##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended July 31, 2004 or [   ]
    
    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
(State of Incorporation)
    
    52-1399362
(IRS Employer Identification No.)
 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. [X] Yes [   ] No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). [X] Yes [   ] No Common stock, par value $.10 per share: 29,320,202 shares outstanding as of September 7, 2004




---



##### 



PART I - FINANCIAL INFORMATION Item 1. Financial Statements
 MARTEK BIOSCIENCES CORPORATION
 Consolidated Balance Sheets
($ in thousands, except share and per share data) July 31,
    
    October 31,2004
    
    2003(Unaudited)AssetsCurrent assetsCash and cash equivalents
    
    $
    18,164
    
    
    $
    29,924Short-term investments and marketable securities
    
    
    19,559
    
    
    
    67,047Accounts receivable, net
    
    
    30,103
    
    
    
    20,164Inventories, net
    
    
    24,909
    
    
    
    14,543Other current assets
    
    
    6,739
    
    
    
    6,666Total current assets
    
    
    99,474
    
    
    
    138,344Property, plant and equipment, net
    
    
    236,916
    
    
    
    88,314Goodwill
    
    
    50,693
    
    
    
    50,274Other intangible assets, net
    
    
    30,019
    
    
    
    18,378Other assets
    
    
    1,547
    
    
    
    213Total assets
    
    $
    418,649
    
    
    $
    295,523Liabilities and stockholders equityCurrent liabilitiesAccounts payable
    
    $
    17,769
    
    
    $
    14,988Accrued liabilities
    
    
    16,259
    
    
    
    12,020Current portion of notes payable and other current obligations
    
    
    617
    
    
    
    2,277Current portion of unearned revenue
    
    
    2,014
    
    
    
    2,841Total current liabilities
    
    
    36,659
    
    
    
    32,126Long-term debt under revolving credit facility
    
    
    77,000
    
    
    
    Notes payable and other long-term obligations
    
    
    11,627
    
    
    
    10,441Long-term portion of unearned revenue
    
    
    9,218
    
    
    
    8,992Total liabilities
    
    
    134,504
    
    
    
    51,559Commitments
    
    
    
    
    
    
    Stockholders 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; 29,290,701 and 28,041,323 shares issued and
and outstanding, respectively
    
    
    2,929
    
    
    
    2,804Additional paid-in capital
    
    
    381,117
    
    
    
    352,728Accumulated other comprehensive loss
    
    
    (94
    )
    
    
    Accumulated deficit
    
    
    (99,807
    )
    
    
    (111,568
    )Total stockholders equity
    
    
    284,145
    
    
    
    243,964Total liabilities and stockholders equity
    
    $
    418,649
    
    
    $
    295,523
 See accompanying notes. 2




---



##### 



MARTEK BIOSCIENCES CORPORATION Consolidated Statements of Income
(Unaudited - $ in thousands, except share and per share data) Three months ended July 31,
    
    Nine months ended July 31,2004
    
    2003
    
    2004
    
    2003Revenues:Product sales:Nutritional product sales
    
    $
    43,396
    
    
    $
    28,748
    
    
    $
    112,331
    
    
    $
    75,183Other product sales
    
    
    561
    
    
    
    292
    
    
    
    1,809
    
    
    
    754Total product sales
    
    
    43,957
    
    
    
    29,040
    
    
    
    114,140
    
    
    
    75,937Contract manufacturing sales
    
    
    3,273
    
    
    
    
    
    
    
    10,350
    
    
    
    Other revenue
    
    
    107
    
    
    
    75
    
    
    
    342
    
    
    
    170Total revenues
    
    
    47,337
    
    
    
    29,115
    
    
    
    124,832
    
    
    
    76,107Costs and expenses:Cost of product sales
    
    
    26,264
    
    
    
    17,017
    
    
    
    70,042
    
    
    
    45,001Cost of contract manufacturing sales
    
    
    2,912
    
    
    
    
    
    
    
    8,549
    
    
    
    Research and development
    
    
    4,932
    
    
    
    3,482
    
    
    
    13,660
    
    
    
    9,394Selling, general and administrative
    
    
    6,872
    
    
    
    4,115
    
    
    
    18,750
    
    
    
    11,550Restructuring reversal
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (250
    )Other operating expenses
    
    
    1,587
    
    
    
    247
    
    
    
    2,691
    
    
    
    1,313Total costs and expenses
    
    
    42,567
    
    
    
    24,861
    
    
    
    113,692
    
    
    
    67,008Income from operations
    
    
    4,770
    
    
    
    4,254
    
    
    
    11,140
    
    
    
    9,099Other income, net
    
    
    241
    
    
    
    349
    
    
    
    651
    
    
    
    656Income before income tax expense
    
    
    5,011
    
    
    
    4,603
    
    
    
    11,791
    
    
    
    9,755Income tax expense
    
    
    
    
    
    
    
    
    
    
    30
    
    
    
    Net income
    
    $
    5,011
    
    
    $
    4,603
    
    
    $
    11,761
    
    
    $
    9,755Net income per shareBasic
    
    $
    0.17
    
    
    $
    0.17
    
    
    $
    0.41
    
    
    $
    0.39Diluted
    
    $
    0.16
    
    
    $
    0.16
    
    
    $
    0.38
    
    
    $
    0.37Weighted average common shares outstandingBasic
    
    
    29,270,301
    
    
    
    27,050,781
    
    
    
    28,936,660
    
    
    
    24,793,415Diluted
    
    
    31,168,113
    
    
    
    29,399,615
    
    
    
    31,105,821
    
    
    
    26,544,481
 See accompanying notes. 3




---



##### 



MARTEK BIOSCIENCES CORPORATION Consolidated Statements of Cash Flows
(Unaudited - $ in thousands) Nine Months Ended July 31,2004
    
    2003Operating activities:Net income
    
    $
    11,761
    
    
    $
    9,755Adjustments to reconcile net income to net cash
(used in)/ provided by operating activities:Depreciation and amortization
    
    
    5,761
    
    
    
    3,691Provision for inventory obsolescence
    
    
    800
    
    
    
    93Other
    
    
    147
    
    
    
    280Changes in operating assets and liabilities:Accounts receivable
    
    
    (9,939
    )
    
    
    (9,908
    )Inventories
    
    
    (11,354
    )
    
    
    (2,393
    )Other assets
    
    
    (1,486
    )
    
    
    (3,192
    )Accounts payable
    
    
    2,781
    
    
    
    (125
    )Accrued liabilities
    
    
    145
    
    
    
    5,946Unearned revenue
    
    
    (601
    )
    
    
    7,178Net cash (used in)/provided by operating activities
    
    
    (1,985
    )
    
    
    11,325Investing activities:Sales (purchase) of short-term investments and marketable securities, net
    
    
    47,488
    
    
    
    (73,751
    )Purchase of property, plant and equipment
    
    
    (153,093
    )
    
    
    (908
    )Capitalization of intangible and other assets
    
    
    (6,968
    )
    
    
    (20,459
    )Cash impact of purchase transactions
    
    
    (231
    )
    
    
    940Net cash used in investing activities
    
    
    (112,804
    )
    
    
    (94,178
    )Financing activities:Repayments of notes payable and other
    
    
    (2,474
    )
    
    
    (107
    )Borrowings under revolving credit facility
    
    
    77,000
    
    
    
