##### 



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 April 30, 2005 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
(Address of principal executive offices) Registrants telephone number, including area code: (410) 740-0081 None
(Former name, former address and former fiscal year, if changed since last report)   Indicate by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days. þ Yes o No Indicate by check mark
whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). þ Yes o No Common stock, par value $.10 per share: 31,666,925 shares outstanding as of June 2, 2005.








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MARTEK BIOSCIENCES CORPORATION
FORM 10-Q For The Quarterly Period Ended April 30, 2005 INDEX PART I
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements
    
    
    1Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    22Item 4.
    
    Controls and Procedures
    
    
    22PART II
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    23Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    24Item 3.
    
    Defaults Upon Senior Securities
    
    
    24Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    25Item 5.
    
    Other Information
    
    
    25Item 6.
    
    Exhibits
    
    
    25Signatures
    
    
    27




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PART I  FINANCIAL INFORMATION
Item 1. Financial Statements. MARTEK BIOSCIENCES CORPORATION CONSOLIDATED BALANCE SHEETS April 30,2005
    
    
    October 31,In thousands, except share and per share data
    
    (unaudited)
    
    
    2004AssetsCurrent assetsCash and cash equivalents
    
    $
    11,472
    
    
    $
    29,445Short-term investments and marketable securities
    
    
    45,600
    
    
    
    13,205Accounts receivable, net
    
    
    36,733
    
    
    
    37,292Inventories, net
    
    
    49,338
    
    
    
    30,379Other current assets
    
    
    5,804
    
    
    
    6,793Total current assets
    
    
    148,947
    
    
    
    117,114Property, plant and equipment, net
    
    
    285,851
    
    
    
    255,430Deferred tax asset
    
    
    47,476
    
    
    
    49,378Goodwill
    
    
    48,251
    
    
    
    48,175Other intangible assets, net
    
    
    30,432
    
    
    
    29,994Other assets, net
    
    
    1,263
    
    
    
    1,307Total assets
    
    $
    562,220
    
    
    $
    501,398Liabilities and stockholders equityCurrent liabilitiesAccounts payable
    
    $
    16,351
    
    
    $
    31,264Accrued liabilities
    
    
    12,468
    
    
    
    10,678Current portion of notes payable and other long-term obligations
    
    
    3,080
    
    
    
    4,946Current portion of unearned revenue
    
    
    904
    
    
    
    2,031Total current liabilities
    
    
    32,803
    
    
    
    48,919Long-term debt under revolving credit facility
    
    
    55,000
    
    
    
    85,000Notes payable and other long-term obligations
    
    
    10,810
    
    
    
    12,175Long-term portion of unearned revenue
    
    
    8,926
    
    
    
    9,140Total liabilities
    
    
    107,539
    
    
    
    155,234CommitmentsStockholders 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
    
    
    
    
    
    
    Common stock, $.10 par value; 100,000,000 shares authorized; 31,656,005 and 29,491,127 shares issued and
outstanding, respectively
    
    
    3,166
    
    
    
    2,949Additional paid-in capital
    
    
    505,632
    
    
    
    407,667Accumulated other comprehensive (loss) income
    
    
    (102
    )
    
    
    68Accumulated deficit
    
    
    (54,015
    )
    
    
    (64,520
    )Total stockholders equity
    
    
    454,681
    
    
    
    346,164Total liabilities and stockholders equity
    
    $
    562,220
    
    
    $
    501,398
 See accompanying notes. 1




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MARTEK BIOSCIENCES CORPORATION CONSOLIDATED STATEMENTS OF INCOME Three months ended April 30,
    
    
    Six months ended April 30,Unaudited - In thousands, except share and per share data
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004RevenuesProduct sales
    
    $
    52,834
    
    
    $
    38,187
    
    
    $
    115,945
    
    
    $
    70,418Contract manufacturing sales
    
    
    2,997
    
    
    
    3,733
    
    
    
    6,375
    
    
    
    7,077Total revenues
    
    
    55,831
    
    
    
    41,920
    
    
    
    122,320
    
    
    
    77,495Costs and expensesCost of product sales
    
    
    32,792
    
    
    
    24,253
    
    
    
    68,894
    
    
    
    43,778Cost of contract manufacturing sales
    
    
    2,585
    
    
    
    2,928
    
    
    
    5,389
    
    
    
    5,637Research and development
    
    
    5,321
    
    
    
    4,701
    
    
    
    10,137
    
    
    
    8,728Selling, general and administrative
    
    
    8,107
    
    
    
    6,111
    
    
    
    16,252
    
    
    
    11,908Other operating expenses
    
    
    2,075
    
    
    
    654
    
    
    
    5,560
    
    
    
    1,104Total costs and expenses
    
    
    50,880
    
    
    
    38,647
    
    
    
    106,232
    
    
    
    71,155Income from operations
    
    
    4,951
    
    
    
    3,273
    
    
    
    16,088
    
    
    
    6,340Other income, net:Interest and other income
    
    
    456
    
    
    
    128
    
    
    
    636
    
    
    
    412Interest expense
    
    
    
    
    
    
    (2
    )
    
    
    (180
    )
    
    
    (2
    )Total other income, net
    
    
    456
    
    
    
    126
    
    
    
    456
    
    
    
    410Income before income taxes
    
    
    5,407
    
    
    
    3,399
    
    
    
    16,544
    
    
    
    6,750Provision for income taxes
    
    
    1,974
    
    
    
    
    
    
    
    6,039
    
    
    
    Net income
    
    $
    3,433
    
    
    $
    3,399
    
    
    $
    10,505
    
    
    $
    6,750Net income per shareBasic
    
    $
    0.11
    
    
    $
    0.12
    
    
    $
    0.34
    
    
    $
    0.23Diluted
    
    $
    0.11
    
    
    $
    0.11
    
    
    $
    0.33
    
    
    $
    0.22Weighted average common shares outstandingBasic
    
    
    31,497,317
    
    
    
    29,209,029
    
    
    
    30,540,473
    
    
    
    28,769,839Diluted
    
    
    32,649,141
    
    
    
    31,250,438
    
    
    
    31,595,277
    
    
    
    31,074,675
 See accompanying notes. 2




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MARTEK BIOSCIENCES CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY AccumulatedAdditional
    
    
    OtherCommon Stock
    
    
    Paid-in
    
    
    Comprehensive
    
    
    AccumulatedUnaudited - In thousands, except share data
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Income (Loss)
    
    
    Deficit
    
    
    TotalBalance at October 31, 2004
    
    
    29,491,127
    
    
    $
    2,949
    
    
    $
    407,667
    
    
    $
    68
    
    
    $
    (64,520
    )
    
    $
    346,164Issuance of common stock, net of issuance costs
    
    
    1,756,614
    
    
    
    176
    
    
    
    81,271
    
    
    
    
    
    
    
    
    
    
    
    81,447Exercise of stock options
    
    
    408,264
    
    
    
    41
    
    
    
    12,093
    
    
    
    
    
    
    
    
    
    
    
    12,134Stock compensation expense
    
    
    
    
    
    
    
    
    
    
    463
    
    
    
    
    
    
    
    
    
    
    
    463Tax benefit of exercise of non-qualified stock options
    
    
    
    
    
    
    
    
    
    
    4,138
    
    
    
    
    
    
    
    
    
    
    
    4,138Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,505
    
    
    
    10,505Other comprehensive income:Unrealized loss on exchange rate forward
contract, net of tax benefit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (170
    )
    
    
    
    
    
    
    (170
    )Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,335Balance at April 30, 2005
    
    
    31,656,005
    
    
    $
    3,166
    
    
    $
    505,632
    
    
    $
    (102
    )
    
    $
    (54,015
    )
    
    $
    454,681
 See accompanying notes. 3




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MARTEK BIOSCIENCES CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Six
months ended April 30,Unaudited  In thousands
    
    2005
    
    
    2004Operating activitiesNet income
    
    $
    10,505
    
    
    $
    6,750Adjustments to reconcile net income to net cash used in operating activities:Depreciation and amortization
    
    
    7,895
    
    
    
    3,454Deferred tax provision
    
    
    6,039
    
    
    
    Other
    
    
    1,117
    
    
    
    (46
    )Changes in operating assets and liabilities:Accounts receivable
    
    
    559
    
    
    
    (6,063
    )Inventories
    
    
    (19,129
    )
    
    
    (10,516
    )Other assets
    
    
    1,738
    
    
    
    (57
    )Accounts payable
    
    
    (10,613
    )
    
    
    (1,798
    )Accrued liabilities
    
    
    568
    
    
    
    (2,305
    )Unearned revenue and other liabilities
    
    
    (1,424
    )
    
    
    (336
    )Net cash used in operating activities
    
    
    (2,745
    )
    
    
    (10,917
    )Investing activities(Purchase) sale of short-term investments and marketable securities, net
    
    
    (32,395
    )
    
    
    47,339Expenditures for property, plant and equipment
    
    
    (45,546
    )
    
    
    (117,592
    )Proceeds from sale/leaseback transaction
    
    
    4,128
    
    
    
    Capitalization of intangible and other assets
    
    
    (1,186
    )
    
    
    (6,135
    )Net cash used in investing activities
    
    
    (74,999
    )
    
    
    (76,388
    )Financing activitiesRepayments of notes payable and other long-term obligations
    
    
    (4,310
    )
    
    
    (2,336
    )Proceeds from the issuance of common stock and exercise of stock options, net
    
    
    93,581
    
    
    
    27,619(Repayments) borrowings under revolving credit facility
    
    
    (30,000
    )
    
    
    67,000Other
    
    
    500
    
    
    
    Net cash provided by financing activities
    
    
    59,771
    
    
    
    92,283Net (decrease) increase in cash and cash equivalents
    
    
    (17,973
    )
    
    
    4,978Cash and cash equivalents, beginning of period
    
    
    29,445
    
    
    
