##### 



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended July 31, 2006
 or
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Transition Period From ___to ___
 
 COMMISSION
FILE NUMBER 0-22354
 MARTEK BIOSCIENCES CORPORATION
  Delaware
    
    52-1399362(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification Number)
 6480 Dobbin Road, Columbia, Maryland 21045
 (410) 740-0081
 
 
 þ o
  þ o o
 o þ




---



##### 



PART I
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements
    
    
    1Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    24Item 4.
    
    Controls and Procedures
    
    
    24PART II
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    25Item 1A.
    
    Risk Factors
    
    
    27Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    36Item 3.
    
    Defaults Upon Senior Securities
    
    
    36Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    36Item 5.
    
    Other Information
    
    
    36Item 6.
    
    Exhibits
    
    
    36Signatures
    
    
    37




---



##### 



PART I  FINANCIAL INFORMATION
 Item 1. Financial Statements.
 MARTEK BIOSCIENCES CORPORATION
  July 31,
    
    
    October 31,2006
    
    
    2005In thousands, except share and per share data
    
    (unaudited)AssetsCurrent assetsCash and cash equivalents
    
    $
    12,727
    
    
    $
    11,047Short-term investments and marketable securities
    
    
    11,250
    
    
    
    22,300Accounts receivable, net
    
    
    30,482
    
    
    
    27,603Inventories, net
    
    
    100,560
    
    
    
    91,535Other current assets
    
    
    10,893
    
    
    
    5,929Total current assets
    
    
    165,912
    
    
    
    158,414Property, plant and equipment, net
    
    
    287,078
    
    
    
    290,733Deferred tax asset
    
    
    38,542
    
    
    
    48,201Goodwill
    
    
    48,596
    
    
    
    48,490Other intangible assets, net
    
    
    34,024
    
    
    
    31,129Other assets, net
    
    
    2,870
    
    
    
    1,518Total assets
    
    $
    577,022
    
    
    $
    578,485Liabilities and stockholders equityCurrent liabilitiesAccounts payable
    
    $
    10,749
    
    
    $
    16,661Accrued liabilities
    
    
    16,007
    
    
    
    13,692Current portion of notes payable and other long-term obligations
    
    
    1,199
    
    
    
    3,113Current portion of deferred revenue
    
    
    3,585
    
    
    
    740Total current liabilities
    
    
    31,540
    
    
    
    34,206Long-term debt under revolving credit facility
    
    
    33,000
    
    
    
    55,000Notes payable and other long-term obligations
    
    
    10,678
    
    
    
    11,115Long-term portion of deferred revenue
    
    
    9,027
    
    
    
    8,959Total liabilities
    
    
    84,245
    
    
    
    109,280CommitmentsStockholders equityPreferred stock, $.01 par value, 4,700,000 shares authorized; none issued or outstanding
    
    
    
    
    
    
    Series A junior participating preferred stock, $.01 par value; 300,000 shares authorized;
none issued or outstanding
    
    
    
    
    
    
    Series B junior participating preferred stock, $.01 par value; 300,000 shares authorized;
none issued or outstanding
    
    
    
    
    
    
    Common stock, $.10 par value; 100,000,000 shares authorized; 32,153,382 and 32,026,595 shares
issued and
outstanding, respectively
    
    
    3,215
    
    
    
    3,203Additional paid-in capital
    
    
    521,208
    
    
    
    515,237Accumulated other comprehensive income
    
    
    420
    
    
    
    1Accumulated deficit
    
    
    (32,066
    )
    
    
    (49,236
    )Total stockholders equity
    
    
    492,777
    
    
    
    469,205Total liabilities and stockholders equity
    
    $
    577,022
    
    
    $
    578,485
 See accompanying notes.
 1




---



##### 



MARTEK BIOSCIENCES CORPORATION
  Three months ended July 31,
    
    
    Nine months ended July 31,Unaudited - In thousands, except share and per share data
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues:Product sales
    
    $
    66,322
    
    
    $
    35,926
    
    
    $
    192,029
    
    
    $
    151,871Contract manufacturing sales
    
    
    4,036
    
    
    
    3,563
    
    
    
    11,439
    
    
    
    9,938Total revenues
    
    
    70,358
    
    
    
    39,489
    
    
    
    203,468
    
    
    
    161,809Cost of revenues:Cost of product sales
    
    
    37,044
    
    
    
    22,429
    
    
    
    107,987
    
    
    
    91,323Cost of contract manufacturing sales
    
    
    3,943
    
    
    
    3,261
    
    
    
    10,759
    
    
    
    8,650Idle capacity costs
    
    
    2,888
    
    
    
    
    
    
    
    6,313
    
    
    
    Total cost of revenues
    
    
    43,875
    
    
    
    25,690
    
    
    
    125,059
    
    
    
    99,973Gross margin
    
    
    26,483
    
    
    
    13,799
    
    
    
    78,409
    
    
    
    61,836Operating expenses:Research and development (1)
    
    
    6,231
    
    
    
    5,309
    
    
    
    17,969
    
    
    
    15,446Selling, general and administrative (1)
    
    
    11,328
    
    
    
    7,834
    
    
    
    31,465
    
    
    
    24,086Other operating expenses
    
    
    207
    
    
    
    1,243
    
    
    
    683
    
    
    
    6,803Total operating expenses
    
    
    17,766
    
    
    
    14,386
    
    
    
    50,117
    
    
    
    46,335Income (loss) from operations
    
    
    8,717
    
    
    
    (587
    )
    
    
    28,292
    
    
    
    15,501Interest and other income, net
    
    
    363
    
    
    
    415
    
    
    
    1,163
    
    
    
    1,051Interest expense
    
    
    (735
    )
    
    
    
    
    
    
    (2,416
    )
    
    
    (180
    )Income (loss) before income tax provision
    
    
    8,345
    
    
    
    (172
    )
    
    
    27,039
    
    
    
    16,372Income tax provision (benefit) (1)
    