    Proceeds from the exercise of warrants and stock options
    
    
    17,222
    
    
    
    10,881Proceeds from the issuance of common stock, net of issuance costs
    
    
    11,281
    
    
    
    83,341Net cash provided by financing activities
    
    
    103,029
    
    
    
    94,115Net (decrease) increase in cash and cash equivalents
    
    
    (11,760
    )
    
    
    11,262Cash and cash equivalents at beginning of period
    
    
    29,924
    
    
    
    20,419Cash and cash equivalents at end of period
    
    $
    18,164
    
    
    $
    31,681
 See accompanying notes. 4




---



##### 



MARTEK BIOSCIENCES CORPORATION Consolidated Statement of Stockholders Equity
(Unaudited - $ in thousands) AccumulatedCommon Stock
    
    AdditionalPaid-in
    
    OtherComprehensive
    
    AccumulatedShares
    
    Amount
    
    Capital
    
    Loss
    
    Deficit
    
    TotalBalance at October 31, 2003
    
    
    28,041,323
    
    
    $
    2,804
    
    
    $
    352,728
    
    
    $
    
    
    
    $
    (111,568
    )
    
    $
    243,964Issuance of common stock,
net of issuance costs
    
    
    176,885
    
    
    
    18
    
    
    
    11,263
    
    
    
    
    
    
    
    
    
    
    
    11,281Exercise of stock options
and warrants
    
    
    1,072,493
    
    
    
    107
    
    
    
    17,115
    
    
    
    
    
    
    
    
    
    
    
    17,222Amortization of
deferred compensation
    
    
    
    
    
    
    
    
    
    
    11
    
    
    
    
    
    
    
    
    
    
    
    11Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,761
    
    
    
    11,761Other comprehensive loss:Unrealized loss on exchange
rate forward contract
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (94
    )
    
    
    
    
    
    
    (94
    )Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,667Balance at July 31, 2004
    
    
    29,290,701
    
    
    $
    2,929
    
    
    $
    381,117
    
    
    $
    (94
    )
    
    $
    (99,807
    )
    
    $
    284,145
 See accompanying notes. 5




---



##### 



MARTEK BIOSCIENCES CORPORATION 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 adjustments) considered necessary for a fair
presentation have been included. Operating results for the nine months ended
July 31, 2004 are not necessarily indicative of the results that may be
expected for the year ending October 31, 2004. 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, 2003. 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 financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. Revenue RecognitionThe Company recognizes revenue when persuasive evidence of
an arrangement exists, delivery has occurred, the fee is fixed or determinable,
and collectibility is probable. 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. Cash received as a payment on future purchases is deferred
and recognized as revenue when the related shipments are made. Revenue from
product licenses is deferred and recognized on a straight-line basis over the
term of the agreement. At July 31, 2004, the Company had approximately $2.0
million in short-term and $9.2 million in long-term unearned revenue relating
to third-party license agreements and prepayments on product purchases. Contract manufacturing revenue is recognized when goods are shipped to
customers and all other conditions for revenue recognition are met. Revenue
recognized is not subject to repayment. 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 as incurred. All
material transactions of the Company are denominated in U.S. dollars with the
exception of purchases of ARA from DSM Food Specialties (DSM) Capua, Italy
plant, which effective January 2004, are denominated in euros. Short-Term Investments and Marketable SecuritiesThe Company has classified all
short-term investments and marketable securities as available-for-sale.
Available-for-sale securities are carried at fair value and consist of U.S.
government obligations, U.S. agency obligations and taxable municipal auction
rate securities with average maturities of less than one year. Unrealized gains
or 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 and declines in value judged to be other than
temporary 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 6




---



##### 



in value below cost for debt securities where it is considered probable that
all contractual terms of the security will be satisfied, 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. 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 and qualification of certain third-party manufacturers
as well as amounts related to the Winchester wastewater treatment matter (See
Note 10). All such costs are expensed as incurred. Income TaxesUnder SFAS 109, deferred tax assets and liabilities are determined
based on differences between financial reporting and the tax basis of assets
and liabilities, and are measured using the enacted tax rates and laws that
will be in effect when the differences are expected to reverse. Valuation
allowances are provided against assets, including net operating losses, if it
is anticipated that some or all of the asset may not be realized through future
taxable earnings. As of October 31, 2003, the Company had net operating loss
carryforwards for federal income tax purposes of approximately $170 million. In
addition, the Company had a deferred tax asset of approximately $65.8 million
as of October 31, 2003, which was, and continues to be, fully reserved through
a valuation allowance since the likelihood of realization of the benefit cannot
be determined. The Company performs regular reviews of the asset and related
valuation allowance, and when and if the likelihood of realization of the
benefit becomes probable, the Company will reverse a portion or all of the
valuation allowance and record an income tax benefit. The Company anticipates
establishing a deferred tax asset in late 2004 or early 2005, based on expected
operating results. Comprehensive IncomeComprehensive income is comprised of net earnings and
other comprehensive income, which include 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
on its Consolidated Statements of Stockholders Equity. Stock-Based CompensationThe Company accounts for its employee stock option
plans using the intrinsic value method under the provisions of APB No. 25,
Accounting for Stock Issued to Employees, and related interpretations. No
stock-based employee compensation cost is reflected in net income, as all
options granted under the plans had an exercise price equal to 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 method in accordance
with Statement of Financial Accounting Standards No. 123 (SFAS No. 123). The
Company has adopted the disclosures outlined in SFAS No. 123, Accounting for
Stock-Based Compensation, as amended by SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure an Amendment of FASB
Statement No. 123. The following table illustrates the effect on net income and earnings per share
as if the Company had applied the fair value recognition provisions of SFAS No.
123, as amended by SFAS No. 148,to stock-based employee compensation: Three months ended
    
    Nine months endedJuly 31,
    
    July 31,In thousands, except per share amounts
    
    2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    5,011
    
    
    $
    4,603
    
    
    $
    11,761
    
    
    $
    9,755Deduct: Total stock-based employee compensation
expense determined under fair value-based
methods for all awards
    
    
    (6,673
    )
    
    
    (4,673
    )
    
    
    (14,326
    )
    
    
    (11,782
    )Pro forma net loss
    
    $
    (1,662
    )
    
    $
    (70
    )
    
    $
    (2,565
    )
    
    $
    (2,027
    )Earnings (loss) per share:Basic - as reported
    
    $
    0.17
    
    
    $
    0.17
    
    
    $
    0.41
    
    
    $
    0.39Basic - pro forma
    
    $
    (0.06
    )
    
    $
    (0.00
    )
    
    $
    (0.09
    )
    
    $
    (0.08
    )Diluted - as reported
    
    $
    0.16
    
    
    $
    0.16
    
    
    $
    0.38
    
    
    $
    0.37Diluted - pro forma
    
    $
    (0.06
    )
    
    $
    (0.00
    )
    
    $
    (0.09
    )
    
    $
    (0.08
    )
 7




---



##### 



The effect of applying SFAS No. 123 on pro forma net income and per share
calculations for the three and nine months ended July 31, 2004, as stated
above, is not necessarily representative of the effect on reported net income
and earnings per share for future years due to such things as the vesting
period of the stock options and the potential for issuance of additional stock
options in future years. The weighted average fair market values of the options at the date of grant for
options granted during the three months ended July 31, 2004 and 2003 and nine
months ended July 31, 2004 and 2003 were $42.29, $25.60, $41.69 and $18.69,
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
    
