Annual Reports

  • 10-K (Feb 25, 2011)
  • 10-K (Dec 29, 2010)
  • 10-K (Dec 29, 2009)
  • 10-K (Dec 29, 2008)
  • 10-K (Dec 28, 2007)
  • 10-K (May 8, 2007)

 
Quarterly Reports

 
8-K

 
Other

Martek Biosciences 10-K 2007
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K/A
Amendment No. 1
     
þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED OCTOBER 31, 2006
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 0-22354
MARTEK BIOSCIENCES CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
     
DELAWARE
(STATE OR OTHER JURISDICTION OF
INCORPORATION OR ORGANIZATION)
  52-1399362
(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
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
     
TITLE OF EACH CLASS:   NAME OF EACH EXCHANGE ON WHICH REGISTERED:
Common Stock, $.10 Par Value   The NASDAQ Stock Market
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES þ NO o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES o NO þ
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). o Yes þ No
The aggregate market value of Common Stock held by non-affiliates of the registrant as of April 28, 2006 was $805,834,927, based on the closing price of the Common Stock on the NASDAQ National Market on April 28, 2006.
The number of shares of Common Stock outstanding as of January 9, 2007 was 32,194,628.
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the Registrant’s Definitive Proxy Statement for its 2007 Annual Meeting of Stockholders (which will be filed with the Commission within 120 days after the end of the Registrant’s 2006 fiscal year) are incorporated by reference into Part III of this Report.
 
 

 


 

EXPLANATORY NOTE
We are filing this Amendment No. 1 to our Annual Report on Form 10-K for the year ended October 31, 2006, as originally filed with the SEC on January 16, 2007, to restate our financial statements and corresponding financial information for the year ended October 31, 2006.
We are restating the financial statements and corresponding financial information to correct our accounting for depreciation of assets held for future use. In previously reported consolidated financial statements, we recorded depreciation of assets held for future use when such assets were placed in or returned to productive service. Upon review, we determined that, in accordance with our adopted straight-line depreciation policy, assets held for future use should have been depreciated when they were available for use, and the depreciation should have been recognized evenly over the life of the asset without regard to whether the asset has been placed in productive service or is in commercial use.
A more complete discussion of this restatement is set forth in Note 1 to the consolidated financial statements included in Part II Item 8 of this Amendment No. 1. Changes also have been made to the following items in this Amendment No. 1 as a result of the restatement:
o   Item 1A – Risk Factors
 
o   Item 6 – Selected Financial Data
 
o   Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
o   Item 8 – Financial Statements and Supplementary Data
 
o   Item 9A – Controls and Procedures
In addition, separate from the changes caused by the restatement, we have added disclosure to Note 7 to the consolidated financial statements regarding certain inventory classified as long-term.
This Amendment No. 1 continues to speak as of the date of the original Form 10-K for the year ended October 31, 2006 and we have not updated or amended the disclosures contained herein to reflect events that have occurred since the filing of the Form 10-K, or modified or updated those disclosures in any way other than as described in the preceding paragraphs. Accordingly, this Amendment No. 1 should be read in conjunction with the portions of the original Form 10-K filed on January 16, 2007 that are not amended by this Amendment No. 1 and all filings made with the SEC subsequent thereto.


 

MARTEK BIOSCIENCES CORPORATION
AMENDMENT NO. 1 TO FORM 10-K
For The Fiscal Year Ended October 31, 2006
INDEX
 
             
PART I
           
Item 1A.
  Risk Factors     1  
 
           
PART II
           
Item 6.
  Selected Financial Data     11  
Item 7.
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     13  
Item 8.
  Financial Statements and Supplementary Data     23  
Item 9A.
  Controls and Procedures     45  
 
           
PART IV
           
Item 15.
  Exhibits and Financial Statement Schedules     46  
 
           
 
  Signatures     47  

 


 

PART I
The information in this Form 10-K/A for Martek Biosciences Corporation (“Martek”, “we”, or the “Company”) contains certain forward-looking statements, including statements related to markets for the Company’s products and trends in its business that involve risks and uncertainties. The Company’s actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause such a difference include those discussed in Item 1. “Business” of our original Form 10-K and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as those discussed elsewhere in this Form 10-K/A, including in Item 1A. Risk Factors.
ITEM 1A. RISK FACTORS.
Investing in our securities involves a high degree of risk. Before making an investment decision, you should carefully consider the risk factors set forth herein, as well as other information we include in this report and the additional information in the other reports we file with the Securities and Exchange Commission (the “SEC” or the “Commission”). If any of the following risks actually occur, our business could be harmed. In such case, the trading price of our securities could decline and you could lose all or part of your investment.
A substantial portion of our nutritional oil products sales is made to four of our existing customers under agreements with no minimum purchase requirements. If demand by these customers for our nutritional oil products decreases, our revenues may materially decline.
We rely on a substantial portion of our product sales to four of our existing customers. Approximately 83% of our product sales revenue during the year ended October 31, 2006 was generated by sales of DHA and ARA to four customers: Mead Johnson Nutritionals, Abbott Laboratories, Nestle and Wyeth. We cannot guarantee that these customers will continue to demand our nutritional products at current or predictable levels. None of our license agreements requires our licensees to purchase any minimum amount of products from us now or in the future, and certain of our license agreements can be terminated within short periods and also allow our licensees to manufacture our products themselves or purchase nutritional oils from other sources. We have limited visibility into our customers’ future actual level of demand, notwithstanding our view of consumer demand. If demand by any of our significant customers for our nutritional products decreases, we may experience a material decline in our revenues. Furthermore, if purchasing patterns by our significant customers continue to be uneven or inconsistent, we will likely experience significant fluctuations in our quarter-to-quarter revenues. In addition, if these customers attempt to utilize their purchasing power in order to receive price reductions on our products, we may be unable to maintain prices of our oils at current levels, which could materially affect future revenues and product margins.
We are aware of several products that are currently available, and products under development, that may present a serious competitive threat to our products. If we are unable to maintain a competitive differentiation from these products, our revenues may be adversely affected.
Our continued success and growth depends upon achieving and maintaining a superior competitive position in the infant formula, supplement and food and beverage product markets. Many potential competitors, which include companies such as BASF AG, Ocean Nutrition, DSM, Cargill Inc., Suntory Limited, Celanese Corporation, Archer Daniels Midland Company, Lonza Group LTD and Nagase & Co. Ltd., have substantially greater research and development capabilities, marketing, financial and managerial resources and experience in the industry. Some of these competitors are currently offering competing sources of DHA and ARA for use in the food and beverage and dietary supplement markets and for use in infant formula. If a competitor develops a better or less expensive product or technology, our competitors’ products gain widespread acceptance, our patents expire, or we lose our patents, the sales of our products may be materially adversely affected and our technologies rendered obsolete.
We are aware that other sources of DHA and ARA are or may be available, any of which could represent a competitive threat that could seriously harm our product sales. Specifically:
    The Ross Products Division of Abbott Laboratories, a significant Martek licensee and customer, filed a generally recognized as safe notification on January 2, 2002 seeking Food and Drug Administration (“FDA”) concurrence that its tuna oil source of DHA and its fungal source of ARA, as manufactured by Suntory, are generally recognized as safe when used as ingredients in infant formula. In April 2006, the FDA notified Ross Products that it had no questions at that time regarding Ross’ conclusion that DHA-rich oil from tuna and ARA-rich oil from Mortierella Alpina are safe as sources of DHA and ARA in term and post-discharge preterm infant formulas. While Ross Products has not announced any introduction of its oils into infant formula in the U.S. nor are we aware of any plans by them or any of our other licensees to do so, the GRAS notification removes a significant regulatory hurdle to the introduction of competitive products in the U.S. If Ross Products introduces such competitive products, we cannot be certain that the economic protection that we believe we have via existing patents, royalty requirements of license agreements and market factors will protect us from the financial impact of such product introductions.
 
    Reliant Pharmaceuticals is currently selling Omacor, a DHA/ EPA ethyl ester for treatment of hyperlipidemia. Omacor is a lipid-regulating agent which includes both EPA and DHA from fish oil. Reliant Pharmaceuticals has recently filed an application with the FDA for an indication that will expand the use of Omacor. Other pharmaceutical applications using omega-3 fatty acids may be expected.
 
    Suntory Limited, Cargill Inc., through a joint venture with a company in China, and other independent Chinese manufacturers are producing and distributing a fungal source of ARA. In addition, we are aware that there may be manufacturers in China attempting to produce an algal source of DHA, but we are uncertain of the overall status and commercial potential of these development efforts.

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    Some infant formulas now on the market outside the United States, including those marketed by certain of Martek’s licensees, use DHA derived from other sources, such as fish oil or eggs.
 
    In December 2005, Lonza Group LTD, a Swiss chemical and biotechnology group, acquired from Nutrinova Specialties & Food Ingredients GmbH, a wholly-owned subsidiary of Celanese Corporation, Nutrinova’s business having as its product a DHA-rich microalgal oil. Since the acquisition, Lonza has actively marketed its DHA oil to the food and beverage and dietary supplement markets in the United States, Europe and China. Both Nutrinova and Lonza are defendants in patent infringement actions involving our DHA patents that we have brought in both the United States and Germany. In October 2006, the infringement action in the United States was tried, and a verdict favorable to Martek was returned. The jury found that Lonza infringed all the asserted claims of three Martek patents and that these patents were valid. It also found that Lonza acted willfully in its infringement of one of these patents. The judge will now determine if any of the jury’s decisions were inappropriate as a matter of law, whether Martek is entitled to a permanent injunction against Lonza, and, if so, whether the permanent injunction should be stayed pending the outcome of any appeal. These lawsuits are further described in Item 3 of Part I of the original Form 10-K, “Legal Proceedings.”
 
    Other companies, several with greater financial resources than ours, are developing plant-based DHA and other companies are developing chemically synthesized DHA.
 
    Several large companies, including BASF AG, DSM and Ocean Nutrition, and a number of smaller companies, manufacture microencapsulated fish oil products. Although microencapsulation of the oil resolves many of the odor, stability and taste issues found with fish oil, a microencapsulated product currently is more costly than regular fish oil. Fish oil-based products (i) are used as a DHA source by some infant formula companies, (ii) currently dominate the adult DHA supplement market and (iii) are included in certain foods on the market in various parts of the world. Because fish oil is generally less costly than our DHA oil and continues to improve in quality and gain general market acceptance, fish oil presents a substantial competitive threat.
If we are unable to obtain or maintain patent protection or if our patents do not provide protection against competitive products, our results of operations may be adversely affected.
Our success is dependent in part on our ability to obtain and maintain patent protection for our products, maintain trade secret protection and operate without infringing the proprietary rights of others. Our policy is to aggressively protect our proprietary technology through patents, where appropriate, and in other cases, through trade secrets. Additionally, in certain cases, we rely on the licenses of patents and technology of third parties. We hold approximately 69 U.S. patents, covering various aspects of our technology, which will expire on various dates between 2007 and 2023. Our core infant formula-related U.S. patents expire between 2011 and 2014. We have filed, and intend to file, applications for additional patents covering both our products and processes as appropriate. Currently, we have over 600 issued patents and pending applications worldwide.
There can be no assurance that (i) any patents issued to or licensed by us will provide us with any competitive advantages or adequate protection for inventions; (ii) any patents issued to or licensed by us will not be challenged, invalidated or circumvented by others; or (iii) issued patents, or patents that may be issued, will provide protection against competitive products or otherwise be commercially valuable. Furthermore, patent law relating to the scope of claims in the fields of healthcare and biosciences is still evolving, and our patent rights are subject to this uncertainty. European and United States patent authorities have not adopted a consistent policy regarding the breadth of claims allowed for health and bioscience patents. Our patent rights on our products therefore might conflict with the patent rights of others, whether existing now or in the future.
In certain competitive geographic markets, we do not have patent protection and may be unable to obtain it. In other competitive markets, we may be unable to maintain the patent protection for our nutritional oils currently afforded to us. A lack of patent protection would have a material adverse effect on our ability to gain a competitive advantage for these oils and may have a material adverse effect on our results of operations, particularly future sales of our nutritional oils. In particular, a lack of patent protection would permit our competitors to manufacture products that would be directly competitive with our nutritional oils using similar or identical processes, and it is possible that our current infant formula or food and beverage licensees or those which may be under license in the future may choose ingredients from these competitors if they choose to include the ingredients at all.

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A number of our competitors have challenged our patents, particularly in Europe:
    Aventis S.A. and Nagase & Co. Ltd. are challenging our European patent covering our DHA-containing oils. At a hearing in October 2000, the Opposition Division of the European Patent Office (“EPO”) revoked our patent on the grounds that it was not novel. We immediately appealed this ruling, and in July 2002 we received a positive ruling from an Appeal Board of the EPO, setting aside the prior decision to revoke this patent. The patent was returned to the Opposition Division for a determination as to whether it has met the legal requirement of “inventive step”. A hearing in August 2005 resulted in a ruling by the Opposition Division that this requirement had been met and the validity of the patent was upheld. Aventis appealed the decision to the Appeal Board of the EPO. Martek filed its answer to Aventis’ grounds for appeal in July 2006. The appeal process is not expected to be completed before the second half of 2007. Claim one of this patent is the basis of the patent infringement suit against Nutrinova and Lonza in Germany, discussed below.
 
    With respect to our ARA patent issued by the EPO, BASF AG, Friesland Brands B.V., and Suntory Limited filed their grounds for opposing this patent with the Opposition Division of the EPO. At a hearing at the Opposition Division in April 2005, the Opposition Division of the EPO upheld the patent in a form containing modified claims that are narrower than the claims originally granted. In an effort to broaden the claims of the patent, we appealed the decision. Suntory and BASF have also appealed. Friesland Brands B.V. has withdrawn from the opposition. The patent in the form containing the claims that were originally granted will remain in full force and effect throughout the appeal process. The appeal process is not expected to be completed until late 2007 or early 2008. Further, in order to broaden the scope of protection, Martek has pending patent applications and intends to pursue new patent applications which would be based on the existing patent. These pending and new applications, if granted, would provide important additional protection. If the patent in the narrower form approved by the Opposition Division is ultimately upheld and certain pending and new related patent applications are not granted with the desired claim scope, it is likely that Martek’s European intellectual property position with respect to ARA would not afford much competitive protection.
 
    With respect to our blended oil (blend of DHA and ARA oils for use in various applications, including infant formula) patent issued by the EPO, BASF AG and Suntory Limited filed their grounds for opposing this patent with the Opposition Division of the EPO. In November 2004, the Opposition Division of the EPO revoked Martek’s European blended oil patent as a result of these challenges. We immediately filed an appeal of this decision; as a consequence, the blended oil patent has been reinstated and will remain in full force and effect during the appeal. Both Suntory and BASF filed responses to our appeal. Further written submissions were filed by Martek in January 2007. A hearing before the Appeal Board of the EPO has been scheduled for February 2007. In the event that the Appeal Board rules against Martek and revokes the patent, that decision would be final. There would be no further recourse for Martek.
 
    Prior to our purchase of OmegaTech, Aventis Research and Technologies GmbH & Co. KG, and Nagase Limited challenged OmegaTech’s European patent covering its DHA-containing oils. At a hearing in December 2000, the Opposition Division of the EPO upheld some of the claims and revoked other claims. OmegaTech immediately appealed this ruling, as did Aventis. At an appeal hearing in May 2005, we received a favorable decision from the Appeal Board of the EPO, which overturned the decision of the Opposition Division and returned the case to the Opposition Division for review on the merits of the patent claims. Any decision made by the Opposition Division can be appealed. Assuming an appeal, the review process is not expected to be completed until 2009, during which time the patent will remain in full force and effect.
 
    An EPO Opposition Division hearing was held on November 15, 2005, with respect to a European DHA patent acquired by Martek as part of the OmegaTech purchase. The patent was upheld in modified form. This patent is directed to processes for fermenting Thraustochytrium and Schizochytrium under low chloride conditions and the resulting products. Nutrinova Nutrition Specialities & Food Ingredients GmbH is the only opponent, and has appealed. The appeal process is not expected to be completed before late 2007.
 
    In September 2003, we filed a patent infringement lawsuit in the U.S. District Court in Delaware against Nutrinova Inc., Nutrinova Nutrition Specialties & Food Ingredients GmbH, Celanese Ventures GmbH, and Celanese AG. Celanese Ventures GmbH and Celanese AG were dropped from the lawsuit. In October 2006, after an almost two week trial in Wilmington, Delaware, the jury returned a favorable verdict to Martek, deciding that all three of the asserted Martek DHA patents were valid and infringed, and that one was willfully infringed. The judge will now determine if any of the jury’s decisions were inappropriate as a matter of law, whether Martek is entitled to a permanent injunction against Lonza, and, if so, whether the permanent injunction should be stayed pending the outcome of any appeal.

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    We also filed a patent infringement suit involving Nutrinova Nutrition Specialties & Food Ingredients GmbH and Celanese Ventures GmbH in Germany in January 2004. The complaint alleges infringement of our European patent relating to DHA-containing oils. A hearing in this case was held in a district court in Dusseldorf in April 2005 and the court delayed its decision pending input from a court-appointed technical expert. The court’s decision is expected at some point in 2007. Lonza has also been added to this lawsuit.
 
    With respect to our ARA patent in South Korea, Suntory has filed an opposition. A hearing on the matter was held in late January 2006 and the Korean Intellectual Property Office Examiners have ruled against Martek. Martek has appealed. The appeal brief is due in February 2007. The patent will remain in full force and effect during the pendency of the appeal.
 
    Suntory has also initiated an invalidation case against our blended oil patent in South Korea. Our response to Suntory was filed in February 2005, Suntory responded in March 2006 and Martek filed further submissions in May 2006. A hearing was held in July 2006. A preliminary ruling was issued in October 2006, rejecting the fish oil plus microbial ARA claims, but finding the fish oil plus microbial ARA and DHA claims to be acceptable. The next ruling is expected in early 2007. The patent will remain in full force and effect during the pendency of the appeal process.
 