    29,924Cash and cash equivalents, end of period
    
    $
    11,472
    
    
    $
    34,902Supplemental cash flow disclosures:Interest paid
    
    $
    1,775
    
    
    $
    378
 See accompanying notes. 4




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES Basis of PresentationThe accompanying unaudited consolidated financial statements of Martek
Biosciences Corporation and its wholly-owned subsidiaries (the Company) have been prepared in
accordance with accounting principles generally accepted in the United States for interim financial
information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by accounting principles
generally accepted in the United States for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered necessary for a
fair presentation have been included. Operating results for the six months ended April 30, 2005
are not necessarily indicative of the results that may be expected for the year ending October 31,
2005. For further information, refer to the consolidated financial statements and footnotes
thereto included in Martek Biosciences Corporations Annual Report on Form 10-K for the year ended
October 31, 2004. ConsolidationThe consolidated financial statements include the accounts of Martek Biosciences
Corporation and its wholly-owned subsidiaries, Martek Biosciences Boulder Corporation (Martek
Boulder) and Martek Biosciences Kingstree Corporation (Martek Kingstree), after elimination of
all significant intercompany balances and transactions. Use of EstimatesThe preparation of consolidated financial statements in conformity with accounting
principles generally accepted in the United States requires management to make estimates and
assumptions that affect the amounts reported in the Companys consolidated financial statements and
accompanying notes. On an ongoing basis, the Company evaluates its estimates and judgments, which
are based on historical and anticipated results and trends and on various other assumptions that
the Company believes to be reasonable under the circumstances. By their nature, estimates are
subject to an inherent degree of uncertainty and, as such, actual results may differ from the
Companys estimates. Segment InformationThe Company currently operates in one business segment, the development and
commercialization of novel products from microalgae and other microbes. The Company is managed and
operated as one business. The entire business is comprehensively managed by a single management
team that reports to the Chief Executive Officer. The Company does not operate any material
separate lines of business or separate business entities with respect to its products or product
candidates. Accordingly, the Company does not accumulate discrete financial information with
respect to separate product areas and does not have separately reportable segments as defined by
Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an
Enterprise and Related Information. Revenue RecognitionThe Company derives revenue principally from two sources: product sales and
contract manufacturing. The Company recognizes product sales revenue when persuasive evidence of an
arrangement exists, the fee is fixed or determinable, collectibility is probable and the product is
shipped thereby transferring title and risk of loss. Typical infant formula license contracts
include an upfront license fee, a prepayment of product sales and established pricing on future
product sales. In accordance with Emerging Issues Task Force No. 00-21 (EITF No. 00-21), Revenue
Arrangements with Multiple Deliverables, the consideration from these contracts is allocated based
on the relative fair values of the separate elements. Revenue is recognized on product sales when
goods are shipped and all other conditions for revenue recognition are met. Cash received as a
prepayment on future product purchases is deferred and recognized as revenue when product is
shipped. Revenue from product licenses is deferred and recognized on a straight-line basis over the
term of the agreement. Royalty income is recorded when earned, based on information provided by
the Companys licensees. Royalty income was approximately $300,000 and $900,000 in the three and
six months ended April 30, 2005, respectively, and $500,000 and $600,000 in the three and six
months ended April 30, 2004, respectively, and is included in product sales revenue in the
consolidated statements of income. Contract manufacturing revenue is recognized when goods are shipped to customers and all other
conditions for revenue recognition are met. Cash received that is related to future performance
under such contracts is deferred and recognized as revenue when earned. Foreign Currency TransactionsForeign currency transactions are translated into U.S. dollars at
prevailing rates. Gains or losses resulting from foreign currency transactions are included in
current period income or loss as incurred. All material transactions of the Company are denominated
in U.S. dollars with the exception of purchases of arachidonic acid (ARA) from DSM Food
Specialties (DSM) Capua, Italy plant, which are denominated in euros. The Company has entered into foreign currency forward contracts to reduce its transactional
foreign currency exposures associated with the purchases of ARA from DSM. At April 30, 2005, these
forward contracts, which qualify for hedge accounting, had outstanding notional values aggregating
approximately 5.4 million euros (equivalent to $7.0 million at April 30, 2005). The resulting
unrealized gains and losses are recorded as a component of other comprehensive income. These
contracts effectively fix our exchange rate between the U.S. dollar and the euro for periods
ranging from 30 to 120 days. Research and DevelopmentResearch and development costs are charged to operations as incurred and
include internal labor, materials and overhead costs associated with the Companys ongoing research
and development activity, in addition to third-party costs for contracted work as well as ongoing
clinical trials costs. 5




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Other Operating ExpensesOther operating expenses relate primarily to production start-up costs,
including materials, training and other such costs, incurred in connection with the expansion of
the Companys internal manufacturing operations, costs incurred in connection with qualification of
certain third-party manufacturers, and amounts related to the Winchester wastewater treatment
matter. All such costs are expensed as incurred. Deferred Income TaxesDeferred tax assets and liabilities are determined based on temporary
differences between the financial reporting bases and the tax bases of assets and liabilities.
Deferred tax assets are also recognized for tax net operating loss carryforwards. These deferred
tax assets and liabilities are measured using the enacted tax rates and laws that will be in effect
when such amounts are expected to reverse or be utilized. The realization of total deferred tax
assets is contingent upon the generation of future taxable income. Valuation allowances are
provided to reduce such deferred tax assets to amounts more likely than not to be ultimately
realized. Income tax expense includes U.S. federal, state and local income taxes and is based on pre-tax
income. The interim period provision for income taxes is based upon the Companys estimate of its
annual effective income tax rate. In determining the estimated annual effective income tax rate,
the Company analyzes various factors, including projections of the Companys annual earnings and
taxing jurisdictions in which the earnings will be generated, the impact of state and local income
taxes and the ability of the Company to use tax credits and net operating loss carryforwards. During the fourth quarter of fiscal 2004, the Company reversed approximately $51 million of its
deferred tax asset valuation allowance, having determined that it is more likely than not that this
portion of the deferred tax asset will be realized. As a result, income tax expense has been
recorded based on pre-tax income for the quarter. The effective income tax rate for the six months
ended April 30, 2005 is 36.5%. There was no provision for income taxes in the six months ended
April 30, 2004. Net Income Per ShareBasic net income per share is computed using the weighted average number of
shares of common stock outstanding during the period. Diluted net income per share is computed
using the weighted average number of shares of common stock outstanding, giving effect to stock
options and warrants using the treasury stock method. Comprehensive IncomeComprehensive income is comprised of net earnings and other comprehensive
income, which includes certain changes in equity that are excluded from net income. The Company
includes unrealized holding gains and losses on available-for-sale securities, if any, as well as
changes in the market value of exchange rate forward contracts in other comprehensive income in the
Consolidated Statement of Stockholders Equity. Comprehensive income, net of related tax, was $3.6
million and $10.3 million in the three and six months ended April 30, 2005, respectively.
Comprehensive income for the three months ended April 30, 2005 includes unrealized gains on
exchange rate forward contracts, net of related tax, of $154,000, and comprehensive income for the
six months ended April 30, 2005 includes unrealized losses on exchange rate forward contracts, net
of related tax, of $170,000. Comprehensive income in the three and six months ended April 30, 2004
was $3.3 million and $6.6 million, respectively, which includes unrealized losses on exchange rate
forward contracts of $108,000 in both the three and six month periods. Cash and Cash EquivalentsCash equivalents consist of highly liquid investments with an
original maturity of three months or less. Short-Term Investments and Marketable SecuritiesThe Company has classified all short-term
investments and marketable securities as available-for-sale. Unrealized gains and losses on these
securities, if any, are reported as accumulated other comprehensive income, which is a separate
component of stockholders equity. Realized gains and losses are included in other income based on
the specific identification method. The Company periodically evaluates whether any declines in the fair value of investments are other
than temporary. This evaluation consists of a review of several factors, including, but not
limited to: length of time and extent that a security has been in an unrealized loss position; the
existence of an event that would impair the issuers future earnings potential; the near term
prospects for recovery of the market value of a security; and the intent and ability of the Company
to hold the security until the market value recovers. Declines in value below cost for debt
securities where it is considered probable that all contractual terms of the security will be
satisfied, where the decline is due primarily to changes in interest rates (and not because of
increased credit risk), and where the Company intends and has the ability to hold the investment
for a period of time sufficient to allow a market recovery, are not assumed to be other than
temporary. If management determines that such an impairment exists, the carrying value of the
investment will be reduced to the current fair value of the investment and the Company will
recognize a charge in the consolidated statements of income equal to the amount of the carrying
value reduction. Fair Value of Financial InstrumentsThe Company considers the recorded cost of its financial assets
and liabilities, which consist primarily of cash and cash equivalents, short-term investments and
marketable securities, accounts receivable, accounts payable, notes payable and long-term debt, to
approximate the fair value of the respective assets and liabilities at April 30, 2005 and October
31, 2004. Trade ReceivablesTrade receivables are reported in the consolidated balance sheets at outstanding
principal less any allowance for doubtful accounts. The Company writes off uncollectible
receivables against the allowance for doubtful accounts when the likelihood of collection is
remote. The Company may extend credit terms up to 50 days and considers receivables past due if not
paid by the due date. The Company performs ongoing credit evaluations of its customers and extends
credit without requiring collateral. The Company maintains an allowance for doubtful accounts,
which is determined based on historical experience, existing economic conditions and managements
expectations of losses. The Company analyzes historical bad debts, customer concentrations,
customer creditworthiness, and current economic trends when evaluating the adequacy of the
allowance for doubtful accounts. Losses have historically been within managements expectations. 6




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InventoriesInventories are stated at the lower of cost or market and include appropriate elements
of material, labor and indirect costs. Inventories are valued using a weighted average approach
that approximates the first-in, first-out method. The Company analyzes both historical and
projected sales volumes and, when needed, reserves for inventory that is either obsolete, slow
moving or impaired. Property, Plant and EquipmentProperty, plant and equipment, including leasehold improvements, is
stated at cost and depreciated or amortized when placed into service using the straight-line
method, based on useful lives as follows: 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
 Leasehold improvements are amortized over the shorter of the useful life of the asset or the
lease term, including renewals when probable. Costs for capital assets not yet placed into service,
including those related to expansion of the Companys Kingstree, South Carolina fermentation
facility, have been capitalized as construction in progress and will be depreciated in accordance
with the above guidelines once placed into service. Costs for repairs and maintenance are expensed
as incurred. Goodwill and Other Intangible AssetsThe Company recorded goodwill and purchased intangible assets
in its acquisition of OmegaTech, Inc. (OmegaTech) in April 2002 and goodwill in its acquisition
of FermPro Manufacturing, LP (FermPro) in September 2003. The goodwill acquired in the OmegaTech
and FermPro acquisitions is subject to the provisions of SFAS No. 142, Goodwill and Other
Intangible Assets (SFAS 142), and, accordingly, is not being amortized. In accordance with SFAS
142, goodwill is tested for impairment on an annual basis and between annual tests in certain
circumstances, and written down when impaired. Furthermore, SFAS 142 requires purchased intangible
assets other than goodwill to be amortized over their useful lives unless these lives are
determined to be indefinite. Purchased intangible assets and patents are carried at cost less
accumulated amortization. Amortization is computed over the estimated useful lives of the
respective assets, generally ten to seventeen years. Impairment of Long-Lived AssetsIn accordance with SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets (SFAS 144), the Company reviews long-lived assets and certain
identifiable intangibles for impairment whenever events or changes in circumstances indicate that
the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and
used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash
flows expected to be generated by the asset. Recoverability measurement and estimating of
undiscounted cash flows is done at the lowest possible level for which there are identifiable
assets. If such assets are considered to be impaired, the impairment to be recognized is measured
by the amount by which the carrying amount of assets exceeds the fair value of the assets. Assets
to be disposed of are reported at the lower of the carrying amount or fair value less costs to
sell. Stock-Based CompensationIn October 1995, the Financial Accounting Standards Board (FASB) issued
SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). SFAS 123 allows companies to
account for employee stock-based compensation under the fair value-based method or using the
intrinsic value method provided by Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees (APB 25) and related interpretations, but requires pro forma
disclosure in the footnotes to the financial statements as if the measurement provisions of SFAS
123 had been adopted. In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure (SFAS 148). SFAS 148 amends SFAS 123 to provide
alternative methods of transition for a voluntary change to the fair value-based method of
accounting for stock-based compensation. The Company has elected to continue accounting for its employee stock-based compensation in
accordance with the provisions of APB 25, and to present the pro forma disclosures required by SFAS
123, as amended by SFAS 148. In accordance with APB 25, stock-based employee compensation cost for
stock options is reflected upon grant based upon the difference between exercise price and the
market value of the underlying common stock on the date of grant. Stock-based compensation for
non-employees is accounted for using the fair value-based method in accordance with SFAS 123. The
Company has adopted the disclosures outlined in SFAS 123, as amended by SFAS 148. See Recently
Issued Accounting Pronouncements for discussion of new accounting rules to be implemented related
to stock options. 7