    Nine months endedJuly 31,
    
    July 31,2004
    
    2003
    
    2004
    
    2003Expected volatility
    
    
    68.1
    %
    
    
    75.0
    %
    
    
    68.1
    %
    
    
    74.7
    %Risk-free interest rate
    
    
    4.3
    %
    
    
    3.1
    %
    
    
    3.6
    %
    
    
    3.4
    %Expected average life of options
    
    
    7 years
    
    
    
    7 years
    
    
    
    7 years
    
    
    
    7 yearsExpected dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
 Net Income Per ShareBasic net income per share is computed using the weighted
average number of common shares outstanding during the period. 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. ReclassificationCertain amounts in the prior periods financial statements
have been reclassified to conform to the current period presentation. 2. Acquisition of FermPro Manufacturing On September 5, 2003, Martek Biosciences Kingstree Corporation (Martek
Kingstree) was created as a wholly-owned subsidiary of Martek to purchase
certain assets and assume certain liabilities of FermPro Manufacturing, LP
(FermPro), which operated a fermentation facility located in Kingstree, SC.
The purchase price of the assets acquired and liabilities assumed included a
payment of approximately $12.1 million, comprised of $5.4 million in cash,
124,788 shares of the Companys common stock valued at approximately $5.6
million, and approximately $1.1 million in acquisition-related fees and
expenses. In addition, a $10 million note was assumed as part of the
transaction. The acquisition has been accounted for as a purchase in accordance with SFAS
141, and accordingly, the results of operations of FermPro have been included
in the accompanying consolidated statements of income from the date of the
acquisition. In accordance with SFAS 142, the purchase price has been allocated
to the assets and liabilities of FermPro based on their relative fair values.
The allocation of the purchase price is preliminary and subject to revision
based on the final determination of fair values that is anticipated to be
completed during the Companys fourth quarter of fiscal year 2004. 3. 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, of which $4 million
was paid upon execution of the agreement, $4 million of which will be 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. (See Note 8). This
agreement also provides for the granting to DSM by the Company of an exclusive
license under certain of the Companys patents and intellectual property rights
for the production by DSM of products containing ARA that are not for human
consumption including animal feed products. 8




---



##### 



4. Acquisition of OmegaTech On April 25, 2002, the Company completed its purchase of OmegaTech, Inc.
(OmegaTech), a DHA-producer located in Boulder, CO. In connection with the
purchase, the Company issued 1,765,728 shares of the Companys common stock in
exchange for all of the outstanding capital stock of OmegaTech. The purchase
agreement also provided for additional stock consideration of up to $40
million, subject to certain pricing adjustments, if four milestones are 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 for the
OmegaTech DHA oil in certain 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 the
third quarter of fiscal 2003 upon the achievement of this milestone. The
payment of this additional consideration was recorded as goodwill. As of July 31, 2004, the Company does not believe the second regulatory related
milestone has been achieved. In addition, the Company does not believe the
first financial milestone related to sales and gross profit margin for the
eighteen-month period ended October 31, 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 first financial milestone should be issued. We
disagree with that conclusion. If this disagreement cannot be resolved, it is
likely that the dispute-resolution procedures contractually provided for will
be utilized. The total Martek common stock that may be issued relating to the
three 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. 5. Short-term Investments and Marketable Securities Available-for-sale securities consist of U.S. government obligations, U.S.
agency obligations and taxable municipal auction rate securities, and totaled
$19.6 million and $67.0 million as of July 31, 2004 and October 31, 2003,
respectively. There were no unrealized holding gains or losses on these
available-for-sale securities as of July 31, 2004 and October 31, 2003. In
addition, there were no realized gains or losses during the three and nine
months ended July 31, 2004 and 2003. 6. Inventories Inventories are stated at the lower of cost or market and are valued using a
weighted average approach that approximates the first-in, first-out method.
Inventories consist of the following (in thousands): July 31,
    
    October 31,In thousands
    
    2004
    
    2003Finished products
    
    $
    11,033
    
    
    $
    5,168Work in process
    
    
    12,661
    
    
    
    7,801Raw materials
    
    
    2,315
    
    
    
    2,074Total
    
    
    26,009
    
    
    
    15,043Less: inventory reserve
    
    
    (1,100
    )
    
    
    (500
    )Inventories, net
    
    $
    24,909
    
    
    $
    14,543
 9




---



##### 



7. Property, Plant and Equipment Property, plant and equipment consist of the following (in thousands): July 31,
    
    October 31,In thousands
    
    2004
    
    2003Land
    
    $
    683
    
    
    $
    683Buildings and improvements
    
    
    40,617
    
    
    
    9,817Machinery and equipment
    
    
    61,667
    
    
    
    56,523Furniture and fixtures
    
    
    2,635
    
    
    
    2,442Computer hardware and software
    
    
    1,793
    
    
    
    285Construction-in-progress
    
    
    148,870
    
    
    
    33,533Property, plant and equipment
    
    
    256,266
    
    
    
    103,283Less: accumulated depreciation
    
    
    (19,350
    )
    
    
    (14,969
    )Property, plant and equipment, net
    
    $
    236,916
    
    
    $
    88,314
 The Company periodically evaluates the recoverability of the carrying value of
its long-lived assets based on the criteria established in Statement of
Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment on
Disposal of Long-Lived Assets. The Company considers historical performance
and anticipated future results in its evaluation of potential impairment.
Accordingly, when indicators of impairment are present, the Company evaluates
the carrying value of these assets in relation to the operating performance of
the business and the undiscounted cash flows expected to result from the use of
these assets. Impairment losses are recognized when the sum of the expected
future cash flows are less than the assets carrying value. No such impairment
losses have been recognized to date. 8. Goodwill and Intangible Assets Intangible assets and related accumulated amortization consist of the following
(in thousands): As of July 31, 2004
    
    As of October 31, 2003Accumulated
    
    
    
    
    
    
    
    
    
    AccumulatedIn thousands
    
    Gross
    
    Amortization
    
    Net
    
    Gross
    
    Amortization
    
    NetTrademarks
    
    $
    2,058
    
    
    $
    (279
    )
    
    $
    1,779
    
    
    $
    2,030
    
    
    $
    (170
    )
    
    $
    1,860Patents
    
    
    7,744
    
    
    
    (1,069
    )
    
    
    6,675
    
    
    
    6,013
    
    
    
    (672
    )
    
    
    5,341Core technology
    
    
    1,708
    
    
    
    (199
    )
    
    
    1,509
    
    
    
    1,708
    
    
    
    (114
    )
    
    
    1,594Current products
    
    
    10,676
    
    
    
    (1,627
    )
    
    
    9,049
    
    
    
    10,676
    
    
    
    (1,093
    )
    
    
    9,583Licenses
    
    
    11,196
    
    
    
    (189
    )
    
    
    11,007
    
    
    
    
    
    
    
    
    
    
    
    Goodwill
    
    
    50,693
    
    
    
    
    
    
    
    50,693
    
    
    
    50,274
    
    
    
    
    
    
    
    50,274Total
    
    $
    84,075
    
    
    $
    (3,363
    )
    
    $
    80,712
    
    
    $
    70,701
    
    
    $
    (2,049
    )
    