    
    3,046
    
    
    
    (63
    )
    
    
    9,869
    
    
    
    5,976Net income (loss)
    
    $
    5,299
    
    
    $
    (109
    )
    
    $
    17,170
    
    
    $
    10,396Net income (loss) per shareBasic
    
    $
    0.16
    
    
    $
    (0.00
    )
    
    $
    0.53
    
    
    $
    0.34Diluted
    
    $
    0.16
    
    
    $
    (0.00
    )
    
    $
    0.53
    
    
    $
    0.33Weighted average common shares outstandingBasic
    
    
    32,143,695
    
    
    
    31,681,496
    
    
    
    32,099,641
    
    
    
    30,924,994Diluted
    
    
    32,473,578
    
    
    
    31,681,496
    
    
    
    32,471,120
    
    
    
    31,867,590(1) Includes the following amounts related to
equity-based compensation expense:Research and development
    
    
    247
    
    
    
    
    
    
    
    907
    
    
    
    Selling, general
and administrative
    
    
    470
    
    
    
    
    
    
    
    1,752
    
    
    
    Income tax
provision (benefit)
    
    
    (262
    )
    
    
    
    
    
    
    (971
    )
    
    
    
 See accompanying notes.
 2




---



##### 



MARTEK BIOSCIENCES CORPORATION
  AccumulatedAdditional
    
    
    OtherCommon Stock
    
    
    Paid-in
    
    
    Comprehensive
    
    
    AccumulatedUnaudited - In thousands, except share data
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Income
    
    
    Deficit
    
    
    TotalBalance at October 31, 2005
    
    
    32,026,595
    
    
    $
    3,203
    
    
    $
    515,237
    
    
    $
    1
    
    
    $
    (49,236
    )
    
    $
    469,205Exercise of stock options and warrants
    
    
    126,787
    
    
    
    12
    
    
    
    2,889
    
    
    
    
    
    
    
    
    
    
    
    2,901Equity-based compensation
    
    
    
    
    
    
    
    
    
    
    3,082
    
    
    
    
    
    
    
    
    
    
    
    3,082Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,170
    
    
    
    17,170Other comprehensive income:Unrealized gain on exchange rate forward
contract, net of tax of $251
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    419
    
    
    
    
    
    
    
    419Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,589Balance at July 31, 2006
    
    
    32,153,382
    
    
    $
    3,215
    
    
    $
    521,208
    
    
    $
    420
    
    
    $
    (32,066
    )
    
    $
    492,777
 See accompanying notes.
 3




---



##### 



MARTEK BIOSCIENCES CORPORATION
  Nine months ended July 31,Unaudited  In thousands
    
    2006
    
    
    2005Operating activitiesNet income
    
    $
    17,170
    
    
    $
    10,396Adjustments to reconcile net income to net cash used in operating activities:Depreciation and amortization
    
    
    12,439
    
    
    
    12,195Deferred tax provision
    
    
    9,869
    
    
    
    5,976Equity-based compensation expense
    
    
    2,659
    
    
    
    Other
    
    
    
    
    
    
    184Changes in operating assets and liabilities:Accounts receivable
    
    
    (2,879
    )
    
    
    15,611Inventories
    
    
    (8,602
    )
    
    
    (42,346
    )Other assets
    
    
    (5,726
    )
    
    
    3,614Accounts payable
    
    
    (5,912
    )
    
    
    (6,716
    )Accrued liabilities
    
    
    1,200
    
    
    
    (1,142
    )Deferred revenue and other liabilities
    
    
    2,938
    
    
    
    (1,510
    )Net cash provided by (used in) operating activities
    
    
    23,156
    
    
    
    (3,738
    )Investing activitiesSale (purchase) of short-term investments and marketable securities, net
    
    
    11,050
    
    
    
    (22,345
    )Expenditures for property, plant and equipment
    
    
    (6,743
    )
    
    
    (51,746
    )Proceeds from sale-leaseback transaction and other
    
    
    
    
    
    
    4,272Capitalization of intangible assets
    
    
    (3,928
    )
    
    
    (3,298
    )Net cash provided by (used in) investing activities
    
    
    379
    
    
    
    (73,117
    )Financing activitiesRepayments of notes payable and other long-term obligations
    
    
    (2,756
    )
    
    
    (4,623
    )Repayments under revolving credit facility, net
    
    
    (22,000
    )
    
    
    (25,500
    )Proceeds from the issuance of common stock and exercise of stock options and warrants, net
    
    
    2,901
    
    
    
    94,210Other
    
    
    
    
    
    
    500Net cash (used in) provided by financing activities
    
    
    (21,855
    )
    
    
    64,587Net increase (decrease) in cash and cash equivalents
    
    
    1,680
    
    
    
    (12,268
    )Cash and cash equivalents, beginning of period
    
    
    11,047
    
    
    
    29,445Cash and cash equivalents, end of period
    
    $
    12,727
    
    
    $
    17,177Supplemental cash flow disclosures:Interest paid
    
    $
    2,895
    
    
    $
    2,576Notes payable issued in acquisition of land
    
    $
    
    
    
    $
    800Income taxes paid
    
    $
    210
    
    
    $
    
 See accompanying notes.
 4




---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
 Basis of Presentation
 Consolidation
 Use of Estimates
 Segment Information
 Revenue Recognition
   Shipping Income and Costs
 Foreign Currency Transactions and Hedging Activities
  5




---



##### 



Research and Development
 Other Operating Expenses
 Deferred Income Taxes
  Equity-Based Compensation
 Net Income (Loss) Per Share
 Comprehensive Income (Loss)
 Cash and Cash Equivalents
 Short-Term Investments and Marketable Securities
   6




---



##### 



Fair Value of Financial Instruments
 Trade Receivables
 Inventories
 Property, Plant and Equipment
 Asset Description
    
