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A Growing Boost for Baby Formula

By Markos Kaminis Martek Biosciences (MATK

; recent price, $49) has spent several years developing its core products -- nutritional oils based on docosahexaenoic acid (DHA), a fatty acid widely recognized as important in infants' development. In our view, the company is now beginning to realize its long-standing goals of penetrating the infant formula market and selling its offerings in the supplement and food and beverage markets.

We anticipate fiscal 2005 will be an eventful year for Martek and see significant volatility in its shares as a result. We believe the impact of positive new product-partnership announcements could be boosted or offset by the results of patent litigation. More importantly, however, we believe growth in fiscal 2005 and beyond, will be supported by the company's first-mover advantage and strong contracted partnerships.

Adding to the shares' appeal: Two key valuation metrics we use indicate the shares are undervalued. Martek carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

GROWING PAINS. After a positive 2003, Martek and its stock suffered setbacks in 2004, as the business experienced growing pains typical of early-stage, growth outfits. We believe new production capacity will drive further infant formula market penetration in 2005.

We also expect an impact from new product-development news and from patent-litigation hearings. We anticipate potential short-term risk to shareholders in April, should Martek's European patent for arachidonic acid (ARA), a key element in its blend of nutritional supplements, be revoked. However, any negative judgment would likely be appealed, leading to a lengthy process during which the company would likely maintain its patent protection.

Martek's European patent for its DHA/ARA oil blends was recently revoked by the European Patent Office. The Columbia (Md.) concern is appealing the decision, leading to the patent's automatic reinstatement during the process. Martek believes this will take about two years. We expect that, due to the automatic reinstatement and other issued patents, there won't be any short-term impact on results.

FIRST-MOVER EDGE. More important, however, we believe Martek's first-mover advantage and its strong contracted partnerships will drive long-term market-share leadership. Martek's contract relationships with infant formula manufacturers extend from 15 to 24 years, depending on individual terms and dates contracted. In the event a customer were to source the additive from another party, assuming there was no patent infringement, a royalty would still be paid to Martek.

While Martek provides a product that must be of high quality to insure children's health, we believe Martek's first-mover advantage is significant due to the trust gained during its business relationships. Any competitive product would first need to be approved by the Food & Drug Administration or any similar organization. Additionally, we think Martek has achieved significant yield improvements through production-process knowledge gained over the years, and its production capacity has increased significantly.

Martek has only recently come of age with the acceptance of its nutritional-oil compound of DHASCO and ARASCO for use in infant formula. The additive's 2001 receipt of FDA generally considered as safe (GRAS) approval and several scientific studies indicating the product's beneficial impact to prenatal and breast-feeding child development were groundbreaking events. This provided, in our view, the means for the company to leap from the pioneering stage of development to the high-growth stage. Since then, it has licensed infant formula makers covering virtually all of the U.S. and nearly 70% of the global formula market to include the additive in their formulas.

CACHET OF DHA. Martek has developed and patented the means to recover DHA from microalgae or microplants and ARA from fungi. These substances are found naturally from several sources and are present in a pregnant mother's placenta and breast milk. Martek's blend of these two important fatty acids approximates their actual proportion in human milk. These substances are found in cell membranes throughout the body, especially in the brain, central nervous system, retina, and heart.

Several independent studies have indicated the mental development and visual activity of infants are positively affected by breast-feeding, and breast-fed infants have higher levels of DHA in their brain tissue and enhanced mental acuity later in life compared to those fed infant formula not containing DHA. DHA and ARA have been recognized as important in babies' diet -- and recommended for inclusion in infant formula -- by leading health organizations worldwide.

Supported by scientific data, infant formula producers have embraced the idea of offering a DHA-inclusive product. In fact, all of the most significant market participants (approximately 14 infant formula manufacturers and 19 companies overall) have been licensed to offer Martek's additive in formula, and we see strong incentive for them to do so. At the start, this offered formula makers the opportunity to differentiate their product and charge premium prices for the DHA-inclusive product. We suspect that as they continue to grow shelf share of the inclusive formula, these producers are boosting earnings growth by expanding margins in a business where top-line growth had matured.

BOOST FROM WIC PROGRAMS. Furthermore, to win Women, Infant, and Children programs (state food-stamp programs), formula manufacturers have presented the DHA-inclusive formula. Since early 2002, about 46 state WIC programs have adopted a brand of infant formula supplemented with Martek's oils, so all food-stamp purchases in those states go for formula that includes Martek's additive.

We estimate the global market for infant formula at $7.9 billion, and Martek's portion at about $400 million. In 2002, the first full year the additive was offered by licensees, penetration exceeded 10%. In the most recently reported quarter (ended October 2004) market penetration in the U.S. was nearly 75%, and the company believes it will reach 100% penetration in 2005. Our model predicts average global penetration of 64% in fiscal 2005 (ending October), 70% in fiscal 2006, and 75% in fiscal 2007.