    $
    68,652
 Core technology and current products relate to the value assigned to the
products purchased as part of the OmegaTech acquisition. The Company recorded
amortization expense on intangible assets of $576,000 and $455,000 for the
three months ended July 31, 2004 and 2003, respectively, and $1.3 million for
both the nine months ended July 31, 2004 and 2003. 9. 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 3% for the three and
nine months ended July 31, 2004 and is based on LIBOR and the Companys
current leverage ratio. Among other things, it contains restrictions on future
debt, the payment of dividends and the further encumbrance of assets. In
addition, the credit facility requires that 10




---



##### 



the Company comply with specified
financial ratios and tests, including minimum liquidity, minimum coverage
ratios and maximum leverage ratios. As of July 31, 2004, the Company is in compliance with all of
these debt covenants and has borrowed $77 million under the revolving credit
facility. All borrowings are due at maturity. This credit facility replaced the
$10 million secured working capital line of credit established in February
2003. The Company did not have any borrowings under the previous working
capital line of credit. In connection with the purchase of certain assets and the assumption of certain
liabilities of FermPro (See Note 2), the Company assumed a $10 million secured
note. The note was amended on January 26, 2004 and is now an unsecured
obligation of the Company with a maturity date of December 31, 2008. The note
has a stated interest rate of 5% and principal is amortized over a 20-year
period with the balance due at maturity. Payments through December 31, 2003
were comprised of interest only. 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. During the three and nine months ended July 31, 2004, the Company incurred
interest on borrowings of approximately $652,000 and $1.2 million,
respectively, and recorded amortization of related debt fees of approximately
$65,000 and $135,000 in the three and nine month periods ended July 31, 2004,
respectively. Substantially all of the interest incurred and debt fee
amortization recorded was capitalized as part of the cost of the Companys
construction at the Kingstree, SC manufacturing facility. 10. Commitments and Contingencies The Company has entered into an agreement to purchase a minimum quantity of
certain material used in DHA production on favorable terms from a third party
manufacturer. The commitment expires on June 30, 2006, with options to extend
by both parties. As of July 31, 2004, the Companys remaining obligation was
approximately $5.2 million, of which the Company has open purchase orders
totaling approximately $1.0 million. In May 2004, the Company amended its existing lease for laboratory and
administrative space at our Columbia, Maryland office to extend the term of the
lease as well as expand our leased space by approximately 15%. The term of the
lease has been extended through January 2011. On March 12, 2003, an explosion occurred at a public wastewater treatment works
in Winchester, KY, resulting in property damage. The Company has entered into
active discussions relating to the cause of and determination of responsibility
for the property damage with the Winchester Municipal Utilities Commission and
its insurer. The Company learned in March 2004 that the federal Environmental
Protection Agency, utilizing personnel from its Criminal Investigation
Division, had asked questions of current and former employees relating to the
explosion at the wastewater treatment plant. Current and former
employees have recently testified before a federal grand jury that is
investigating the matter. As of July 31, 2004, the Company has recorded a
liability totaling approximately $500,000 as an estimate of certain future
costs that might be incurred as a result of this incident. While we cannot be
certain of the outcome, the Company believes that the outcome will not have a
material adverse impact on its financial condition or results of operations. 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 the Company
is unlikely, either individually or in the aggregate, to have a material
adverse effect on the Companys results of operations or financial condition. 11. Stockholders Equity On February 5, 2004, the Company completed an underwritten public offering of
176,885 shares of common stock at a price of $65.59 per share pursuant to a
shelf registration. Net proceeds to the Company, after deducting underwriters
fees and estimated expenses, amounted to approximately $11.4 million. 11




---



##### 



12. Net Income per Share The following table presents the calculation of basic and diluted net income
per share: Three months ended
    
    Nine months endedJuly 31,
    
    July 31,In thousands, except per share amounts
    
    2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    5,011
    
    
    $
    4,603
    
    
    $
    11,761
    
    
    $
    9,755Weighted
average shares outstanding  basic
    
    
    29,270
    
    
    
    27,051
    
    
    
    28,937
    
    
    
    24,793Effect of dilutive potential common shares:Employee stock options
    
    
    1,855
    
    
    
    2,242
    
    
    
    2,125
    
    
    
    1,646Warrants
    
    
    43
    
    
    
    107
    
    
    
    44
    
    
    
    105Total dilutive potential common shares
    
    
    1,898
    
    
    
    2,349
    
    
    
    2,169
    
    
    
    1,751Weighted
average shares outstanding  diluted
    
    
    31,168
    
    
    
    29,400
    
    
    
    31,106
    
    
    
    26,544Net income
per share  basic
    
    $
    0.17
    
    
    $
    0.17
    
    
    $
    0.41
    
    
    $
    0.39Net income
per share  diluted
    
    $
    0.16
    
    
    $
    0.16
    
    
    $
    0.38
    
    
    $
    0.37
 Employee stock options to purchase approximately 684,000, 671,000 and 33,000
shares were outstanding but were not included in the computation of diluted net
income per share for the three months ended July 31, 2004 and the nine months
ended July 31, 2004 and 2003, respectively because the effects would have been
antidilutive. There were no antidilutive stock options outstanding for the
three months ended July 31, 2003. 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 DHA and ARA oils;-
    
    expectations regarding future research and development costs;-
    
    expectations regarding the integration of the former FermPro
Manufacturing, LP (FermPro) facility with Martek;-
    
    expectations regarding our expansion at our Kingstree, SC facility
(formerly FermPro);-
    
    expectations regarding the impact of the incident at the Winchester
Wastewater Treatment Plant;-
    
    expectations regarding the impact of the incident at DSMs Belvidere, NJ
facility; and-
    
    expectations regarding additional capital expenditures needed in relation
to our fermentation and oil processing activities. Forward-looking statements include those statements containing words such as:  -
    
    will,-
    
    should,-
    
    could,-
    
    anticipate,-
    
    believe, 13




---



##### 



-
    
    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
99.1 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. 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. Many researchers believe that these fatty acids may enhance
mental and visual development in infants, may play a pivotal role in brain
function throughout life and may reduce risks associated with coronary heart
disease. Low levels of DHA in adults have also been linked with a variety of
health risks. Research is underway to assess what impact, if any,
supplementation with our DHA will have on these health risks. Additional
applications of our patented technology based upon microalgae include our algal
genomics technology and our currently marketed fluorescent detection products
and technologies that can be used by researchers as an aid in drug discovery
and diagnostics. We currently have license agreements with fifteen 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 and three companies whose identities we
have agreed not to disclose at this time. Collectively, these companies
represent more than 70% of the estimated $8.5 to $9.5 billion worldwide
wholesale market for infant formula and 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 (W.I.C.) rebates. W.I.C. is a federal
grant program administered by the states for the benefit of low income,
nutritionally at-risk women, infants and children. Twelve licensees are now
marketing term infant formula products containing our oils in over 30 countries
and pre-term infant formula products containing our oils in over 60 countries
around the world. The three licensees that are not currently marketing term
infant formula products containing our oils represent less than 5% of the
estimated worldwide wholesale market for infant formula. Supplemented term
infant formulas manufactured by Mead Johnson Nutritionals, Abbott Laboratories,
Wyeth and Nestle are currently being marketed in the United States. Prior to fiscal 2003, we incurred losses in each year since our inception and
as of July 31, 2004, our accumulated deficit was approximately $100 million.
Although we anticipate significant continued growth in sales of our nutritional
oils, and we achieved an operating profit in fiscal 2003 and in the first nine
months of fiscal 2004, 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 extent and timing of
future oils-related revenues are largely dependent upon the following factors:  
    