    There are additional intellectual property oppositions pending against Martek that are not considered material.
If any of the challenges described above or any other challenges to our patents that we do not currently consider material or that may arise in the future are successful, our competitors may be able to produce similar products and, as a result, we may experience decreases in the future sales of our nutritional oils. Specifically, the revocation of our European DHA patent, ARA patent or blended oils patent could result in a decrease in revenues under our license agreements. In addition, if our products are found to infringe on the intellectual property rights of others, we may have to pay substantial damages. Furthermore, it is our accounting policy to capitalize legal and related costs incurred in connection with patent applications and the defense of our patents. As of October 31, 2006, the net book value of our patent assets totaled $17.4 million, which includes approximately $9.2 million of costs incurred by us in defending our patents in the Nutrinova/ Lonza matter discussed above, which will be amortized over a period of approximately 7 years. If, in the future, it is determined to be unlikely that our patents will be successfully defended in connection with the challenges described above or if it is concluded that certain of our patents will no longer provide an economic benefit to the Company, a write-off of the costs ascribed to the particular patent or patents would be required. The effect of such write-off could be material to our results of operations.
We expect that in the future, as our nutritional oils continue to be commercialized, opposition to our intellectual property by our competitors will continue and most likely increase. We may incur substantial costs in the future protecting and defending our patents and cannot be sure that we will be able to successfully defend our patents or that our competitors will not be able to “design around” our intellectual property.
If clinical trials do not continue to yield positive results on the benefits of DHA on cognitive function, cardiovascular health or other health applications, our future revenues may be limited in the food and beverage and the dietary supplement markets.
During the years ended October 31, 2006 and 2005, approximately 3% of our product sales revenues came from sales of our nutritional oils for uses outside of the infant formula and pregnancy and nursing markets. Investigators at universities and at other research centers, such as NIH, have observed a relationship between low levels of DHA and a variety of health risks. We are currently trying to establish what contribution, if any, supplementation with our oils will make in addressing these problems. Although clinical data are not required to market food and beverage ingredients or dietary supplements outside of the infant formula market, we believe that further clinical studies may be needed to validate the benefits of DHA supplementation in order to gain widespread entry into these markets. If clinical trials do not continue to yield positive results on the benefits of DHA or if these benefits are not considered significant by our targeted consumers, our future revenues in these markets may be limited.
If our oils are unable to be used in organic food and beverage products, the opportunity for sales of our oils into the food and beverage market will be limited to non-organic products.
The Organic Foods Production Act of 1990 required the U.S. Department of Agriculture (“USDA”) to develop national standards for organically produced agricultural products to assure consumers that agricultural products marketed as organic meet consistent, uniform standards. Accordingly, the USDA has put in place a set of national standards (the “National Organic Program” or “NOP”) that food labeled “organic” must meet, whether it is grown in the United States or imported from other countries. Under the NOP regulations, only a USDA-accredited certifying agent may make the determination that a food product may be labeled as organic. Martek is not a USDA-accredited certifying agent.
Some of our customers have obtained organic certification from USDA-accredited certifying agents and have received authorization to use the USDA’s organic seal on certain products which contain our oils. In some instances such products have been further reviewed and the authorization to use Martek’s oils has been explicitly ratified by the USDA. Because the NOP regulations are subject to change and interpretation, there can be no guarantee that our oils will be acceptable for use in all organic products. Organic food sales accounted for only 2.5% of the total U.S. food sales in 2005; however, we believe that interest from food manufacturers in producing and selling organic products is expanding. If our oils are ineligible for inclusion in some products that bear the USDA organic seal, our sales opportunity in the food and beverage market may be adversely impacted.
Because food and beverage pricing is very competitive, the premium that our oils adds to the cost of the food or beverage may never allow it to be priced at levels that will allow acceptance by consumers.
Food and beverage pricing is very competitive and the market is very sensitive to product price changes. Because the inclusion of our oils may add to the retail cost of these products, there is the risk that our potential customers in this market may not be able to sell supplemented products at prices that will allow them to gain market acceptance while, at the same time, remaining profitable. This may lead to price pressure on us. If we have to reduce our prices, we may not be able to sell our oils to the food and beverage market at a price that would enable us to sell them profitably.

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If we are unable to gain broad approvals for the incorporation of our oils into foods and beverages worldwide, our future revenues in the food and beverage market may be limited.
In June 2002, the Australia New Zealand Food Authority authorized the use of DHA-S oil for use as a Novel Food ingredient in Australia and New Zealand. In June 2003, the European Commission authorized the use of our DHA-S oil as a Novel Food ingredient in certain foods in the European Community. This Novel Food designation authorizes the use of our DHA-S as an ingredient in certain foods such as certain dairy products, including cheese and yogurt (but not milk-based drinks), spreads and dressings, breakfast cereals, food supplements and dietary foods for special medical purposes in the European Community. In February 2004, the FDA completed a favorable review of our GRAS notification for the use of DHA-S in food and beverage applications. In October 2006, Health Canada approved per serving levels of Martek’s DHA of not less than eight mg and not more than 100 mg of DHA when used as a food ingredient.
With respect to our European Novel Food approval, we have been working to extend approval into additional food categories but thus far, we have been unsuccessful. We will continue efforts to extend food categories to which DHA-S oil can be added in Europe, but our ability to succeed in this regard is uncertain. Additionally, in 2006, we initiated efforts to register our oils in China for use in foods and beverages. The Ministry of Health in China reviewed our application and responded by requiring that additional work be performed by us prior to final review and approval. In other parts of the world, laws and regulations with respect to the addition of our oils into foods and beverages are diverse and our ability to gain the necessary regulatory approvals is unclear. If we are unable to gain broad approvals for the incorporation of our oils into foods and beverages worldwide, our future revenues in the food and beverage market may be limited.
If it is determined that large amounts of eicosapentaenoic acid (“EPA”) must accompany DHA in order to achieve optimal health benefits, we may never be able to gain large- scale entry into the food and beverage market.
The rationale for supplementing foods and beverages with DHA is to, in part, improve overall cardiovascular system and/or central nervous system development and health. In September of 2004, the FDA authorized a qualified health claim that may be utilized for food and beverage products containing both DHA and EPA relating to the reduction of risk of coronary heart disease. No minimum amounts for either DHA or EPA were established as prerequisites for the claim. Our DHA-S oil includes limited amounts of EPA and therefore products containing the DHA-S oil qualify for use of the qualified health claim. Studies have been completed in the past to investigate the independent effects of DHA and EPA on health and additional studies may be ongoing or conducted in the future. If the consensus of results from these studies establishes that relatively large amounts of EPA are required to be supplemented with DHA in order to achieve the optimal health benefit, then our penetration of the food and beverage market may be limited.
Our oils are very sensitive to oxidation and may not be very compatible with many liquid or dry foods that are currently on the market. If economical methods are not developed to successfully incorporate our oils into various food and beverage applications, we may never be able to gain large-scale entry into the food and beverage market.
Although we believe that the food and beverage market could be a large market for DHA fortification with our DHA-S oil, the potential in this market could be limited if methods are not developed that allow incorporation of the oil into various foods and beverages with acceptable flavor, odor and texture for the duration of the shelf life of the food and beverage products. While DHA-enriched food and beverage products with acceptable flavor and stability have been developed, risks exist for other finished food and beverage products, such as cereals, milk and certain types of nutritional bars for which DHA fortification has not yet been successfully established. Even if we can successfully incorporate our oils into foods and beverages, manufacturers of these products will have to develop methods to demonstrate feasibility in their production processes. The timing and extent of our sales into the food and beverage market, therefore, are dependent not only on market demand, but also on customer formulation and production issues over which we have little or no control.
We have a single third-party supplier of our ARA with whom we have a contractual relationship. If this supplier of our ARA is unable to supply us with our required amounts of ARA or if an over-capacity situation by our supplier leads to higher cost ARA, our results of operations and/or financial position may be adversely affected.
We have entered into an agreement with a third-party manufacturer, DSM, to supply us with ARA. Because DSM is a third-party manufacturer, we have only limited control over the timing and level of its Capua and Belvidere production volumes. If DSM fails to supply us with required amounts of ARA under our agreement, we would not be able to meet our customers’ demands unless we were able to utilize alternative sources of supply. In this regard, we would have to either manufacture the ARA at one or both of our plants, which may be more costly and would also reduce our DHA oil production capacity, or enter into other third-party manufacturer supply agreements, which we may not be able to do in a timely manner. Furthermore, due to certain contractual provisions, if our demand for ARA falls short of DSM’s supply capability, this excess capacity by our supplier will result in higher unit-based ARA costs to us. If we are unable to purchase or produce sufficient and/or cost-effective quantities of ARA, our future results of operations and/or financial position may be adversely affected.

5


 

As we and our major suppliers increase production of our nutritional oils, we may experience certain risks associated with the start-up/ ramp-up of commercial manufacturing that could have a material adverse effect on our business, financial condition, and/ or results of operations.
In 2005, we completed our extensive expansion in Kingstree for the fermentation and processing of our nutritional oils and DSM completed its ARA production expansion in Belvidere, New Jersey and Capua, Italy. 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 production capacity for all DHA and ARA products in excess of $500 million in annualized sales of our oils to the infant formula, dietary supplement and food and beverage markets. Our and DSM’s ability to maintain commercial production at these higher levels has not been successfully tested. Further, we may have periods of overcapacity because of potential excess supply versus customer demand.
As we and our major suppliers increase our production, we may encounter many risks associated with our commercial manufacturing such as:
    we may experience problems processing, handling and shipping the higher quantities of oil produced from our expanded facilities;
 
    the costs of expanding, operating and maintaining our production facilities may exceed our expectations;
 
    product defects may result;
 
    lower than anticipated fermentation success rates may result;
 
    lower downstream processing yields may result;
 
    environmental and safety problems may result from our production process; and
 
    regulatory issues relating to the scale-up and operation regarding our production processes may arise.
If we were to experience any one or more of these problems, there could be a material adverse effect on our business, financial condition, and/ or results of operations.
We have significantly increased our manufacturing capacity and have incurred substantial costs in doing so. If we are unable to increase our revenues from our nutritional oils produced at these facilities, we may continue to experience excess production capacity and we may be unable to recover these plant expansion costs, which could result in a write-down of certain production assets.
In connection with our efforts to alleviate supply constraints with our infant formula licensees and to prepare for other applications of our products, we expanded our internal production capacity and incurred significant expansion costs in doing so. Furthermore, in October 2006, the Company completed a restructuring of its plant operations which transferred to our Kingstree plant a substantial portion of production formerly taking place in Winchester. As of October 31, 2006, the Company had $87.2 million of production assets that are available for commercial use but are not in productive service. Our ability to recover the costs of these and certain other assets will depend on increased revenue from our nutritional oils produced at our facilities. There are no assurances that we will be able to achieve this goal. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” if it is estimated that we will not be able to ultimately recover the carrying amounts of the production assets, we would be required to record an asset impairment write-down. The effect of such write-down could be material. In addition, when experiencing excess capacity, we may be unable to produce the required quantities of oil cost-effectively, which could have a material adverse effect on our product margins and overall profitability.
Failure to effectively manage our growth could disrupt our operations and prevent us from generating the revenues and gross profit margins we expect.
In response to current and expected demand for our nutritional oils, we have expanded our production capabilities. To manage our growth successfully we must implement, constantly improve and effectively utilize our operational and financial systems while expanding our production capacity and workforce. We must also maintain and strengthen the breadth and depth of our current strategic relationships while developing new relationships. Our existing or planned operational and financial systems may not be sufficient to support our growth; we may not successfully control production costs and maintain current and anticipated gross profit levels; and our management may not be able to effectively identify, manage and exploit existing and emerging market opportunities. If we do not adequately manage our growth, our business and future revenues will suffer.

6


 

Experts differ in their opinions on the importance of DHA and/or ARA in infant formula and the levels of DHA and/or ARA required to achieve health benefits for babies. Some experts feel that they are not necessary ingredients for infant development. If clinical trials do not continue to yield positive results, certain favorable regulatory guidelines are not enacted or current favorable regulatory guidelines are amended, our future revenues in the infant formula market may be limited.
Our continued success in the infant formula industry depends on sustained acceptance of our nutritional oils as necessary or beneficial additives to infant formulas. Notwithstanding existing clinical results that have demonstrated the beneficial effects of adding our nutritional oils to infant formula, some experts in the field of infant nutrition do not believe that our nutritional oils are necessary or that they provide any long-term beneficial effects. There have also been clinical studies where no beneficial effects have been found, possibly due to dose, duration or other factors. Experts generally recommend that mothers breastfeed rather than use infant formulas whether or not they contain our nutritional oils. Some experts also believe that infant formulas without our oils or with greatly reduced levels are sufficient as infants can convert precursor fats into DHA and ARA as needed. In addition, some physicians are unimpressed by studies showing that infant formulas fortified with our oils improve infants’ cognitive ability at early ages, suggesting that these results may not carry over to improved results later in life. Due to these differences in opinion, if clinical studies do not continue to yield positive results, our future revenues in the infant formula market may be limited.
Furthermore, a failure by one or more regulatory authorities to enact or maintain guidelines for minimum levels of DHA and/or ARA for supplementation of infant formula products could result in lower-potency formula products in specific affected countries which could reduce the market opportunity for DHA and ARA ingredients. Any regulatory guidelines for infant formula which permit inclusion of DHA and ARA ingredients containing higher levels of EPA than covered in Martek’s patents could also reduce the market opportunity for Martek’s DHA and ARA ingredients in affected countries.
Food Standards Australia New Zealand (“FSANZ”) has received an application from the Infant Formula Manufacturers Association of Australia and the New Zealand Infant Formula Marketer’s Association seeking to amend the regulations for infant and follow-on formula. The application requests removal of the requirement for formula to contain long-chain omega-6 fatty acids and omega-3 fatty acids in a ratio of approximately two to one when these products are added to formula. On May 31, 2006, FSANZ asked for comments on the application from outside groups to be submitted by August 11, 2006. FSANZ has stated that there are two options available for this application. One, maintain the status quo or, two, amend the regulation by removing the requirement for infant formula to contain omega-6 and omega-3 long-chain fatty acids in a ratio of approximately two to one, when long-chain fatty acids are added to these products. We submitted a statement supporting the status quo. The agency has taken no further action at this time.
Our opportunity in the U.S. infant formula market may be limited by the renewal rate of supplemented formulas into the Women, Infants and Children program or if the eligibility requirements for participating in the program are made more restrictive.
We estimate that of the total current annual U.S. market opportunity for sales of supplemented infant formula, approximately half represents Women, Infant and Children (“WIC”)-funded sales. WIC is a federal grant program that is state-administered for the benefit of low-income nutritionally at-risk women, infants and children. Most WIC state agencies provide only one brand of infant formula to its participants, depending on which company has the rebate contract in a particular state. Currently, WIC programs in 48 states and the District of Columbia offer term infant formula supplemented with our oils and WIC programs in all 50 states and the District of Columbia have adopted certain specialty infant formula products supplemented with our oils. If supplemented formulas are removed from WIC programs that previously adopted them, eligibility requirements for participating in WIC become more restrictive, or if any of our licensees fail to renew, in a timely fashion, their contract awards from WIC agencies for the adoption of a supplemented infant formula, then our future revenues from supplemented infant formula sales in the U.S. would be limited.
Our business would be harmed if we fail to comply with applicable good manufacturing practices as required by the FDA.
In connection with the manufacture of certain of our products, we are required to adhere to applicable current “good manufacturing practice” (“GMP”) requirements as required by the FDA. GMP regulations specify component and product testing standards, control quality assurance requirements and records and other documentation controls. As the manufacturer of DHA and ARA that are marketed as dietary supplements and used as ingredients in infant formulas sold in the United States and in food and beverages, we are subject to GMP and various other requirements applicable to such products. There can be no assurance that we will be able to continue to manufacture our nutritional oils in accordance with relevant dietary supplement and infant formula requirements for commercial use. Ongoing compliance with GMP and other applicable regulatory requirements is monitored through periodic inspections by state and federal agencies, including the FDA and comparable agencies in other countries. A determination that we are in violation of such GMP and other regulations could lead to an interruption of our production output and the imposition of civil penalties, including fines, product recalls or product seizures, and, in the most egregious cases, criminal sanctions.
Our manufacturing process involves the handling of hazardous materials and emission of regulated waste. If we fail to properly handle these hazardous materials and/ or waste emissions, substantial costs and harm to our business could result.
In connection with our research and manufacturing activities, we utilize some hazardous materials and emit regulated waste. We are subject to federal, state and local laws and regulations governing the use, storage, handling, discharge and management of hazardous materials and waste products. The cost of compliance with these laws and regulations could be significant, and our ability to comply is somewhat dependent upon raw materials produced by others, over whom we have little or no control. Moreover, we could be subject to loss of our permits, government fines or penalties and/or other adverse governmental or private party action if such hazardous materials or waste products are used, stored, handled, emitted or otherwise managed in violation of law or any permit. In addition, we could be subject to liability if hazardous materials or waste are released into the environment. A substantial fine, penalty or judgment, the payment of significant environmental remediation costs or property or personal injury damages, or the loss of a permit or other authorization to operate or engage in our ordinary course of business could result in material, unanticipated expenses and the possible inability to satisfy customer demand for our nutritional oils.