We believe it's likely that products featuring Martek's supplements will eventually replace current products on the shelf in almost all instances.

GOOD FOR BABIES.. Further scientific evidence exists that prenatal fetus development can benefit from the mother's supplementation of DHA. We believe that growing numbers of mothers and expecting women will become increasingly aware of DHA and choose to supplement during pregnancy and while breast-feeding. We value this potential market to Martek at about $900 million globally. We anticipate penetration of 3% in 2006 in the nutritional supplement market, resulting in revenues of $27 million that year.

Whether DHA provides significant benefits to the child after the first year of life or not, we see a market developing in baby/toddler food, based upon the same selling points and incentives to manufacturers that exist in infant. We value the global market for baby food at approximately $11 billion, with roughly $550 million available to DHA suppliers. We forecast $23.6 million of revenue from this market in 2005 for Martek, growing to $55 million in 2006.

Martek is also targeting the food and beverage industry, and we believe there may be opportunities there as well. That's because DHA may have beneficial effects for adults, especially regarding cardiovascular health. Martek reports it has been successful in adding its DHA to several food and beverage products during in-house trials, as well as to a nutritional bar currently on the market. In March, 2004, the FDA completed a favorable review of the company's GRAS notification for use of Martek's DHA strain for food applications.

OTHER TARGETS. The business is currently marketing food and beverage and animal-feed applications to both U.S. and international concerns. Several egg producers, including Gold Circle Farm, are producing eggs using Martek's animal-feed ingredient, and these eggs are sold in several grocery stores chains in the U.S. and Europe. We expect 2005 to include multiple new product partnership announcements in the food industry.

Martek suffered growing pains in 2003 and 2004, as it experienced supply interruptions of arachidonic acid due to a power outage in Italy and a fire in the U.S. However, we think it has taken steps to mitigate future potential events by re-contracting with its supplier of ARA, DSM Food Specialties, to produce a limited amount of it on its own to compensate for instances in which supply may be inadequate.

DSM has also expanded its own capacity to support growth. In December, 2004, Martek announced it was running at a capacity level, allowing $270 million to $280 million in sales. Its goal is to have production capacity for DHA and ARA oils equivalent to about $500 million in annualized sales by the 2005 second half.

LIMITED SUPPLIES. In fiscal 2005, we see revenue growth of 76%, to $324 million, as we estimate Martek's patented additive to penetrate 64% of the global infant formula market. However, we expect product delivery to be restricted through the first half of fiscal 2005 by limited ARA supply. We see revenues finding traction in nutritional supplements for pregnant and lactating women, and we also expect entry and penetration into other food markets.

Fiscal 2004 gross margins narrowed, largely due to what we regard as temporary costs of air shipping ARA from Italy to meet demand. As normal ARA production resumes, we think that gross margins will widen to 45% in fiscal 2005. Despite near-term increases in operating expenses, as Martek ramps up to support growth, we believe that much of the long-term product marketing necessary will be indirectly covered by licensees. While R&D investment is increasing as well, we still see operating leverage in fiscal 2005, on rapidly growing revenues.

Despite the expected reporting of taxes at 37.5% for 2005, vs. no taxes, we see fiscal 2005 net margins widening by 120 basis points. For fiscal 2006, we forecast 500 basis points of net margin expansion. We see fiscal 2005 earnings per share of $1.34, up from fiscal 2004's 72 cents, before a nonrecurring tax benefit.

POTENTIAL RISKS. We project Standard & Poor's Core EPS of 83 cents for fiscal 2005 and $2.01 for fiscal 2006, vs. our operating EPS estimates of $1.34 and $2.48. The difference reflects the impact of expensing stock options.

Our discounted free-cash flow valuation model yields an intrinsic value one year forward of $70. Applying a p-e multiple of 42, based on our five-year EPS growth forecast, to our fiscal 2005 EPS estimate of $1.34, implies a fair value of $56. By averaging these metrics, we arrive at our 12-month target price of $63.

We view the key risks to our recommendation and target price as: The potential inadequacy of Martek to meet the demand of infant formula manufacturers; pending and future patent litigation; the potential failure of further consumer acceptance in the market for infant formula; the possible failure of extension markets to develop significantly; the potential for any later discovery of any detrimental effects of DHA or ARA; exchange-rate risk; a possible disturbance in the supply of ARA from the company's supplier; and potential governmental or regulatory restrictions placed on the company's manufacturing facility due to unanticipated complications. Analyst Kaminis follows shares of emerging growth companies for Standard & Poor's Equity Research Services

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