The Roller Coaster That Is Martek

Your favorite Greek Fool here stumbled across Martek Biosciences (Nasdaq: MATK  ) at a conference in Philadelphia one winter morning in 2003. What a ride it has been ever since!

Seeing Martek present was filling time for me. I was there to see Headwaters (NYSE: HW  ) , a company I never ended up adding to my analytical coverage. As I skimmed the schedule the evening before, Martek looked like an interesting story to fill my 11 a.m. slot. The company's omega-3 docosahexaenoic acid/arachidonic acid (DHA/ARA) combination had just received "Generally Recognized as Safe" approval from the Food and Drug Administration, and the company was actively signing up licensees who wanted to add the fatty acid to infant formula. You see, studies show it'll make your kid smarter. Even though its revenue to date was insignificant, I viewed Martek as a company on the cusp of generating a significant and steady stream of income.

I was right: Martek was my best-performing "strong buy" selection as its stock price rose more than 160% in 2003. However, I was not married to the name. I noted 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. And that's just what happened, as the company experienced a fire at an important plant. And remember that blackout in Italy a few years back, around the same time as the East Coast blackout? Well, that wiped out the inventory of Martek's only supplier of ARA, severely impeding Martek's ability to serve customers.

The first drop
Then, down the road a bit, Martek came to understand the importance of maintaining active communication with clients. As it turned out, a major client had stocked up its own inventory to protect itself from supply disruption and hadn't bothered to notify the company that it would reduce purchases later, when Martek had stocked up for itself. The analyst and investment community didn't appreciate all the mishaps, and when deals with food companies didn't 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 put Martek's healthy-for-your-heart DHA in everything from baby food to yogurt to health bars to cereal. The stock price collapsed as the company bore the cost of carrying excess capacity.

But the roller coaster looks to be ready to climb again. Martek is signing deals, and its earnings are again growing impressively on even a quarter-by-quarter basis. In Martek's just-reported third quarter, EPS grew 27% over the second-quarter number. So, then, you might be wondering why the shares sank Thursday morning.

The latest drop
In growing its revenue 11% year over year, to $77.8 million for the quarter, Martek missed consensus revenue forecasts for $78.5 million and was toward the low end of the range that stretched from $77.3 million to $79.5 million. Besides this, much of the company's improvement in its gross margin for the quarter was because issues with its ARA supplier, DSM Food Specialties, had been resolved. Also, based on information gleaned from the conference call, selling, general, and administrative expenses came in about $1 million above the company forecast.

Still, management indicated that fourth-quarter gross margin should meet or exceed the third-quarter number because of ongoing benefits of the company's revised agreement with DSM Food Specialties and because of 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 diluted EPS guidance of $0.20 to $0.21 a share for Q4, ahead of analysts' view of $0.19.

In a case like this, this Fool 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 Martek's stock was penalized Thursday morning. Times like this can create a buying opportunity. What's most important in this case is that Martek added eight new product partners offering its DHA in 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 opportunities in non-infant formula that numbered more than 180. At the same time, Martek was also increasing its partnerships for pregnancy and nursing products.

The upside
Now amounting to a double-digit portion of total sales, non-infant formula is 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 abroad. And Martek's DHA from vegetarian sources, versus fish, remains the gold standard.

But that's not all. The company seems focused on maintaining stability and improving operational results and measures. I 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 stock's drop. I do not expect any noteworthy problem to develop; surely by now management must have a handle on this issue. Here are Martek's closest competitors:

Company

 Trailing-12-Months P/E

Estimated 5-Year EPS Growth

PEG

Martek Biosciences

57

18.5%

3.1

Techne (NASDAQ:TECH)

29

13

2.2

LifeCell (NASDAQ:LIFC)

45

30

1.5

Medicis Pharmaceutical (NYSE:MRX)

90

23.1

3.9

American Oriental Bioengineering (NYSE:AOB)

18

49.9

0.36

Source: Yahoo! 

It's tough to value Martek on a relative basis, because it's hard to find close peers. Besides, biotechs are a different animal requiring in-depth 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 Ph.D.s with medical industry experience to cover biotechs instead of run-of-the-mill business school grads.

During my time following the company as a small- and mid-cap generalist, I trusted in intrinsic measures to value the company. Based on the stock's latest closing price, and the consensus forecast for EPS of $0.83 in fiscal 2008, I generate a forward P/E ratio of 33.5. 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 forward PEG of 1.8. Earnings per share are expected to grow 32% over fiscal 2007's troubling result. To me, Martek's shares do not look valued for a near-term rise, but I like the company over the long term, and perhaps this slump is a good time to buy.

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