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Docosahexaenoic acid is a formidable-looking term, but under its friendlier acronym, DHA, Martek Biosciences (MATK) sells the omega-3 fatty acid to infant-formula producers. But it seems the domestic industry leader in DHA needs to nurse itself back to health. The stock excelled in the second half of 2002 and during 2003, eventually topping $70 per share, but later, it stumbled badly. Early this September, it hit a multiyear low of $20.57—and it might still be overvalued.
After Martek issued a disappointing outlook for the fourth quarter, shares dropped about 25% to close at $21.54 on Sept. 7. Though Martek dominates its niche, with relatively few major customers, the Columbia (Md.)-based company remains exposed to their whims. Standard & Poor's analyst Jeffrey Loo rates the stock four stars out of five and thinks the recent plunge was "overblown." Even so, he says there's some uncertainty over how much the company will manage to diversify its customers.
The company sells oils containing DHA to infant-formula manufacturers. It also sells oils containing the omega-6 fatty acid arachidonic acid (ARA), which it purchases from the Dutch outfit DSM.
According to Martek, DHA contributes to a baby's brain and eye development. The Mayo Clinic is less sure. According to the renowned institution's Web site, testing remains inconclusive. "Short-term benefits have been reported compared to formulas without DHA, although these benefits may not be meaningful in the long-term." Also found in breast milk, ARA aids in infant brain development, Martek says.
Morningstar analyst Heather Brilliant says there is at least a "positive circumstantial benefit" to DHA. If nothing else, she says breast milk contains DHA and ARA, and she says formula aims to replicate breast milk as closely as possible.
DHA can be found in fish oils, but Martek's microalgae-derived DHA is thought to be preferable because it does not have the same unpleasant odor. In addition, it does not risk exposing consumers to waterborne contaminants that can sometimes be found in fish.
Martek is the only major retailer of DHA for infant formula in the U.S. market, but with so few customers, the company's investors are familiar with highs and lows. To wit, product sales for the quarter ending July 31, 2006, were $66.3 million, up from $35.9 million in 2005. The quarter before that, product sales were $52.8 million.
Martek has moved to boost its international DHA sales and expand into new product lines for adults. Martek and the Mayo Clinic agree that DHA can benefit patients with heart disease. Success in marketing its compounds to these segments could cut down on the stock's volatility.
For the moment, Martek's DHA appears in several food products, including the Oh Mama nutrition bar for pregnant women and Odwalla (KO) brand soy milk. But analysts say the slow introduction of new foods containing the fatty acid has frustrated investors.
POTENTIAL 2007 PAYOFF.
Brilliant, of Morningstar, says Martek hasn't "been able to procure the number of clients" to satisfy its expanded production capability. She also gives the stock four out of five stars, but she thinks it's still overvalued in its current range. "If it fell another 20%, it would be something worth looking at," she says, since the price wouldn't depend on further expansion.
A recent report from Merrill Lynch upgraded the firm's rating on the stock to Neutral from Sell. It states that, while the company's setbacks are priced in already, it does "not see a significant catalyst to boost the stock in the near term." (Merrill seeks business with companies in its coverage universe.)
Despite these frustrations, there are ways that Martek could score big. The company has agreements with Kellogg (K) and rival General Mills (GIS). DHA-infused cereals from either or both could appear in 2007. Tests surrounding DHA's shelf life have caused delays in the Kellogg rollout, S&P's Loo says, but a home run could advance Martek's goal of balancing out its sales to formula makers. "It's one of those companies where it has a lot of potential," he says. "Unfortunately, people have been waiting and waiting."
Click here to see the "Better Brains Through Chemistry?" slide show.