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Seeking Alpha

Thursday, September 21, 2006

Time to Buy Martek?

Well readers, you have had some time now to get over your stomach upset following Martek's(NASDAQ: MATK) earnings guidance adjustment lower. You may have finally resigned yourself to the losses of the day and may now have an open ear to hear about why we believe now may be the best opportunity to buy the shares for years to come.

Management told the investment public the cause of the miscue was a combination of matters, and that clouded the picture a bit, adding to the depth of decline on that miserable day. I believe my take on the cause was helpful. Also, for more detail on the Martek story in general, please refer to my first story on the stock.

I suggested previously that Martek consider flexing its muscle, as it is the sole source of vegetarian DHA. I stated that its patent protection, first-mover advantage and contracted relationships with the infant formula industry should afford it more power with its customers and possibly its suppliers. So much so, that I thought they should not have to accept higher prices for buying less ARA, or they should be able to do the same to their own customers should those manufacturers decide to buy in a non-fluid manner impacting quarterly results and the MATK share price.

Those points are important. What I am communicating now is further reasoning why this quarter's event should not be a continuing problem, or at least be one to a lesser degree with time. Even if Martek stands pat, and continues to experience these types of buying patterns, its revenue flow does not necessarily have to be impacted this significantly nor does it have to surprise the investment community. First, it's clear, and has been so since the build up of inventory at its customers incident, that Martek should employ a customer liaison so as to better evaluate customer activity. However, even if they do not, Martek should be fine in the future. Currently, Martek is dependent upon a handful of customers for its revenues, but in the near future that situation will change. Revenue streams will be born throughout the food industry, and this should dilute the impact of any one customer's plant maintenance from time to time. I am of course speaking of the recent food deals signed with the likes of Kellogg's, General Mills, Coca Cola's Odwalla, Hains Celestial and others.

There are some other very good reasons why investors should be considering MATK these days. Insider purchases are intensifying, and nobody knows better than insiders what the near future looks like. Besides the insider purchases, you have one of the stock's loudest naysayers now coming aboard, or at least not jumping ship. Merrill Lynch upgraded the stock to neutral from sell. So, maybe many of Merrill's clients are now considering reversing their short positions. And, that's not all.... The company is scheduled to present at a conference next week. Now, because of securities regulation, if Martek has important information about its current quarter, say perhaps evidence that its bad news was a bit overstated, than it might just report that at or before the conference. Besides that possibility, it's also commonplace for companies to make important announcements at conferences. In this case, the best case scenario would be news about the date of a product launch, but that would require a food partner's cooperation. We could also see another food partnership announced or international expansion of its infant formula component.

The stock currently trades at 30X the $0.73 consensus EPS estimate for fiscal 2007 (Oct.), but this estimate, down from $0.97 previously is probably underestimated in our view considering the likelihood of food product launches in '07 and the potentially short-term nature of the cause of this quarter's pending and anticipated EPS weakness. It's true that the high cost ARA will take 6-9 months to work through the income statement, but production efficiency as capacity is used in increasing DHA production in FY 07 should help offset that some. Also, we believe revenues should recover quickly.

We feel the main question investors should be asking is, when will food products begin to sell, at what degree and at what rate will those sales grow. Management indicated in the conference call for FY Q3 that we could see food products on shelves anytime from the end of October through 12-18 months. This should not be misinterpreted. We anticipate several food products to roll out at varying times, the first of which can be expected anytime after the end of the FY. Long-term growth is estimated by analysts measured by Yahoo! to rise 25% on average over the next five years. When a company has disappointed, this estimate is likely to be understated if that company's prospects are truly feasible. I believe they are. So, if these numbers are correct, we can estimate the PEG ratio at 1.2, still modest in our view for a high growth company. I expect growth is understated and that the news of product launches will lead to P/E expansion. As revenues exceed expectations over the next three years, in my view, I believe short interest will leave the stock further aiding the shares to rise. If EPS estimates rise to $0.85 for FY 07 and the P/E expands to 40 with improved expectations in foods, the stock should be valued at approximately $34.

We think there are two important catalysts that must happen for our forecast to be realized, excluding all other possible events. First, this quarter's weakness should be short-lived, and not extend to a significant extent into FY 07. We will get a better idea of this over the coming few months, as Martek's management fills us in on progress. We will closely monitor revenue and margin trends, but we expect revenue to recover quickly, aiding margins some. Secondly, we must have our first significant product launch within cereal or yogurt or another item. This will aid P/E expansion and reduce short interest some. I believe my estimate is more likely to prove conservative than it is to prove aggressive, but that's just my opinion. I am very familiar with the company and the stock, after having followed it as an analyst at Standard & Poor's. I should note that my pen name is different than my given name. I also currently have a long interest in derivative investments related to Martek shares.



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