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##### 



In December 2004 and January and May 2005, the Company modified the terms of all outstanding and
unvested stock options whose exercise prices were greater than Marteks closing stock price on the
modification dates. Total modifications served to immediately vest approximately 1.2 million
unvested stock options with the May 2005 modification serving to immediately vest approximately
90,000 unvested stock options held by non-officers. The following table illustrates the effect on
net income and net income per share as if the Company had applied the fair value recognition
provisions of SFAS 123, as amended by SFAS 148, to stock-based employee compensation (in thousands,
except per share amounts): Three months ended April 30,
    
    
    Six months ended April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net income, as reported
    
    $
    3,433
    
    
    $
    3,399
    
    
    $
    10,505
    
    
    $
    6,750Add: Total stock-based employee compensation expense
included in reported net income, net of related tax effect
    
    
    286
    
    
    
    
    
    
    
    294
    
    
    
    Deduct: Total stock-based employee compensation expensedetermined under fair value-based methods for all awards
    
    
    (8,462
    )
    
    
    (4,462
    )
    
    
    (44,264
    )
    
    
    (7,350
    )Pro forma net loss
    
    $
    (4,743
    )
    
    $
    (1,063
    )
    
    $
    (33,465
    )
    
    $
    (600
    )Net income (loss) per share:Basic  as reported
    
    $
    0.11
    
    
    $
    0.12
    
    
    $
    0.34
    
    
    $
    0.23Basic  pro forma
    
    $
    (0.15
    )
    
    $
    (0.04
    )
    
    $
    (1.10
    )
    
    $
    (0.02
    )Diluted  as reported
    
    $
    0.11
    
    
    $
    0.11
    
    
    $
    0.33
    
    
    $
    0.22Diluted  pro forma
    
    $
    (0.15
    )
    
    $
    (0.04
    )
    
    $
    (1.10
    )
    
    $
    (0.02
    )
 The effect of applying SFAS 123 on pro forma net income and per share calculations for the
three and six months ended April 30, 2005, as stated above, is not representative of the effect on
reported net income and net income per share for future periods due to such things as the vesting
period of the stock options, the issuance of additional stock options in future periods and the
potential granting of alternative forms of equity-based compensation. The weighted average fair market values of the options at the date of grant for options granted
during the three months ended April 30, 2005 and 2004 were $33.52 and $41.63, respectively. The
weighted average fair market values of the options at the date of grant for options granted during
the six months ended April 30, 2005 and 2004 were $32.05 and $41.71, respectively. The fair market
value of each option grant is estimated on the date of grant using the Black-Scholes option pricing
model with the following weighted average assumptions for the respective periods: Three months ended April 30,

    
    Six months ended April 30,2005
    
    2004

    
    2005
    
    2004Expected volatility
    
    67.0%
    
    68.9%
    
    67.0%
    
    68.9%Risk-free interest rate
    
    3.9%
    
    3.5%
    
    3.6%
    
    3.6%Expected average life of options
    
    5 years
    
    7 years
    
    5 years
    
    7 yearsExpected dividend yield
    
    0%
    
    0%
    
    0%
    
    0%
 ReclassificationCertain amounts in the prior periods financial statements have been
reclassified to conform to the current period presentation. Recently Issued Accounting PronouncementsIn October 2004, the FASB concluded that SFAS No. 123
(revised 2004), Share-Based Payment (SFAS 123R), which would require all companies to measure
compensation cost for all share-based payments (including employee stock options) at fair value,
would be effective for interim or annual periods beginning after June 15, 2005. In April 2005, the
Securities and Exchange Commission delayed the effective date of SFAS 123R to the annual period
beginning after June 15, 2005. SFAS 123R provides two tentative adoption methods. The first method
is a modified prospective transition method whereby a company would recognize share-based employee
costs from the beginning of the fiscal period in which the recognition provisions are first applied
as if the fair-value-based accounting method had been used to account for all employee awards
granted, modified, or settled after the effective date and to any awards that were not fully vested
as of the effective date. Measurement and attribution of compensation cost for awards that are
unvested as of the effective date of SFAS 123R would be based on the same estimate of the grant-date fair value and the same attribution method used previously under SFAS
123. The second adoption method is a modified retrospective transition method whereby a company
would recognize employee compensation cost for periods presented prior to the adoption of 8




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##### 



SFAS 123R
in accordance with the original provisions of SFAS 123; that is, an entity would recognize employee
compensation costs in the amounts reported in the pro forma disclosures provided in accordance with
SFAS 123. A company would not be permitted to make any changes to those amounts upon adoption of
SFAS 123R unless those changes represent a correction of an error. For periods after the date of
adoption of SFAS 123R, the modified prospective transition method described above would be applied.
In December 2004 and January and May 2005, the Company modified the terms of all outstanding and
unvested stock options whose exercises prices were greater than Marteks closing stock price on the
modification dates. Total modifications served to immediately vest approximately 1.2 million
unvested stock options with the May 2005 modification serving to immediately vest approximately
90,000 unvested stock options held by non-officers. The accelerations will enable the Company to
avoid recording approximately $27 million of future compensation cost that would have been required
to be recognized under SFAS 123R. The Company currently expects to adopt SFAS 123R in the quarter
ended January 31, 2006, using the modified prospective method, although the Company continues to
review its options for adoption under this new pronouncement. After giving effect to these
accelerations of vesting and based upon the Companys projection of unvested stock options at the
implementation date, the Company expects the adoption to result in the recognition of additional
compensation cost of approximately $3.0 million during fiscal 2006. In December 2004, the FASB issued SFAS No. 151, Inventory Costs (SFAS 151). SFAS 151 requires
abnormal amounts of inventory costs related to idle facility, freight handling and wasted material
expenses to be recognized as current period charges. Additionally, SFAS 151 requires that
allocation of fixed production overheads to the costs of conversion be based on the normal capacity
of the production facilities. The standard is effective for fiscal years beginning after June 15,
2005. The Company is currently evaluating the impact on its consolidated financial statements that
will result from adopting SFAS 151. 2. DSM SUPPLY AND LICENSE AGREEMENT In April 2004, the Company entered into a new agreement with DSM Food Specialties B.V. (DSM)
extending the existing relationship between the two companies involving the production and supply
of arachidonic acid (ARA), one of the Companys nutritional oils that it sells to its infant
formula licensees. Among other things, this agreement provides for the sale to the Company by DSM
of a license related to certain technologies associated with the manufacture of ARA. This sale
involved a license fee totaling $10 million, $4 million of which was paid upon execution of the
agreement, $4 million of which was paid on November 2, 2004, and the remaining $2 million of which
will be paid by the Company on November 2, 2005. The license fee is being amortized over the
15-year term of the agreement using the straight-line method and the remaining obligation as of
April 30, 2005 is recorded as a current obligation in the consolidated balance sheet. This
agreement also provides for the guarantee by Martek of DSMs recovery of certain expansion costs
incurred by them. This guarantee will decline in value as Martek purchases ARA from DSM in the
future. As of April 30, 2005, the value of the Companys current guarantee to DSM, which is
related to DSMs phase one expansion, is approximately $1.6 million. In addition, the Company is
in the process of negotiating an amendment to the April 2004 agreement with DSM. This amendment is
expected to establish the overall economics associated with DSMs current expansions at both of its
facilities, including the Companys guarantee of such expansion costs, with such guarantee expected
to approximate $40 million. In addition, the amendment will establish the pricing to Martek for
certain ARA that Martek has purchased and will purchase from DSM during calendar 2005. Annual ARA
pricing utilizes a cost-plus arrangement and is based on the prior years actual costs incurred
adjusted for current year expectations. Calendar 2005 ARA purchases have been valued by Martek
based on amounts invoiced from DSM, but certain such amounts are still subject to final adjustment. Based
on cost estimates received from DSMs Capua and Belvidere facilities, the Company expects its
current valuation to approximate the agreed-upon amounts when the negotiations with DSM are
complete. 3. SHORT-TERM INVESTMENTS AND MARKETABLE SECURITIES The Companys available-for-sale securities consist of federally-sponsored debt securities and
taxable municipal auction rate securities, and totaled $45.6 million and $13.2 million as of April
30, 2005 and October 31, 2004, respectively. There were no unrealized holding gains or losses on
these available-for-sale securities as of April 30, 2005 and October 31, 2004. There were no
realized gains or losses during the three and six months ended April 30, 2005 and April 30, 2004.
At April 30, 2005 and October 31, 2004, the estimated fair value of these securities approximated
cost. 9




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##### 



4. INVENTORIES Inventories consist of the following (in thousands): April 30,
    
    
    October 31,2005
    
    
    2004Finished goods
    
    $
    17,520
    
    
    $
    7,648Work in process
    
    
    29,618
    
    
    
    21,350Raw materials
    
    
    3,550
    
    
    
    2,381Total inventory
    
    
    50,688
    
    
    
    31,379Less: inventory reserve
    
    
    (1,350
    )
    
    
    (1,000
    )Inventories, net
    
    $
    49,338
    
    
    $
    30,379
 5. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following (in thousands): April 30,
    
    
    October 31,2005
    
    
    2004Land
    
    $
    712
    
    
    $
    712Building and improvements
    
    
    43,789
    
    
    
    29,421Machinery and equipment
    
    
    182,689
    
    
    
    133,886Furniture and fixtures
    
    
    2,963
    
    
    
    2,772Computer hardware and software
    
    
    7,426
    
    
    
    5,173Construction in progress
    
    
    75,530
    
    
    
    104,053Property, plant and equipment
    
    
    313,109
    
    
    
    276,017Less: accumulated depreciation and amortization
    
    
    (27,258
    )
    
    
    (20,587
    )Property, plant and equipment, net
    
    $
    285,851
    
    
    $
    255,430
 6. GOODWILL AND OTHER INTANGIBLE ASSETS Intangible assets and related accumulated amortization consist of the following (in thousands): April 30, 2005
    
    
    October 31, 2004Accumulated
    
    
    
    
    
    
    
    
    
    
    AccumulatedIntangible Asset
    
    Gross
    
    
    Amortization
    
    
    Net
    
    
    Gross
    
    
    Amortization
    
    
    NetTrademarks
    
    $
    2,049
    
    
    $
    (351
    )
    
    $
    1,698
    
    
    $
    2,023
    
    
    $
    (284
    )
    
    $
    1,739Patents
    
    
    9,950
    
    
    
    (1,500
    )
    
    
    8,450
    
    
    
    8,409
    
    
    
    (1,226
    )
    
    
    7,183Core technology
    
    
    1,708
    
    
    
    (285
    )
    
    
    1,423
    
    
    
    1,708
    
    
    
    (228
    )
    
    
    1,480Current products
    
    
    10,676
    
    
    
    (2,160
    )
    
    
    8,516
    
    
    
    10,676
    
    
    
    (1,805
    )
    