    Useful Life (years)Building
    
    
    15  30Fermentation equipment
    
    
    10  20Oil processing equipment
    
    
    10  20Other machinery and equipment
    
    
    5  10Furniture and fixtures
    
    
    5  7Computer hardware and software
    
    
    3  7
  Goodwill and Other Intangible Assets
 Impairment of Long-Lived Assets
 Recently Issued Accounting Pronouncements
 7




---



##### 



2. DSM SUPPLY AND LICENSE AGREEMENT
   3. SHORT-TERM INVESTMENTS AND MARKETABLE SECURITIES
  4. INVENTORIES
  July 31,
    
    
    October 31,2006
    
    
    2005Finished goods
    
    $
    50,288
    
    
    $
    34,328Work in process
    
    
    48,759
    
    
    
    55,073Raw materials
    
    
    3,513
    
    
    
    3,634Total inventory
    
    
    102,560
    
    
    
    93,035Less: inventory reserve
    
    
    (2,000
    )
    
    
    (1,500
    )Inventories, net
    
    $
    100,560
    
    
    $
    91,535
 8




---



##### 



5. PROPERTY, PLANT AND EQUIPMENT
  July 31,
    
    
    October 31,2006
    
    
    2005Land
    
    $
    2,320
    
    
    $
    2,318Building and improvements
    
    
    50,619
    
    
    
    45,515Machinery and equipment
    
    
    182,044
    
    
    
    164,039Furniture and fixtures
    
    
    3,369
    
    
    
    3,161Computer hardware and software
    
    
    8,922
    
    
    
    8,085247,274
    
    
    
    223,118Less: accumulated depreciation and amortization
    
    
    (36,466
    )
    
    
    (26,764
    )210,808
    
    
    
    196,354Construction in progress
    
    
    47,354
    
    
    
    56,840Assets held for future use, net
    
    
    28,916
    
    
    
    37,539Property, plant and equipment, net
    
    $
    287,078
    
    
    $
    290,733
  6. GOODWILL AND OTHER INTANGIBLE ASSETS
  July 31, 2006
    
    
    October 31, 2005Accumulated
    
    
    
    
    
    
    
    
    
    
    AccumulatedIntangible Asset
    
    Gross
    
    
    Amortization
    
    
    Net
    
    
    Gross
    
    
    Amortization
    
    
    NetTrademarks
    
    $
    2,043
    
    
    $
    (506
    )
    
    $
    1,537
    
    
    $
    2,026
    
    
    $
    (401
    )
    
    $
    1,625Patents
    
    
    15,692
    
    
    
    (1,521
    )
    
    
    14,171
    
    
    
    11,741
    
    
    
    (1,734
    )
    
    
    10,007Core technology
    
    
    1,708
    
    
    
    (427
    )
    
    
    1,281
    
    
    
    1,708
    
    
    
    (342
    )
    
    
    1,366Current products
    
    
    10,676
    
    
    
    (3,050
    )
    
    
    7,626
    
    
    
    10,676
    
    
    
    (2,516
    )
    
    
    8,160Licenses
    
    
    11,091
    
    
    
    (1,682
    )
    
    
    9,409
    
    
    
    11,091
    
    
    
    (1,120
    )
    
    
    9,971Goodwill
    
    
    48,596
    
    
    
    
    
    
    
    48,596
    
    
    
    48,490
    
    
    
    
    
    
    
    48,490$
    89,806
    
    
    $
    (7,186
    )
    
    $
    82,620
    
    
    $
    85,732
    
    
    $
    (6,113
    )
    
    $
    79,619
 7. NOTES PAYABLE AND LONG-TERM DEBT
  9




---



##### 



8. COMMITMENTS AND CONTINGENCIES
 Purchase Commitments
 Scientific Research Collaborations
 OmegaTech Contingent Purchase Price
 Class Action Lawsuits
 Other
 9. STOCKHOLDERS EQUITY
 Equity-Based Compensation
   10




---



##### 



Three months ended July 31,
    
    
    Nine months ended July 31,2006
    
    
    2005
    
    
    2006
    
    
    2005Net income (loss), as reported
    
    $
    5,299
    
    
    $
    (109
    )
    
    $
    17,170
    
    
    $
    10,396Deduct: Total equity-based employee compensation expense
determined under fair value-based methods for all awards
    
    
    
    
    
    
    (10,927
    )
    
    
    
    
    
    
    (54,897
    )Pro forma net income (loss)
    
    $
    5,299
    
    
    $
    (11,036
    )
    
    $
    17,170
    
    
    $
    (44,501
    )Net income (loss) per share:Basic  as reported
    
    $
    0.16
    
    
    $
    (0.00
    )
    
    $
    0.53
    
    
    $
    0.34Basic  pro forma
    
    $
    0.16
    
    
    $
    (0.35
    )
    
    $
    0.53
    
    
    $
    (1.44
    )Diluted  as reported
    
    $
    0.16
    
    
    $
    (0.00
    )
    
    $
    0.53
    
    
    $
    0.33Diluted  pro forma
    
    $
    0.16
    
    
    $
    (0.35
    )
    
    $
    0.53
    
    
    $
    (1.44
    )
   Nine months endedJuly 31, 2006Expected volatility
    
    
    61.1
    %Risk-free interest rate
    
    
    4.7
    %Expected life of options
    
    5 yearsExpected dividend yield
    
    
    0
    %Forfeiture rate
    
    
    1
    %
 Expected Volatility
 Risk-Free Interest Rate
 11




---



##### 



Expected Life of Options
 Expected Dividend Yield
 Forfeiture Rate
    Weighted AverageWeighted
    
    
    
    
    
    
    RemainingNumber of
    
    
    Average
    
    
    Aggregate
    
    
    ContractualShares
    
    
    Price/Share
    
    
    Intrinsic Value
    
    
    Term (years)Options outstanding at October 31, 2005
    
    
    3,924
    
    
    $
    38.39Options exercisable at October 31, 2005
    
    
    3,438
    
    
    $
    40.14Granted
    
    
    59
    
    
    $
    31.71Exercised
    
    
    (95
    )
    