    the ability by us and our third-party manufacturers to produce adequate levels of our nutritional oils;
    
    the timing of the completion of construction at our Kingstree facility and related expanded production capabilities;
    
    the timing and extent of production by DSM Food Specialties (DSM) at its recently acquired Belvidere facility;
    
    the timing of infant formula market introductions by our licensees;
    
    the timing and extent of introductions of DHA into various child and/or adult applications;
    
    the timing and extent of acceptance of products containing our oils under state-administered reimbursement programs in the
U.S.;
    
    the acceptance of these products by consumers;
    
    our ability to protect against competitive products through our patents;
    
    competition from alternative sources of DHA and ARA; and 14




---



##### 




    
    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 During the first nine months of 2004, we have continued with our extensive
expansion at our recently acquired Kingstree location for the fermentation and
processing of our nutritional oils. We have spent approximately $140 million on
the expansion since the inception of the project and expect the total cost of
the expansion to be between $170 and $180 million when complete. Certain
components of the initial phase of the expansion commenced commercial operation
during the third quarter of fiscal 2004 with additional components of this
phase, including the fermentation area, expected to commence commercial
operation and generate products available for sale in the fourth quarter of
fiscal 2004. Upon completion of the second phase of construction in the first
quarter of fiscal 2005, Marteks DHA production capacity should nearly triple
over fiscal 2003 levels. In May 2004, a fire occurred at the Belvidere, New Jersey manufacturing plant
of DSM causing a temporary shutdown of the ARA production line. In June 2004,
DSM restarted the production line at the Belvidere facility. Since that time,
Belvidere has continued to increase its monthly output of ARA. It is
anticipated that by the end of fiscal 2004, we will be receiving approximately
40% of our ARA from DSMs Belvidere facility with that percentage expected to
grow in the future. Two infant formula manufacturers have launched new toddler products
supplemented with Marteks DHA and ARA. The new lines are formulated to meet
the nutritional needs of children from nine to twenty-four months of age, and
are the first of their kind in the U.S. to be fortified with DHA and ARA. In September 2004, the results of a study conducted by the UCLA School of
Medicine of the effects of Marteks DHA on the advancement of Alzheimers
disease in laboratory mice were published in the journal Neuron. The study
found that a diet rich in DHA significantly lessened the memory loss and cell
damage caused by Alzheimers disease in laboratory mice. These findings add to
the evidence that DHA may play a role in countering the progression of
Alzheimers disease in humans, although further research is needed. Also in September 2004, the FDA announced that it would allow producers of
conventional foods and dietary supplements containing DHA to make a qualified
health claim for reduced risk of coronary heart disease on their product
packaging. The claim was, in part, a result of our petition to the FDA in
November of 2003. A qualified health claim must be supported by credible
scientific evidence. Upon review of this scientific evidence, the FDA concluded
that supportive but not conclusive research shows that consumption of DHA and
eicosapentaenoic acid (EPA) may reduce the risk of coronary heart disease. Management Outlook We believe that the outlook for future revenue growth continues to be positive,
although quarterly results may show fluctuations. Specifically, we believe that
for the remainder of fiscal 2004, 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. As we have discussed, to date,
twelve of our infant formula licensees have obtained the regulatory approval,
where required, to sell term infant formula products containing our oils in
over 30 countries and pre-term infant formula products containing our oils in
over 60 countries around the world. Supplemented term infant formulas
manufactured by four of our licensees are currently being marketed in the
United States and we expect these sales to increase throughout the remainder of
fiscal 2004. In the first nine months of fiscal 2004, approximately 90% of our revenues
related to the sales of our oils for use in infant formula 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 much larger potential market than infant
formula. 15




---



##### 



We have an aggressive growth plan that includes substantial additional
investments in our manufacturing facilities. To accommodate our growth plan, we
will need to continue to improve our operational and financial information
systems and controls, expand our management team, continue to attract and
retain new employees, accurately anticipate demand for our products and
effectively bring on line and integrate new production capacity. In addition, we will rely on
third-party manufacturers to effectively bring on line and integrate new
production capacity. All of these factors present numerous challenges and could
result in unanticipated costs and delays in product manufacture. Production As in fiscal 2003, during the first nine months of fiscal 2004, the demand for
our nutritional oils for use in infant formula products significantly exceeded
production capacity. These shortfalls have resulted from an acceleration of
such demand over what our customers had projected coupled with a shortage of
ARA production capacity from DSM that began in the first quarter of fiscal
2004. As customer demand has increased, we have requested that our customers
provide us with longer lead-times in order to fill their orders. Even with the
longer lead-times and increased production each quarter, we continue to limit
the orders we accept for our nutritional oils. We currently have the production capacity equivalent to approximately $190
million in annual sales. We are now in the process of an extensive expansion at
our Kingstree facility. Certain components of the initial phase of the
expansion commenced commercial operation during the third quarter of fiscal
2004 with additional components of this phase, including the fermentation area,
expected to commence commercial operation and generate products available for
sale in the fourth quarter of fiscal 2004. Upon completion of the second phase
of construction in the first quarter of fiscal 2005, our DHA production
capacity should nearly triple over fiscal 2003 levels. 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. Our ARA oil is currently produced by DSM, primarily at its plant in Capua,
Italy. DSM has recently added ARA production capacity in the U.S. by converting
existing facilities in Belvidere, NJ to the production of ARA. To continue to
meet the growing demand for ARA, plans for additional production capacity at these plants
are in preparation pursuant to the terms of our existing supply agreement
with DSM. Two events have recently occurred that have affected DSMs ability to
produce sufficient ARA to satisfy our purchase order requirements. First, the
production of ARA by DSM in Capua, Italy was impacted by a nationwide power
failure in Italy in late September 2003. In addition, in May 2004, an incident
occurred at the Belvidere, NJ manufacturing plant of DSM involving a fire in an
outside dust collection unit and caused a temporary shut-down of the ARA
production line between mid-May and early-June 2004 at the Belvidere facility.
The Italian power outage resulted in a production loss of ARA that negatively
impacted our revenues in the first quarter of fiscal year 2004, and the
production loss of ARA resulting from the fire in Belvidere caused a reduction
in revenue during the third quarter of fiscal 2004. In June 2004, DSM restarted
the production line at the Belvidere facility and since that time, Belvidere
has continued to increase its monthly output of ARA. Of the total ARA produced
by DSM, we anticipate approximately 40% of such total volumes to be produced at
DSMs Belvidere facility by the end of fiscal 2004 with that percentage
expected to grow in the future. Because DSM is a third-party manufacturer,
however, we have limited control over the timing and extent of its Capua and
Belvidere production volumes. We have attempted to reduce the risk inherent in having a single supplier, such
as DSM, through certain elements of a new supply agreement entered into with
DSM in April 2004. In connection with the new 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, however, to any amounts ordered by us that DSM is
unable to fulfill or, beginning January 1, 2005, for each calendar year, the
greater of (i) 100 tons of ARA oil (an amount that equals approximately 10% of
Marteks current demand for ARA oil) and (ii) any amounts ordered by us that
DSM is unable to fulfill. DSM and Martek are in the process of transferring
technology under the agreement and we anticipate being capable of producing ARA
and holding it for future sale, to the extent permitted by the supply
agreement, in the first half of fiscal 2005. To further reduce our ARA
production risk, we have directly engaged and recently added a new U.S.-based
provider of certain post-fermentation ARA manufacturing services. Historically,
these services had been provided by two European vendors through DSM. Along
with our pending ARA extraction capabilities at Kingstree, which we anticipate
being available by the second quarter of fiscal 2005, the addition of a new
third-party facility will give us multiple U.S. sites for the downstream
processing of ARA. When combining our current and projected DHA production capabilities in
Winchester and Kingstree with DSMs current and projected ARA production
capabilities in Italy and the U.S., we expect to have total production capacity
equivalent to approximately $260 million to $270 million in annualized sales of
our nutritional oils by the end of fiscal 2004 and equivalent to approximately 16