7


 

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 a March 12, 2003 explosion that occurred at a public wastewater treatment plant in Winchester, Kentucky and relating to n-hexane. Current and former employees have testified before a federal grand jury. We 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.
Our corporate compliance program cannot guarantee that we are in compliance with all potentially applicable federal and state regulations.
Our business is subject to extensive federal and state regulation. Current products and products in development cannot be sold if we or our customers do not obtain or maintain regulatory approvals. While we have developed and instituted a corporate compliance program, we cannot assure you that we or our employees are or will be in compliance with all potentially applicable federal and state regulations. If we fail to comply with any of these regulations a range of actions could result, materially affecting our business and financial condition , including, but not limited to, the failure to approve a product candidate, restrictions on our products or manufacturing processes, including withdrawal of our products from the market, significant fines, or other sanctions.
Our business exposes us to potential product liability claims and recalls, which could adversely impact our financial condition or performance.
Our development, manufacture and marketing of products involve an inherent risk of exposure to product liability claims, product recalls, product seizures and related adverse publicity. In addition, as only a small amount of our oils resides in our customers’ end product, a recall of our oils could impact a much larger recall of our customers’ end products. Insurance coverage is expensive and difficult to obtain, and we may be unable to obtain coverage in the future on acceptable terms, if at all. Although we currently maintain product liability and recall insurance for our products in the amounts we believe to be commercially reasonable, we cannot be certain that the coverage limits of our insurance policies or those of our strategic partners will be adequate. If we are unable to obtain sufficient insurance at an acceptable cost, a product liability claim or recall could adversely impact our financial condition. Furthermore, if a product liability claim is made against us or if there is a product recall, whether fully covered by insurance or not, our future sales could be adversely impacted due to, among other things, an inability to effectively market our products.
We may need additional capital in the future to continue our research and development efforts, to conduct product testing, including preclinical and clinical trials, and to market our products. We may also need additional capital to expand our production capacity if market demand for our products continues to grow.
As of October 31, 2006, we had approximately $26.8 million in cash, cash equivalents and short-term investments as well as $99 million of our revolving credit facility available to meet future capital requirements. We may require additional capital to fund, among other things, our research and development, product testing, and marketing activities. Our ability to meet future demand may require even further expansion of our production capability for our nutritional oils, which would also require additional capital. The timing and extent of our additional cash needs will primarily depend on: (a) the timing and extent of future launches of infant formula products containing our oils by our licensees; (b) the timing and extent of introductions of DHA into foods and beverages and/or dietary supplements for children and adults; and (c) our ability to generate profits from the sales of our nutritional products.
To continue to fund our growth, we will pursue various sources of funding, which may include debt financing, equity issuances, asset-based borrowing, lease financing, and collaborative arrangements with partners. In September 2005, we amended and expanded our secured revolving credit facility to $135 million and extended the term until September 2010. This debt financing arrangement requires us to comply with financial covenants, which we may not be able to meet if demand for our products was to significantly decline, if there was a significant change in our financial position or if our cash needs are greater than we currently anticipate. Additionally, funding from other sources may not be available, or may not be available on terms that would be commercially acceptable or permit us to continue the planned commercialization of our products or expansion of our production capacity. In August 2004, our shelf registration statement was declared effective by the SEC. The shelf registration statement enables us to issue debt securities, preferred stock, common stock and warrants in the aggregate amount of up to $200 million, of which approximately $110 million is currently available for future issuance. Future equity issuances may be dilutive to our existing shareholders. If we obtain funds through collaborative or strategic partners, these partners may require us to give them technology or product rights, including patent rights, that could ultimately diminish our value. If we cannot secure adequate funding, we may need to scale back our research, development, manufacturing, and commercialization programs, which may have a material adverse effect on our future business.

8


 

The market price of our common stock may experience a high level of volatility due to factors such as the volatility in the market for biotechnology stocks generally, and the short-term effect of a number of possible events.
We are a public growth company in the biosciences sector. As frequently occurs among these companies, the market price for our common stock may experience a high level of volatility. During the fifty-two week period ending October 31, 2006, our common stock traded between $37.22 and $20.15 per share. During the fifty-two week period ending October 31, 2005, our common stock traded between $70.50 and $28.20 per share. The following are examples of items that may significantly impact the market price for our common stock:
    announcements of technical innovations, new commercial products and product launches by us or our competitors;
 
    announcements of use of competitors’ DHA and/or ARA products by our customers;
 
    arrangements or strategic partnerships by us or our competitors;
 
    announcements of license agreements, acquisitions or strategic alliances;
 
    announcements of sales by us or our competitors;
 
    patent or other intellectual property achievements or adverse developments;
 
    quarterly fluctuations in our revenues and results of operations;
 
    failure to enter into favorable third-party manufacturing agreements;
 
    regulatory decisions (approvals or disapprovals) or changes concerning our products and our competitors’ products;
 
    events related to threatened, new or existing litigation, or the results thereof;
 
    changes in our estimates of financial performance or changes in recommendations by securities analysts; and
 
    general market conditions for growth companies and bioscience companies.
Because we may experience a high level of volatility in our common stock, you should not invest in our stock unless you are prepared to absorb a significant loss of your capital. At any given time, you may not be able to sell your shares at a price that you think is acceptable.
The market liquidity for our stock is relatively low. As of October 31, 2006, we had 32,156,162 shares of common stock outstanding. The average daily trading volume in our common stock during the fifty-two week period ending October 31, 2006 was approximately 800,000 shares. Although a more active trading market may develop in the future, the limited market liquidity for our stock may affect your ability to sell at a price that is satisfactory to you.
If significant shares eligible for future sales are sold, the result may depress our stock price by increasing the supply of our shares in the market at a time when demand may be limited.
As of October 31, 2006, we had 32,156,162 shares of common stock outstanding and stock options outstanding to purchase an aggregate of approximately 3.7 million shares of common stock. Of these options, approximately 3.4 million were exercisable at January 9, 2007, and approximately 900,000 had exercise prices that were below the market price on this date. Furthermore, we have filed a universal shelf registration statement with the SEC, which was declared effective in August 2004, pursuant to which we may issue debt securities, preferred stock, common stock and warrants to purchase debt securities, preferred stock or common stock in an aggregate amount of up to $200 million, of which approximately $110 million is currently available for future issuance. To the extent that these options for our common stock are exercised or we issue additional shares to raise capital, the increase in the number of our outstanding shares of common stock may adversely affect the price for our common stock. This could hurt our ability to raise capital through the sale of equity securities. If we continue to require additional outside sources of capital to finance, among other things, our research and development, product testing and the manufacturing and marketing of our products, we may need to raise additional capital through the sale of equity securities.
We have agreed to issue and register for resale up to 1,931,853 additional shares, to former OmegaTech stockholders and option holders pursuant to our Agreement and Plan of Merger with OmegaTech, if certain regulatory and financial milestones were achieved by October 31, 2004. The representative for these interest holders has asserted that shares related to two of these milestones should be issued, an assertion with which we do not agree. While we have not resolved this matter, a substantial number of these additional shares would be issued and become eligible for resale if it were determined that these two milestones were achieved. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market or the perception that these sales could occur, which could limit your ability to sell at a price satisfactory to you.

9


 

Changes in foreign currency exchange rates or interest rates could result in losses.
Our total purchase price of ARA from DSM’s Capua, Italy plant and a portion of the purchase price of ARA from DSM’s Belvidere, New Jersey plant are denominated in euros. Fluctuations in the euro-U.S. dollar exchange rate can adversely impact our cost of ARA oil and our gross margins. To reduce the risk of unpredictable changes in these costs, we may, from time to time, enter into forward foreign exchange contracts. However, due to the variability of timing and amount of payments under these contracts, the forward foreign exchange contracts may not mitigate the potential adverse impact on our financial results and in fact may themselves cause financial harm. We have entered into foreign currency forward contracts with outstanding notional values aggregating approximately 9.8 million euros at October 31, 2006. The terms of these contracts are from 30 to 120 days.
We are a defendant in a putative class action lawsuit which, if determined adversely, could have a material adverse affect on us.
We, our Chairman and former Chief Executive Officer and our Chief Financial Officer were named as defendants in putative class action lawsuits filed in the United States District Court for the District of Maryland. The District Court consolidated these lawsuits into one action. The consolidated complaint generally seeks recovery of unspecified damages for persons who purchased our shares during the period from December 9, 2004 through April 27, 2005. The complaint asserts claims under federal securities laws alleging that we and the individually named defendants made materially false and misleading public statements and failed to disclose material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, concerning our business and prospects.
We are vigorously defending against the plaintiffs’ claims. At this stage, management is unable to predict the outcome or its ultimate effect, if any, on our financial condition. We expect that the costs and expenses related to this litigation could be significant. Although we have director and officer liability insurance policies (which, subject to the terms and conditions thereof, also provide “entity coverage” for us for this litigation) in place, we are responsible for certain costs and expenses relating to the lawsuits. Also, a judgment in or settlement of this action could exceed our insurance coverage. If we are not successful in defending this action, our business and financial condition could be adversely affected. In addition, whether or not we are successful, the defense of this action will divert the attention of our management and other resources that would otherwise be engaged in running our business.

10


 

PART II
ITEM 6.   SELECTED FINANCIAL DATA.
The selected financial data set forth below with respect to the Company’s consolidated statements of income for each of the years in the three-year period ended October 31, 2006 and with respect to the consolidated balance sheets as of October 31, 2006 and 2005 are derived from the audited consolidated financial statements included elsewhere in this Form 10-K/A. The statements of operations data for each of the years in the two-year period ended October 31, 2003 and the balance sheet data at October 31, 2004, 2003 and 2002 are derived from audited financial statements not included in this Form 10-K/A. The information presented as of and for the year ended October 31, 2006 has been adjusted to reflect the restatement of the Company’s financial statements which is more fully described in Note 1 to the Company’s consolidated financial statements.
The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes contained in this Form 10-K/A.
                                         
    Year ended October 31,  
In thousands, except per share data   2006     2005     2004     2003     2002  
    (restated)                          
 
                                       
Consolidated Statements of Operations Data
                                       
Revenues:
                                       
Product sales
  $ 255,838     $ 203,765     $ 170,565     $ 112,298     $ 46,055  
Contract manufacturing sales
    14,816       14,087       13,928       2,439        
 
                             
 
                                       
Total revenues
    270,654       217,852       184,493       114,737       46,055  
 
                             
 
                                       
Cost of revenues:
                                       
Cost of product sales, including idle capacity costs
    158,600       120,865       103,423       66,347       29,794  
Cost of contract manufacturing sales
    14,676       12,516       11,570       2,192        
 
                             
 
                                       
Total cost of revenues
    173,276       133,381       114,993       68,539       29,794  
 
                             
 
                                       
Gross margin
    97,378       84,471       69,500       46,198       16,261  
 
                             
 
                                       
Operating expenses:
                                       
Research and development (1)
    24,823       20,468       18,596       13,154       12,188  
Selling, general and administrative (1)
    41,614       33,404       25,804       16,275       11,804  
Restructuring charge
    4,729                   (250 )     1,266  
Other operating expenses
    1,158       7,654       4,000       1,943       406  
Acquired in-process research and development
                            15,788  
 
                             
 
                                       
Total operating expenses
    72,324       61,526       48,400       31,122       41,452  
 
                             
 
                                       
Income (loss) from operations
    25,054       22,945       21,100       15,076       (25,191 )
Interest and other income (expense), net
    (1,528 )     1,125       772       916       958  
 
                             
 
                                       
Income (loss) before income tax provision (benefit)
    23,526       24,070       21,872       15,992       (24,233 )
Income tax provision (benefit) (1)
    8,588       8,786       (25,176 )            
 
                             
 
                                       
Net income (loss)
  $ 14,938     $ 15,284     $ 47,048     $ 15,992     $ (24,233 )
 
                                       
 
                             
 
                                       
Net income (loss) per share, basic
  $ 0.47     $ 0.49     $ 1.62     $ 0.63     $ (1.10 )
Net income (loss) per share, diluted
  $ 0.46     $ 0.48     $ 1.55     $ 0.58     $ (1.10 )
 
                                       
 
                             
 
                                       
Shares used in computing basic earnings per share
    32,113       31,164       29,033       25,510       21,982  
Shares used in computing diluted earnings per share
    32,343       32,032       30,386       27,417       21,982  
 
                                       
 
                             
 
                                       
 
(1)   Includes the following amounts related to equity-based compensation expense:
 
                                       
Research and development
    1,143                          
Selling, general and administrative
    2,129                          
Income tax provision (benefit)
    (1,194 )                        

11


 

                                         
    October 31,
    2006   2005   2004   2003   2002
    (restated)                
 
                                       
Consolidated Balance Sheets and Other Data
                                       
Cash, cash equivalents, short-term investments and marketable securities
  $ 26,828     $ 33,347     $ 42,650     $ 96,971     $ 22,419  
Working capital
    120,182       124,208       68,195       106,218       30,457  
Total assets
    597,973       578,485       501,398       295,523       124,312  
Long-term debt, notes payable and other long-term obligations
    46,277       66,115       97,175       10,441        
Long-term portion of deferred revenue
    9,335       8,959       9,140       8,992       2,246  
Accumulated deficit
    (34,298 )     (49,236 )     (64,520 )     (111,568 )     (127,560 )
Total stockholders’ equity
    492,575       469,205       346,164       243,964       105,977  
Cash dividends declared — common stock
                             

12


 

ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements concerning our business and operations, including, among other things, statements concerning the following:
    expectations regarding future revenue growth, gross margin and overall profitability;
 
    expectations regarding product introductions and growth in nutritional product sales;
 
    expectations regarding potential collaborations and acquisitions
 
    expectations regarding demand for products with our nutritional oils;
 
    expectations regarding sales to and by our infant formula licensees and supplemented infant formula market penetration levels;
 
    expectations regarding marketing of our oils by our infant formula licensees;
 
    expectations regarding continued interest by and agreements with food, beverage and supplement companies;
 
    expectations regarding growing consumer recognition of the key health benefits of DHA and ARA;
 
    expectations regarding competitive products;
 
    expectations regarding future efficiencies and improvements in manufacturing processes and the cost of production of our nutritional oils;
 
    expectations regarding future purchases of third-party manufactured oils;
 
    expectations regarding the amount of production capacity and our ability to meet future demands for our nutritional oils;
 
    expectations regarding the amount of inventory held by us or our customers;
 
    expectations regarding production capacity utilization and the effects of excess production capacity;
 
    expectations regarding future selling, general and administrative and research and development costs;
 
    expectations regarding future capital expenditures;
 
    expectations regarding levels of consumption through governmental programs of infant formula products containing our nutritional oils;
 
    expectations regarding possibly significant expenses to defend putative securities class action lawsuits alleging false and material misstatements and omissions of material facts concerning our business and prospects; and
 
    expectations regarding our ability to protect our intellectual property.
Forward-looking statements include those statements containing words such as the following:
    “will,”
 
    “should,”
 
    “could,”
 
    “anticipate,”
 
    “believe,”
 
    “plan,”
 
    “estimate,”
 
    “expect,”
 
    “intend,” and other similar expressions.
All of these forward-looking statements involve risks and uncertainties. They and other forward-looking statements in this Form 10-K/A are all made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. We wish to caution you that our actual results may differ significantly from the results we discuss in our forward-looking statements. We discuss some of the risks that could cause such differences in Item 1A. Risk Factors in this report on Form 10-K/A 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.

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GENERAL
Martek was founded in 1985. We are a leader in the innovation and development of omega-3 DHA products that promote health and wellness through every stage of life. We produce life’sDHA™ , a vegetarian source of the omega-3 fatty acid DHA (docosahexaenoic acid), for use in infant formula, perinatal products, foods and beverages and dietary supplements, and ARA (arachidonic acid), an omega-6 fatty acid, for use in infant formula. We sell oils containing these fatty acids as DHASCO®, life’sDHA™, Neuromins® and ARASCO®. We derive DHA from microalgae and ARA from fungi, using proprietary processes. Cell membranes throughout the body contain these fatty acids, and they are particularly concentrated in the brain, central nervous system, retina and heart. Research has shown that DHA and ARA may enhance mental and visual development in infants. In addition, research has shown that DHA may play a pivotal role in brain function throughout life and 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 and dementia. Further research is underway to assess the role of supplementation with our DHA on mitigating 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.
In 1992, we realized our first revenues from license fees related to our nutritional oils containing DHA and ARA and sales of sample quantities of these oils. In 1995, we recognized our first product and royalty revenues from sales of infant formula containing these oils, and in 1996 we began to realize revenues from the sale of Neuromins®, a DHA dietary supplement. In 2001, the FDA completed a favorable review of our generally recognized as safe notification for the use of our DHA and ARA oil blend in specified ratios in infant formula. We have entered into license agreements with 24 infant formula manufacturers, who collectively 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 include infant formula market leaders Mead Johnson Nutritionals, Nestle, Abbott Laboratories, Wyeth and Royal Numico, each of whom is selling infant formula fortified with our nutritional oils. Our licensees are now selling term infant formula products containing our oils collectively in over 30 countries and preterm infant formula products containing our oils collectively in over 60 countries around the world. Preterm infant formula products comprise less than 3% of the total infant formula market worldwide. Supplemented infant formulas manufactured by Mead Johnson Nutritionals, Abbott Laboratories, PBM Products and Nestle are currently being sold in the United States.
Martek has patented certain separate and distinct DHA technology, which we refer to as DHA-S, that is derived from a different algal strain than our DHA authorized for addition to infant formula. We have received authorization from both the European Commission and the Australia New Zealand Food Authority for the use of DHA-S oil as a Novel Food ingredient. This Novel Food designation authorizes the use of our DHA-S as an ingredient in certain foods such as certain dairy products, including cheese and yogurt (but not milk-based drinks), spreads and dressings, breakfast cereals, food supplements and dietary foods for special medical purposes in the European Community. We have also received a favorable review by the FDA of our GRAS notification for the use of DHA-S in food and beverage applications in the U.S. and have received similar approvals in Canada.
During the past three years, several new products were launched that contained life’sDHA™, including:
    Mead Johnson launched Expecta™ LIPIL®, a DHA supplement for pregnant and nursing women containing life’sDHA™.
 
    PBM Products launched a beverage containing life’sDHA™ that is formulated for diabetics and people with atypical glucose tolerance.
 