    $
    25.14Cancelled
    
    
    (145
    )
    
    $
    40.86Options outstanding at July 31, 2006
    
    
    3,743
    
    
    $
    38.53
    
    
    $
    10,643
    
    
    
    6.7Options exercisable at July 31, 2006
    
    
    3,447
    
    
    $
    39.49
    
    
    $
    9,363
    
    
    
    6.6
   Stockholder Rights Plan
   12




---



##### 



10. NET INCOME (LOSS) PER SHARE
   Three months ended July 31,
    
    
    Nine months ended July 31,2006
    
    
    2005
    
    
    2006
    
    
    2005Net income (loss)
    
    $
    5,299
    
    
    $
    (109
    )
    
    $
    17,170
    
    
    $
    10,396Weighted average shares outstanding, basic
    
    
    32,144
    
    
    
    31,681
    
    
    
    32,100
    
    
    
    30,925Effect of dilutive potential common shares:Stock options
    
    
    330
    
    
    
    
    
    
    
    371
    
    
    
    924Warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19Total dilutive potential common shares
    
    
    330
    
    
    
    
    
    
    
    371
    
    
    
    943Weighted average shares outstanding, diluted
    
    
    32,474
    
    
    
    31,681
    
    
    
    32,471
    
    
    
    31,868Net income per share, basic
    
    $
    0.16
    
    
    $
    (0.00
    )
    
    $
    0.53
    
    
    $
    0.34Net income per share, diluted
    
    $
    0.16
    
    
    $
    (0.00
    )
    
    $
    0.53
    
    
    $
    0.33
  13




---



##### 



11. COMPREHENSIVE INCOME
  Three months ended July 31,
    
    
    Nine months ended July 31,2006
    
    
    2005
    
    
    2006
    
    
    2005Net income (loss), as reported
    
    $
    5,299
    
    
    $
    (109
    )
    
    $
    17,170
    
    
    $
    10,396Other comprehensive income (loss):Unrealized gain (loss) on exchange rate forward contract,
net of income tax provision
(benefit) of $(162), $48,
$251 and $(14),
respectively
    
    
    (420
    )
    
    
    79
    
    
    
    419
    
    
    
    (91
    )`Comprehensive income (loss)
    
    $
    4,879
    
    
    $
    (30
    )
    
    $
    17,589
    
    
    $
    10,305
 14




---



##### 



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.
 This Managements Discussion and Analysis of Financial Condition and Results of Operations contains
forward-looking statements concerning our business and operations, including, among other things,
statements concerning the following:
 
    
    expectations regarding future revenue growth, gross margin and overall profitability;
    
    expectations regarding product introductions and growth in nutritional product sales;
    
    expectations regarding potential collaborations and acquisitions
    
    expectations regarding demand for products with our nutritional oils;
    
    expectations regarding sales to and by our infant formula licensees and supplemented infant formula market penetration levels;
    
    expectations regarding marketing of our oils by our infant formula licensees;
    
    expectations regarding continued interest by and agreements with food, beverage and supplement companies;
    
    expectations regarding growing consumer recognition of the key health benefits of DHA and ARA;
    
    expectations regarding future efficiencies and improvements in manufacturing processes and the cost of production of our nutritional oils;
    
    expectations regarding future purchases of third-party manufactured oils;
    
    expectations regarding the amount of production capacity and our ability to meet future demands for our nutritional oils;
    
    expectations regarding the amount of inventory held by us or our customers;
    
    expectations regarding production capacity utilization and the effects of excess production capacity;
    
    expectations regarding future selling, general and administrative and research and development costs;
    
    expectations regarding future capital expenditures;
    
    expectations regarding levels of consumption through governmental programs of infant formula products containing our
nutritional oils;
    
    expectations regarding possibly significant expenses to defend putative securities
class action lawsuits alleging false and material misstatements and omissions of
material facts concerning our business and prospects; and
    
    expectations regarding our ability to protect our intellectual property.
 Forward-looking statements include those statements containing words such as the following:
 
    
    will,
    
    should,
    
    could,
    
    anticipate,
    
    believe,
    
    plan,
    
    estimate,
    
    expect,
    
    intend, and other similar expressions.
 All of these forward-looking statements involve risks and uncertainties. They and other
forward-looking statements in this Form 10-Q are all made pursuant to the safe harbor provisions of
the Private Securities Litigation Reform Act of 1995. We wish to caution you that our actual
results may differ significantly from the results we discuss in our forward-looking statements. We
discuss some of the risks that could cause such differences in Item 1A. Risk Factors in this report
on Form 10-Q and in our various other filings with the Securities and Exchange Commission. Our
forward-looking statements speak only as of the date of this document, and we do not intend to
update these statements to reflect events or circumstances that occur after that date.
 GENERAL
  15




---



##### 




    
    the timing of infant formula market introductions by our customers both domestically and internationally;
    
    the timing of our customers production and ordering patterns;
    
    the timing and extent of stocking and destocking of inventory by our customers,
including the potential that customers will move to just in time inventory purchasing now
that we have reached a base finished goods inventory level;
    
    the timing and extent of our customers plant maintenance shutdowns;
    
    the timing and extent of introductions of DHA into various child and/or adult applications;
    
    the continued acceptance of products containing our oils under WIC programs in the U.S.;
    
    the continued acceptance of these products by consumers and continued demand by our customers;
    
    the ability by us, DSM and other third-party manufacturers to produce adequate levels of our nutritional oils on a consistent basis;
    
    our ability to protect against competitive products through our patents;
    
    competition from alternative sources of DHA and ARA; and
    
    agreements with other future third-party collaborators to market our products or develop new products.
  RECENT HIGHLIGHTS
 lifesDHA
 lifesDHA lifesDHA lifesDHA
   
    
    In June 2006, South Korean infant formula market leader Namyang Dairy Products Co., Ltd.
signed a license and supply agreement with Martek for rights to use Marteks DHA and ARA in
infant formula sold in South Korea.
 16




---



##### 




    
    In August 2006, The Hain Celestial Group, Inc., a leading natural and organic food and
personal care products company, entered into a license and supply agreement with the
Company whereby Martek will serve as the exclusive DHA and ARA supplier for Hain
Celestials infant formula products in the United States. Hain Celestial recently unveiled
a new infant formula as part of its Earths Best® brand. In addition, the companies
announced that they are in discussions regarding the potential expansion of their
relationship into other food and beverage products.
   