---



##### 



$500 million in annualized sales of our nutritional oils by the second half of
2005. If, however, the production expansion in Kingstree does not proceed as
planned or if DSM is not able to scale up and further expand production in the
U.S., our ability to produce at these levels may be negatively impacted. Our DHA-S oil, which is currently used in the adult supplement market and
animal feed market, is currently produced by third-party contract manufacturers
including C.P. Kelco U.S. Inc. (CP Kelco). We have a minimum purchase
commitment with CP Kelco that expires on June 30, 2006 with possible annual
renewals. See Liquidity and Capital Resources for further discussion of
purchase commitments. On March 12, 2003, an explosion occurred at a public wastewater treatment works
in Winchester, KY, resulting in property damage. On April 8, 2003, we received
a report from the state fire marshal that concluded that the incident resulted
from the introduction of n-hexane into the local sewer system. We use n-hexane
in the production process for our DHA oil. The state fire marshal report did
not rule out other possible contributors to the incident. Although n-hexane was
found at the site of the incident, there are other factors which need to be
considered, including the presence of other flammable substances that were not
discharged from our plant and existing conditions at the water treatment
facility. We have entered into active discussions relating to the cause of and
determination of responsibility for the property damage with the Winchester
Municipal Utilities Commission (WMU) and its insurer. We have received and are
analyzing information from the utility and its insurer concerning the details
of the incident. We have entered into an agreement with the City of Winchester,
WMU, and WMUs insurer to extend any applicable statute of limitations and
allow the parties to continue discussing this matter. We learned in March 2004
that the federal Environmental Protection Agency, utilizing personnel from its
Criminal Investigation Division, had asked questions of current and former
employees relating to the explosion at the wastewater treatment plant and
n-hexane. Current and former employees have recently testified before a federal
grand jury that is investigating the matter. As of July 31, 2004, we have
recorded a liability totaling approximately $500,000 as an estimate of certain
future costs that we might incur as a result of this incident, including
approximately $250,000 accrued during the three months ended July 31, 2004.
Through July 31, 2004, we have incurred approximately $337,000 in legal fees
related to the incident. While we cannot be certain of the ultimate outcome of
our discussions with WMU and its insurer or the EPA and grand jury activity, we believe that
they will not have a material adverse impact on our production, financial
condition or results of operations. Critical Accounting Policies and the Use of Estimates The preparation of our consolidated financial statements in conformity with
accounting principles generally accepted in the U.S. 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
in our Annual Report to shareholders on Form 10-K for the year ended October
31, 2003. Results of Operations Revenues The following table presents revenues by category: Three months ended
    
    Nine months endedJuly 31,
    
    July 31,In thousands
    
    2004
    
    2003
    
    2004
    
    2003Product sales:Nutritional product sales
    
    $
    43,396
    
    
    $
    28,748
    
    
    $
    112,331
    
    
    $
    75,183Other product sales
    
    
    561
    
    
    
    292
    
    
    
    1,809
    
    
    
    754Total product sales
    
    
    43,957
    
    
    
    29,040
    
    
    
    114,140
    
    
    
    75,937Contract manufacturing sales
    
    
    3,273
    
    
    
    
    
    
    
    10,350
    
    
    
    Other revenues
    
    
    107
    
    
    
    75
    
    
    
    342
    
    
    
    170Total revenues
    
    $
    47,337
    
    
    $
    29,115
    
    
    $
    124,832
    
    
    $
    76,107
 17




---



##### 



Nutritional product sales increased by $14.6 million or 51% in the quarter
ended July 31, 2004 as compared to the quarter ended July 31, 2003 and
increased by $37.1 million or 49% in the nine months ended July 31, 2004 as
compared to the nine months ended July 31, 2003. The increases are primarily
due to a continued increase in sales of our oils to both existing and new
infant formula licensees. Substantially all of our product sales in the quarter
and nine months ended July 31, 2004 relate to the sale of our oils for use in
infant formulas. Approximately 90% of our nutritional product sales during the
quarter and nine months ended July 31, 2004, respectively were generated by
sales of DHA and ARA to four companies. Approximately 60% of these sales were
to Mead Johnson Nutritionals and the remaining 40% were to Abbott Laboratories,
Wyeth and Nestle combined. Collectively, these four companies are currently
manufacturing term infant formulas supplemented with our oils for sale in the
U.S., and in over 30 countries around the world. 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
65% of our sales to infant formula licensees for the quarter and nine months
ended July 31, 2004, 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
July 31, 2004, formula supplemented with Marteks oils had gained more than a
60% penetration in the U.S. infant formula market. We anticipate sales of
nutritional products will continue to grow as infant formulas containing our
oils are introduced by new licensees and by current licensees in additional
countries. We also anticipate that sales of our nutritional oils will continue
to grow in countries where our oils are currently sold. Our future sales
growth, however, is dependent upon our ability to expand our production
capabilities at our Kingstree facility and the ability of DSM to continue to
expand production of ARA at their Belvidere facility. Other product sales increased $300,000 or 92% in the three months ended July
31, 2004 as compared to the three months ended July 31, 2003 and increased $1.1
million or 140% in the nine months ended July 31, 2004 as compared to the same
period last year due primarily to the additional product revenue recognized by
our recently acquired Kingstree facility. Contract manufacturing sales, totaling $3.3 million and $10.4 million for the
three and nine months ended July 31, 2004, respectively, relate to fermentation
work performed for various third parties at our Kingstree, SC facility, which
was acquired by the Company in the fourth quarter of fiscal 2003. Contract
manufacturing sales are expected to decrease in the future as this business is
phased out over the next few years to allow for increased fermentation capacity
for our DHA and ARA production. As a result of the above, total revenues increased by $18.2 million or 63% in
the quarter ended July 31, 2004 as compared to the quarter ended July 31, 2003
and increased by $48.7 million or 64% in the nine months ended July 31, 2004 as
compared to the same period last year. Costs and Expenses The following table presents our operating costs and expenses: Three months ended
    
    Nine months endedJuly 31,
    
    July 31,In thousands
    
    2004
    
    2003
    
    2004
    
    2003Cost of revenue:Cost of product sales
    
    $
    26,264
    
    
    $
    17,017
    
    
    $
    70,042
    
    
    $
    45,001Cost of contract manufacturing sales
    
    
    2,912
    
    
    
    
    
    
    
    8,549
    
    
    
    Operating expenses:Research and development
    
    
    4,932
    
    
    
    3,482
    
    
    
    13,660
    
    
    
    9,394Selling, general and administrative
    
    
    6,872
    
    
    