    GlaxoSmithKline launched a second powdered drink mix containing life’sDHA™ in India. The product, Junior Horlicks, is formulated for a child’s developing brain and nervous system. GlaxoSmithKline had previously launched an adult DHA beverage.
 
    Sciele Pharma, Inc. launched OptiNate™ and Mission Pharmacal launched Citracal® Prenatal + DHA. Both of these products are prescription prenatal supplements containing life’sDHA™.
 
    Vincent Foods, LLC is selling Oh Mama! nutrition bars containing life’sDHA™, which also target pregnant and nursing women.
 
    Several egg producers, including Gold Circle Farms®, are producing eggs and liquid eggs using life’sDHA™. These eggs are sold in several grocery store chains in the U.S. and Europe.
 
    Priégola is selling Simbi + Omega-3 yogurt with life’sDHA ™, which is now available in major supermarket chains throughout Spain and is being marketed to children and adults for its brain health benefits.
 
    Odwalla, Inc. is selling Odwalla Soymilk and the Soy Smart™ Chai Soymilk drink, both of which feature life’sDHA™, in the U.S.
 
    Dynamic Confections recently re-formulated the Botticelli Choco-Omeg® line of nutritional bars to include life’sDHA™. The bars are available at Canadian retailers.
 
    Flora, Inc. recently launched Udo’s Choice® DHA Oil Blend, a flaxseed oil blend, containing life’sDHA™. Flora’s Udo’s Choice brand is a line of vegetarian, organic and sustainable health oils.
 
    Italian dairy company Latteria Merano/Milchhof Meran recently launched Mente Viva™ fortified drinkable yogurt with life’sDHA™. This product is available in supermarkets throughout Italy.
 
    Italian company Centrale Del Latte Di Brescia launched Sprintissimo™ fortified drinkable yogurt with life’sDHA™. This product is available in supermarkets throughout Italy.
 
    NutraBella is selling Bellybar™ nutrition bars containing life’sDHA™.
 
    Life Science Nutritionals recently launched Nutri-Kids Nutrition-to-Go™ including life’sDHA™. This ready-to-drink milk product is available at select grocery and nutrition retailers in the U.S. and Canada.
 
    General Mills has introduced Yoplait Kids® featuring life’sDHA™. This yogurt product will be available at U.S. retailers nationwide in mid-February 2007.

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These products are expected to generate additional revenue for us during fiscal 2007. In addition, during fiscal 2005 and 2006, we entered into license agreements with several large food and beverage companies which we expect to yield multiple launches of products containing life’sDHA™ and revenues to us beginning in the next 3 to 18 months.
For the years ended October 31, 2006, 2005 and 2004, we recognized approximately $14.9 million, $15.3 million and $47.0 million of net income, respectively, and as of October 31, 2006, our accumulated deficit was approximately $34.3 million. Although we anticipate future growth in annual sales of our nutritional oils, we are likely to 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 future oils-related revenues are largely dependent upon the following factors:
    the timing of infant formula market introductions by our customers both domestically and internationally;
 
    the timing of our customers’ production and ordering patterns;
 
    the timing and extent of stocking and destocking of inventory by our customers, including the potential that customers will move to “just in time” inventory purchasing now that we have reached a base finished goods inventory level;
 
    the timing and extent of our customers’ plant maintenance shutdowns;
 
    the timing and extent of introductions of DHA into various child and/or adult applications;
 
    the continued acceptance of products containing our oils under WIC programs in the U.S.;
 
    the continued acceptance of these products by consumers and continued demand by our customers;
 
    the ability by us and our third-party manufacturers to produce adequate levels of our nutritional oils on a consistent basis;
 
    our ability to protect against competitive products through our patents;
    competition from alternative sources of DHA and ARA; and
 
    agreements with other future third-party collaborators to market our products or develop new products.
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.
MANAGEMENT OUTLOOK
At present, we estimate that infant formula supplemented with our oils has penetrated approximately 85% of the U.S. infant formula market. As such, our revenue growth in the U.S. infant formula market is slowing. International demand for supplemented formulas, however, is increasing, particularly in Asian markets, which should drive higher revenues for Martek. With respect to the food and beverage market, over the next several quarters, we anticipate more announcements of supply agreements with food companies that will position us for increased future sales of our oils. We also expect additional launches of products containing life’sDHA™ and increased sales in fiscal 2007 of our oils to food, beverage and supplement customers for products promoting cognitive function and cardiovascular health. Management believes that over the next few years, non- infant formula sales will continue to expand and could ultimately represent a larger opportunity than infant formula.
Absent a favorable resolution of our current negotiations with our third-party ARA supplier, our gross margins during much of fiscal 2007 will be negatively impacted by higher ARA costs. We expect, however, that the impact of ARA cost increases will be largely offset by the gross margin improvements resulting from the Company’s October 2006 plant restructuring. The restructuring is expected to reduce manufacturing costs and operating expenses due to improved overall manufacturing efficiency and a reduction in Martek’s workforce at its Winchester, Kentucky site. During fiscal 2007, we will continue to work with our third-party ARA supplier and pursue other strategies in efforts to improve future margins.
In fiscal 2007, we intend to invest heavily in our sales and marketing efforts, particularly in the food and beverage area, as we aggressively pursue this market. These costs, which are intended to accelerate growth in future years, will impact our results of operations in the coming year, but nonetheless, we expect increases to overall profitability in fiscal 2007 as compared with fiscal 2006.
PRODUCTION
We manufacture oils rich in DHA at our fermentation and oil processing facilities located in Winchester, Kentucky and Kingstree, South Carolina. In 2005, we completed the extensive expansion at our Kingstree facility for the fermentation and processing of our nutritional oils and now have two fully redundant production facilities. The oils that we produce in these facilities are certified kosher by the Orthodox Union and are certified Halal by the Islamic Food and Nutrition Council of America. In addition, both manufacturing facilities have received a rating of “superior,” the highest possible rating, by the American Institute of Baking (“AIB”). In October 2006, we restructured our plant operations following a review of the Company’s current production and cost structure. Under the restructuring, a substantial portion of production formerly taking place in Winchester was transferred to Kingstree. The restructuring is expected to reduce manufacturing costs and operating expenses, starting in the first quarter of fiscal 2007, due to improved manufacturing efficiency and a reduction in our workforce at the Winchester site. We plan to maintain the essential redundancy of dual-plant manufacturing capacity in order to mitigate production risk and to meet future customer demand. We believe that we can bring the Winchester assets back to full production in a matter of months as required by customer demand.

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Our ARA oils are purchased from DSM as manufactured at its Capua, Italy and Belvidere, New Jersey plants. In fiscal 2006, we received approximately one-half of our ARA from each of DSM’s facilities, and in fiscal 2007, we expect to receive approximately 40% from Capua and 60% from Belvidere. Because DSM is a third-party manufacturer, we have only limited control over the timing and level of its Capua and Belvidere production volumes.
In February 2006, we and DSM entered into an amendment to the original agreement (“the Amendment”). The Amendment served to provide certain clarifying and updating language to the original agreement and to establish the overall economics associated with DSM’s expansion at both its Belvidere, New Jersey and Capua, Italy production facilities. We guaranteed the recovery of certain costs incurred by DSM in connection with these expansions, up to $40 million, with such amount being reduced annually through December 31, 2008 (the “Recoupment Period”) based upon ARA purchases by us in excess of specified minimum thresholds. As of October 31, 2006, the guarantee amount has been reduced to approximately $25.0 million. The guarantee amount payable, if any, at the end of the Recoupment Period, must be paid by January 31, 2009. The amount paid, if any, will be credited against a portion of DSM invoices for purchases made after the Recoupment Period. Annual ARA unit pricing under the agreement with DSM utilizes a cost-plus approach that is based on the prior year’s actual costs incurred adjusted for current year volume and cost expectations. Calendar 2006 ARA purchases have been valued by us based on amounts and unit prices invoiced by DSM. Certain issues, however, still need to be resolved in order to finalize 2006 ARA pricing. Absent a favorable resolution to us, our recorded cost of ARA will approximate, in all material respects, the agreed-upon amounts when 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 our supply agreement with DSM. In connection with this agreement, we have the ability to produce, either directly or through a 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 demonstrated the ability to produce limited amounts of ARA in our plants. To further improve our overall ARA supply chain, we have directly engaged a U.S.-based provider of certain post-fermentation ARA manufacturing services. Along with our ARA downstream processing capabilities at Kingstree and Winchester, this third-party facility provides us with multiple U.S. sites for the full 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 have production capacity for DHA and ARA products in excess of $500 million in annualized sales to the infant formula, perinatal, food and beverage and dietary supplement markets. As such, our production capabilities exceed current demand; however, we have the ability to manage production levels and, to a certain extent, control our manufacturing costs. Nonetheless, when experiencing excess capacity, we may be unable to produce the required quantities of oil cost-effectively due to the existence of significant levels of fixed production costs at our plants and the plants of our suppliers.
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 align our production with customer demand. If market demand subsides due to our inability to meet demand for our products, our customers’ use of competing products or for any other reason, 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, those 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 a process for making our oils.
CRITICAL ACCOUNTING POLICIES AND
THE USE OF ESTIMATES
The preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles 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 believe that the following significant accounting policies and assumptions involve a higher degree of judgment and complexity than others.
Valuation of Long-lived Assets We review our long-lived assets, including fixed assets and certain identified intangibles, for impairment as events or changes in circumstances occur indicating that the carrying amount of the asset may not be recoverable. As of October 31, 2006, these long-lived assets had a total net book value of $372.4 million. Included in these long-lived assets are approximately $87.2 million of production equipment whose use is not currently required based on present customer demand. Undiscounted cash flow analyses are used to assess impairment. The estimates of future cash flows involve considerable management judgment and are based on many assumptions for each target market, including the food and beverage market. Such assumptions include market size, penetration levels and future product margins. While management believes that its projections are reasonable and that no impairment of these assets exists, different assumptions could affect these evaluations and result in material impairment charges against the carrying value of these assets.

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Revenue Recognition We derive revenue principally from two sources: product sales and contract manufacturing. We recognize 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, which also may include discounts based on the achievement of certain volume purchases. In accordance with Emerging Issues Task Force No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF No. 00-21”), 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. If volume pricing discounts are deemed to be a separate element, revenue on related product shipments is recognized using the estimated average price to the customer over the term of the discount period, which requires an estimation of total production shipments over that time frame. Once the requisite volume thresholds have been satisfied, the previously recorded deferred revenue is recognized over the remaining discount period. 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 our licensees.
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.
Deferred Income Taxes We provide for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial reporting bases and the tax bases of assets and liabilities. We also recognize deferred tax assets for tax net operating loss carryforwards. These deferred tax assets and liabilities are measured using the enacted tax rates and laws expected to be in effect when such amounts are projected to reverse or be utilized. As of October 31, 2006, our total gross deferred tax asset was $61.4 million. The realization of total deferred tax assets is contingent upon the generation of future taxable income. When appropriate, we recognize a valuation allowance to reduce such deferred tax assets to amounts more likely than not to be ultimately realized. The calculation of deferred tax assets (including valuation allowances) and liabilities requires management to apply significant judgment related to such factors as the application of complex tax laws and the changes in such laws. We have also considered our future operating results which require assumptions such as future market penetration levels, forecasted revenues and the mix of earnings in the jurisdictions in which we operate in determining the need for a valuation allowance. We review our deferred tax assets on a quarterly basis to determine if a change to our valuation allowance is required based upon these factors. As of October 31, 2006, our deferred tax asset valuation allowance was $18.6 million, which related primarily to certain net operating loss carryforwards whose realization is uncertain. Changes in our assessment of the need for a valuation allowance could give rise to a change in such allowance, potentially resulting in material amounts of additional expense or benefit in the period of change.
Inventory We carry our inventory 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. We regularly review inventory quantities on hand and record a reserve for excess, obsolete and “off-spec” inventory based primarily on an estimated forecast of product demand and the likelihood of consumption in the normal course of manufacturing operations. Those reserves are based on significant estimates. Our estimates of future product demand or assessments of future consumption may prove to be inaccurate, in which case we may have understated or overstated the provision required. Although we make every effort to ensure the accuracy of our forecasts and assessments, any significant unanticipated changes, particularly in demand or competition levels, could have a significant impact on the values of our inventory and our reported operating results. In addition, abnormal amounts of inventory costs related to, among other things, idle facilities, freight handling and waste material expenses are recognized as period charges and expensed as incurred. The determination of such period costs requires the use of judgment in establishing the level of production that the Company considers normal. A different conclusion as to what constitutes normal production levels could result in material changes to idle capacity expenses recognized.
Equity-Based Compensation Expense Effective November 1, 2005, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Shared-Based Payment” (“SFAS 123R”), using the modified prospective transition method, and therefore have not restated prior periods’ results. Under this method, we recognize equity-based compensation expense for all share-based payment awards granted after November 1, 2005 and granted prior to but not yet vested as of November 1, 2005, in accordance with SFAS 123R. Under the fair value recognition provisions of SFAS 123R, we recognize equity-based compensation expense net of an estimated forfeiture rate and recognize compensation cost for only those shares expected to vest on a straight-line basis over the requisite service period of the award. Prior to SFAS 123R adoption, we accounted for share-based payment awards under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and, accordingly, we were required to recognize compensation expense only when options were granted with a discounted exercise price.
Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. Management determined that our historical volatility is a better indicator of expected volatility and future stock price trends. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our equity-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the equity-based compensation expense could be significantly different from what we have recorded in the current period.
Restructuring Charge In October 2006, we restructured our plant operations. An accounting charge resulted from this restructuring, which required management to utilize significant estimates related to expenses for severance and other employee separation costs and the realizable values of certain assets formerly supporting production. If the actual amounts differ from our estimates, the amount of the restructuring charges could be materially impacted.
Patent Cost Capitalization We capitalize legal and related costs incurred in connection with pending patent applications. Such costs are amortized over the life of the patent, if successful, or charged to operations upon denial or in the period during which a determination not to further pursue such application is made. We also capitalized external legal costs incurred in the defense of our patents when it is believed that the future economic benefit of the patent will be increased and a successful defense is probable. Capitalized patent defense costs are amortized over the remaining life of the related patent. Our assessment of future economic benefit and/ or a successful defense of our patents involves considerable management judgment. A different conclusion could result in material write-offs of the carrying value of these assets.

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RESULTS OF OPERATIONS
Revenues
The following table presents revenues by category (in thousands):
                         
    Year ended October 31,
    2006   2005   2004
     
 
                       
Product sales
  $ 255,838     $ 203,765     $ 170,565  
Contract manufacturing sales
    14,816       14,087       13,928  
     
Total revenues
  $ 270,654     $ 217,852     $ 184,493  
     
Product sales increased by $52.1 million or 26% in fiscal 2006 as compared to fiscal 2005 and increased by $33.2 million or 19% in fiscal 2005 as compared to fiscal 2004, primarily due, in both comparative periods, to higher sales of nutritional products to our infant formula licensees. Substantially all of our product sales in fiscal 2006, 2005 and 2004 relate to the sale of our oils for use in infant formulas, and continued sales increases in both the U.S. and international markets contributed to our revenue growth. Included in product sales in fiscal 2006 and 2005 was $4.0 and $5.6 million, respectively, in sales of DHA oil to the pregnancy and nursing market. Sales to the pregnancy and nursing market began during the fourth quarter of fiscal 2004 and initial customer stocking occurred in fiscal 2005. Also included in product sales in fiscal 2006, 2005 and 2004 was $7.6 million, $5.4 million and $4.0 million, respectively, of sales of our oils for uses outside of the infant formula and pregnancy and nursing markets.
Approximately 83%, 88% and 90% of our product sales in fiscal 2006, 2005 and 2004, respectively, 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 60%, 67% and 67% of our sales to infant formula licensees for fiscal 2006, 2005 and 2004, respectively, 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 October 31, 2006, we estimate that formula supplemented with our oils had penetrated approximately 85% of the U.S. infant formula market.
Although we anticipate that annual product sales will continue to grow, our future sales growth is dependent to a significant degree upon the following factors: (i) the launches and expansions of current products containing our nutritional oils by our customers in new and existing markets; (ii) the launches of new products containing our nutritional oils by current or future customers; (iii) the timing and extent of stocking and destocking of inventory by our customers; and (iv) the availability and use by our customers and others of competitive products.
Contract manufacturing sales revenues, totaling approximately $14.8 million, $14.1 million and $13.9 million in fiscal 2006, 2005 and 2004, respectively, relate to fermentation work performed for various third parties at our Kingstree, South Carolina facility.
As a result of the above, total revenues increased by $52.8 million or 24% in fiscal 2006 as compared to fiscal 2005 and increased by $33.4 million or 18% in fiscal 2005 as compared to fiscal 2004.
Cost of Revenues
The following table presents our cost of revenues (in thousands):
                         
    Year ended October 31,
    2006   2005   2004
     
    (restated)        
 
                       
Cost of product sales, including idle capacity costs
  $ 158,600     $ 120,865     $ 103,423  
Cost of contract manufacturing sales
    14,676       12,516       11,570  
     
Total cost of revenues
  $ 173,276     $ 133,381     $ 114,993  
     
Cost of product sales, including idle capacity costs, as a percentage of product sales increased to 62% in fiscal 2006 from 59% in fiscal 2005. The increase was due to idle capacity charges (6%), partially offset by DHA productivity improvements (1%) and decreases in our overall cost of ARA (2%). Idle capacity costs were $14.1 million in fiscal 2006. Idle capacity costs represent certain fixed period costs associated with underutilized manufacturing capacity.
Cost of product sales decreased as a percentage of product sales to 59% in fiscal 2005 from 61% in fiscal 2004. The decrease was primarily due to DHA productivity improvements (a decrease of approximately 4%) partially offset by an increase in our overall cost of ARA due primarily to the decline of the U.S. dollar against the euro, the currency in which we purchase a portion of our ARA.
Cost of contract manufacturing sales, totaling $14.7 million, $12.5 million and $11.6 million in fiscal 2006, 2005 and 2004, respectively, are the costs related to 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. These overall margins will vary between periods primarily due to contract mix and volume.
We expect our overall gross profit margin in fiscal 2007 to reflect the improvements derived from the October 2006 plant restructuring, which will reduce idle capacity costs. We expect, however, that for much of fiscal 2007 these benefits will be more than offset by increases to our ARA purchase costs from our third-party supplier. We are currently in negotiations with our ARA supplier in attempts to mitigate such price increases.