    
    A review conducted by Dr. Chenchen Wang and others published in July 2006 in The
American Journal of Clinical Nutritionstated that evidence suggests that increased
consumption of long-chain omega-3 fatty acids, but not alpha-linolenic acid, reduces all
cause mortality, cardiac and sudden death, and possibly stroke. Martek DHA is a long-chain
omega-3 fatty acid.
    
    A Scientific Statement entitled Diet and Lifestyle Recommendations Revision 2006
published by Dr. A. Lichtenstein and other members of the American Heart Association
Nutrition Committee published in July 2006 in Circulationincluded a recommendation that
people
with documented heart disease consume approximately one gram of DHA and eicosapentaenoic acid
(EPA) per week. They affirm that with appropriate medical advice, use of supplements may be
substituted for fish.
    
    A commentary published by Dr. P.J. Aggett and other members of the European Society for
Pediatric Gastroenterology, Hepatology and Nutrition (ESPGHAN) in May 2006 in the Journal
of Pediatric Gastroenterology and Nutritionrecommended that preterm infants, if formula
fed, receive at hospital discharge a formula containing long-chain polyunsaturated fatty
acids (LCPUFA) until at least a post conception age of 40 weeks and possibly up to 52
weeks. Currently, Martek oils are the primary sources of LCPUFA in infant formulas.
 MANAGEMENT OUTLOOK
     17




---



##### 



PRODUCTION
       CRITICAL ACCOUNTING POLICIES AND
THE USE OF ESTIMATES
  18




---



##### 



RESULTS OF OPERATIONS
 Revenues
  Three months ended July 31,
    
    
    Nine months ended July 31,2006
    
    
    2005
    
    
    2006
    
    
    2005Product sales
    
    $
    66,322
    
    
    $
    35,926
    
    
    $
    192,029
    
    
    $
    151,871Contract manufacturing sales
    
    
    4,036
    
    
    
    3,563
    
    
    
    11,439
    
    
    
    9,938Total revenues
    
    $
    70,358
    
    
    $
    39,489
    
    
    $
    203,468
    
    
    $
    161,809
     Cost of Revenues
  Three months ended July 31,
    
    
    Nine months ended July 31,2006
    
    
    2005
    
    
    2006
    
    
    2005Cost of product sales
    
    $
    37,044
    
    
    $
    22,429
    
    
    $
    107,987
    
    
    $
    91,323Cost of contract manufacturing sales
    
    
    3,943
    
    
    
    3,261
    
    
    
    10,759
    
    
    
    8,650Idle capacity costs
    
    
    2,888
    
    
    
    
    
    
    
    6,313
    
    
    
    Total cost of revenues
    
    $
    43,875
    
    
    $
    25,690
    
    
    $
    125,059
    
    
    $
    99,973
  19




---



##### 



Operating Expenses
  Three months ended July 31,
    
    
    Nine months ended July 31,2006
    
    
    2005
    
    
    2006
    
    
    2005Research and development
    
    $
    6,231
    
    
    $
    5,309
    
    
    $
    17,969
    
    
    $
    15,446Selling, general and administrative
    
    
    11,328
    
    
    
    7,834
    
    
    
    31,465
    
    
    
    24,086Other operating expenses
    
    
    207
    
    
    
    1,243
    
    
    
    683
    
    
    
    6,803Total operating expenses
    
    $
    17,766
    
    
    $
    14,386
    
    
    $
    50,117
    
    
    $
    46,335
 Research and Development
 Selling, General and Administrative
 Other Operating Expenses
 Interest and Other Income, Net
  Interest Expense
  Income Tax Provision (Benefit)
   20




---



##### 



Net Income (Loss)
     RECENTLY ISSUED
ACCOUNTING PRONOUNCEMENTS
  LIQUIDITY AND CAPITAL RESOURCES
  
    
    cash generated from operations;
    
    proceeds from the sale of equity securities;
    
    cash received from the exercise of stock options and warrants; and
    
    debt financing.
  21




---



##### 



Less than
    
    
    1-3
    
    
    3-5
    
    
    More thanIn thousands
    
    Total
    
    
    1 year
    
    
    years
    
    
    years
    
    
    5 yearsNotes payable (1)
    
    $
    11,665
    
    
    $
    1,169
    
    
    $
    9,272
    
    
    $
    397
    
    
    $
    827Borrowings under revolving credit facility
    
    
    33,000
    
    
    
    
    
    
    
    
    
    
    
    33,000
    
    
    
    Operating and capital lease obligations (2)
    
    
    13,378
    
    
    
    3,683
    
    
    
    7,287
    
    
    
    2,056
    
    
    
    352Unconditional purchase obligations (3)
    
    
    43,049
    
    
    
    5,477
    
    
    
    37,572
    
    
    
    
    
    
    
    Total contractual cash obligations
    
    $
    101,092
    
    
    $
    10,329
    
    
    $
    54,131
    
    
    $
    35,453
    
    
    $
    1,179
 
 (1)
    
    Minimum payments above include interest and principal due under these notes.(2)
    
    In August 2006, we entered into an agreement to repurchase for $10.9 million
certain production equipment at our Kingstree facility that is currently subject to an
operating lease as part of the sale-leaseback transactions in October and December 2004.
Repurchase in November 2006 is planned, and upon repurchase, future minimum lease payments of $8.0 million, currently
included herein, will be eliminated.(3)
    