    4,115
    
    
    
    18,750
    
    
    
    11,550Restructuring reversal
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (250
    )Other operating expenses
    
    
    1,587
    
    
    
    247
    
    
    
    2,691
    
    
    
    1,313Total costs and expenses
    
    $
    42,567
    
    
    $
    24,861
    
    
    $
    113,692
    
    
    $
    67,008
 18




---



##### 



Cost of Product SalesDuring the third quarter of 2004, we continued to satisfy
as much customer demand as possible, while, at times, sacrificing cost
efficiencies. As such, our cost of product sales increased as a percentage of
product sales to 60% in the quarter ended July 31, 2004 from 58% in the quarter
ended July 31, 2003 and increased to 61% in the nine months ended July 31, 2004
compared to 59% in the corresponding period last year. The increases resulted
from the Companys continued use of air freight in connection with
ARA shipments from Europe (an increase of approximately 2% for both the
comparative three and nine month periods) and internal production
inefficiencies in connection with the commencement of DHA manufacturing at the
Kingstree plant (an increase of approximately 1% for both the comparative three
and nine month periods). The gross profit margins were also impacted by an
increase in the Companys overall cost of ARA due to the decline of the U.S.
dollar against the euro, the currency in which we are required to pay DSM for
their supply of ARA from Italy (an increase of approximately 3 % for both the
comparative three and nine month periods). Such increase, however was offset by
the benefits of certain DHA production improvements recently developed (a
decrease of approximately 2% for both the comparative three and nine month
periods) and insurance receipts by Martek associated with incidents at DSM
production plants which served to decrease cost of product sales as a
percentage of product sales by approximately 2% for both the three and nine
month periods, respectively. We expect our gross profit margins in 4th Qtr 04
to continue to reflect the benefits of the newly implemented production methods
and expect the impact of the negative factors noted above to be greatly
mitigated by the end of Marteks 2004 fiscal year. Cost of Contract Manufacturing SalesCosts of contract manufacturing sales,
totaling $2.9 million and $8.5 million for the three and nine months ended July
31, 2004, respectively, are the costs related to the fermentation work
performed for various third parties at our Kingstree, SC facility, which was
acquired by the Company in the fourth quarter of fiscal 2003. Contract
manufacturing sales are to be phased out over the next few years to allow for
increased fermentation capacity for our DHA and ARA production. Research and DevelopmentOur research and development costs increased by $1.5
million or 42% in the quarter ended July 31, 2004 as compared to the quarter
ended July 31, 2003 and increased by $4.3 million or 45% in the nine months
ended July 31, 2004 compared to the nine months ended July 31, 2003. The
increases are primarily the result of the commencement of new development
projects, including research to lower our DHA production cost by increasing our
fermentation production yields and developing new downstream processing
techniques as well as efforts in connection with the development of ARA
fermentation methods, development of DHA products for the food and beverage
industry, exploration of new DHA applications and long-term development of
plant-based DHA under the collaboration agreement with SemBioSys. Selling, General and AdministrativeOur selling, general and administrative
costs increased by $2.8 million or 67% in the quarter ended July 31, 2004 as
compared to the corresponding prior year quarter and increased by $7.2 million
or 62% in the nine months ended July 31, 2004 as compared to nine months ended
July 31, 2003. Of the increases, approximately $800,000 and $2.0 million for
the quarter and nine months ended July 31, 2004, respectively relate to our
Kingstree, SC plant acquired in September 2003, for which an administrative
infrastructure has been added to support the new facility and its expansion.
The remaining increases are primarily due to additional personnel (an increase
of $1.3 million and $3.7 million for the comparative three and nine month
periods, respectively), and insurance costs (an increase of $500,000 and $1.2
million for the comparative three and nine month periods, respectively)
required to accelerate and manage the Companys overall growth. Specifically,
we have increased staffing in our business development, food and beverage sales
and marketing and finance departments. Other Operating ExpensesOther operating expenses totaled $1.6 million and
$2.7 million in the three and nine months ended July 31, 2004, respectively.
These expenditures related primarily to production start-up costs associated
with the expansion at our Kingstree facility and qualifications of certain
third-party manufacturers as well as expenses related to the Winchester
wastewater treatment matter. We anticipate continuing to incur these types of
expenses for the remainder of fiscal 2004. Other Income, netOur other income, net, decreased by $100,000 in the quarter
ended July 31, 2004 as compared to the corresponding prior year periods
primarily due to changes in interest income resulting from varying levels of
cash on-hand. See Liquidity and Capital Resources for further discussion of
cash on-hand. No significant change occurred between the comparative nine month
periods. Income Tax ExpenseDuring the nine months ended July 31, 2004, we recorded
approximately $30,000 of state income tax expense. As of October 31, 2003, we
had net operating loss carryforwards for federal income tax purposes of
approximately $170 million. In addition, we had a deferred tax asset of
approximately $65.8 million as of October 31, 2003 which was and continues to
be fully reserved through a valuation allowance since the likelihood of
realization of the benefit cannot be determined. When and if the likelihood of
realization of the benefit becomes probable, we will reverse a portion or
potentially all of the valuation allowance and recognize an income tax benefit. 19




---



##### 



Net IncomeAs a result of the foregoing, we earned $5.0 million of net income
in the quarter ended July 31, 2004 as compared to net income of $4.6 million in
the same period last year and net income of $11.8 million in the nine months
ended July 31, 2004 as compared to net income of $9.8 million in the nine
months ended July 31, 2003. Liquidity and Capital Resources We have financed our operations primarily from the following sources:  
    
    proceeds from the sale of equity securities,
    
    product sales and receipt of license fees,
    
    cash received from the exercise of stock option and warrants, and
    
    debt financing. At July 31, 2004, our primary source of liquidity was our cash, cash
equivalents and short-term investments totaling $37.7 million as well as the
unused portion of our revolving credit facility of $23.0 million.Cash, cash
equivalents and short-term investments decreased $59.2 million from October 31,
2003. This decrease was primarily attributable to $153.1 million in capital
expenditures, the majority of which were related to the expansion of the newly
acquired Kingstree facility to increase output of our nutritional oils. In
addition, the Company used cash flow from operations of $2.0 million which was
primarily the result of a buildup of DHA inventory which could not be blended
with ARA for sales to infant formula manufacturers because of a shortage of
ARA. These cash outflows were offset by the proceeds from the exercise of stock
options and issuance of common stock which approximated $28.5 million, and
borrowings under the Companys new revolving credit facility, which provided
$77.0 million in cash during the nine months ended July 31, 2004. The expansion of our production facility in Kingstree, SC and, to a lesser
degree, production improvements at our facility in Winchester, KY, have and
will continue to have a material effect upon our liquidity and capital
resources in fiscal 2004. We expect to spend approximately $40 - $50 million
over the next 12 months in plant and equipment to complete the expansion and
production improvements as well as for other company-wide capital needs.
Throughout the construction period in Kingstree, SC, all interest incurred on
borrowings will be capitalized. To date, we have incurred interest on
borrowings of approximately $1.2 million and recorded amortization of related
debt fees of approximately $135,000. Substantially all of the interest incurred
and debt fee amortization recorded was capitalized as part of the cost of our
construction. The table below sets forth our contractual obligations at July 31, 2004: Less than
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations (in thousands)
    