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Operating Expenses
The following table presents our operating expenses (in thousands):
                         
    Year ended October 31,
    2006   2005   2004
     
 
                       
Research and development
  $ 24,823     $ 20,468     $ 18,596  
Selling, general and administrative
    41,614       33,404       25,804  
Restructuring charge
    4,729              
Other operating expenses
    1,158       7,654       4,000  
     
Total operating expenses
  $ 72,324     $ 61,526     $ 48,400  
     
Research and Development Our research and development costs increased by $4.4 million or 21% in fiscal 2006 as compared to fiscal 2005. The increase is primarily due to additional costs incurred on clinical studies focusing on the cognitive benefits of DHA. Research and development expenses also include $1.2 million of non-cash equity-based compensation charges in fiscal 2006.
Our research and development costs increased by $1.9 million or 10% in fiscal 2005 as compared to fiscal 2004 due to additional resources focused on DHA and ARA production improvements, the development of new DHA products for the food and beverage industry and the commencement of new DHA clinical studies.
Selling, General and Administrative Our selling, general and administrative costs increased by $8.2 million or 25% in fiscal 2006 as compared to fiscal 2005. The increase was largely due to higher personnel costs, including an expansion of our sales and marketing staff (increase of $3.8 million), and legal costs (increase of $1.4 million). Selling, general and administrative expenses also include $2.1 million of non-cash equity-based compensation charges in fiscal 2006.
Our selling, general and administrative costs increased by $7.6 million or 29% in fiscal 2005 as compared to fiscal 2004. The increase was primarily due to increased personnel costs (increase of $1.8 million), legal costs (increase of $1.6 million) and insurance costs (increase of $1.1 million) required to manage our overall growth as well as the costs of Sarbanes-Oxley Act compliance (increase of $1.0 million) and certain patent-related expenses (increase of $1.1 million).
Restructuring Charge We recognized a charge of $4.7 million in fiscal 2006 resulting from the plant restructuring announced in October 2006 following a review of our current production and cost structure. This charge primarily includes employee separation costs and a write-down of certain assets supporting production in Winchester. We anticipate incurring approximately $500,000 of additional restructuring costs in fiscal 2007 related mainly to outplacement services and employee relocation costs. See Note 12 to the consolidated financial statements for further discussion.
Other Operating Expenses We incurred other operating expenses of $1.2 million, $7.7 million and $4.0 million in fiscal 2006, 2005 and 2004, respectively. These costs were significantly lower in fiscal 2006 as production start-up costs incurred by us have greatly diminished as a result of the completion in late 2005 of the Kingstree facility expansion. These expenditures in fiscal 2005 and 2004 related primarily to production start-up costs associated with the expansion at our Kingstree facility, which include training expenses and costs related to the scale-up and validation of new equipment and production processes. These costs also include qualification of certain third-party manufacturers as well as expenses related to the Winchester wastewater treatment matter in fiscal 2004.
Interest and Other Income, Net
Interest and other income, net, increased by $100,000 in fiscal 2006 as compared to fiscal 2005 and increased by $700,000 in fiscal 2005 as compared to fiscal 2004, due primarily to varying levels of cash, cash equivalents and short-term investments and changes in interest rates.
Interest Expense
Interest expense increased by $2.7 million in fiscal 2006 as compared to fiscal 2005 and increased by $300,000 in fiscal 2005 as compared to fiscal 2004, as capitalization of interest costs has largely ceased with the completion of the Kingstree expansion. See “Liquidity and Capital Resources” for further discussion.
Income Tax Provision (Benefit)
The non-cash provision for income taxes totaled $8.6 million and $8.8 million in fiscal 2006 and 2005, respectively, and has been recorded based upon our effective tax rate of 36.5%.
In fiscal 2004, we reversed approximately $51 million of our deferred tax asset valuation allowance. This reversal resulted in the recognition of an income tax benefit totaling $25.2 million, a direct increase to stockholders’ equity of approximately $22.8 million due to non-qualified stock option exercises and a decrease to goodwill of approximately $2.6 million due to certain basis differences and net operating loss carryforwards resulting from our acquisition of OmegaTech. As of October 31, 2006, the net recorded value of our deferred tax asset was approximately $42.8 million. Realization of deferred tax assets is contingent upon the generation of future taxable income. As such, the realization of this $42.8 million asset will require the generation of approximately $118 million of future taxable income.
As of October 31, 2006, we had net operating loss carryforwards for Federal income tax purposes of approximately $183 million, which expire at various dates between 2010 and 2025. Of the total net operating loss carryforwards, the tax effect of approximately $51.6 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 $9.9 million of the resulting benefit will be reflected as an income tax benefit upon reversal of the allowance, approximately $7.3 million will be reflected as a reduction to goodwill and approximately $1.4 million will be reflected as an increase to stockholders’ equity.

19


 

Net Income
As a result of the foregoing, net income was $14.9 million in fiscal 2006 as compared to net income of $15.3 million in fiscal 2005 and net income of $47.0 million in fiscal 2004.
Prior to November 1, 2005, we accounted for our equity-based compensation plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Effective November 1, 2005, we adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method. Under the modified prospective transition method, compensation cost recognized in fiscal 2006 includes: (a) compensation cost for all share-based payments granted prior to but not yet vested as of November 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123 and (b) compensation cost for all share-based payments granted subsequent to November 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Results for prior periods have not been restated.
As a result of adopting SFAS 123R on November 1, 2005, income before income taxes and net income in fiscal 2006 were $3.3 million and $2.1 million lower, respectively, than if we had continued to account for equity-based compensation under APB 25. Basic and diluted earnings per share in fiscal 2006 were each $0.06 lower than if we had continued to account for equity-based compensation under APB 25. As of October 31, 2006, there was $2.3 million of total unrecognized compensation cost related to unvested stock options granted under our equity-based compensation plans. The cost is expected to be recognized through fiscal 2011 with a weighted average recognition period of approximately one year.
In December 2004 and January and May 2005, we modified the terms of certain outstanding and unvested stock options whose exercise prices were greater than our closing stock price on the modification dates. Total modifications served to immediately vest approximately 1.2 million unvested stock options. The accelerations enabled us to avoid recording approximately $27 million of compensation cost that would have been required to be recognized under SFAS 123R.
RECENTLY ISSUED
ACCOUNTING PRONOUNCEMENTS
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting and disclosure for uncertain income tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. This interpretation will be effective for the fiscal year beginning November 1, 2007. We are currently assessing the effect of adopting FIN 48 on our consolidated financial position and results of operations.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We are currently evaluating the effect that the adoption of SFAS 157 will have on our consolidated financial position and results of operations.
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 October 31, 2006, our primary sources of liquidity were our cash, cash equivalents and short-term investments totaling $26.8 million as well as the $99 million available portion of our revolving credit facility. Cash, cash equivalents and short-term investments decreased $6.5 million from October 31, 2005. This decrease was due primarily to repayment of borrowings under our revolving credit facility, partially offset by our net income which allowed for the generation of positive operating cash flows.

20


 

In general, we believe that our current production infrastructure can accommodate our short- and medium-term growth objectives in all material respects. As such, in total, we expect that capital expenditures over the next twelve months will not exceed $20 million. In fiscal 2006, we incurred interest on borrowings of approximately $3.6 million and recorded amortization of related debt fees of approximately $200,000, of which, in total, approximately $700,000 was capitalized. Interest costs have been capitalized to the extent that the related borrowings were used to cover the balance of projects under construction.
Since our inception, we have raised approximately $420 million from public and private sales of our equity securities, as well as from option and warrant exercises. 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 October 31, 2006.
The following table sets forth our future minimum payments under contractual obligations at October 31, 2006:
                                         
            Less than     1-3     3-5     More than  
In thousands   Total     1 year     years     years     5 years  
 
                                       
Notes payable(1)
  $ 11,368     $ 1,163     $ 9,043     $ 370     $ 792  
Borrowings under revolving credit facility
    36,000                   36,000        
Operating lease obligations(2)
    4,422       1,013       1,895       1,172       342  
Unconditional purchase obligations(3), (4)
    35,667       4,289       31,378              
 
                             
Total contractual cash obligations
  $ 87,457     $ 6,465     $ 42,316     $ 37,542     $ 1,134  
 
                             
 
(1)   Minimum payments above include interest and principal due under these notes.
 
(2)   Does not include lease payments on equipment formerly subject to operating lease at our Kingstree facility that we repurchased for $3.9 million in November 2006.
 
(3)   Primarily includes future inventory purchases from DSM pursuant to the guarantee described below in “Off-Balance Sheet Arrangements.”
 
(4)   Does not include $750,000 license payment for plant-based DHA technology due upon execution of an amendment to collaboration agreement between Martek and a Canadian biotechnology company in January 2007.
Included within notes payable is a $10 million note with a stated interest rate of 5% that we assumed as part of the acquisition of FermPro. The note was amended in January 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.
In September 2005, we entered into a $135 million secured revolving credit facility that amended and expanded our existing $100 million credit facility. The revolving credit facility is collateralized by accounts receivable, inventory and all capital stock of our subsidiaries and expires in September 2010. The weighted average interest rate on amounts outstanding under the credit facility was approximately 6.4%, 4.9% and 3.5% for the years ended October 31, 2006, 2005 and 2004, respectively, and the weighted average commitment fee rate on unused amounts was approximately 0.2%, 0.3% and 0.3%, respectively. Both the interest and commitment fee rates are 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 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 October 31, 2006, we were in compliance with all of these debt covenants and had outstanding borrowings of $36 million under the revolving credit facility.

21


 

In December 2003, we entered into a collaboration agreement with a Canadian biotechnology company to co-develop DHA products from plants. This arrangement included the reimbursement of expenses incurred by the co-collaborator as well as the payment by us of potential royalties and additional milestone payment amounts if certain scientific results were achieved in the future. In January 2007, an amendment to this agreement was executed. Pursuant to the amendment, the co-collaborator will continue its research and development until June 2007, with expenses to be reimbursed by us through April 2007. Furthermore, we acquired exclusive license rights to the plant-based DHA technology developed by the co-collaborator for a period of at least 16 years. As consideration for this exclusive license, we will make a license payment of $750,000, with additional payments of up to $750,000 due in certain circumstances, subject to minimum royalties of 1.5% of gross margin, as defined, if we ultimately commercialize a plant-based DHA using any technology. During the term of the license, we may be required to pay additional royalties of up to 6.0% of gross margin, as defined, on sales of products in the future which utilize certain licensed technologies. At the amendment date, the respective milestones provided for in the original agreement had not been achieved, and no milestone payments specified in the original agreement have been or will be made.
We believe that the revolving credit facility, when combined with our cash, cash equivalents and short-term investments of $26.8 million on-hand at October 31, 2006, 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:
    our ability to operate profitably and generate positive cash flow;
 
    growth in our infant formula, food and beverage and other nutritional product sales;
 
    the extent and progress of our research and development programs;
 
    the progress of pre-clinical and clinical studies;
 
    the time and costs of obtaining and maintaining regulatory clearances for our products that are subject to such clearances;
 
    the costs involved in filing, protecting and enforcing patent claims;
 
    competing technological and market developments;
 
    the development or acquisition of new products;
 
    the cost of acquiring additional and/or operating and expanding existing manufacturing facilities for our various products and potential products (depending on which products we decide to manufacture and continue to manufacture ourselves);
 
    the costs associated with our internal build-up of inventory levels;
 
    the costs associated with our defense against a putative securities class action and other lawsuits;
 
    the costs of merger and acquisition activity; and
 
    the costs of marketing and commercializing our products.
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.
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 $4.4 million over the remaining lease terms, which expire through 2011.
In February 2006, we and DSM entered into an amendment to the April 2004 agreement (“the Amendment”). The Amendment served to provide certain clarifying and updating language to the original agreement and to establish the overall economics associated with DSM’s expansion at both its Belvidere, New Jersey and Capua, Italy production facilities. We guaranteed the recovery of certain costs incurred by DSM in connection with these expansions, up to $40 million, with such amount being reduced annually through December 31, 2008 (the “Recoupment Period”) based upon ARA purchases by us in excess of specified minimum thresholds. As of October 31, 2006, the guarantee amount has been reduced to approximately $25.0 million. The guarantee amount payable, if any, at the end of the Recoupment Period, must be paid by January 31, 2009. The amount paid, if any, will be credited against a portion of DSM invoices for purchases made after the Recoupment Period.
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.

22


 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
     
INDEX TO THE CONSOLIDATED FINANCIAL STATEMENTS   PAGE
 
   
 
   
Report of Ernst &Young LLP, Independent Registered Public Accounting Firm
  24
 
   
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm, on Internal Control Over Financial Reporting
  25
 
   
Consolidated Balance Sheets as of October 31, 2006 and 2005
  26
 
   
Consolidated Statements of Income for the years ended October 31, 2006, 2005 and 2004
  27
 
   
Consolidated Statements of Stockholders’ Equity for the years ended October 31, 2006, 2005 and 2004
  28
 
   
Consolidated Statements of Cash Flows for the years ended October 31, 2006, 2005 and 2004
  29
 
   
Notes to Consolidated Financial Statements
  30

23


 

Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Martek Biosciences Corporation
We have audited the accompanying consolidated balance sheets of Martek Biosciences Corporation as of October 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended October 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Martek Biosciences Corporation at October 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended October 31, 2006, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, the accompanying consolidated balance sheet as of October 31, 2006 and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended have been restated.
As discussed in Note 4 to the consolidated financial statements, in fiscal year 2006, Martek Biosciences Corporation changed its method of accounting for equity-based compensation in accordance with guidance provided in Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment.”
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Martek Biosciences Corporation’s internal control over financial reporting as of October 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated January 9, 2007, except for the effect of the material weakness described in the fifth paragraph of that report as to which the date is May 8, 2007, expressed an unqualified opinion on management’s assessment and an adverse opinion on the effectiveness of our internal control over financial reporting.
/s/ Ernst & Young LLP
McLean, Virginia
January 9, 2007, except for Note 1 as to which the date is
May 8, 2007

24


 

Report of Independent Registered Public Accounting Firm on
Internal Control over Financial Reporting
The Board of Directors and Stockholders
Martek Biosciences Corporation
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Martek Biosciences Corporation did not maintain effective internal control over financial reporting as of October 31, 2006, because of the effect of the material weakness described below, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Martek Biosciences Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our report dated January 9, 2007, we expressed an unqualified opinion on management’s previous assessment that the Company maintained effective internal control over financial reporting, and an unqualified opinion on the effectiveness of internal control over financial reporting as of October 31, 2006. Management has subsequently determined that a material weakness existed as of October 31, 2006 and has revised its assessment, which is presented in the accompanying Management’s Report on Internal Control over Financial Reporting, to include this material weakness. Accordingly, our present opinion on the effectiveness of the Company’s internal control over financial reporting as of October 31, 2006, as expressed herein, is different from that expressed in our previous report.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment. Martek Biosciences Corporation did not maintain effective controls over the accounting for depreciation of assets held for future use. This deficiency resulted in the misstatement of property, plant and equipment, deferred tax assets, idle capacity cost of goods sold, and related footnote disclosures, which necessitated the restatement of the Company’s consolidated financial statements as of and for the year ended October 31, 2006, and its interim financial statements for the quarters ended January 31, 2006, April 30, 2006 and July 31, 2006.
This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements as of and for the year ended October 31, 2006, and this report does not affect our report dated January 9, 2007, except for Note 1 as to which the date is May 8, 2007, on those financial statements.
In our opinion, management’s assessment that Martek Biosciences Corporation did not maintain effective internal control over financial reporting as of October 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Martek Biosciences Corporation did not maintain effective internal control over financial reporting as of October 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Martek Biosciences Corporation as of October 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended October 31, 2006, and our report dated January 9, 2007, except for Note 1 as to which the date is May 8, 2007, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
January 9, 2007, except for the effect of the material weakness described in the fifth paragraph above, as to which the date is May 8, 2007

25


 

MARTEK BIOSCIENCES CORPORATION
CONSOLIDATED BALANCE SHEETS
                 
    October 31,  
In thousands, except share and per share data   2006     2005  
    (restated)        
 
               
Assets
               
Current assets
               
Cash and cash equivalents
  $ 15,578     $ 11,047  
Short-term investments and marketable securities
    11,250       22,300  
Accounts receivable, net
    32,746       27,603  
Inventories, net
    100,320       91,535  
Other current assets
    10,074       5,929  
 
           
Total current assets
    169,968       158,414  
 
               
Property, plant and equipment, net
    286,922       290,733  
Deferred tax asset
    41,619       48,201  
Goodwill
    48,603       48,490  
Other intangible assets, net
    36,828       31,129  
Other assets, net
    14,033       1,518  
 
           
 
               
Total assets
  $ 597,973     $ 578,485  
 
           
 
               
Liabilities and stockholders’ equity
               
Current liabilities
               
Accounts payable
  $ 21,663     $ 16,661  
Accrued liabilities
    24,098       13,692  
Current portion of notes payable and other long-term obligations
    1,231       3,113  
Current portion of deferred revenue
    2,794       740  
 
           
Total current liabilities
    49,786       34,206  
 
               
Long-term debt under revolving credit facility
    36,000       55,000  
Notes payable and other long-term obligations
    10,277       11,115  
Long-term portion of deferred revenue
    9,335       8,959  
 
           
 
               
Total liabilities
    105,398       109,280  
 
           
 
               
Commitments
               
 
               
Stockholders’ equity
               
Preferred stock, $.01 par value, 4,700,000 shares authorized; none issued or outstanding
           
Series A junior participating preferred stock, $.01 par value; 300,000 shares authorized; none issued or outstanding
           
Series B junior participating preferred stock, $.01 par value; 300,000 shares authorized; none issued or outstanding
           
Common stock, $.10 par value; 100,000,000 shares authorized; 32,156,162 and 32,026,595 shares issued and outstanding, respectively
    3,216       3,203  
Additional paid-in capital
    523,486       515,237  
Accumulated other comprehensive income
    171       1  
Accumulated deficit
    (34,298 )     (49,236 )
 
           
 
               
Total stockholders’ equity
    492,575       469,205  
 
           
 
               
Total liabilities and stockholders’ equity
  $ 597,973     $ 578,485  
 
           
See accompanying notes.