    
    8,871Licenses
    
    
    11,091
    
    
    
    (746
    )
    
    
    10,345
    
    
    
    11,091
    
    
    
    (370
    )
    
    
    10,721Goodwill
    
    
    48,251
    
    
    
    
    
    
    
    48,251
    
    
    
    48,175
    
    
    
    
    
    
    
    48,175$
    83,725
    
    
    $
    (5,042
    )
    
    $
    78,683
    
    
    $
    82,082
    
    
    $
    (3,913
    )
    
    $
    78,169
 10




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##### 



7. NOTES PAYABLE AND LONG-TERM DEBT In May 2004, the Company entered into a $100 million secured revolving credit facility which
amended and expanded the $85 million credit facility established in January 2004. The revolving
credit facility is collateralized by accounts receivable and inventory and expires in February
2007. The weighted average interest rate on the credit facility was approximately 4.8% and 4.5%
for the three and six months ended April 30, 2005, respectively, and is based on LIBOR and the
Companys current leverage ratio. Among other things, the credit facility agreement contains
restrictions on future debt, the payment of dividends and the further encumbrance of assets. In
addition, the credit facility requires that the Company comply with specified financial ratios and
tests, including minimum liquidity, minimum coverage ratios and maximum leverage ratios. As of
April 30, 2005, the Company was in compliance with all of these debt covenants and had outstanding
borrowings of $55 million under the revolving credit facility. All borrowings are due at maturity. In connection with the purchase of certain assets and the assumption of certain liabilities of
FermPro in September 2003, the Company assumed a $10 million secured note. The note was amended in
January 2004 and is now an unsecured obligation of the Company with a maturity date of December 31,
2014. The note has a stated interest rate of 5% and principal is amortized over a 20-year period
with the balance due at maturity. Also as part of the FermPro acquisition, the Company assumed a
long-term note of approximately $400,000, due in 2023 with a 7% stated interest rate. Throughout the construction at the Kingstree, South Carolina and Winchester, Kentucky manufacturing
facilities, all interest incurred on borrowings will be capitalized to the extent that the
borrowings are used to cover the balance of projects under construction. During the three and six
months ended April 30, 2005, the Company incurred interest on borrowings of approximately $700,000
and $1.8 million and recorded amortization of related debt fees of approximately $100,000 and
$200,000, of which approximately $800,000 and $1.7 million was capitalized, respectively. The
Company incurred interest on borrowings of approximately $200,000 and $400,000 during the three and
six months ended April 30, 2004, respectively, and recorded amortization of related debt fees of
approximately $100,000 in both the three and six months ended April 30, 2004, all of which was
capitalized. The carrying amounts of notes payable and the line of credit at April 30, 2005 and October 31, 2004
approximate their fair values. 8. COMMITMENTS AND CONTINGENCIES LeasesIn October 2004, the Company entered into an operating lease for equipment at its Kingstree
facility as part of a sale/leaseback transaction. The equipment subject to lease was sold at its
cost basis and fair value of $10.8 million and simultaneously leased back to the Company. The
lease expires in October 2009 and contains the same restrictions as the Companys revolving credit
facility. In December 2004, the Company entered into an operating lease for equipment at its
Kingstree facility subject to the same terms and expiration as the October 2004 transaction. This
second sale/leaseback transaction involved the sale of equipment with a cost basis and fair value
of $4.1 million. The Company is contingently liable for a residual value guarantee of
approximately $2.3 million under these agreements. The fair value associated with these guarantees
is not material. Purchase CommitmentsThe Company has entered into an agreement to purchase a minimum quantity of
certain material used in the production of Marteks food docosahexaenoic acid (DHA) product from
a third-party manufacturer. The commitment expires on June 30, 2006. As of April 30, 2005, the
Companys remaining obligation was approximately $3.2 million. The Company has entered into an agreement to purchase from a third-party manufacturer a minimum
quantity of extraction services to be utilized in ARA production. The commitment expires on
December 31, 2007. As of April 30, 2005, the Companys remaining obligation was approximately
$14.6 million. Kentucky Wastewater MatterOn March 12, 2003, an explosion occurred at a public wastewater
treatment works in Winchester, Kentucky, resulting in property damage. While maintaining its lack
of any liability, the Company believed it to be in its best interest to settle this outstanding
matter. To this end, the Company has recently settled the matter. The settlements provide for a
full release from any claims that the parties may have against the Company in connection with the
matter and include settlement payments for amounts previously accrued. As such, the settlements
did not have a material impact on the Companys financial condition or results of operations. The Company learned in March 2004 that the federal Environmental Protection Agency (EPA),
utilizing personnel from its Criminal Investigation Division, had asked questions of current and
former Martek employees relating to the explosion at the wastewater treatment plant and n-hexane.
Current and former employees have testified before a federal grand jury that is investigating the
matter. The Company further learned in April 2005 that the EPA has interviewed two additional
employees of Martek and has requested information from the Winchester Municipal Utilities
Commission on a number of matters including the March 12, 2003 explosion. While the Company cannot
be certain of the outcome of the EPA investigation, the Company believes that the outcome of the
investigation will not have a material impact on its financial condition or results of operations. OmegaTech Contingent Purchase PriceIn connection with the Companys purchase of OmegaTech, the
purchase agreement provided for additional stock consideration of up to $40 million, subject to
certain pricing adjustments, if four milestones were met. Two of these milestones relate to
operating results (sales and gross profit margin objectives by October 2003 and October 2004) and
two relate to regulatory and labeling approvals in the U.S. and Europe. In June 2003, the
Commission of the European Community granted approval of the use of the OmegaTech DHA oil in
certain 11




---



##### 



foods in Europe, meeting the conditions of one of the regulatory milestones. Accordingly,
approximately 358,566 shares of Martek common stock, valued at approximately $14.2 million, were
issued during fiscal 2003 upon the achievement of this milestone. The payment of this additional
consideration was recorded as goodwill. As of April 30, 2005, the Company does not believe the
second regulatory milestone has been achieved. In addition, the Company does not believe that
either financial milestone related to sales and gross profit margin for the periods ended October
31, 2004 and 2003 has been achieved. The representative of the former OmegaTech stockholders has
advised us that he believes that the common stock issuable with respect to the second regulatory
milestone as well as the financial milestone related to the period ended October 31, 2003 should be
issued. Martek disagrees with that conclusion. The parties are currently involved in litigation to
resolve this dispute with respect to the second regulatory milestone. The total Martek common
stock that may be issued relating to any remaining milestones is subject to a formula that is based
on the average market price of the Companys stock on the dates that the individual milestones are
determined to have been achieved, up to a maximum of 1.9 million shares. Any contingent
consideration paid related to these milestones would be recorded as goodwill. Class Action LawsuitsSince the end of April 2005, several lawsuits were filed against the Company
and certain of its officers, all of which are seeking class action status. The lawsuits were filed
in United States District Court for the District of Maryland and allege, among other things, that
the defendants, including the Company, made false and misleading public statements and omissions of
material facts concerning the Company. The Company believes it has meritorious defenses and intends
to defend vigorously against these actions. The Company is unable at this time to predict the
outcome of these lawsuits or reasonably estimate a range of possible loss, if any. OtherThe Company is involved in various other legal actions primarily concerning its intellectual
property. Management believes that these actions, either individually or in the aggregate, will not
have a material adverse effect on the Companys results of operations or financial condition. 9. STOCKHOLDERS EQUITY In January 2005, the Company completed an underwritten public offering of 1,756,614 shares of
common stock at price of $49.10 per share pursuant to a shelf registration statement. Net proceeds
to the Company, after deducting an underwriting discount and offering expenses, amounted to
approximately $81.4 million. Of the proceeds, $30 million was used for the partial repayment of
debt with the remainder intended to be used for capital expenditures, working capital and general
corporate purposes. During the six months ended
April 30, 2005, approximately 400,000 stock options were exercised
resulting in proceeds to the Company of $12.1 million. Of the stock
options exercised, approximately 60% related to stock options held by
two former directors of the Company that retired from the Board of
Directors in March 2005. 10. NET INCOME PER SHARE Basic net income per share is computed using the weighted average number of common shares
outstanding. Diluted net income per share is computed using the weighted average number of common
shares outstanding, giving effect to stock options and warrants using the treasury stock method. The following table presents the calculation of basic and diluted net income per share (in
thousands, except per share amounts): Three months ended April 30,
    
    
    Six months ended April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net income
    
    $
    3,433
    
    
    $
    3,399
    
    
    $
    10,505
    
    
    $
    6,750Weighted average shares outstanding, basic
    
    
    31,497
    
    
    
    29,209
    
    
    
    30,540
    
    
    
    28,770Effect of dilutive potential common shares:Employee stock options
    
    
    1,131
    
    
    
    1,996
    
    
    
    1,035
    
    
    
    2,260Warrants
    
    
    21
    
    
    
    45
    
    
    
    20
    
    
    
    45Total dilutive potential common shares
    
    
    1,152
    
    
    
    2,041
    
    
    
    1,055
    
    
    
    2,305Weighted average shares outstanding, diluted
    
    
    32,649
    
    
    
    31,250
    
    
    
    31,595
    
    
    
    31,075Net income per share, basic
    
    $
    0.11
    
    
    $
    0.12
    
    
    $
    0.34
    
    
    $
    0.23Net income per share, diluted
    
    $
    0.11
    
    
    $
    0.11
    
    
    $
    0.33
    
    
    $
    0.22
 Employee stock options to purchase approximately 600,000, 100,000, 1.1 million and 100,000
shares were outstanding but were not included in the computation of diluted net income per share
for the three months ended April 30, 2005 and 2004 and the six months ended April 30, 2005 and
2004, respectively, because the effects would have been antidilutive. 12




---



##### 



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, product introductions, growth in
nutritional product sales, margin and productivity improvements and potential
collaborations and acquisitions;
    expectations regarding sales to and by our infant formula licensees;
    expectations regarding marketing of our oils by our infant formula licensees;
    expectations regarding future efficiencies in manufacturing processes and the cost of production of our nutritional oils;
    expectations regarding future purchases of third-party manufactured oils and expansion of third-party manufacturing facilities;
    expectations regarding the timing and amount of production capacity and our ability
to meet future demands for our nutritional oils;
    expectations regarding future research and development costs;
    expectations regarding our expansion at our Kingstree, South Carolina facility;
    expectations regarding the impact of the incident at the Winchester Wastewater Treatment Plant;
    expectations regarding additional capital expenditures needed in relation to our fermentation and oil processing activities;
    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 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 the risks that could cause such differences in Exhibit 99.01
to this report incorporated by reference into this 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 Martek was founded in 1985. We are a leader in the development and commercialization of products
derived from microalgae and other microbes. Our leading products are nutritional oils used as
ingredients in infant formula and foods and as ingredients in, and encapsulated for use as, dietary
supplements. Our nutritional oils are comprised of fatty acid components, primarily docosahexaenoic
acid, commonly known as DHA, and arachidonic acid, commonly known as ARA. Research has shown that
these fatty acids may enhance mental and visual development in infants, that they may play a
pivotal role in brain function throughout life, and that they may reduce the risk of cardiovascular
disease. Low levels of DHA in adults have been linked to a variety of health risks, including
Alzheimers disease. Further research is underway to assess the role of supplementation with our
DHA on a variety of health risks. Additional applications of our patented technology based upon
microalgae include our currently marketed fluorescent detection products that can be used by
researchers as an aid in drug discovery and diagnostics. We currently have license agreements with sixteen infant formula manufacturers, including Mead
Johnson Nutritionals, Wyeth, Abbott Laboratories, Nestle, Royal Numico N.V. (formerly Nutricia),
Novartis, Maabarot, Heinz-Watties, Laboratorios Ordesa, American St. George Biological
Corporation, International Nutrition Company, PT Sanghiang Perkasa, Takaso Rubber and three
companies whose identities we have agreed not to disclose at this time. Collectively, these
companies represent approximately 70% of the estimated $8.5 to $9.5 billion worldwide wholesale
market for infant formula and nearly 100% of the estimated $3.0 to $3.5 billion U.S. wholesale
market for infant formula, including the wholesale value of Women, Infant & Children program
(WIC) rebates. WIC is a federal grant program administered by the states for the benefit of
low-income, nutritionally at-risk women, infants and children. Our licensees are now selling term
infant formula products containing our oils collectively in over 30 countries and pre-term infant
formula products containing our oils collectively in over 60 countries around the world. 13




