Riding the Martek Roller Coaster

If you have owned Martek Biosciences (Nasdaq: MATK) over the past few years, you could probably use some motion sickness medication.

Your favorite Greek here stumbled across Martek (Nasdaq: MATK) at a conference one winter morning in Philadelphia in 2003. What a ride it has been ever since! Seeing Martek present was a time fill for me. I was there to see Headwaters (NYSE: HW), a company I never ended up adding to my analytical coverage. As I skimmed over the presentation schedule in my hotel room the evening before the conference, Martek looked like an interesting story to fill my 11:00 AM slot.

The company’s DHA/ARA combination had just received FDA “Generally Recognized as Safe” (GRAS) approval status, and the company was actively signing up licensees who wanted to add the omega 3 fatty acid to infant formula. You see, studies show it’ll make your kid smarter. Even though its revenues to date were insignificant, I viewed Martek as a company on the cusp of generating a significant and steady stream of income.

I was right and Martek was my best performing “strong buy” selection that year, and a quick look at the chart will show you why. MATK soared 160% in 2003. However, I was not married to the name. I made note to clients that the company was manufacturing on an industrial scale for the first time in its history, and was likely to run into some growing pains. I was right again, and the company experienced a fire at an important plant; and remember that black out in Italy a few years back, around the same time as the Northeast black out. Well that wiped out the inventory of Martek’s only supplier of ARA, and severely impeded MATK’s ability to service customers.

Then, down the road a bit, Martek came to understand the importance of maintaining active communications with clients. As it turned out, a major client had stocked up its own store of inventory to protect itself from the risk of supply disruption, and did not bother to notify the company that it would reduce purchases later, when Martek had properly stocked up for itself. The analyst and investment community did not appreciate all the mishaps, and when deals with foods companies did not materialize as quickly as had been expected, the shorts smelled blood.

Martek had aggressively built capacity to meet the expected demand from all sorts of food producers who would place Martek’s healthy for your heart DHA in everything from baby food, to yogurt, to health bars, to cereal. The stock collapsed as the company bore the cost of carrying such excess capacity.

But the roller coaster looks to be ready to climb again. Martek is signing deals and its earnings are back growing impressively on even a sequential quarter basis. In its last reporting period, Martek’s fiscal third quarter, EPS grew 27% over the fiscal second quarter result. Still its shares sank in after hours trading that day.

Here's why...

In growing its revenue 11%, to $77.8 million, Martek missed consensus revenue forecasts for $78.5 million, and was toward the low end of the range that stretched from $77.3 to $79.5 million. Besides this, much of the company’s gross margin expansion in the quarter was due to the resolution of prior issues with its supplier of arachidonic acid (ARA), DSM Food Specialties B.V. Also, based on information gleaned from the conference call, SG&A expenses came in about $1 million above company forecast.

Still, management indicated that fourth quarter gross margin should meet or exceed the third quarter result, due to ongoing benefits from the company’s revised agreement with DSM, and on increased sales. And let’s not overlook the fact that Martek managed to exceed the analysts’ EPS consensus view, as measured by Thomson Financial, by a penny in earning $0.19 a share. The company also provided EPS guidance for Q4 of $0.20 to $0.21 a share, ahead of analysts’ view for $0.19.

In a case like this, The Greek thinks it’s important for investors to differentiate the truly significant information from the noise. It’s clear that operations are improving. It’s just the gauging of the rate of improvement that is in question, and that’s likely why MATK was penalized in the after hours. Times like this can create a buying opportunity, in our view. What’s most important in this case is that Martek added eight new product partners offering its DHA within their ingredients. During the call, CEO, Steve Dubin, indicated that the company was ahead of his food product forecast for the year, and had a growing list of potential product opportunities that numbered more than 180. At the same time, Martek was also increasing its partnerships in the Pregnancy and Nursing Products Category.

Now amounting to a double-digit portion of total sales, non-infant formula products are increasingly becoming the company’s growth driver. Meanwhile, Martek continues to expand its international opportunities, recently achieving novel food ingredient status in China. Management still sees plenty of opportunity in second tier providers of infant formula overseas. And Martek’s vegetarian sourced DHA, versus fish based, remains the gold standard.

But that’s not all…

The company seems focused now on maintaining stability and improvement of operational results and measures. We just have one concern, its expectation for inventory to rise in Q4. Considering inventory problems held the company back in the past, this could also be the source of the after-hour headache. We do not expect any noteworthy problem to develop; surely by now management must have a handle on this issue (read its investors hope and pray).

Company ----------- Ticker ------------- Ttm P/E -- Est. 5-Yr Gr -- PEG
Martek Biosciences - NASDAQ: MATK -- 70 ------- 18.5% ------- 1.9
Techne --------------- NASDAQ: TECH --- 31 -------- 27 ------------ 2.1
LifeCell --------------- NASDAQ: LIFC ---- 56 -------- 39 ----------- 1.3
Medicis Pharma ---- NYSE: MRX -------- 69 -------- 23 ----------- 0.75
American Oriental - NYSE: AOB -------- 23 --------- 50 ----------- 0.3

It’s tough to value Martek on a relative basis, because it’s hard to find close peers. That said, some of the valuations above have attracted my attention, and I'll be taking a closer look at a few of the firms in the future. Biotechs are a different animal, requiring indepth knowledge of medicine, specific drugs in the pipeline, the FDA approval process and the rest of the technicals specific to the industry. This is the reason most investment banks hire PHD’s with medical industry experience to cover biotechs and not run of the mill business school brats.

During my time following Martek as a small and mid-cap generalist, I trusted in intrinsic measures to value the company. Ignore MATK's trailing twelve month P/E ratio. Based on the stock's close on October 12, 2007, and the consensus forecast for EPS of $0.84 in FY 08 (Oct.), we generate a forward P/E ratio of 36X. If analysts are correct, and the company is only going to grow earnings at an 18.5% clip over the next five years, that supplies a P/E-to-Growth ratio of 1.9, which is pricey.

In the near-term, earnings per share are expected to grow 33% over FY 07’s troubled result. That's significantly more than the 18.5% long-term estimate. Based on recent sequential growth and expanding opportunities in foods, we expect Martek's real long-term growth will be more like 25%. Calculating a P/E/G ratio based on that figure gives us a measure of 1.4X. This is much more appealing a valuation for the growth offered, and we expect analysts are under-appreciating the MATK opportunity because of historic painful memories. We expect growth expectations to be revised higher along with EPS views. However, because of the divergence in real expectations and our view, the margin of safety is not very wide. At the same time, if we are correct, return should be special. Therefore, we view MATK attractive now for picking at, and would certainly look to add shares on any broad market weakness.

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