    Primarily includes future inventory purchases from DSM pursuant to the guarantee
described below in Off-Balance Sheet Arrangements.      
    
    the cost and extent of capital expenditures at our manufacturing facilities;
    
    growth in our infant formula, food and beverage and other nutritional product sales;
    
    the extent and progress of our research and development programs;
    
    the progress of pre-clinical and clinical studies;
    
    the time and costs of obtaining and maintaining regulatory clearances for our products that are subject to such clearances;
    
    the costs involved in filing, protecting and enforcing patent claims;
 22




---



##### 




    
    competing technological and market developments;
    
    the development or acquisition of new products;
    
    the cost of acquiring additional and/or operating and expanding existing manufacturing
facilities for our various products and potential products (depending on which products we
decide to manufacture and continue to manufacture ourselves);
    
    the costs associated with our internal build-up of inventory levels;
    
    the costs associated with our defense against a putative securities class action and other lawsuits;
    
    the costs of merger and acquisition activity; and
    
    the costs of marketing and commercializing our products.
  OFF-BALANCE SHEET ARRANGEMENTS
    23




---



##### 



Item 3. Quantitative and Qualitative Disclosures about Market Risk.
    Item 4. Controls and Procedures.
 a)
    
    Evaluation of Disclosure Controls and Procedures.The Chief Executive Officer and Chief
Financial Officer of Martek Biosciences Corporation have evaluated the effectiveness of our
disclosure controls and procedures pursuant to Exchange Act rules 13a-15(e) and 15d-15(e)
and have concluded that, as of the end of the period covered by this report, the disclosure
controls and procedures were effective.b)
    
    Internal Control Over Financial Reporting.There was no change in our internal control
over financial reporting in connection with the evaluation required by paragraph (d) of
Rules 13a-15 or 15d-15 under the Exchange Act that occurred during Marteks quarter ended
July 31, 2006 that materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.
 24




---



##### 



PART II  OTHER INFORMATION
 Item 1. Legal Proceedings.
 In re Martek Biosciences Corp. Securities
Litigation
    Thraustochytrium Schizochytrium
  25




---



##### 



26




---



##### 



Item 1A. Risk Factors.
  A substantial portion of our nutritional oil products sales is made to four of our existing
customers under agreements with no minimum purchase requirements. If demand by these customers
for our nutritional oil products declines, our revenues may materially decline.
  We are aware of several products that are currently available, and products under development,
that may present a serious competitive threat to our products.
   
    
    The Ross Products Division of Abbott Laboratories, a significant Martek licensee and
customer, filed a generally recognized as safe notification on January 2, 2002 seeking Food
and Drug Administration (FDA) concurrence that its tuna oil source of DHA and its fungal
source of ARA, as manufactured by Suntory, are generally recognized as safe when used as
ingredients in infant formula. In April 2006, the FDA notified Ross Products that it had no
questions at this time regarding Ross generally recognized as safe notification While Ross
Products has not announced any introduction of its oils into infant formula, the GRAS
notification removes a significant regulatory hurdle to the introduction of competitive
products in the U.S. If Ross Products introduces such competitive products, we cannot be
certain that the economic protection that we believe we have via existing patents, royalty
requirements of license agreements and market factors will protect us from the financial
impact of such product introductions.
    
    Reliant Pharmaceuticals is currently selling Omacor, a DHA/ EPA ethyl ester for
treatment of hyperlipidemia. Omacor is a lipid-regulating agent which includes both EPA
and DHA from fish oil. We expect additional studies to expand the approved indications for
Omacor. Other pharmaceutical applications using omega-3 fatty acids may be expected.
    
    Suntory Limited, Cargill Inc., through a joint venture with a company in China, and
other independent Chinese manufacturers are producing and distributing a fungal source of
ARA. In addition, we are aware that there may be manufacturers in China attempting to
produce an algal source of DHA, but we are uncertain of the overall status and commercial
potential of these development efforts.
    
    Some infant formulas now on the market outside the United States, including those
marketed by certain of Marteks licensees, use DHA derived from other sources, such as fish
oil or eggs.
    
    In December 2005, Lonza Group LTD, a Swiss chemical and biotechnology group, acquired
from Nutrinova Specialties & Food Ingredients GmbH, a wholly-owned subsidiary of Celanese
Corporation, Nutrinovas business having as its product a DHA-rich microalgal oil. Since
the acquisition, Lonza has been actively marketing its DHA oil to the food and beverage and
dietary supplement markets in the United States, Europe and China. Both Nutrinova and Lonza
are defendants in patent infringement actions involving our DHA patents that we have
brought in both the United States and Germany. These lawsuits are
further described in Item 1 of
Part II of this Form 10-Q, Legal Proceedings.
    
    Other companies, several with greater financial resources than ours, are developing
plant-based DHA and other companies are developing chemically synthesized DHA.
 27




---



##### 




    
    Several large companies, including BASF AG, DSM and Ocean Nutrition, and a number of
smaller companies, manufacture microencapsulated fish oil products. Although
microencapsulation of the oil resolves many of the odor, stability and taste issues found
with fish oil, a microencapsulated product currently is more costly than regular fish oil.
Fish oil-based products (i) are used as a DHA source by some infant formula companies, (ii)
currently dominate the adult DHA supplement market and (iii) are included in certain foods
on the market in various parts of the world. Because fish oil is generally less costly than
our DHA oil and continues to improve in quality and gain general market acceptance, fish
oil presents a substantial competitive threat.
 If we are unable to obtain or maintain patent protection or if our patents do not provide
protection against competitive products, our results of operations may be adversely affected.
    