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##### 



For the six months ended April 30, 2005, we generated approximately $10.5 million in net income on
revenues of $122.3 million. Although we anticipate continued growth in annual sales of our
nutritional oils, and we have achieved annual operating profits since fiscal 2003, we may continue
to experience quarter-to-quarter and year-to-year fluctuations in our future operating results,
some of which may be significant. The timing and extent of such fluctuations will depend, in part,
on the timing and receipt of oils-related revenues. The timing and extent of future oils-related
revenues are largely dependent upon the following factors:  
    the ability by us, DSM and other third-party manufacturers to produce adequate levels of our nutritional oils on a consistent basis;
    the timing and extent of production expansion by us and DSM;
    the timing of infant formula market introductions by our licensees both domestically and internationally;
    the timing and extent of stocking and destocking of inventory by our licensees;
    the timing and extent of introductions of DHA into various child and/or adult applications;
    the continued acceptance of products containing our oils under state-administered reimbursement programs in the U.S.;
    the acceptance of these products by consumers and demand by our customers;
    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. As such, the likelihood, timing and extent of future profitability are largely dependent on factors
such as those mentioned above, as well as others, over which we have limited or no control. OVERVIEW As of April 30, 2005, we have substantially completed construction of our extensive expansion at
our Kingstree facility for the fermentation and processing of our nutritional oils. We have spent
approximately $186 million on the expansion since the inception of the project. With respect to
fermentation, four new fermentors commenced commercial operation in late 2004 and four additional
fermentors will be available for commercial operation in the second half of fiscal 2005. In
addition, DSM is continuing to expand its ARA production at its Belvidere, New Jersey facility
which began production in April 2004. With our Kingstree expansion, a phase-in of the current DSM
Belvidere expansion and the expected commencement of dedicated downstream ARA processing capacity
from a third-party provider, we expect to have aggregate maximum available production capacity,
including the capacity available through third parties, of infant formula and food DHA products
equivalent to approximately $500 million in annualized sales at some point in the second half of
fiscal 2005 should demand require it. Monthly production averaged approximately $330 million in
annualized sales during the second quarter of fiscal 2005. The results of several studies were recently published, further supporting the health benefits of
DHA. All of the following studies utilized Martek DHA.  
    Protection Against Alzheimers Disease The results of an animal study demonstrate that
DHA may protect against the accumulation of a protein believed to be linked to Alzheimers
disease.
    Improvement in Cholesterol Particle Size in At-Risk Children The results of a study
report that DHA causes beneficial changes in blood cholesterol measurements in children
with high cholesterol and a family history of heart disease.
    Infant Formula Supplemented with DHA and ARA Significantly Benefits Infant Development
The results of two studies further support the benefits of DHA and ARA to infant
development. The first study found that term infants fed infant formula supplemented with
DHA and ARA during the first year of life demonstrated better visual acuity than infants
not fed the supplemented formula. The second study found that infant formula supplemented
with DHA and ARA resulted in enhanced growth and higher Bayley psychomotor development
scores in preterm infants. The study indicated that infant formula with Martek DHA
resulted in greater growth in preterm infants than fish oil-DHA. The results of two adult cardiovascular studies which utilized Martek DHA were recently
released. We believe that these results add support to the use of Martek DHA in food applications
for cardiovascular health. Additional research will be needed to determine if Martek DHA can be
used in pharmaceutical applications. In May 2005, we learned that the Food and Drug Administration did not object to a Martek petition
filed earlier this year regarding a nutrient content claim. This claim now enables products
containing at least 32 milligrams of Martek DHA per serving to indicate that such products contain
an excellent source of DHA. We believe that the nutrient content claim should improve our current
and potential food customers ability to successfully market Martek DHA in their products. We recently received favorable rulings on two pending European patent matters. The first was a
ruling by the Opposition Division of the European Patent Office (EPO) which served to uphold our
European ARA patent in a form containing modified claims, which are narrower than the claims
originally granted, but provided the potential for additional patent protection. In the second
ruling, we received a decision from the Appeal Board of 14




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the EPO relating to one of our European DHA patents, covering primarily production processes and
human and animal food uses. This decision returns the case to the Opposition Division of the EPO to
review the patents claims on its merits. In March 2005, Hidden Villa Ranch began selling Gold Circle Farms liquid egg whites containing
Martek DHA. MANAGEMENT OUTLOOK We believe that the outlook for future revenue growth remains positive, although quarterly results
may show fluctuations, particularly if we experience unforeseen variances in production or continue
to experience inconsistent supply from DSM, our third-party ARA manufacturer. Specifically, we
believe that over the next twelve to twenty four months, current term infant formula products
containing our oils will continue to gain market share in existing markets, new products will be
added in those markets and term infant formulas containing our oils will also be introduced in
additional countries. During the third quarter of fiscal 2005, however, we anticipate a decline in
revenues and net income compared to the second quarter of fiscal 2005 as certain customers utilize
some accumulated safety stock inventory and delay anticipated new market launches internationally.
We believe that both the inventory build-up and the delays in expansion were responses, in part, to
our inability, including our third-party suppliers, to keep up with demand in fiscal 2004. To
date, twelve of our infant formula licensees are selling term infant formula products containing
our oils collectively in over 30 countries and pre-term infant formula products containing our oils
collectively in over 60 countries around the world. In the three and six months ended April 30, 2005, approximately 93% of our product sales revenues
related to the sales of our oils for use in infant formula and recently introduced toddler
products. We anticipate increased future sales of our oils for other products such as products
developed for pregnant and nursing mothers, cardiovascular health, and the food and beverage
market. We expect that the majority of these sales will come through partnering relationships with
larger companies in the nutritional and food and beverage markets. We anticipate that over the next
few years, these sales will expand and represent a larger potential market than infant formula. During fiscal 2004 and 2003,
the demand for our nutritional oils by our customers for use in infant formula products
exceeded production output and capacity and as such, we limited the orders we accepted for our
nutritional oils. Some of our customers responded to the shortages
and inconsistent supply by building inventory, and we have
had difficulty in predicting with certainty what our customers future ordering would be in light
of limited visibility into our customers supply chain and expansion
plans. To address our production output and capacity
issues, we and DSM have added production capacity. In this regard, DSM continues to increase its
quarterly ARA output, but has been unable to produce optimally over an extended period at its
Belvidere facility; however, we do not expect these inconsistencies
in ARA production to affect our ability to meet orders during the
remainder of fiscal 2005 and we do continue to expect to build ARA
inventory during this period. To improve visibility into our customers planned orders and to better
understand the base level of orders required to meet current demand, we have worked closely with
our customers to obtain new order projections. Over the next twelve to eighteen months, we expect
infant formula sales for the U.S. market to continue to grow at a measured pace consistent with the
consumer demand growth that has been experienced in recent months. Expansion by our customers into
new international markets offers a potentially faster growth rather, but is subject to the timing
of the launches. We are aware of some recent international launches by our customers, but we still
do not yet have information sufficient to determine the level to which these international
expansions will contribute to short-term revenue and earnings. PRODUCTION We manufacture oils rich in DHA at our fermentation and oil processing facilities located in
Winchester, Kentucky and Kingstree, South Carolina. As of April 30, 2005, we have substantially
completed construction of our extensive expansion at our Kingstree facility for the fermentation
and processing of our nutritional oils. We have spent approximately
$186 million on the expansion
since the inception of the project. With respect to fermentation, four new fermentors commenced
commercial operation in late 2004 and four additional fermentors will be available for commercial
operation in the second half of fiscal 2005. As the construction in
Kingstree is near completion, the construction and project management services formerly provided by
Clark Construction
Group to Martek have been completed. Our ARA oils are purchased from DSM as manufactured at its Capua, Italy and Belvidere, New Jersey
plants. DSM is currently expanding its ARA production capabilities at its Belvidere facility,
which has been increasing its quarterly output. However, Belvidere also continues to incur startup
costs and experience inconsistencies in monthly output, which we believe should be resolved by DSM
in the upcoming months. We do not expect these inconsistencies in ARA production to affect our
ability to meet orders during the remainder of fiscal 2005 and we do continue to expect to build ARA
inventory during this period. We are now receiving a significant portion of our ARA from DSMs
Belvidere facility with that portion expected to grow as DSM completes its current expansion at
Belvidere. Because DSM is a third-party manufacturer, we do not have full control over the timing
and extent of its Capua and Belvidere production volumes. As part of the April 2004 agreement with
DSM, we are required to guarantee the recovery to DSM of certain expansion costs incurred by them.
This guarantee will decline in value as we purchase ARA from DSM in the future. As of April 30,
2005, the value of our current guarantee to DSM, which is related to DSMs phase one expansion, is
approximately $1.6 million. In addition, we are in the process of negotiating an amendment to the
April 2004 agreement with DSM. This amendment is expected to establish the overall economics
associated with DSMs current expansions at both facilities, including our guarantee of such
expansion costs, with such guarantee expected to approximate $40 million. In addition, the
amendment will establish the pricing to us for certain ARA that we have purchased and will purchase
from DSM during calendar 2005. Annual ARA pricing utilizes a cost-plus arrangement and is based
on the prior years actual costs incurred adjusted for current year expectations. Calendar 2005 ARA purchases have been valued by us
based on amounts invoiced from DSM, but 15