26


 

MARTEK BIOSCIENCES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
                         
    Year ended October 31,  
In thousands, except share and per share data   2006     2005     2004  
    (restated)        
 
                       
Revenues:
                       
Product sales
  $ 255,838     $ 203,765     $ 170,565  
Contract manufacturing sales
    14,816       14,087       13,928  
 
                 
 
                       
Total revenues
    270,654       217,852       184,493  
 
                 
 
                       
Cost of revenues:
                       
Cost of product sales, including idle capacity costs
    158,600       120,865       103,423  
Cost of contract manufacturing sales
    14,676       12,516       11,570  
 
                 
 
                       
Total cost of revenues
    173,276       133,381       114,993  
 
                 
 
                       
Gross margin
    97,378       84,471       69,500  
 
                 
 
                       
Operating expenses:
                       
Research and development (1)
    24,823       20,468       18,596  
Selling, general and administrative (1)
    41,614       33,404       25,804  
Restructuring charge
    4,729              
Other operating expenses
    1,158       7,654       4,000  
 
                 
 
                       
Total operating expenses
    72,324       61,526       48,400  
 
                 
 
                       
Income from operations
    25,054       22,945       21,100  
 
                 
 
                       
Interest and other income, net
    1,490       1,428       777  
Interest expense
    (3,018 )     (303 )     (5 )
 
                 
 
                       
Income before income tax provision (benefit)
    23,526       24,070       21,872  
Income tax provision (benefit) (1)
    8,588       8,786       (25,176 )
 
                 
 
                       
Net income
  $ 14,938     $ 15,284     $ 47,048  
 
                 
 
                       
Net income per share
                       
Basic
  $ 0.47     $ 0.49     $ 1.62  
 
                 
Diluted
  $ 0.46     $ 0.48     $ 1.55  
 
                 
 
                       
Weighted average common shares outstanding
                       
Basic
    32,113,301       31,164,149       29,033,241  
Diluted
    32,343,015       32,031,503       30,385,707  
 
                       
(1)   Includes the following amounts related to equity-based compensation expense:
Research and development
    1,143              
Selling, general and administrative
    2,129              
Income tax provision (benefit)
    (1,194 )            
See accompanying notes.

27


 

MARTEK BIOSCIENCES CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
                                                 
                            Accumulated              
                    Additional     Other              
    Common Stock     Paid-in     Comprehensive     Accumulated        
In thousands, except share data   Shares     Amount     Capital     Income     Deficit     Total  
 
                                               
Balance at October 31, 2003
    28,041,323     $ 2,804     $ 352,728     $     $ (111,568 )   $ 243,964  
 
                                               
Issuance of common stock, net of issuance costs
    176,885       18       11,272                   11,290  
Exercise of stock options and warrants
    1,272,919       127       20,817                   20,944  
Equity-based compensation
                28                   28  
Tax benefit of exercise of non-qualified stock options
                22,822                   22,822  
Net income
                            47,048       47,048  
Other comprehensive income:
                                               
Unrealized gain on exchange rate forward contract, net of tax of $0
                      68             68  
 
                                             
 
                                               
Comprehensive income
                                            47,116  
 
                                   
 
                                               
Balance at October 31, 2004
    29,491,127       2,949       407,667       68       (64,520 )     346,164  
 
                                               
Issuance of common stock, net of issuance costs
    1,756,614       176       81,268                   81,444  
Exercise of stock options
    778,854       78       18,592                   18,670  
Equity-based compensation
                36                   36  
Tax benefit of exercise of non-qualified stock options
                7,674                   7,674  
Net income
                            15,284       15,284  
Other comprehensive income:
                                               
Unrealized loss on exchange rate forward contract, net of tax of $0
                      (67 )           (67 )
 
                                             
 
                                               
Comprehensive income
                                            15,217  
 
                                   
 
                                               
Balance at October 31, 2005
    32,026,595       3,203       515,237       1       (49,236 )     469,205  
 
                                               
Exercise of stock options and warrants
    129,567       13       2,909                   2,922  
Equity-based compensation
                3,753                   3,753  
Tax benefit of exercise of non-qualified stock options
                1,587                   1,587  
Net income
                            14,938       14,938  
Other comprehensive income:
                                               
Unrealized gain on exchange rate forward contract, net of tax of $102
                      170             170  
 
                                             
 
                                               
Comprehensive income
                                            15,108  
 
                                   
 
                                               
Balance at October 31, 2006 (restated)
    32,156,162     $ 3,216     $ 523,486     $ 171     $ (34,298 )   $ 492,575  
 
                                   
See accompanying notes.

28


 

MARTEK BIOSCIENCES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
                         
    Year ended October 31,  
In thousands   2006     2005     2004  
    (restated)        
 
                       
Operating activities
                       
 
                       
Net income
  $ 14,938     $ 15,284     $ 47,048  
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
                       
Depreciation and amortization
    21,672       16,494       8,687  
Provision for inventory obsolescence
    500       2,000       500  
Deferred tax provision (benefit)
    8,588       8,786       (25,176 )
Equity-based compensation expense
    3,272              
Incremental tax benefit from exercise of non-qualified stock options
    (1,587 )            
Loss from disposal and write-down of assets and other
    2,845       1,131       169  
Changes in operating assets and liabilities:
                       
Accounts receivable
    (5,143 )     9,689       (17,128 )
Inventories
    (20,804 )     (63,156 )     (15,525 )
Other assets
    (4,393 )     1,413       1,324  
Accounts payable
    5,002       (10,303 )     9,150  
Accrued liabilities
    8,527       2,947       1,552  
Deferred revenue and other liabilities
    2,205       (1,429 )     (511 )
 
                 
 
                       
Net cash provided by (used in) operating activities
    35,622       (17,144 )     10,090  
 
                 
 
                       
Investing activities
                       
 
                       
Sale (purchase) of short-term investments and marketable securities, net
    11,050       (9,095 )     53,842  
Expenditures for property, plant and equipment
    (10,902 )     (57,181 )     (180,409 )
(Repurchase) proceeds from sale-leaseback transaction and other
    (6,877 )     4,272       10,895  
Capitalization of intangible and other assets
    (6,862 )     (4,989 )     (9,383 )
 
                 
 
                       
Net cash used in investing activities
    (13,591 )     (66,993 )     (125,055 )
 
                 
 
                       
Financing activities
                       
 
                       
Repayments of notes payable and other long-term obligations
    (3,009 )     (4,875 )     (2,748 )
(Repayments) borrowings under revolving credit facility, net
    (19,000 )     (30,000 )     85,000  
Proceeds from the issuance of common stock, net of issuance costs
          81,444       11,290  
Proceeds from the exercise of stock options and warrants
    2,922       18,670       20,944  
Incremental tax benefit from exercise of non-qualified stock options
    1,587              
Other
          500        
 
                 
 
                       
Net cash (used in) provided by financing activities
    (17,500 )     65,739       114,486  
 
                 
 
                       
Net increase (decrease) in cash and cash equivalents
    4,531       (18,398 )     (479 )
Cash and cash equivalents, beginning of year
    11,047       29,445       29,924  
 
                 
 
                       
Cash and cash equivalents, end of year
  $ 15,578     $ 11,047     $ 29,445  
 
                 
 
                       
Supplemental cash flow disclosures:
                       
Interest paid
  $ 3,625     $ 3,528     $ 2,084  
Income taxes paid
  $ 280     $     $  
Notes payable issued in acquisition of land
  $     $ 800     $  
Purchase of DSM license through long-term obligation
  $     $     $ 6,000  
See accompanying notes.

29


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS
In April 2007, the Company determined that, in accordance with its adopted straight-line depreciation policy, assets held for future use should be depreciated when available for use, and depreciation should be recognized evenly over the life of the asset without regard to whether the asset has been placed in productive service or is in commercial use. Previously, assets held for future use were not depreciated until placed in or returned to productive service. Accordingly, the Company has restated its consolidated financial statements for the fiscal year ended October 31, 2006 and its unaudited quarterly financial information for the interim periods of fiscal 2006.
The following tables set forth, by impacted line item, the net effect of the restatements on the Company’s consolidated balance sheet and consolidated statement of income as of and for the year ended October 31, 2006 (see Note 19 “Quarterly Financial Information” for the quarterly impact of the fiscal 2006 restatement adjustments).
The line item amounts in the Company’s consolidated balance sheet as of October 31, 2006 impacted by the restatement are as follows (in thousands):
                         
    As             As  
    Reported     Adjustment     Restated  
Property, plant and equipment, net
  $ 291,445     $ (4,523 )   $ 286,922  
Deferred tax asset
    39,969       1,650       41,619  
Total assets
    600,846       (2,873 )     597,973  
Accumulated deficit
    (31,425 )     (2,873 )     (34,298 )
Total stockholders’ equity
    495,448       (2,873 )     492,575  
Total liabilities and stockholders’ equity
    600,846       (2,873 )     597,973  
The line item amounts in the Company’s consolidated statement of income for the year ended October 31, 2006 impacted by the restatement are as follows (in thousands):
                         
    As             As  
    Reported     Adjustment     Restated  
Cost of product sales, including idle capacity costs
  $ 154,077     $ 4,523     $ 158,600  
Total cost of revenues
    168,753       4,523       173,276  
Gross margin
    101,901       (4,523 )     97,378  
Income from operations
    29,577       (4,523 )     25,054  
Income before income tax provision (benefit)
    28,049       (4,523 )     23,526  
Income tax provision (benefit)
    10,238       (1,650 )     8,588  
Net income
    17,811       (2,873 )     14,938  
Net income per share:
                       
Basic
  $ 0.55     $ (0.08 )   $ 0.47  
Diluted
  $ 0.55     $ (0.09 )   $ 0.46  

30


 

2. ORGANIZATION AND DESCRIPTION OF BUSINESS
Martek Biosciences Corporation (the “Company” or “Martek”), a Delaware corporation, was founded in 1985. The Company develops, manufactures and sells naturally produced products derived from microalgae, fungi and other microbes. The Company’s products and services include: (1) specialty, nutritional oils for infant formula, dietary supplements and food and beverage fortification ingredients, (2) contract manufacturing services and (3) fluorescent marker products for diagnostics, rapid miniaturized screening and gene and protein detection.
Martek’s 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 and play a pivotal role in brain function throughout life. Low levels of DHA in adults have also been linked to a variety of health risks, including cardiovascular problems and various neurological and visual disorders. Additional research is underway to assess what impact, if any, supplementation with the Company’s DHA will have on these health risks. Martek’s fluorescent detection products and technologies aid researchers in drug discovery and diagnostics.
Martek also provides contract manufacturing services. These services are for both large and small companies and relate primarily to the production of enzymes, specialty chemicals, vitamins, agricultural specialties and intermediates.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation The consolidated financial statements include the accounts of Martek and its wholly-owned subsidiaries, Martek Biosciences Boulder Corporation (“Martek Boulder”) and Martek Biosciences Kingstree Corporation (“Martek Kingstree”), (collectively, “the Company”) after elimination of all significant intercompany balances and transactions. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.
Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“U.S. generally accepted accounting principles”) 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 Information The Company currently operates in one material business segment, the development and commercialization of novel products from microalgae, fungi 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 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 Recognition The 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, which also may include discounts based on the achievement of certain volume purchases. In accordance with Emerging Issues Task Force No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF No. 00-21”), 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. If volume pricing discounts are deemed to be a separate element, revenue on related product shipments is recognized using the estimated average price to the customer. Once the requisite volume thresholds have been satisfied, the previously recorded deferred revenue is recognized over the remaining discount period. 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 $3.6 million, $2.4 million and $2.2 million in fiscal 2006, 2005 and 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.
Shipping Income and Costs The Company accounts for income and costs related to shipping activities in accordance with the Emerging Issues Task Force Issue No. 00-10, “Accounting for Shipping and Handling Revenues and Costs.” Shipping costs charged to customers are recorded as revenue in the period that the related product sale revenue is recorded, and associated costs of shipping are included in cost of product sales.

31


 

Foreign Currency Transactions and Hedging Activities Foreign 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 certain purchases of ARA from DSM Food Specialties’ B.V. (“DSM”), 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. The Company does not use derivative financial instruments for speculative purposes. These forward contracts have been designated as highly effective cash flow hedges and thus, qualify for hedge accounting under the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” As of October 31, 2006, outstanding forward contracts had notional values aggregating approximately 9.8 million euros (equivalent to $12.5 million at October 31, 2006). 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 Development Research 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 and third-party costs for contracted work as well as ongoing clinical trials costs.
Advertising Advertising costs are expensed as incurred. Advertising costs were approximately $1,000,000 in each of fiscal 2006, 2005 and 2004.
Other Operating Expenses Other 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 Taxes Deferred 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 are expected to be in effect when such amounts are projected 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.
Equity-Based Compensation Prior to November 1, 2005, the Company accounted for its equity-based compensation plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Effective November 1, 2005, the Company adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method. Under the modified prospective transition method, compensation cost recognized in fiscal 2006 includes: (a) compensation cost for all equity-based payments granted prior to but not yet vested as of November 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123 and (b) compensation cost for all equity-based payments granted subsequent to November 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R.
Net Income Per Share Basic 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 (see Note 15).
Comprehensive Income Comprehensive 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 Statements of Stockholders’ Equity.
Cash and Cash Equivalents Cash equivalents consist of highly liquid investments with an original maturity of three months or less.
Short-Term Investments and Marketable Securities The 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.
At October 31, 2006 and 2005, the Company’s short-term investments consisted primarily of auction rate debt securities issued by state and local government-sponsored agencies. The Company’s investments in these securities are recorded at cost which approximates market value due to their variable interest rates that reset approximately every 30 days. The underlying maturities of these investments range from 15 to 40 years. Despite the

32


 

long-term nature of their stated contractual maturities, there is a readily liquid market for these securities and, therefore, these securities have been classified as short-term.
Fair Value of Financial Instruments The 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 October 31, 2006 and 2005.
Trade Receivables Trade 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. The allowance for doubtful accounts was approximately $40,000 and $100,000 as of October 31, 2006 and 2005, respectively.
Concentration of Credit Risk and Significant Customers Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of accounts receivable. Concentrations of credit risk with respect to accounts receivable are present due to the small number of customers comprising the Company’s customer base. However, the credit risk is reduced through the Company’s efforts to monitor its exposure for credit losses and by maintaining allowances, if necessary. Four customers accounted for approximately 83%, 88% and 90% of the Company’s product sales in fiscal 2006, 2005 and 2004, respectively. At October 31, 2006 and 2005, four customers accounted for approximately 70% and 77%, respectively, of the Company’s outstanding accounts receivable balance. Included in these amounts, one of the Company’s customers accounted for approximately 45%, 49% and 55% of total product sales in fiscal 2006, 2005 and 2004, respectively, and represented 43% and 55% of the Company’s outstanding accounts receivable balance at October 31, 2006 and 2005, respectively. Approximately 60% of the Company’s sales were to domestic customers in fiscal 2006 and approximately 67% of the Company’s sales were to domestic customers in each of fiscal 2005 and 2004.
Inventories Inventories 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. Abnormal amounts of inventory costs related to, among other things, idle facilities, freight handling and waste material expenses are recognized as period charges and expensed as incurred.
Property, Plant and Equipment Property, plant and equipment, including leasehold improvements, is stated at cost and depreciated or amortized when available for commercial use by applying the straight-line method, based on useful lives as follows:
         
Asset Description   Useful Life (years)
 
       
Building
    15 — 30  
Fermentation equipment
    10 — 20  
Oil processing equipment
    10 — 20  
Other machinery and equipment
    5 — 10  
Furniture and fixtures
    5 — 7  
Computer 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 available for commercial use have been capitalized as construction in progress. Costs for repairs and maintenance are expensed as incurred.
Patent Costs The Company has filed a number of patent applications in the U.S. and in foreign countries. Legal and related costs incurred in connection with pending patent applications have been capitalized. Costs related to patent applications are amortized over the life of the patent, if successful, or charged to operations upon denial or in the period during which a determination not to further pursue such application is made. The Company has also capitalized external legal costs incurred in the defense of its patents when it is believed that the future economic benefit of the patent will be increased and a successful defense is probable. Capitalized patent defense costs are amortized over the remaining life of the related patent.
Goodwill and Other Intangible Assets The Company recorded goodwill and purchased intangible assets in its acquisition of OmegaTech in April, 2002 and goodwill in its acquisition of 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 (see Note 9).