    
    Aventis S.A. and Nagase & Co. Ltd. are challenging our European patent covering our
DHA-containing oils. At a hearing in October 2000, the Opposition Division of the European
Patent Office (EPO) revoked our patent on the grounds that it was not novel. We
immediately appealed this ruling, and in July 2002 we received a positive ruling from an
Appeal Board of the EPO, setting aside the prior decision to revoke this patent. The patent
was returned to the Opposition Division for a determination as to whether it has met the
legal requirement of inventive step. A hearing in August 2005 resulted in a ruling by the
Opposition Division that this requirement had been met and the validity of the patent was
upheld. Aventis has appealed the decision to the Appeal Board of the EPO. The appeal
process is not expected to be completed before the second half of 2007. Claim one of this
patent is the basis of the patent infringement suit against Nutrinova and Lonza in Germany,
discussed below.
    
    With respect to our ARA patent issued by the EPO, BASF AG, Friesland Brands B.V., and
Suntory Limited filed their grounds for opposing this patent with the Opposition Division
of the EPO. At a hearing at the Opposition Division in April 2005, the Opposition Division
of the EPO upheld the patent in a form containing modified claims that are narrower than
the claims originally granted. In an effort to broaden the claims of the patent, we
appealed the decision. Suntory and BASF have also appealed. Friesland Brands B.V. has
withdrawn from the opposition. The patent in the form containing the claims that were
originally granted will remain in full force and effect throughout the appeal process. The
appeal process is not expected to be completed until late 2007 or 2008. Further, in order
to broaden the scope of protection, Martek has pending patent applications and intends to
pursue new patent applications which would be based on the existing patent. If the patent
in the narrower form approved by the Opposition Division is ultimately upheld and certain
pending and new related patent applications are not granted with the desired claim scope,
it is likely that Marteks European intellectual property position with respect to ARA
would not afford much competitive protection.
    
    With respect to our blended oil (blend of DHA and ARA oils for use in various
applications, including infant formula) patent issued by the EPO, BASF AG and Suntory
Limited filed their grounds for opposing this patent with the Opposition Division of the
EPO. In November 2004, the Opposition Division of the EPO revoked Marteks European blended
oil patent as a result of these challenges. We immediately filed an appeal of this
decision; as a consequence, the blended oil patent has been reinstated and will remain in
full force and effect during the appeal. Both Suntory and BASF have now filed responses to
our appeal. The hearing before the Appeal Division of the EPO has been scheduled for early
February 2007.
 28




---



##### 




    
    Prior to our purchase of OmegaTech, Aventis Research and Technologies GmbH & Co. KG, and
Nagase Limited challenged OmegaTechs European patent covering its DHAcontaining oils. At
a hearing in December 2000, the Opposition Division of the EPO upheld some of the claims
and revoked other claims. OmegaTech immediately appealed this ruling, as did Aventis. At an
appeal hearing in May 2005, we received a favorable decision from the Appeal Board of the
EPO, which overturned the decision of the Opposition Division and returned the case to the
Opposition Division for review on the merits of the patent claims. Any decision made by the
Opposition Division can be appealed. Assuming an appeal, the review process is not expected
to be completed until 2009, during which time the patent will remain in full force and
effect.
    
    An EPO Opposition Division hearing was held on November 15, 2005, with respect to a
European DHA patent acquired by Martek as part of the OmegaTech purchase. The patent was
upheld in modified form. This patent is directed to processes for fermenting
Thraustochytriumand Schizochytriumunder low chloride conditions and the resulting
products. Nutrinova Nutrition Specialities & Food Ingredients GmbH is the only opponent,
and has appealed. The appeal process is not expected to be completed before late 2007.
    
    In September 2003, we filed a patent infringement lawsuit in the U.S. District Court in
Delaware against Nutrinova Inc., Nutrinova Nutrition Specialties & Food Ingredients GmbH,
Celanese Ventures GmbH, and Celanese AG alleging infringement of two of our U.S. patents.
Celanese Ventures GmbH and Celanese AG have been dropped from the lawsuit. We have added an
additional three patents to the suit, bringing the total number that Nutrinova was accused
of infringing at that time to five patents. The lawsuit alleges that Nutrinova has been
making, using, offering to sell, selling and/or importing into the United States DHA that
infringes the patents. In October 2003, Nutrinova filed counterclaims alleging inequitable
conduct and invalidity, unenforceability and/or noninfringement of 19 of our U.S. patents,
but the parties reached an agreement to limit the counterclaims to the patents involved in
the suit at the time of the agreement. A scheduling hearing in the case was held in
January 2005, and the trial is scheduled for October 2006. In July 2005, the court granted
Marteks motion to add as a defendant in the case a company that is a U.S. customer for
Nutrinovas DHA, and in January 2006, Martek settled its dispute with this defendant on
terms favorable to Martek. A hearing before the court on the meaning and scope of the
patent claims in dispute was held in late November 2005, and the judge issued his written
decision in December 2005. As a result of this decision by the judge, Martek has decided to
limit the number of patents that it is accusing Nutrinova of infringing to three. In
December
2005, Nutrinovas DHA business was sold to Lonza Group LTD, a Swiss chemical and
biotechnology group, and the parties agreed to add Lonza to the U.S. lawsuit. We also filed a
patent infringement suit involving Nutrinova Nutrition Specialties & Food Ingredients GmbH
and Celanese Ventures GmbH in Germany in January 2004. The complaint alleges infringement of
our European patent relating to DHA-containing oils. A hearing in this case was held in a
district court in Dusseldorf in April 2005 and the court delayed its decision pending input
from a court-appointed technical expert. The courts decision is expected at some point in
2007. Lonza has also been added to this lawsuit.
    
    With respect to our ARA patent in South Korea, Suntory has filed an opposition. A
hearing on the matter was held in late January 2006 and the Korean Intellectual Property
Office Examiners have ruled against Martek. Martek intends to appeal, during which time
the patent would remain in full force and effect. Suntory has also initiated an
invalidation case against our blended oil patent in South Korea. Our response to Suntory
was filed in February 2005, Suntory responded in March 2006 and Martek filed further
submissions in May 2006. A hearing was held in July 2006, and a decision is expected by
the end of 2006.
    
