By Markos Kaminis
Although its primary business has been in the developmental stage over the past nine years, Martek Biosciences (MATK ) has really just come of age. The reason? U.S. regulators' acceptance two years ago of its nutritional oil compound for use to enhance infant formula. With this emerging biotechnology company poised to achieve high growth, Standard & Poor's initiated coverage on Apr. 14 with its highest investment recommendation of 5 STARS (buy) for Martek shares.
The ball really started rolling in 2001. That's when its compound -- which blends the fatty acids docosahexaenoic acid (DHA) and arachidonic acid (ARA) -- received Food & Drug Administration "generally considered as safe" (GRAS) approval for use in infant formula. In addition, several scientific studies indicated that the product has a beneficial effect on prenatal and breast-feeding child development. Since then, Martek has licensed its additive to manufacturers covering 85% to 90% of the U.S. and 60% of the global infant formula market, which S&P values at $7.8 billion annually. This is providing Martek the means to leap forward from the pioneering stage of development to the high growth stage.
Martek has developed and patented the means to recover DHA from microalgae, or microscopic plants, and ARA from fungi. These substances are found naturally from several sources and are present in the pregnant mother's placenta and the lactating mother's milk. Several independent studies have indicated that mental development and visual activity of infants are positively affected by breast feeding, and that breast-fed infants have higher levels of DHA in their brain tissue and enhanced mental acuity later in life when compared to those fed infant formula not containing DHA.
Supported by scientific data, infant-formula producers have embraced the idea of offering a product that included DHA. We at S&P estimate that Martek's portion of the global market is approximately $390 million. In 2002, the first full year the additive was offered by licensees, Martek's market penetration exceeded 10%. In the most recent reported quarter ended in January, market penetration approximated 16%. S&P projects average penetration of 24% in 2003 and 40% in 2004.
Aided by publicity generated from the anticipated wider use of DHA in infant formula, S&P believes a natural extension market will be born in nutritional supplements for pregnant and lactating mothers. S&P estimates the value of this market to Martek at approximately $890 million globally. While we haven't forecast a significant impact to revenues from this market over the next two years -- our estimates are for $4.5 million in 2003 and $9 million in 2004 -- we do anticipate market penetration of 3% in 2005, resulting in revenues of $27 million that year.
Martek's products are likely to find a wider use in baby food as well. S&P values the global baby food market at approximately $10.9 billion, with $540 million of that representing the potential available to DHA suppliers. We forecast $2.7 million of revenue from this market in 2003 and $11 million in 2004, with penetration hitting 4% in 2005, or $22 million.
S&P projects revenue growth for Martek of approximately 120% in fiscal 2003 (ending October), to $102 million, driven by 24% penetration of the infant formula market. In fiscal 2004, we expect that level to reach 40%, with contributions of $9 million and $11 million from the nutritional supplement and baby food markets, respectively, to drive revenues 76% higher. As manufacturing capacity is more fully utilized, we forecast gross profit margin expansion to 42% in fiscal 2003, from 35% in fiscal 2002. For fiscal 2004, we forecast further gross margin increases to 46%.
With much of its product marketing indirectly covered by licensees and a great deal of initial research and development behind it, Martek should enjoy significant operating leverage as revenues ramp up. Despite share dilution (with shares outstanding forecast to increase 19% in fiscal 2003) we estimate earnings per share of 50 cents in fiscal 2003, rising to $1.31 in fiscal 2004, and growing at a 35% rate on average over a five-year period.
On a Standard & Poor's Core Earnings basis, we expect a per-share loss of 73 cents in fiscal 2003 and EPS of 62 cents in fiscal 2004. We believe the significant discount of S&P Core EPS estimates vs. our operating EPS estimates reflects Martek's recent status as an early-stage product developer, where stock options had been offered as a significant portion of compensation. The degree ratio of exercised options to those available for exercise at the beginning of each fiscal year has increased accordingly, and we expect it to increase further in fiscal 2003, assuming our expectation for stock-price appreciation holds.
In fiscal 2002, the impact of options expense would have been offset by an adjustment for acquired research and development. We do not adjust for the restructuring charge taken in the third quarter of fiscal 2002.
With Martek's prospects for an expanded presence in infant formula, S&P projects rapid growth in free cash flow to equity through fiscal 2007, after first turning positive in fiscal 2004. Based on our discounted cash-flow projections, as well as our expectation of reduced volatility in the shares as Markek begins to generate sales and earnings at a predictable pace, we've set our 12-month share-price target at $40.
WHAT COULD GO WRONG.
S&P believes the risks of a development-stage company are many. For Martek they include: potential difficulty in meeting the demand from infant formula manufacturers, which could lead them to purchase additive from alternative sources; patent litigation; the failure of significant consumer acceptance in the market for infant formula; the failure of extension markets to develop significantly; any later discovery of detrimental effects of DHA or ARA.
Other risk factors to consider are exchange-rate risk, disturbance in the availability of ARA from Martek's supplier, and potential restrictions placed on the company's manufacturing facility due to a March, 2003, explosion attributed to inadvertent discharge of n-hexane from its plant.
Analyst Kaminis follows emerging growth stocks for Standard & Poor's