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certain such amounts are still subject to final adjustment. Based
on cost estimates received from DSMs Capua and Belvidere facilities, we expect our current
valuation to approximate the agreed-upon amounts when the negotiations with DSM are complete. We have attempted to reduce the risk inherent in having a single supplier, such as DSM, through
certain elements of the supply agreement entered into with DSM in April 2004. In connection with
this agreement, we have licensed the DSM technology associated with ARA production. Through this
license and the overall supply arrangement, we have the ability to produce, either directly or
through another third party, an unlimited amount of ARA. The sale of such self-produced ARA is
limited annually, however, to the greater of (i) 100 tons of ARA oil or (ii) any amounts ordered by
us that DSM is unable to fulfill. We have begun the internal fermentation of ARA at both our
Kingstree and Winchester facilities and anticipate having the resulting ARA oil available for sale
by the end of the third quarter of fiscal 2005. We may increase the amount of ARA fermented
internally in order to grow our ARA finished goods inventory levels. This internally produced ARA,
however, will likely result in significant start-up costs and may impact gross profit margin until
our ARA production techniques are able to generate standard commercial yields. To further improve
our overall ARA supply chain, we have directly engaged and recently added a new U.S.-based provider
of certain post-fermentation ARA manufacturing services and have added additional ARA downstream
processing capacity at Kingstree. Along with our ARA extraction capabilities at Kingstree, the
addition of the new third-party facility will give us multiple U.S. sites for the downstream
processing of ARA. When combining our current DHA production capabilities in Winchester and Kingstree with DSMs
current ARA production capabilities in Italy and the U.S., we currently have maximum capacity for
all DHA and ARA products in place equivalent to $380 million to $400 million of annual revenue,
although production is not yet consistently reaching this level as there have been some start-up
related fluctuations in output at DSMs Belvidere facility, as noted above. Monthly production was
as high as the equivalent of $400 million of revenue on an annualized basis during the second quarter, but averaged $330
million on an annualized basis. As such, actual output could be up to 30% lower versus maximum
available production levels. Maximum capacity is expected to increase throughout the remainder of
fiscal 2005 as DSM expands its Belvidere plant, and we expect to have maximum available production
capacity equivalent to approximately $500 million in annualized sales of infant formula and food
DHA products at some point in the second half of fiscal 2005. We also believe that production
optimization efforts will continue at our plants for the next several years as new technologies and
additional algal strains are tested to further increase output and reduce costs. With our pending
increase to $500 million of annualized production capacity, our production capabilities are
expected to exceed current demand; however, we have the ability to
control output and will do so based on anticipated demand levels.
During the third quarter of fiscal 2005, we expect
that we will no longer have to limit the orders we accept from customers. We have several other contractual agreements with third-party manufacturers to assist in the
production of our nutritional oils. We have an agreement for the production of DHA-S biomass that
we sell to animal feed companies or process further for use in the adult supplement and food and
beverage markets. We currently have a minimum purchase commitment under this agreement that
expires on June 30, 2006. As of April 30, 2005, our remaining obligation was approximately $3.2
million. We also have an agreement to purchase from a third-party manufacturer a minimum quantity
of extraction services to be utilized in ARA production. This commitment expires on December 31,
2007. As of April 30, 2005, our remaining obligation under this commitment was approximately $14.6
million. The commercial success of our nutritional oils will depend, in part, on our ability to manufacture
these oils or have them manufactured at large scale on a continuous basis and at a commercially
acceptable cost. Our success will also be somewhat dependent on our ability to better predict
customer demand and align that with our production. If the production expansion plans of DSM do
not proceed as anticipated or if market demand subsides due to our inability to meet demand for our
products, our results could be negatively impacted. There can also be no assurance that we will be
able to successfully optimize production of our nutritional oils, or continue to comply with
applicable regulatory requirements, including GMP requirements. Under the terms of several of our
infant formula licenses, our licensees may elect to manufacture these oils themselves. We are
currently unaware of any of our licensees producing our oils or preparing to produce our oils, and
estimate that it would take a licensee a minimum of one year to implement our process of making our
oils. CRITICAL ACCOUNTING POLICIES AND
THE USE OF ESTIMATES The preparation of our consolidated financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates and assumptions that
affect the amounts reported in our consolidated financial statements and accompanying notes. On an
ongoing basis, we evaluate our estimates and judgments, which are based on historical and
anticipated results and trends and on various other assumptions that we believe are reasonable
under the circumstances, including assumptions as to future events. By their nature, estimates are
subject to an inherent degree of uncertainty and, as such, actual results may differ from our
estimates. We discuss accounting policies and assumptions that involve a higher degree of judgment
and complexity than others in our Managements Discussion and Analysis of Financial Condition and
Results of Operations in our Annual Report to shareholders on Form 10-K for the year ended October
31, 2004. 16




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RESULTS OF OPERATIONS Revenues
The following table presents revenues by category (in thousands): Three months ended April 30,
    

    
    Six months ended April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Product sales
    
    $
    52,834
    
    
    $
    38,187
    
    
    $
    115,945
    
    
    $
    70,418Contract manufacturing sales
    
    
    2,997
    
    
    
    3,733
    
    
    
    6,375
    
    
    
    7,077Total revenues
    
    $
    55,831
    
    
    $
    41,920
    
    
    $
    122,320
    
    
    $
    77,495
 Product sales increased by $14.6 million or 38% in the quarter ended April 30, 2005 as compared
to the quarter ended April 30, 2004 and increased by $45.5 million or 65% in the six months ended
April 30, 2005 as compared to the six months ended April 30, 2004. The increases are primarily due
to an increase in sales of our oils to both existing and new infant formula licensees.
Substantially all of our product sales in the quarter and six months ended April 30, 2005 and 2004
relate to the sale of our oils for use in infant formulas. Included in product sales in the
quarter and six months ended April 30, 2005 were $1.8 and $4.1 million, respectively, in sales of
DHA oil for the pregnancy and nursing market, such sales having begun during the fourth quarter of
fiscal 2004. Approximately 90% of our product sales in the quarter and six months ended April 30,
2005 was generated by sales to Mead Johnson Nutritionals, Abbott Laboratories, Nestle and Wyeth.
Although we are not given precise information by our customers as to the countries in which infant
formula containing our oils is ultimately sold, we estimate that approximately two-thirds of our
sales to infant formula licensees for the three and six months ended April 30, 2005 relate to sales
in the U.S. The first infant formulas containing our oils were introduced in the U.S. in February
2002 and, as of April 30, 2005, we estimate that formula
supplemented with our oils had penetrated approximately 75%
of the U.S. infant formula market. We anticipate that annual product sales will continue to grow as our licensees expand in countries
where our products are currently sold and as our licensees introduce infant formulas and other
products containing our oils in additional countries. We also anticipate, however, that product
sales and total revenues in the third quarter of fiscal 2005 will decline from the levels achieved
in the first and second quarters of fiscal 2005 as certain customers utilize some accumulated
safety stock inventory and delay anticipated new market launches. Our future sales growth is
dependent to a significant degree upon the following factors:
(i) the launches of existing products
containing our nutritional oils by our customers in new markets; (ii) the ability of DSM to
complete the expansion of its production of ARA at its Belvidere, New Jersey facility; (iii) our
ability to maintain a consistent flow of production, both internally and from DSM, from month to
month; and (iv) the launches of new products containing our nutritional oils by current or future
customers. Contract manufacturing sales revenues, totaling $3.0 million and $6.4 million in the three and six
months ended April 30, 2005, respectively, and $3.7 million and $7.1 million in the three and six
months ended April 30, 2004, respectively, relate to fermentation work performed for various third
parties at the Kingstree, South Carolina facility. As a result of the above, total revenues increased by $13.9 million or 33% in the quarter ended
April 30, 2005 as compared to the quarter ended April 30, 2004 and increased by $44.8 million or
58% in the six months ended April 30, 2005 as compared to the six months ended April 30, 2004. Costs and
Expenses
The following table presents our operating costs and expenses (in thousands): Three months ended April 30,
    
    
    Six months ended April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Cost of revenue:Cost of product sales
    
    $
    32,792
    
    
    $
    24,253
    
    
    $
    68,894
    
    
    $
    43,778Cost of contract manufacturing sales
    
    
    2,585
    
    
    
    2,928
    
    
    
    5,389
    
    
    
    5,637Operating expenses:Research and development
    
    
    5,321
    
    
    
    4,701
    
    
    
    10,137
    
    
    
    8,728Selling, general and administrative
    
    
    8,107
    
    
    
    6,111
    
    
    
    16,252
    
    
    
    11,908Other operating expenses
    
    
    2,075
    
    
    
    654
    
    
    
    5,560
    
    
    
    1,104Total costs and expenses
    
    $
    50,880
    
    
    $
    38,647
    
    
    $
    106,232
    
    
    $
    71,155
 Cost of Product SalesCost of product sales decreased as a percentage of product sales to 62%
in the quarter ended April 30, 2005 from 64% in the quarter ended April 30, 2004 and decreased as a
percentage of product sales to 59% in the six months ended April 30, 2005 from 62% in the six
months ended April 30, 2004. The decrease was primarily due to the benefits of certain DHA
production improvements recently implemented and the elimination of
certain cost inefficiencies that existed during the expansion of
Kingstree in the prior year. Cost of Contract Manufacturing SalesCost of contract manufacturing sales, totaling $2.6 million
and $5.4 million in the three and six months ended April 30, 2005, respectively, and $2.9 million
and $5.6 million in the three and six months ended April 30, 2004, respectively, are the costs
related to 17




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the fermentation work performed for various third parties at our Kingstree, South Carolina
facility. Our contract manufacturing sales achieve significantly lower gross margins than our
product sales but contribute to the recovery of our fixed overhead costs. Research and DevelopmentResearch and development expenses, primarily development, increased by
$600,000 or 13% in the quarter ended April 30, 2005 as compared to the quarter ended April 30, 2004
and increased by $1.4 million or 16% in the six months ended April 30, 2005 as compared to the six
months ended April 30, 2004. The increase was primarily the result of additional efforts to
improve fermentation yields for DHA, ARA and food DHA and to optimize downstream processes for food
DHA. Selling, General and AdministrativeOur selling, general and administrative costs
increased by $2.0 million or 33% in the quarter ended April 30, 2005 as compared to the quarter
ended April 30, 2004 and increased by $4.3 million or 36% in the six months ended April 30, 2005 as
compared to the six months ended April 30, 2004. The increase was primarily due to additional
personnel costs (increases of $900,000 and $1.8 million in the comparative three and six months,
respectively), legal costs (increases of $400,000 and $800,000 in the comparative three and six
months, respectively) and insurance costs (increases of $400,000 and $800,000 in the comparative
three and six months, respectively) required to accelerate and manage our overall growth as well as
increases related to Sarbanes-Oxley Act compliance (increases of $300,000 and $400,000 in the
comparative three and six months, respectively). Other Operating ExpensesWe incurred other operating expenses of $2.1 million and $5.6 million in
the three and six months ended April 30, 2005, respectively, and $700,000 and $1.1 million in the
three and six months ended April 30, 2004, respectively. These costs in fiscal 2005 were
comprised primarily of start-up costs related to large-scale trials with certain fermentors and
extraction facilities at both Kingstree and Winchester for the production of ARA and costs
associated with the expansion in Kingstree. Other Income, Net Our other income, net, increased by $300,000 and $46,000 in the three and six months ended April
30, 2005 as compared to the three and six months ended April 30, 2004, respectively, due primarily
to increases in interest and other income related to increased amounts of cash, cash equivalents
and short-term investments. Provision for Income Taxes The provision for income taxes totaled $2.0 million and $6.0 million in the three and six months
ended April 30, 2005, respectively, and has been recorded based upon our estimated effective tax
rate for fiscal 2005. Based on our positive historical earnings trend and projected operating
results, during the fourth quarter of fiscal 2004, we reversed approximately $51 million of our
deferred tax asset valuation allowance, having determined that it is more likely than not that this
portion of the deferred tax asset will be realized. As a result, income tax expense has been
recorded based on pre-tax income for the quarter despite the fact that we continue to have
significant net operating loss carryforwards which will mitigate much of our cash tax expenditures
during fiscal 2005. As of October 31, 2004, we had net operating loss carryforwards for federal income tax purposes of
approximately $200 million. Approximately $3 million of this amount will expire, if unused, by the
end of fiscal 2007 with the remainder expiring through fiscal 2023. Of the total net operating
loss carryforwards, approximately $56 million continues to be fully reserved through a valuation
allowance as realizability of these assets is uncertain at this time. Should realization of these
and other deferred tax assets become more likely than not, approximately $9.4 million of the
resulting benefit will be reflected as an income tax benefit upon reversal of the allowance,
approximately $8.8 million will be reflected as a reduction to goodwill and approximately $3.9
million will be reflected as an increase to stockholders equity. Net Income As a result of the foregoing, net income was $3.4 million in both the three months ended April 30,
2005 and the three months ended April 30, 2004, and net income was $10.5 million in the six months
ended April 30, 2005 as compared to net income of $6.8 million in the six months ended April 30,
2004. RECENTLY ISSUED
ACCOUNTING PRONOUNCEMENTS In October 2004, the FASB concluded that SFAS No. 123 (revised 2004), Share-Based Payment (SFAS
123R), which would require all companies to measure compensation cost for all share-based
payments (including employee stock options) at fair value, would be effective for interim or annual
periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission
delayed the effective date of SFAS 123R to the annual period beginning after June 15, 2005. SFAS
123R provides two tentative adoption methods. The first method is a modified prospective transition
method whereby a company would recognize share-based employee costs from the beginning of the
fiscal period in which the recognition provisions are first applied as if the fair-value-based
accounting method had been used to account for all employee awards granted, modified, or settled
after the effective date and to any awards that were not fully vested as of the effective date.
Measurement and attribution of compensation cost for awards that are unvested as of the effective
date of SFAS 123R would be based on the same estimate of the grant-date fair value and the same
attribution method used previously under SFAS No. 123, Accounting for Stock-Based Compensation
(SFAS 123). The second adoption method is a modified retrospective transition method whereby a
company would recognize employee compensation cost for periods presented prior to the adoption of
SFAS 123R in accordance with the original provisions of SFAS 123; that is, an entity would
recognize employee 18




