers. That did result in the first two months of our third quarter really lower sales than we were tracking. Fourth quarter came in at a higher amount. But we do expect next quarter that the distribution of sales is fairly even across the different months, and that that will result in DSOs coming back down closer to 44 days

Scott Van Winkle - Canaccord Adams

Perfect, perfect and contract manufacturing margin, I know they bounce around on a quarter-to-quarter basis, but if you look at them the first nine months this year versus last, they are up a lot. What did you do to change those contract manufacturing margins?

Peter Buzy

I think we announced in December of last year that we probably went from about 12 products down to about three or four products. There's a fair amount of fixed costs associated with any individual product. So that helped. The margins do fluctuate, and part of the reason is that even a small change in our productivity in one quarter will drive that margin up or down because the margins are fairly thin to begin with.

Scott Van Winkle - Canaccord Adams

Back on the food revenue timing, you talked about the economy and such, were there big products launched in the last couple of quarters where maybe the initial fill to get into the food company and then ship it out to 20,000 retail doors – are you just comparing against that? Is it just -- it is just timing and it kind of bounces back next quarter? I was wondering if there were big products a couple quarters ago, and maybe this quarter we are a little smaller, even though there was some good announcements?

Steve Dubin

I can't say there is none of that, but I don't think that was a major factor. I think more of it was on some of the seasonality issues with some of the kids' products out there, and the kids aren't home during the summer, they are all on vacation and those kinds of things. I don't really see it as being a big factor.

Scott Van Winkle - Canaccord Adams

The currency impact on arachidonic acid, can you go ahead and explain how that rolls through as far timing goes? You have got a pretty good volume of arachidonic acid inventory. When do you get to the higher priced stuff from maybe January or February of this year and February of this year, and when do you get the benefit of maybe the cheaper stock that you're getting out of Europe, which obviously is only half your arachidonic acid, but when does that start to positively impact the P&L?

Steve Dubin

I guess the unit cost of arachidonics that we have on our balance sheet now is fairly similar to what has gone through our P&L over the last quarter or two. About a year ago we restructured the DSM arrangement so that only about one-quarter of our arachidonic acid purchases are subject to currency fluctuations. And then our total arachidonic sales are just a component of Martek's overall sales. The risk is not incredibly high. The improvement that we have seen in currency really on a theoretical basis we will start to see over the next probably two quarters from now. But the delta between – or the higher the euro to where it is today does not have a huge impact on our margin one way or the other.

Scott Van Winkle - Canaccord Adams

You’re talking about gross margin improvement in the fourth quarter. Well, the same in the fourth quarter and a little bit next year. Can you go through – I have talked to you guys about it before, just to kind of refresh our memory, what are the items that are driving gross margin? You talked about productivity improvement. I think there is a new deal on the manufacturing of arachidonic acid. Can you give the items that are really going drive the gross margin?

Peter Buzy

The big item first is our arachidonic acid costs. Theoretically, that should continue to improve with higher purchase levels. Both Martek and DSM continue to work on efficiencies, both in the biology and downstream processing. The next component of cost is Martek’s DHA cost. And really we can improve that cost in two different areas. One is both the biology how well we run our plants. And then with higher volumes that will also continue to drive unit costs down. And then to a lesser extent the mix of some of the tolling impacts the margin as well.

Steve Dubin

Getting back to your initial question, the one that – the stocking, if you want to call it that. It will affect the supplements to some extent, if you have a new customer that is loading up their shelves. But it won’t really affect the food and beverage area that much because the shelf life isn’t that long for those types of products.

Scott Van Winkle - Canaccord Adams

You’ve got a faster turn in those products, so it is not a big deal.

Steve Dubin

Yes.

Scott Van Winkle - Canaccord Adams

Okay. And on the formula side, where internationally, can you – I mean I am sure USA-Asia is where you are seeing the most growth internationally. Can you break that into a little more specific on which markets? I mean you’ve had some announcements over the last year, the most recent I think was Russia, a product. Where in Asia are you seeing, if it is Asia, the fastest growth of formula? And Steve, is it being impacted by growing formula feeding rates versus breast feeding rates maybe the opposite might be the same in the U.S.?

Peter Buzy

Yes, Scott, a few things, the rate that they are growing overseas and then just the overall market – which is translating the overall market for infant formula increasing. In general, for most of our customers, we ship to maybe total two or three of their ex outside the States plant. So, we do have a difficulty in tracking exactly the end-country user. One thing that Martek does, and some of our investors do, is track what our customers are saying in their public filings where they are really outlining what’s happening in their overseas markets for infant formula. And in general, the increases have been in the Asian markets.

Scott Van Winkle - Canaccord Adams

Okay, great. Thank you.

Operator

(Operator Instructions). And there are no further questions at this. I’ll now turn the conference back over to you.

Steve Dubin

Well, thank you all for your attention today, and we look forward to reporting back to you for the fourth quarter. As I say, we’re going to have a very good fourth quarter and we’re excited about some of the new products coming out and that have come out and we should have better data and see how they are doing. So, thanks very much, talk to you in about 90 days.

Operator

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

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