33


 

Impairment of Long-Lived Assets In 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 is 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.
Recently Issued Accounting Pronouncements In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting and disclosure for uncertain income tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. This interpretation will be effective for the fiscal year beginning November 1, 2007. The Company is currently assessing the effect of adopting FIN 48 on its consolidated financial position and results of operations.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is currently evaluating the effect that the adoption of SFAS 157 will have on its consolidated financial position and results of operations.
4. EQUITY-BASED COMPENSATION
Prior to November 1, 2005, the Company accounted for its equity-based compensation plans under the recognition and measurement provisions of APB 25, and related interpretations, as permitted by SFAS 123. Effective November 1, 2005, the Company adopted the fair value recognition provisions of SFAS 123R, using the modified prospective transition method. Under the modified prospective transition method, compensation cost recognized in fiscal 2006 includes: (a) compensation cost for all equity-based payments granted prior to but not yet vested as of November 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123 and (b) compensation cost for all equity-based payments granted subsequent to November 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Results for prior periods have not been restated.
As a result of adopting SFAS 123R on November 1, 2005, the Company’s income before income taxes and net income for the year ended October 31, 2006 were $3.3 million and $2.1 million lower, respectively, than if the Company had continued to account for equity-based compensation under APB 25. Basic and diluted earnings per share for the year ended October 31, 2006 were each $0.06 lower than if the Company had continued to account for equity-based compensation under APB 25.
The following table (in thousands, except per share amounts) 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 to equity-based compensation for the years ended October 31, 2005 and 2004. The reported and pro forma net income and net income per share for the year ended October 31, 2006 are the same because equity-based compensation is calculated under the provisions of SFAS 123R. The amounts for the year ended October 31, 2006 are included in the following table only to provide net income and net income per share for a comparative presentation to the periods of the previous years. The pro forma disclosure for the years ended October 31, 2005 and 2004 utilized the Black-Scholes-Merton option-pricing formula to estimate the value of the respective options with such value amortized to expense over the options’ vesting periods.
                         
    Year ended October 31,  
    2006     2005     2004  
    (restated)        
 
                       
Net income, as reported
  $ 14,938     $ 15,284     $ 47,048  
 
                       
Deduct: Total equity-based employee compensation expense determined under fair value-based methods for all awards
          (58,349 )     (17,920 )
 
                 
 
                       
Pro forma net income (loss)
  $ 14,938     $ (43,065 )   $ 29,128  
 
                 
 
                       
Net income (loss) per share:
                       
Basic — as reported
  $ 0.47     $ 0.49     $ 1.62  
 
                 
Basic — pro forma
  $ 0.47     $ (1.38 )   $ 1.00  
 
                 
 
                       
Diluted — as reported
  $ 0.46     $ 0.48     $ 1.55  
 
                 
Diluted — pro forma
  $ 0.46     $ (1.38 )   $ 0.96  
 
                 

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In December 2004 and January and May 2005, the Company modified the terms of certain 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. The accelerations enabled the Company to avoid recording approximately $27 million of compensation cost that would have been required to be recognized under SFAS 123R.
The Company has utilized the Black-Scholes-Merton valuation model for estimating the fair value of the stock options granted during the year ended October 31, 2006, as well as for option grants during all prior periods. As follows are the weighted average assumptions used in valuing the stock options granted during the years ended October 31, 2006, 2005 and 2004, and a discussion of the Company’s methodology for developing each of the assumptions used:
                         
    Year ended October 31,
    2006   2005   2004
     
Expected volatility
    61.1 %     62.7 %     78.9 %
Risk-free interest rate
    4.7 %     3.9 %     3.9 %
Expected life of options
  5 years   5 years   5 years
Expected dividend yield
    0 %     0 %     0 %
Forfeiture rate
    1 %     2 %     2 %
Expected Volatility — Volatility is a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. The Company uses the historical volatility over the preceding five-year period to estimate expected volatility. Since fiscal 2001, the Company’s annual volatility has ranged from 61.1% to 78.9% with an average of 68.1%.
Risk-Free Interest Rate — This is the average U.S. Treasury rate (having a term that most closely resembles the expected life of the option) for the quarter in which the option was granted.
Expected Life of Options — This is the period of time that the options granted are expected to remain outstanding. This estimate is based primarily on historical exercise data. Options granted during the years ended October 31, 2006, 2005 and 2004 have a maximum term of ten years.
Expected Dividend Yield — The Company has never declared or paid dividends on its common stock and does not anticipate paying any dividends in the foreseeable future.
Forfeiture Rate — This is the estimated percentage of options granted that are expected to be forfeited or cancelled on an annual basis before becoming fully vested. The Company estimates the forfeiture rate based on past turnover data with further consideration given to the level of the employees to whom the options were granted.
As of October 31, 2006, the Company had several equity-based compensation plans, which are described below. The compensation cost that has been charged against income for those plans for the year ended October 31, 2006 was approximately $3.3 million. The total income tax benefit recognized in the income statement for equity-based compensation arrangements was approximately $1.2 million in the year ended October 31, 2006. Compensation cost capitalized as part of inventory during the year ended October 31, 2006 was approximately $500,000. For stock subject to graded vesting, the Company has utilized the “straight-line” method for allocating compensation cost by period.
Stock Option Plans
As of October 31, 2006, the Company had stock options outstanding that were previously granted under the Company’s 1986 Stock Option Plan, the 1994 Directors’ Option Plan, the 1997 Stock Option Plan, the 2001 Stock Option Plan, the 2002 Stock Incentive Plan, the 2003 New Employee Stock Option Plan and the 2004 Stock Incentive Plan, collectively referred to as the “Option Plans.” With exception of the 1994 Directors’ Option Plan, option awards under the Option Plans are granted at prices as determined by the Compensation Committee, but shall not be less than the fair market value of the Company’s common stock on the date of grant. Stock options granted include both qualified and non-qualified options and vest over a period of up to five years and have a maximum term of ten years from the date of grant. At October 31, 2006, approximately 1.3 million shares of common stock were available for future grants under the Option Plans.
As result of the Company’s purchase of OmegaTech in 2002, the Company assumed 154,589 options from the OmegaTech, Inc. 1996 Stock Option Plan (“OmegaTech Plan”). No new options may be issued under this plan as of the date of the purchase. Under the OmegaTech Plan, exercise prices were determined by the Compensation Committee, but at an exercise price not less than the fair market value of OmegaTech’s common stock on the date of grant. Stock options granted include both qualified and non-qualified options and were all 100% vested as of the purchase date. The 2003 New Employee Stock Option Plan (“2003 Plan”) was adopted in conjunction with the acquisition of FermPro in 2003.
A summary of option activity under the Option Plans as of October 31, 2006 and changes during the three years then ended are as follows (shares and intrinsic value in thousands):

35


 

                                 
                            Weighted Average  
                            Remaining  
    Number of     Weighted Average     Aggregate     Contractual  
    Shares     Price/Share     Intrinsic Value     Term (years)  
 
                               
Options outstanding at October 31, 2003
    4,294     $ 22.55                  
Options exercisable at October 31, 2003
    2,514     $ 18.45                  
 
                           
 
                               
Granted
    1,067     $ 59.60                  
Exercised
    (1,240 )   $ 16.39                  
Cancelled
    (71 )   $ 36.39                  
 
 
                               
Options outstanding at October 31, 2004
    4,050     $ 33.91                  
Options exercisable at October 31, 2004
    2,138     $ 26.33                  
 
                           
 
                               
Granted
    700     $ 48.69                  
Exercised
    (779 )   $ 23.98                  
Cancelled
    (47 )   $ 44.79                  
 
 
                               
Options outstanding at October 31, 2005
    3,924     $ 38.39                  
Options exercisable at October 31, 2005
    3,438     $ 40.14                  
 
                           
 
                               
Granted
    59     $ 31.71                  
Exercised
    (98 )   $ 24.92                  
Cancelled
    (171 )   $ 40.21                  
 
 
                               
Options outstanding at October 31, 2006
    3,714     $ 38.56     $ 6,483       6.2  
Options exercisable at October 31, 2006
    3,466     $ 39.32     $ 6,049       6.2  
 
                       
 
Detailed information on the options outstanding under the Option Plans on October 31, 2006 by price range is set forth as follows:
                                         
    OPTIONS OUTSTANDING   OPTIONS EXERCISABLE
            Weighted                
            Average                
            Remaining   Weighted           Weighted
            Contractual   Average           Average
Range of   Options   Life   Exercise   Options   Exercise
Exercise Prices   Outstanding   (years)   Price   Exercisable   Price
 
                                       
$6.25 — $9.37
    32,675       2.5     $ 7.35       32,675     $ 7.35  
$9.38 — $14.07
    128,529       3.3     $ 11.84       128,529     $ 11.84  
$14.08 — $21.12
    602,839       4.2     $ 16.48       537,129     $ 16.39  
$21.13 — $31.69
    1,151,962       6.0     $ 27.68       1,046,994     $ 27.85  
$31.70 — $47.55
    170,075       7.8     $ 39.40       115,635     $ 41.78  
$47.56 — $68.08
    1,628,369       7.2     $ 57.07       1,605,369     $ 57.13  
 
                                       
 
    3,714,449       6.2     $ 38.56       3,466,331     $ 39.32  
 
                                       
 
 
The weighted average fair market value of the options at the date of grant for options granted during the years ended October 31, 2006, 2005 and 2004 was $17.84, $28.59 and $39.21, respectively. The total intrinsic value of stock options exercised during the year ended October 31, 2006 was approximately $600,000.
As of October 31, 2006, there was $2.3 million of total unrecognized compensation cost related to unvested stock options granted under the Option Plans. The cost is expected to be recognized through fiscal 2011 with a weighted average recognition period of approximately one year.

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5. DSM SUPPLY AND LICENSE AGREEMENT
In April 2004, the Company entered into an 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 provides for the grant to the Company by DSM of a license related to certain technologies associated with the manufacture of ARA. This grant involved a license fee totaling $10 million, which is being amortized over the 15-year term of the agreement using the straight-line method. In February 2006, the Company and DSM entered into an amendment to the original agreement (“the Amendment”). The Amendment served to provide certain clarifying and updating language to the original agreement and to establish the overall economics associated with DSM’s expansion at both its Belvidere, New Jersey and Capua, Italy production facilities. Martek guaranteed the recovery of certain costs incurred by DSM in connection with these expansions, up to $40 million, with such amount being reduced annually through December 31, 2008 (the “Recoupment Period”) based upon ARA purchases by us in excess of specified minimum thresholds. As of October 31, 2006, the guarantee amount has been reduced to approximately $25.0 million. The guarantee amount payable, if any, at the end of the Recoupment Period, must be paid by January 31, 2009. The amount paid, if any, will be credited against a portion of DSM invoices for purchases made after the Recoupment Period. Annual ARA unit pricing under the agreement with DSM utilizes a cost-plus approach that is based on the prior year’s actual costs incurred adjusted for current year volume and cost expectations. Calendar 2006 ARA purchases have been valued by us based on amounts and unit prices invoiced by DSM. Certain issues, however, still need to be resolved in order to finalize 2006 ARA pricing. Absent a favorable resolution to us, the recorded cost of ARA will approximate, in all material respects, the agreed-upon amounts when negotiations with DSM are complete.
6. SHORT-TERM INVESTMENTS AND MARKETABLE SECURITIES
The Company has classified all short-term investments and marketable securities as available-for-sale. Available-for-sale securities are carried at fair value, based on specific identification. Unrealized gains and losses on these securities, if any, are reported as accumulated other comprehensive income, which is a separate component of stockholders’ equity. The Company’s available-for-sale securities consist primarily of taxable municipal auction rate securities, and totaled $11.3 million and $22.3 million as of October 31, 2006 and October 31, 2005, respectively. There were no unrealized holding gains or losses or realized gains or losses during the years ended October 31, 2006, 2005 and 2004.
7. INVENTORIES
Inventories consist of the following (in thousands):
                 
    October 31,  
    2006     2005  
 
               
Finished goods
  $ 43,928     $ 34,328  
Work in process
    66,968       55,073  
Raw materials
    3,024       3,634  
 
           
 
               
Total inventories
    113,920       93,035  
Less: inventory reserve
    (1,600 )     (1,500 )
 
           
 
               
Total inventories, net
    112,320       91,535  
Less: long-term portion
    (12,000 )      
 
           
 
               
Inventories, net
  $ 100,320     $ 91,535  
 
           
Idle capacity costs totaled $14.1 million for the year ended October 31, 2006 and related primarily to certain fixed costs associated with the underutilized portion of the Company’s Kingstree, South Carolina production plant. See Note 12 for a discussion of the Company’s restructuring of plant operations in October 2006.
During fiscal 2006, the Company began the full internal production of its non-infant formula DHA ("DHA-S"), which is used in and sold for applications in the nutritional supplements, animal feed and food and beverage markets. In order to establish competencies in the large-scale production of DHA-S, the Company completed several DHA-S production campaigns during fiscal 2006. Consequently, the Company’s DHA-S inventory increased during this period to approximately $21 million, ultimately resulting in $12 million of DHA-S work-in-progress inventory being classified as long-term as of October 31, 2006. Inventory levels are evaluated by management based upon product demand, shelf-life, future marketing plans and other factors, and reserves for obsolete and slow-moving inventories are recorded for amounts that may not be realizable. Management believes that all inventories currently classified as long-term are fully realizable and expects that by October 31, 2007, all of such inventory will be classified as current.

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8. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following (in thousands):
                 
    October 31,  
    2006     2005  
    (restated)        
 
               
Land
  $ 2,320     $ 2,318  
Building and improvements
    61,855       45,515  
Machinery and equipment
    248,107       187,922  
Furniture and fixtures
    2,716       3,161  
Computer hardware and software
    11,413       8,085  
 
           
 
    326,411       247,001  
Less: accumulated depreciation and amortization
    (50,473 )     (33,143 )
 
           
 
    275,938       213,858  
Construction in progress
    10,984       76,875  
 
           
 
Property, plant and equipment, net
  $ 286,922     $ 290,733  
 
           
Certain 2005 amounts in the above table have been reclassified in order to conform with the presentation of the restated 2006 amounts.
Depreciation and amortization expense on property, plant and equipment totaled approximately $18.9 million, $14.0 million and $6.8 million for the years ended October 31, 2006, 2005 and 2004, respectively.
Assets available for commercial use that were not in productive service totaled $87.2 million and $17.5 million at October 31, 2006 and 2005, respectively. See Note 12 for discussion of assets being held for sale.
9. GOODWILL AND OTHER INTANGIBLE ASSETS
Intangible assets and related accumulated amortization consist of the following (in thousands):
                                                 
    October 31, 2006     October 31, 2005  
            Accumulated                     Accumulated        
Intangible Asset   Gross     Amortization     Net     Gross     Amortization     Net  
 
                                               
Trademarks
  $ 2,053     $ (545 )   $ 1,508     $ 2,026     $ (401 )   $ 1,625  
Patents
    19,233       (1,835 )     17,398       11,741       (1,734 )     10,007  
Core technology
    1,708       (455 )     1,253       1,708       (342 )     1,366  
Current products
    10,676       (3,228 )     7,448       10,676       (2,516 )     8,160  
Licenses
    11,091       (1,870 )     9,221       11,091       (1,120 )     9,971  
Goodwill
    48,603             48,603       48,490             48,490  
 
                                   
 
                                               
 
  $ 93,364     $ (7,933 )   $ 85,431     $ 85,732     $ (6,113 )   $ 79,619  
 
                                   
Core technology and current products relate to the value assigned to the products purchased as part of the OmegaTech acquisition in fiscal 2002. The Company recorded amortization expense on intangible assets of approximately $2.8 million, $2.5 million and $1.9 million during the years ended October 31, 2006, 2005 and 2004, respectively. Based on the current amount of intangible assets subject to amortization, the estimated amortization expense for each of the succeeding five years will be approximately $3.2 million.
The Company recorded patent amortization expense of approximately $1.1 million, $800,000 and $600,000 in the years ended October 31, 2006, 2005 and 2004, respectively.