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compensation costs in the amounts reported in the pro forma disclosures provided in accordance with
SFAS 123. A company would not be permitted to make any changes to those amounts upon adoption of
SFAS 123R unless those changes represent a correction of an error. For periods after the date of
adoption of SFAS 123R, the modified prospective transition method described above would be applied.
We currently expect to adopt SFAS 123R in the quarter ended January 31, 2006 using the modified
prospective method, although we continue to review our options for adoption under this new
pronouncement. After giving effect to the accelerated vesting of certain stock options in December
2004 and January and May 2005 and based upon our projection of unvested stock options at the
implementation date, we expect the adoption to result in the recognition of additional compensation
cost of approximately $3.0 million during fiscal 2006. In December 2004, the FASB issued SFAS No. 151, Inventory Costs (SFAS 151). SFAS 151 requires
abnormal amounts of inventory costs related to idle facility, freight handling and wasted material
expenses to be recognized as current period charges. Additionally, SFAS 151 requires that
allocation of fixed production overheads to the costs of conversion be based on the normal capacity
of the production facilities. The standard is effective for fiscal years beginning after June 15,
2005. We are currently evaluating the impact on our consolidated financial statements that will
result from adopting SFAS 151. LIQUIDITY AND CAPITAL RESOURCES We have financed our operations primarily from the following sources:  
    cash generated from operations;
    proceeds from the sale of equity securities;
    cash received from the exercise of stock options and warrants; and
    debt financing. At April 30, 2005, our primary sources of liquidity were our cash, cash equivalents and short-term
investments totaling $57.1 million as well as the available portion of our revolving credit
facility of $45.0 million. Cash, cash equivalents and short-term investments increased $14.4
million from October 31, 2004. This increase was primarily generated by the proceeds from the
issuance of common stock under our shelf registration statement of $81.4 million, partially offset
by the repayment of borrowings under our revolving credit facility of $30 million and capital
expenditures of $45.5 million, the majority of which related to the expansion of the Kingstree
facility to increase output of our nutritional oils. Investments in our production facilities in Kingstree, South Carolina and Winchester, Kentucky have
and will continue to have a material effect upon our liquidity and capital resources in fiscal
2005. We expect to invest at least $15 million over the remainder of fiscal 2005 in plant and
equipment expenditures as well as for other company-wide capital needs. Throughout the construction
periods, all interest incurred on borrowings will be capitalized to the extent that the borrowings
are used to cover the balance of projects under construction. In the three and six months ended
April 30, 2005, we incurred interest on borrowings of approximately $700,000 and $1.8 million and
recorded amortization of related debt fees of approximately $100,000 and $200,000, of which
approximately $800,000 and $1.7 million was capitalized, respectively. Since our inception, we have raised approximately $410 million from public and private sales of our
equity securities, as well as from option and warrant exercises. Including net income of $10.5
million in the six months ended April 30, 2005, our accumulated deficit at April 30, 2005 is $54.0
million. The following table sets forth our future minimum payments under contractual obligations at April
30, 2005: Less than
    
    
    1-3
    
    
    3-5
    
    
    More thanIn thousands
    
    Total
    
    
    1 year
    
    
    years
    
    
    years
    
    
    5 yearsNotes payable (1)
    
    $
    14,017
    
    
    $
    1,146
    
    
    $
    2,141
    
    
    $
    2,038
    
    
    $
    8,692Borrowings under revolving credit facility
    
    
    55,000
    
    
    
    
    
    
    
    55,000
    
    
    
    
    
    
    
    Operating and capital lease obligations
    
    
    16,907
    
    
    
    3,435
    
    
    
    7,050
    
    
    
    5,486
    
    
    
    936DSM license fee and other obligations
    
    
    2,917
    
    
    
    2,333
    
    
    
    584
    
    
    
    
    
    
    
    Unconditional inventory purchase obligations
    
    
    17,750
    
    
    
    9,780
    
    
    
    7,970
    
    
    
    
    
    
    
    Total contractual cash obligations
    
    $
    106,591
    
    
    $
    16,694
    
    
    $
    72,745
    
    
    $
    7,524
    
    
    $
    9,628
    As part of the acquisition of FermPro, we assumed a $10 million note with a stated interest rate of
5%. The note was amended in January 2004 and is now an unsecured obligation with a maturity date of
December 31, 2014. Principal is amortized over a 20-year period, with the balance due at maturity.
Also as part of the FermPro acquisition, we assumed a long-term note of approximately $400,000, due
in 2023 with a 7% stated interest rate. 19




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##### 



In April 2004, we entered into a new agreement with DSM extending the existing relationship between
the two companies involving the production and supply of ARA, one of our nutritional oils that we
sell to our infant formula licensees. Among other things, this agreement provides for the sale to
us by DSM of a license related to certain technologies associated with the manufacture of ARA. This
sale involved a license fee totaling $10 million, $4 million of which was paid upon execution of
the agreement, $4 million of which was paid on November 2, 2004, and the remaining $2 million of
which will be paid on November 2, 2005. This agreement also provides for the guarantee by us of
DSMs recovery of certain expansion costs incurred by them. This guarantee will decline in value
as we purchase ARA from DSM in the future. As of April 30, 2005, the value of our current
guarantee to DSM related to DSMs phase one expansion is approximately $1.6 million. In addition,
we are in the process of negotiating an amendment to the April 2004 agreement with DSM. This
amendment is expected to establish the overall economics associated with DSMs current expansions
at both of its facilities, including our guarantee of such expansion costs, with such guarantee
expected to approximate $40 million. In May 2004, we entered into a $100 million secured revolving credit facility. The revolving
credit facility is collateralized by accounts receivable and inventory and expires in February
2007. The weighted average interest rate on the credit facility was approximately 4.8% and 4.5% for
the three and six months ended April 30, 2005, respectively, and is based on LIBOR and our current
leverage ratio. Among other things, the credit facility agreement contains restrictions on future
debt, the payment of dividends and the further encumbrance of assets. In addition, the credit
facility requires that we comply with specified financial ratios and tests, including minimum
liquidity, minimum coverage ratios and maximum leverage ratios. We do not believe that these
covenants restrict our ability to carry out our current business plan. As of April 30, 2005, we
were in compliance with all of these debt covenants and had outstanding borrowings of $55 million
under the revolving credit facility. In August 2004, our shelf registration statement was declared effective by the Securities and
Exchange Commission. The shelf registration statement enables us to raise funds through the
offering of debt securities, preferred stock, common stock and warrants, as well as any combination
thereof, from time to time and through one or more methods of distribution, in an aggregate amount
of up to $200 million. In January 2005, we completed an underwritten public offering of 1,756,614
shares of our common stock at price of $49.10 per share pursuant to the shelf registration
statement. Net proceeds to us, after deducting an underwriting discount and offering expenses,
amounted to approximately $81.4 million. Of the proceeds, $30 million was used for the partial
repayment of debt with the remainder intended to be used for capital expenditures, working capital
and general corporate purposes. Remaining availability under the shelf registration statement is
approximately $110 million at April 30, 2005. In October 2004, we entered into an operating lease for equipment at our Kingstree facility as part
of a sale/leaseback transaction. The equipment subject to lease was sold at its cost basis and
fair value of $10.8 million and simultaneously leased back to us. The lease expires in October
2009 and contains the same restrictions as our revolving credit facility. In December 2004, we
entered into an operating lease for equipment at our Kingstree facility subject to the same terms
and expiration as the October 2004 transaction. This second sale/leaseback transaction involved
the sale of equipment with a cost basis and fair value of $4.1 million. We believe that the revolving credit facility, when combined with our cash and short-term
investments of $57.1 million on-hand at April 30, 2005, and anticipated operating cash flows, will
provide us with adequate capital to meet our obligations for at least the next twelve to eighteen
months. The ultimate amount of additional funding that we may require will depend, among other things, on
one or more of the following factors:  
    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 costs to us if DSM cannot produce the ARA we require;
    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;
    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 putative securities class action lawsuits; and
    the costs of marketing and commercializing our products. We can offer no assurance that, if needed, any of our financing alternatives will be available to
us on terms that would be acceptable, if at all. 20




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##### 



OFF-BALANCE SHEET ARRANGEMENTS We have entered into lease agreements for certain laboratory and administrative space as well as
manufacturing equipment with rental payments aggregating $16.9 million over the remaining lease
terms, which expire through 2011. Included in these aggregate rentals are amounts related to
certain equipment leases, for which we are contingently liable for a residual value guarantee of
approximately $2.3 million. As part of our agreement with DSM, we agreed to guarantee DSMs recovery of certain expansion costs
incurred by them. This guarantee will decline in value as we purchase ARA from DSM in the future.
As of April 30, 2005, the value of our current guarantee to DSM related to DSMs phase one
expansion is approximately $1.6 million and the value of our guarantee to DSM related to DSMs
phase two expansion is expected to approximate $40 million upon completion of the current
negotiations. We do not engage in any other off-balance sheet financing arrangements. In particular, we do not
have any interest in entities referred to as variable interest entities, which include special
purpose entities and structured finance entities. 21