    Total
    
    1 Year
    
    1 - 3 Years
    
    4 - 5 Years
    
    5 YearsNotes payable
    
    $
    10,163
    
    
    $
    567
    
    
    $
    1,537
    
    
    $
    7,738
    
    
    $
    321Borrowings under revolving credit
facility
    
    
    77,000
    
    
    
    
    
    
    
    77,000
    
    
    
    
    
    
    
    Operating and capital lease obligations
    
    
    4,618
    
    
    
    889
    
    
    
    1,985
    
    
    
    1,388
    
    
    
    355DSM license fee payable
    
    
    6,000
    
    
    
    4,000
    
    
    
    2,000
    
    
    
    
    
    
    
    Unconditional purchase obligation
    
    
    5,245
    
    
    
    2,725
    
    
    
    2,521
    
    
    
    
    
    
    
    Total contractual cash obligations
    
    $
    103,026
    
    
    $
    8,181
    
    
    $
    85,043
    
    
    $
    9,126
    
    
    $
    676
 As part of the acquisition of FermPro, we assumed a $10 million note with a
stated interest rate of 5%. The note was amended on January 26, 2004 and is now
an unsecured obligation of the Company with a maturity date of December 31,
2008. Principal is amortized over a 20-year period, with the balance due at
maturity date. Payments through December 31, 2003 were comprised of interest
only. 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. 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 the Companys nutritional oils that it sells to its infant formula
licensees. Among other things, this agreement provided for the sale to us by
DSM of a license related to certain technologies associated with the
manufacture of ARA. Such license fee totaled $10 million, of which $4 million
was paid upon execution of the agreement, $4 million of which will be paid on
November 2, 2004, and the remaining $2 million of which will 20




---



##### 



be paid on
November 2, 2005. This agreement also provides for the granting to DSM by us of
an exclusive license under certain of our patents and intellectual property
rights for the production by DSM of products containing ARA that are not for
human consumption, including animal feed products. In May 2004, we entered into a $100 million secured revolving credit facility
which amended and expanded the $85 million credit facility established in
January 2004. This credit facility replaced a $10 million line of credit, which
had no borrowings under it. The new revolving credit facility is collateralized
by accounts receivable and inventory. Among other things, it 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 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 and
that we are in compliance with all of these debt covenants. We have borrowed
$77.0 million under the revolving credit facility in fiscal 2004 under the
terms of the agreement. In February 2004, we completed an underwritten public offering of 176,885
shares of our common stock at a price of $65.59 per share pursuant to a shelf
registration. Net proceeds to the Company, after deducting underwriters fees
and estimated expenses, amounted to approximately $11.4 million. The proceeds
from this offering, together with funds on-hand and borrowings under our bank
credit facility, have been used to finance the expansion of our manufacturing
capacity to meet increased demand for our DHA and ARA oils and for various
general corporate purposes. In August 2004, the Companys shelf registration statement was declared
effective by the Securities and Exchange Commission. The shelf registration
statement enables the Company 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. We believe that the new revolving credit facility, when combined with our cash
and short-term investments of $37.7 million on-hand at July 31, 2004, and
anticipated operating cash flows, will provide us with adequate capital to meet
our obligations for at least the next 12 to 18 months. If we determine that
additional production capacity is needed to meet anticipated demand, or if we
believe that our financial requirements otherwise warrant it, we may
raise more capital in the form of equity securities or debt, or a combination
of equity and debt. Off-Balance Sheet Arrangements We do not engage in any 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. Item 3. Quantitative and Qualitative Disclosure 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 2% to 2.5%. 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, NJ facility. In April 2004, we
began entering into foreign currency cash flow hedges to reduce the related
market risk. Item 4. Controls and Procedures  a)
    
    Evaluation of disclosure controls and proceduresThe Chief Executive
Officer and the Chief Financial Officer of Martek Biosciences Corporation
have evaluated the effectiveness of the design and operation 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 have concluded as of the end of the period
covered by this report that the disclosure controls and procedures were
effective. 21




---



##### 



b)
    
    Changes in internal controlsDuring the quarterly period covered by this
report, 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 is reasonably
likely to materially affect the internal controls over financial
reporting. 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 of the
Opposition Division is now scheduled for November 2004. During the appeal
process, the patent will remain in full force and effect. The appeal process is
not expected to be completed until some time in 2006. 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. The validity of the patent is
unaffected by these filings. An initial hearing at the Opposition Division is
scheduled for November 2004. The opposition process is not expected to be
completed until some time in 2006. 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. The validity of the patent is unaffected by

these filings. A hearing at the Opposition Division is scheduled to be held in
November 2004. The opposition process is not expected to be completed until
some time in 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. During the appeal
process the patent will remain in full force and effect. The appeal process is
not expected to be completed until some time in 2006. On March 12, 2003, an explosion occurred at a public wastewater treatment
works in Winchester, KY, resulting in property damage. On April 8, 2003, we
received a report from the state fire marshal that concluded that the incident
resulted from the introduction of n-hexane into the local sewer system. We use
n-hexane in the production process for our DHA oil. The state fire marshal
report did not rule out other possible contributors to the incident. Although
n-hexane was found at the site of the incident, there are other factors which
need to be considered, including the presence of other flammable substances
that were not discharged from our plant and existing conditions at the water
treatment facility. We have entered into active discussions relating to the
cause of and determination of responsibility for the property damage with the
Winchester Municipal Utilities Commission (WMU) and its insurer. We have
received and are analyzing information from the utility and its insurer
concerning the details of the incident. We have entered into an agreement with
the City of Winchester, WMU, and WMUs insurer to extend any applicable statute
of limitations and allow the parties to continue discussing this matter. We
learned in March 2004 that the federal Environmental Protection Agency,
utilizing personnel from its Criminal Investigation Division, had asked
questions of current and former employees relating to the explosion at the
wastewater treatment plant and n-hexane. Current and former employees have
recently testified before a federal grand jury that is investigating the
matter. While we cannot be certain of the ultimate outcome of our discussions
with WMU and its insurer or the EPA and grand jury activity, we believe that they will not
have a material adverse impact on our production, financial condition or
results of operations. On September 23, 2003, we filed a patent infringement lawsuit in the US
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. The lawsuit alleges that
Nutrinova and Celanese have been making, using, offering to sell, selling
and/or importing into the United States DHA marketed under the brand name
DHActive that is made by a process and employs compositions that infringe
the patents. On October 24, 2003. Nutrinova and Celanese filed counterclaims
alleging inequitable conduct 22




---



##### 



and invalidity, unenforceability and/or
noninfringement of all our U.S. patents and rights. We filed a second patent
infringement suit involving Nutrinova in Germany on January 16, 2004. Named as
defendants were Nutrinova Nutrition Specialties and Food Ingredients GmbH and
Celanese Ventures GmbH. The complaint alleges infringement of our European
patent relating to DHA-containing oils. A hearing in this case is now scheduled
to be held in December 2004. 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 Item 4. Submission of Matters to a Vote of Security Holders. None Item 5. Other Information. None Item 6. Exhibits. 31.1
    Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.31.2
    Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.32.1
    Certification of Chief Executive
Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.32.2
    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 2002.99.1
    Cautionary Statements for purposes of the safe harbor provisions
of the Private Securities Litigation Reform Act of 1995.
 23




---



##### 



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: September 14, 2004
    
    /s/ Peter L. BuzyPeter L. Buzy, Chief Financial and Accounting Officer
 24