    There are additional intellectual property oppositions pending against Martek that are
not considered material.
   If clinical trials do not continue to yield positive results on the benefits of DHA on cognitive
function, cardiovascular health or other health applications, our future revenues may be limited
in the food and beverage and the dietary supplement markets.
  29




---



##### 



If our oils are unable to be used in organic food and beverage products, the opportunity for
sales of our oils into the food and beverage market will be limited to non-organic products.
   Because food and beverage pricing is very competitive, the premium that our oils adds to the
cost of the food or beverage may never allow it to be priced at levels that will allow
acceptance by consumers.
  If it is determined that large amounts of eicosapentaenoic acid (EPA) must accompany DHA in
order to achieve optimal health benefits, we may never be able to gain large- scale entry into
the food and beverage market.
  Our oils are very sensitive to oxidation and may not be very compatible with many liquid or dry
foods that are currently on the market. If economical methods are not developed to successfully
incorporate our oils into various food and beverage applications, we may never be able to gain
large-scale entry into the food and beverage market.
  We have a single third-party supplier of our ARA with whom we have a contractual relationship.
If this supplier of our ARA is unable to supply us with our required amounts of ARA or if an
over-capacity situation by our supplier leads to higher cost ARA, our results of operations
and/or financial position may be adversely affected.
  30




---



##### 



If we are unable to continuously utilize and adequately manage our production capacity or are
unable to enter into favorable agreements with third parties to produce our oils or if our
suppliers fail to produce and supply us with adequate amounts of oil, our customers may not be
able to obtain a sufficient supply of DHA and ARA from us and our future revenues from these
products may be limited.
  As we and our major suppliers increase production of our nutritional oils, we may experience
certain risks associated with the start-up/ ramp-up of commercial manufacturing that could have
a material adverse effect on our business, financial condition, and/ or results of operations.
   
    
    we may experience problems processing, handling and shipping the higher quantities of oil produced from our expanded facilities;
    
    the costs of expanding, operating and maintaining our production facilities may exceed our expectations;
    
    product defects may result;
    
    lower than anticipated fermentation success rates may result;
    
    lower downstream processing yields may result;
    
    environmental and safety problems may result from our production process; and
    
    regulatory issues relating to the scale-up and operation regarding our production processes may arise.
  We have significantly increased our manufacturing capacity and have incurred substantial costs
in doing so. If we are unable to increase our revenues from our nutritional oils produced at
these facilities, we may continue to experience excess production capacity and we may be unable
to recover these plant expansion costs.
  31




---



##### 



Failure to effectively manage our growth could disrupt our operations and prevent us from
generating the revenues and gross profit margins we expect.
  Experts differ in their opinions on the importance of DHA and/or ARA in infant formula and the
levels of DHA and/or ARA required to achieve health benefits for babies. Some experts feel that
they are not necessary ingredients for infant development and that supplemented formulas will
remain a premium product and never gain widespread acceptance worldwide. If clinical trials do
not continue to yield positive results, certain favorable regulatory guidelines are not enacted
or current favorable regulatory guidelines are amended, our future revenues in the infant
formula market may be limited.
    We may need additional capital in the future to continue our research and development efforts,
to conduct product testing, including preclinical and clinical trials, and to market our
products. We may also need significant additional capital to expand our production capacity if
market demand for our products continues to grow.
   32




---



##### 



The market price of our common stock may experience a high level of volatility due to factors
such as the volatility in the market for biotechnology stocks generally, and the short-term
effect of a number of possible events.
  
    
    announcements of technical innovations, new commercial products and product launches by us or our competitors;
    
    announcements of use of competitors DHA and/or ARA products by our customers;
    
    arrangements or strategic partnerships by us or our competitors;
    
    announcements of license agreements, acquisitions or strategic alliances;
    
    announcements of sales by us or our competitors;
    
    patent or other intellectual property achievements or adverse developments;
    
    quarterly fluctuations in our revenues and results of operations;
    
    failure or delay in expansion and continuous operation regarding our commercial
manufacturing or failure or delay of our third-party manufacturers in expansion and
continuous operation regarding their commercial manufacturing;
    
    failure to enter into favorable third-party manufacturing agreements;
    
    regulatory decisions (approvals or disapprovals) or changes concerning our products and our competitors products;
    
    announcements related to threatened, new or existing litigation;
    
    changes in our estimates of financial performance or changes in recommendations by securities analysts; and
    
    general market conditions for growth companies and bioscience companies.
   If significant shares eligible for future sales are sold, the result may depress our stock price
by increasing the supply of our shares in the market at a time when demand may be limited.
   33




---



##### 



Our business would be harmed if we fail to comply with applicable good manufacturing practices
as required by the FDA.
  Our corporate compliance program cannot guarantee that we are in compliance with all potentially
applicable federal and state regulations.
  Our business exposes us to potential product liability claims and recalls, which could adversely
impact our financial condition or performance.
  Our opportunity in the U.S. infant formula
market may be limited by the renewal rate of
supplemented formulas into the Women, Infants and Children program or if the eligibility requirements
for participating in the program are made more restrictive.
  Our manufacturing process involves the handling of hazardous materials and emission of regulated
waste. If we fail to properly handle these hazardous materials and/ or waste emissions,
substantial costs and harm to our business could result.
  34




---



##### 



Changes in foreign currency exchange rates or interest rates could result in losses.
  We are a defendant in a putative class action lawsuit which, if determined adversely, could
have a material adverse affect on us.
   35




---



##### 



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
  Item 3. Defaults Upon Senior Securities.
  Item 4. Submission of Matters to a Vote of Security Holders.
  Item 5. Other Information.
  Item 6. Exhibits.
 31.01
    
    Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).*31.02
    
    Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).*32.01
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *32.02
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
 
 *
    
    Filed or furnished herewith. 36




---



##### 



SIGNATURES
  MARTEK BIOSCIENCES CORPORATION(Registrant)Date:  September 11, 2006
    /s/ Peter L. BuzyPeter L. Buzy, Chief Financial Officer and Treasurer(Principal Financial and Accounting Officer) 37