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Item 3. Quantitative and Qualitative Disclosures about Market Risk. Beginning in January 2004, purchases of ARA from DSMs plant in Capua, Italy were denominated in
euros, which exposes us to risks related to changes in exchange rates between the U.S. dollar and
the euro. Fluctuations between the U.S. dollar and the euro will impact our cost of ARA oil and
gross margins. We estimate that a 5% change in the exchange rate would impact gross margins of our
infant formula products by approximately 1.5%. Our exposure to these currency fluctuations has
begun to slightly decrease as DSM has now commenced ARA production in the U.S. at its Belvidere,
New Jersey facility. In April 2004, we began entering into foreign currency cash flow hedges to
reduce the related market risk on our payment obligations. We do not enter into foreign currency
cash flow hedges for speculative purposes. At April 30, 2005, we had unrealized losses on such
hedge instruments totaling $102,000, net of income tax benefit. We are subject to risk from adverse changes in interest rates, primarily relating to variable-rate
borrowings used to maintain liquidity and finance our manufacturing facility expansion. Based on
our variable-rate debt outstanding at April 30, 2005, a 1% change in LIBOR would change annual
interest by $550,000. At April 30, 2005, the carrying amounts of debt approximate fair value. Item 4. Controls and Procedures.  a)
    Evaluation of Disclosure Controls and Procedures.The management of Martek Biosciences
Corporation, with the participation of our Chief Executive Officer and the Chief Financial
Officer, has evaluated the effectiveness of our disclosure controls and procedures (as
defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as
amended (the Exchange Act)), as required by paragraph (b) of Rules 13a-15 and 15d-15
under the Exchange Act, and has concluded as of the end of the period covered by this
report that the disclosure controls and procedures were effective.b)
    Changes in Internal Controls.There were no changes in our internal controls 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 last fiscal quarter
that materially affected or are reasonably likely to materially affect the internal
controls over financial reporting. 22




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PART II  OTHER INFORMATION Item 1. Legal Proceedings. 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. Consistent with our request, the patent has been returned to the
Opposition Division for a determination as to whether it has met the legal requirement of
inventive step. A hearing is now scheduled for August 2005 and the process is not expected to be
completed until 2007. With respect to our ARA patent issued by the EPO, BASF AG, Friesland Brands B.V., and Suntory
Limited have 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 which are narrower than the claims originally
granted. We believe it is likely that the opponents will appeal the decision. In an effort to
broaden the claims of the patent, Martek also intends to appeal the decision. Marteks ARA oil
patent will remain in full force and effect throughout the appeal process. The appeal process is
not expected to be completed until some time in late 2006 or 2007. 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 have 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. The Company 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. The
appeal process is not expected to be completed until 2006. 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, Martek received a favorable decision from the Appeal Board of the EPO, which overturns the
decision of the Opposition Division and returns the case to the Opposition Division for review on
the merits of the patent claim. Any decision made by the Opposition Division can be appealed.
Assuming an appeal, the review process is expected to take approximately three to four years to
complete, during which time the patent will remain in full force and effect. We have entered into settlement agreements with the City of Winchester, the Winchester Municipal
Utilities Commission (WMU) and the insurer for the WMU with respect to a March 12, 2003 explosion
that occurred at a public wastewater treatment works in Winchester, Kentucky, resulting in property
damage. The settlement agreements provide for a full release with
respect to any claims that the City of Winchester, the WMU or the WMUs insurer may have against
the Company in connection with the matter and include settlement payments for amounts previously
accrued. As such, the settlements did not have a material impact on our financial condition or
results of operations. We learned in March 2004 that the federal Environmental Protection Agency (EPA), utilizing
personnel from its Criminal Investigation Division, had asked questions of current and former
Martek employees relating to the explosion at the wastewater treatment plant and n-hexane. Current
and former employees have testified before a federal grand jury that is investigating the matter.
We further learned in April 2005 that the EPA has interviewed two additional employees of Martek
and has requested information from the WMU on a number of matters including the March 12, 2003
explosion. While we cannot be certain of the outcome of the EPA investigation, we believe that the
outcome of the investigation will not have a material impact on our financial condition or results
of operations. 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 two patents to the
suit, bringing the total number that Nutrinova is accused of infringing to four 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. A scheduling hearing in the case was held in January 2005, and the trial
is scheduled for October 2006. A hearing before the court on the meaning and scope of the patent
claims in dispute is scheduled to be held in late November 2005. 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 by April 2006. Suntory has opposed our blended oil patent in Japan, where we believe there currently are no sales
of infant formula containing our blended oils. The patent was revoked by the Japanese Patent Office
and the revocation upheld by the Tokyo High Court in September 2004. We appealed this decision to
the Japanese Supreme Court and, as expected, that court has declined to hear the matter. Thus, the
revocation of this patent has become final. With respect to our Japanese ARA patent, the same
result has been reached. On October 18, 2004, we filed a Declaratory Judgment Complaint in the United States District Court
for the District of Maryland against Robert Zuccaro, as stockholders representative of the former
security holders of OmegaTech, Inc. The complaint was brought to seek to resolve Mr. 23




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##### 



Zuccaros claim that the former OmegaTech security holders are owed 666,119 additional Martek
shares under the Agreement and Plan of Merger by which we acquired OmegaTech because a milestone
under that agreement was allegedly met. That milestone was to be triggered if a report issued by
the Institute of Medicine of the National Academy of Science regarding the nutritional properties
of DHA met criteria specified in the merger agreement. We have asked the Court to declare that the
report does not fulfill the requirements of the milestone and that we are not required to
distribute the shares to the former security holders of OmegaTech. While we believe that our
position is meritorious and that the milestone was not met, no assurance can be given as to the
outcome of the litigation. On October 25, 2004, Mr. Zuccaro submitted a demand to the Judicial
Arbitration and Mediation Service, seeking to arbitrate this dispute. In December 2004, the
District Court ruled that the dispute over the milestone is not subject to arbitration.
Thereafter, on February 9, 2005, Mr. Zuccaro filed an answer and counterclaim. We have filed a
timely answer denying the allegations set forth in the counterclaim. Discovery is currently being
conducted. At this point, we project that a trial of the case would take place in the first half
of 2006. With respect to our ARA patent in South Korea, where we believe there are limited sales of infant
formula containing our ARA oil, Suntory has also filed an opposition. A hearing on the matter has
not been scheduled. Suntory has also initiated an invalidation case against our blended oil patent
in South Korea. Our response to Suntory was filed in February 2005. No hearing date has been set.
At this point, it is not possible to indicate what the likely outcome of these two South Korean
matters will be. On May 4, 2005, a putative class action lawsuit was filed in the United States District Court for
the District of Maryland, against us and certain of our officers, captioned Reed Black v. Martek
Biosciences Corporation, et al., Case No. MJG 05 CV1224. Since then, several other putative class
action lawsuits were filed against us and certain of our officers in the United States District
Court of Maryland making similar allegations.
These other putative class actions lawsuits are captioned as follows: Brocco v. Martek Biosciences
Corp., et. al., Case No. MJG 05 CV 1257; Sowattanangkul v. Martek Biosciences Corp., et. al., Case
No. MJG 05 CV 1309; Wright v. Martek Biosciences Corp., et. al., Case No. 05-1354; Epstein v.
Martek Biosciences Corp., et. al.,Case No. MJG 05 CV 1508; and Fujitake v. Martek Biosciences
Corp., et. al., Case No. MJG 05 CV 1514. The Court has not yet entered any Orders regarding the
consolidation of the pending cases or the appointment of lead plaintiffs or the approval of such
plaintiffs selection of lead counsel nor has the Court made a determination of whether a putative
class can be certified. At this time, plaintiffs have not specified the amount of damages they are
seeking in the actions. These actions claim to be filed on behalf of the purchasers of the
Companys common stock during a purported class period beginning December 9, 2004 and ending April
27, 2005. The complaints allege, among other things, violations of Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended, and Rule 10b-5, promulgated thereunder. In addition,
one of the complaints purports to be brought on behalf of those persons who purchased or
otherwise acquired our common stock in our public offering in
January 2005 and alleges violations of
Sections 11, 12(a)(2) and 15 of the Securities Act of 1933, as amended. The complaints allege
generally that we and the individual defendants made false or misleading public statements and
failed to disclose material facts regarding our business and prospects in public statements we
made or failed to make during the period and, in the case of the Securities Act of 1933 claims, in
our January 2005 prospectus. In addition, from time to time, Martek is a party to litigation or administrative proceedings
relating to claims arising from its operations in the normal course of business. Management
believes that the ultimate resolution of any such litigation or administrative proceedings
currently pending against Martek is unlikely, either individually or in the aggregate, to have a
material adverse effect on Marteks results of operations or financial condition. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. None. Item 3. Defaults Upon Senior Securities. Not Applicable. 24




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##### 



Item 4. Submission of Matters to a Vote of Security Holders. Marteks Annual Meeting of Stockholders was held on March 17, 2005. Following are descriptions of
the matters voted on and the results of such voting: Proposal 1: Election of Directors: The following members were elected to Marteks Board of Directors to hold office for the term
expiring at the 2008 Annual Meeting of Stockholders: Votes For
    
    
    Votes Withheld%
    
    
    
    
    
    
    
    %Henry Linsert, Jr.
    
    
    26,369,297
    
    
    
    98.0
    
    
    
    532,096
    
    
    
    2.0Sandra Panem, Ph.D.
    
    
    25,941,380
    
    
    
    96.4
    
    
    
    960,013
    
    
    
    3.6
 In addition, the following directors retired on March 17, 2005: Jules Blake, Ph.D. and Ann L.
Johnson, M.D. The following directors are continuing in office for the terms noted: Term ExpiresJames R. Beery
    
    2006Robert J. Flanagan
    
    2006Gordon S. Macklin
    
    2006Douglas J. MacMaster, Jr.
    
    2007John H. Mahar
    
    2007Richard J. Radmer
    
    2006Eugene H. Rotberg
    
    2007
 Proposal 2: Approval of the Amendment and Restatement of the Companys 2004 Stock Incentive Plan: The proposal was approved by the following vote: For
    
    
    Against
    
    
    Abstain
    
    
    Non-vote%
    
    
    
    
    
    
    
    %
    
    
    
    
    
    
    
    %
    
    
    
    
    
    
    
    %17,424,004
    
    
    84.2
    
    
    
    3,273,436
    
    
    
    15.8
    
    
    
    43,249
    
    
    
    0.0
    
    
    
    6,160,704
    
    
    
    0.0
 Item 5. Other Information. None. Item 6. Exhibits. 3.01
    
    Amended By-Laws of Registrant.*10.01
    
    Martek Biosciences Corporation Amended and Restated 2004 Stock Incentive Plan (filed as
Appendix A to the Companys Definitive Proxy, Schedule 14A, filed on February 8, 2005 and
incorporated by reference herein). +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. *
 25




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##### 



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.*99.01
    
    Cautionary Statements for purposes of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995.*
     26




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##### 



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized. MARTEK BIOSCIENCES CORPORATION(Registrant)Date: June 9, 2005
    
    /s/ Peter L. BuzyPeter L. Buzy, Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)
 27