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10. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
                 
    October 31,  
    2006     2005  
 
               
Salaries and employee benefits
  $ 12,328     $ 7,214  
Inventory receipt obligations
    3,094       1,544  
Other
    8,676       4,934  
 
           
 
               
 
  $ 24,098     $ 13,692  
 
           
11. NOTES PAYABLE AND LONG-TERM DEBT
In September 2005, the Company entered into a $135 million secured revolving credit facility that amended and expanded the $100 million credit facility entered into in May 2004. The revolving credit facility is collateralized by accounts receivable, inventory and all capital stock of the Company’s subsidiaries and expires in September 2010. The weighted average interest rate on amounts outstanding under the credit facility was approximately 6.4%, 4.9% and 3.5% for the years ended October 31, 2006, 2005 and 2004, respectively, and the weighted average commitment fee rate on unused amounts was approximately 0.2%, 0.3% and 0.3% for the years ended October 31, 2006, 2005 and 2004, respectively. Both the interest and commitment fee rates are 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 coverage ratios and maximum leverage ratios. As of October 31, 2006, the Company was in compliance with all of these debt covenants and had outstanding borrowings of $36 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 fiscal 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, 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.
The annual maturities of the Company’s notes payable and long-term debt at October 31, 2006 are summarized as follows (in thousands):
         
Fiscal Year        
2007
  $ 670  
2008
    686  
2009
    7,777  
2010
    183  
2011
    100  
Subsequent to 2011
    626  
 
     
 
       
 
  $ 10,042  
 
     
During the years ended October 31, 2006, 2005 and 2004, the Company incurred interest on borrowings of approximately $3.6 million, $3.5 million and $2.1 million, respectively, and recorded amortization of related debt fees of approximately $200,000, $300,000 and $200,000, respectively. Interest costs have been capitalized to the extent that the related borrowings were used to cover the balance of projects under construction. Accordingly, during the years ended October 31, 2006, 2005 and 2004, approximately $700,000, $3.5 million and $2.3 million of interest has been capitalized in the accompanying financial statements.
The carrying amounts of notes payable and long-term debt under the revolving credit facility at October 31, 2006 and 2005 approximate their fair values based on instruments of similar terms available to the Company.
12. RESTRUCTURING CHARGE
In October 2006, the Company restructured its plant operations following a review of production and cost structure. Under the restructuring, a substantial portion of production previously taking place at the Winchester, Kentucky manufacturing facility was transferred to the Kingstree, South Carolina manufacturing facility. The restructuring is expected to reduce manufacturing costs and operating expenses due to improved overall manufacturing efficiency and a reduction in the Company’s workforce at the Winchester site.
As a result of the restructuring, a charge of approximately $4.7 million was recorded in fiscal 2006. This charge includes employee separation costs of $2.0 million, a write-down of certain assets of $2.6 million and professional fees of $100,000. Employee separation costs include salary

39


 

continuation, severance, medical and other benefits. The recorded asset write-down relates primarily to certain assets which formerly supported Winchester production and which are now being held for sale. The resulting net book value of these assets included in the Company’s consolidated financial statements is approximately $200,000 at October 31, 2006, which represents their estimated fair market value less costs to sell. The Company anticipates incurring approximately $500,000 of additional restructuring costs in fiscal 2007 related to employee separation costs.
The following table summarizes the activity related to the restructuring charge and liability for restructuring costs (in thousands):
                                 
    Employee                    
    Separation     Asset              
    Costs     Write-down     Other     Total  
 
                               
Initial charge in the fourth quarter of fiscal 2006
  $ 2,032     $ 2,568     $ 129     $ 4,729  
Cash payments
    (60 )           (55 )     (115 )
Asset write-down
          (2,568 )           (2,568 )
 
                       
Liability for restructuring costs at October 31, 2006
  $ 1,972     $     $ 74     $ 2,046  
 
                       
13. COMMITMENTS AND CONTINGENCIES
Leases The Company leases its Columbia, Maryland premises under an operating lease. In May 2004, the Company amended its existing lease for laboratory and administrative space at the Columbia, Maryland office to extend the term of the lease as well as expand the Company’s leased space by approximately 15%. In fiscal 2006, the Company expanded its Columbia leased space by an additional 20%. The leases expire in January 2011. The terms of the lease include annual rent escalations of 2.5%.
The Company also leases its premises in Boulder, Colorado under an operating lease that expires in May 2008. The terms of the lease include annual rent escalations of 3.5%. Additionally, the Company leases certain property classified as operating leases at its Winchester, Kentucky and Kingstree, South Carolina manufacturing facilities and its Boulder offices.
Rent expense was approximately $5.0 million, $4.0 million and $1.6 million for the years ended October 31, 2006, 2005 and 2004, respectively. The Company received sublease income of approximately $100,000 for the year ended October 31, 2004 for office and lab space that it had previously subleased in Columbia, Maryland.
Future minimum lease payments under operating leases at October 31, 2006 are as follows (in thousands):
         
Fiscal Year        
         
2007
  $ 1,013  
2008
    997  
2009
    898  
2010
    915  
2011
    257  
After 2011
    342  
 
     
 
  $ 4,422  
 
     
Scientific Research Collaborations The Company has entered into various collaborative research and license agreements for its non-nutritional algal technology. Under these agreements, the Company is required to fund research or to collaborate on the development of potential products. Certain of these agreements also commit the Company to pay royalties upon the sale of certain products resulting from such collaborations. Martek incurred approximately $100,000 in each of fiscal 2006, 2005 and 2004 in royalties under such agreements pertaining to the Company’s fluorescent detection products.
In December 2003, the Company entered into a collaboration agreement with a Canadian biotechnology company to co-develop DHA products from plants. This arrangement included the reimbursement of expenses incurred by the co-collaborator as well as the payment by the Company of potential royalties and additional milestone payment amounts if certain scientific results were achieved in the future. In January 2007, an amendment to this agreement was executed. Pursuant to the amendment, the co-collaborator will continue its research and development until June 2007, with expenses to be reimbursed by the Company through April 2007. Furthermore, the Company acquired exclusive license rights to the plant-based DHA technology developed by the co-collaborator for a period of at least 16 years. As consideration for this exclusive license, the Company will make a license payment of $750,000, with additional payments of up to $750,000 due in certain circumstances, subject to minimum royalties of 1.5% of gross margin, as defined, if Martek ultimately commercializes a plant-based DHA using any technology. During the term of the license, the Company may be required to pay additional royalties of up to 6.0% of gross margin, as defined, on sales of products in the future which utilize certain licensed technologies. At the amendment date, the respective milestones provided for in the original agreement had not been achieved, and no milestone payments specified in the original agreement have been or will be made.

40


 

Purchase Commitments 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, 2008. As of October 31, 2006, the Company’s remaining obligation was approximately $10.2 million.
OmegaTech Milestone In April 2002, the Company completed its acquisition of OmegaTech, Inc. (“OmegaTech”), a DHA producer located in Boulder, Colorado. 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 aggregate purchase price for OmegaTech was approximately $54.1 million. 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 and two relate to regulatory and labeling approvals in the U.S. and Europe. In June 2003, the conditions of one of the regulatory milestones were met, and accordingly, approximately 358,566 shares of Martek common stock, valued at approximately $14.2 million, were issued. The payment of this additional consideration was recorded as goodwill.
As of October 31, 2006, the Company does not believe the second regulatory milestone has been achieved. In addition, the Company does not believe that either financial milestone 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 and one of the financial milestones 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 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.
Patent Infringement Litigation In September 2003, the Company filed a patent infringement lawsuit in the U.S. District Court in Delaware against Nutrinova Nutrition Specialties & Food Ingredients GmbH (Nutrinova) and others alleging infringement of certain of our U.S. patents. In December 2005, Nutrinova’s DHA business was sold to Lonza Group LTD, a Swiss chemical and biotechnology group, and the parties agreed to add Lonza to the U.S. lawsuit. In October 2006, the infringement action in the United States was tried, and a verdict favorable to Martek was returned. The jury found that Lonza infringed all the asserted claims of several Martek patents and that these patents were valid. It also found that Lonza acted willfully in its infringement of one of these patents. The judge will now determine if any of the jury’s decisions were inappropriate as a matter of law, whether Martek is entitled to a permanent injunction against Lonza, and, if so, whether the permanent injunction should be stayed pending the outcome of any appeal. In connection with its patent defense, the Company has incurred and capitalized costs totaling $9.6 million.
Class Action Lawsuit Since the end of April 2005, several lawsuits have been filed against the Company and certain of its officers, which have been consolidated and in which plaintiffs are seeking class action status. The consolidated lawsuit was filed in United States District Court for the District of Maryland and alleges, 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 is defending vigorously against this action. The Company is unable at this time to predict the outcome of this lawsuit or reasonably estimate a range of possible loss, if any. The Company believes that the costs and expenses related to this litigation could be significant. These lawsuits are further described in Item 3 of Part I in the original Form 10-K, “Legal Proceedings.”
Other The Company is involved in various other legal actions. 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.
14. LICENSE AGREEMENTS
The Company has licensed certain technologies and recognized license fee revenue under various agreements. License fees are recorded as deferred revenue and amortized on a straight-line basis over the term of the agreement, generally 15 to 25 years. The Company recognized approximately $500,000, $500,000 and $400,000 as license revenue for the years ended October 31, 2006, 2005 and 2004, respectively. The balance of these license fees and prepaid product purchases remaining in deferred revenue was approximately $12.1 million and $9.7 million at October 31, 2006 and 2005, respectively.

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15. 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):
                         
    Year ended October 31,  
    2006     2005     2004  
    (restated)        
 
                       
Net income
  $ 14,938     $ 15,284     $ 47,048  
 
                       
Weighted average shares outstanding, basic
    32,113       31,164       29,033  
Effect of dilutive potential common shares:
                       
Stock options
    230       849       1,315  
Warrants
          19       38  
 
                 
Total dilutive potential common shares
    230       868       1,353  
 
                 
Weighted average shares outstanding, diluted
    32,343       32,032       30,386  
 
                 
 
                       
Net income per share, basic
  $ 0.47     $ 0.49     $ 1.62  
 
                 
Net income per share, diluted
  $ 0.46     $ 0.48     $ 1.55  
 
                 
Employee stock options to purchase approximately 2.7 million, 1.7 million and 600,000 shares were outstanding but were not included in the computation of diluted net income per share for the years ended October 31, 2006, 2005 and 2004, respectively, because the effects would have been antidilutive.
16. STOCKHOLDERS’ EQUITY
Issuance of Common Stock
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.
In February 2004, the Company completed an underwritten issuance 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 expenses, amounted to approximately $11.3 million.
Stockholder Rights Plan
In February 2006, the Company’s Board of Directors approved the renewal of its Stockholder Rights Plan through the adoption of a new Rights Agreement. The new Rights Agreement was effective as of February 7, 2006, which was the date that Martek’s then-existing Rights Agreement expired. All rights under the previous Rights Agreement were cancelled upon its expiration.
In connection with the adoption of the new Rights Agreement, preferred stock purchase rights (“Rights”) were granted as a dividend at the rate of one Right for each share of the Company’s common stock held of record at the close of business on February 7, 2006. Each share issued after February 7, 2006 also is accompanied by a Right. Each Right provides the holder the opportunity to purchase 1/1000th of a share of Series B Junior Participating Preferred Stock under certain circumstances at a price of $150 per share of such preferred stock. All rights expire on February 7, 2016.
At the time of adoption of the Rights Plan, the Rights were neither exercisable nor traded separately from the common stock. The Rights will be exercisable only if a person or group in the future becomes the beneficial owner of 20% or more of the common stock or announces a tender or exchange offer which would result in its ownership of 20% or more of the common stock. Ten days after a public announcement that a person or group has become the beneficial owner of 20% or more of the common stock, each holder of a Right, other than the acquiring person, would be entitled to purchase $300 worth of the common stock of the Company for each Right at the exercise price of $150 per Right, which would effectively enable such Right-holders to purchase the common stock at one-half of the then-current price.
If the Company is acquired in a merger, or 50% or more of the Company’s assets are sold in one or more related transactions, each Right would entitle the holder thereof to purchase $300 worth of common stock of the acquiring company at the exercise price of $150 per Right, which would effectively enable such Right-holders to purchase the acquiring company’s common stock at one-half of the then-current market price.
At any time after a person or group of persons becomes the beneficial owner of 20% or more of the common stock, the Board of Directors, on behalf of all stockholders, may exchange one share of common stock for each Right, other than Rights held by the acquiring person.

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The Board of Directors may authorize the redemption of the Rights, at a redemption price of $.001 per Right, at any time until ten days (as such period may be extended or shortened by the Board) following the public announcement that a person or group of persons has acquired beneficial ownership of 20% or more of the outstanding common stock.
The Rights Agreement provides that at least once every three years the Board of Directors will review and evaluate the Rights Agreement in order to consider whether the maintenance of the Rights Agreement continues to be in the interests of the Company and its stockholders.
17. INCOME TAXES
The difference between the tax provision and the amount that would be computed by applying the statutory Federal income tax rate to income before taxes is attributable to the following (in thousands):
                         
    Year ended October 31,  
    2006     2005     2004  
    (restated)        
 
                       
Federal income tax expense at 35%
  $ 8,234     $ 8,425     $ 7,656  
 
                       
State taxes, net of Federal benefit
    210       283       828  
Change in valuation allowance
                (33,593 )
Other
    144       78       (67 )
 
                 
 
                       
Total provision (benefit)
  $ 8,588     $ 8,786     $ (25,176 )
 
                 
During the year ended October 31, 2004, the Company reversed approximately $51 million of its deferred tax asset valuation allowance. This reversal resulted in the recognition of an income tax benefit totaling $25.2 million, a direct increase to stockholders’ equity of approximately $22.8 million due to historical non-qualified stock option exercises and a decrease to goodwill of approximately $2.6 million due to certain basis differences and net operating loss carryforwards resulting from the Company’s acquisition of OmegaTech.
Substantially all of the provision or benefit for income taxes in fiscal 2006, 2005 and 2004 results from changes in deferred income taxes.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes as well as net operating loss carryforwards. Significant components of the Company’s net deferred income taxes are as follows (in thousands):
                 
    October 31,  
    2006     2005  
    (restated)        
 
               
Deferred tax assets:
               
Accruals and reserves
  $ 1,815     $ 1,408  
Patents and trademarks
    309       528  
Net operating loss carryforwards
    66,437       77,833  
Deferred revenue
    4,271       3,494  
Equity-based compensation
    1,306        
Other
    79       214  
 
           
 
               
Total assets
    74,217       83,477  
 
           
 
               
Deferred tax liabilities:
               
Property, plant and equipment
    (8,863 )     (5,958 )
Acquired intangibles
    (3,051 )     (3,507 )
Goodwill
    (816 )     (559 )
Other
    (101 )    
 
           
 
               
Total liabilities
    (12,831 )     (10,024 )
 
           
 
               
Total deferred tax asset
    61,386       73,453  
Valuation allowance
    (18,586 )     (23,832 )
 
           
 
               
Deferred tax asset, net of valuation allowance
    42,800       49,621  
Less: current deferred tax asset
    (1,181 )     (1,420 )
 
           
 
               
Long-term deferred tax asset
  $ 41,619     $ 48,201  
 
           

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Realization of total deferred tax assets is contingent upon the generation of future taxable income. Due to the uncertainty of realization, a valuation allowance against certain deferred tax assets primarily related to net operating loss carryforwards has been recorded as of October 31, 2006 and 2005. Should realization of these deferred tax assets become more likely than not, approximately $9.9 million of the resulting benefit will be reflected as an income tax benefit upon reversal of the allowance, approximately $7.3 million will be reflected as a reduction to goodwill and approximately $1.4 million will be reflected as an increase to stockholders’ equity. Although the Company has net operating losses available to offset future taxable income, the Company may be subject to Federal alternative minimum taxes.
In connection with its implementation of SFAS 123R on November 1, 2006, the Company adopted the tax law method for determining the order in which deductions, carryforwards and credits are realized by the Company. Consistent with the tax law approach, the Company recorded increases to additional paid-in capital of approximately $4.9 million in fiscal 2006 which related to the realization of the tax benefits associated with fiscal 2006 non-qualified stock exercises and the reversal of valuation allowance on certain net operating loss carryforwards related to stock option exercises in prior years that were deemed realized during fiscal year 2006. Furthermore, during the fiscal 2006, the Company made a correction to its accounting for certain prior year stock option exercises whose benefit had been fully recognized as an increase to additional paid in capital. This correction resulted in a $3.3 million decrease to deferred tax asset and a corresponding decrease to additional paid-in capital.
As of October 31, 2006, the Company had net operating loss carryforwards for Federal income tax purposes of approximately $183 million, which expire at various dates between 2010 and 2025. The timing and manner in which U.S. net operating loss carryforwards may be utilized may be limited if the Company incurs a change in ownership as defined under Section 382 of the Internal Revenue Code.
18. EMPLOYEE 401(K) PLAN
The Company maintains an employee 401(k) Plan (the “Plan”). The Plan, which covers all employees 21 years of age or older, stipulates that participating employees may elect an amount up to 100% of their total compensation to contribute to the Plan, not to exceed the maximum allowable by Internal Revenue Service regulations. The Company may make “matching contributions” equal to a discretionary percentage up to 3% of a participant’s salary, based on deductions of up to 6% of a participant’s salary. All amounts deferred by a participant under the 401(k) Plan’s salary reduction feature vest immediately in the participant’s account while contributions the Company may make would vest over a five-year period in the participant’s account. The Company contribution was approximately $900,000, $800,000 and $600,000 for the years ended October 31, 2006, 2005 and 2004, respectively.
19. QUARTERLY FINANCIAL INFORMATION (unaudited)
Quarterly unaudited financial information for fiscal 2006, as restated, and 2005 is presented in the following table (in thousands, except per share data):
                                 
    1st     2nd     3rd     4th  
    Quarter     Quarter     Quarter     Quarter  
2006 (restated)
                               
Total revenues
  $ 62,892     $ 70,218     $ 70,358     $ 67,186  
Cost of revenues
    39,489       44,293       44,952       44,542  
Income from operations
    8,015       8,962       7,640       437 (1)
Net income
    4,770       5,451       4,615       102 (1)
Net income per share, basic
    0.15       0.17       0.14       0.00  
Net income per share, diluted
    0.15       0.17       0.14       0.00  
 
2005
                               
Total revenues
  $ 66,489     $ 55,831     $ 39,489 (2)   $ 56,043  
Cost of revenues
    38,906       35,377       25,690       33,408  
Income (loss) from operations
    11,137       4,951       (587 )(2)     7,444  
Net income (loss)
    7,072       3,433       (109 )(2)     4,888  
Net income (loss) per share, basic
    0.24       0.11       (0.00 )     0.15  
Net income (loss) per share, diluted
    0.23       0.11       (0.00 )     0.15  
 
(1)   In the fourth quarter of fiscal 2006, Martek recognized a charge of $4.7 million related to the restructuring of plant operations (see Note 12).
 
(2)   In the third quarter of fiscal 2005, revenues declined due to a build-up of inventory by certain customers.

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ITEM 9A. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
On October 31, 2006, Martek Biosciences Corporation (“Martek”) management, including Martek’s principal executive and principal financial officers, evaluated Martek’s disclosure controls and procedures and concluded that its disclosure controls and procedures were effective. Subsequent to that date and in connection with the filing of this Amendment No. 1 to Martek’s Annual Report on Form 10-K to restate the Company’s financial statements and corresponding financial information for the year ended October 31, 2006, Martek management re-evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of October 31, 2006. As a result of a material weakness in internal control over financial reporting related to the Company’s accounting for depreciation of assets held for future use, management has concluded that the Company’s disclosure controls and procedures were not effective as of October 31, 2006.
To address the material weakness described below, Martek has corrected its accounting policy for the depreciation of assets held for future use. Accordingly, management believes that the financial statements included in this report fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented and that the factors rendering Martek’s disclosure controls and procedures ineffective as of October 31, 2006 have been remediated.
Changes in Internal Control over Financial Reporting
Other than the matter described in this Item 9A, there have been no significant changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. As part of the filing of this Amendment No. 1 to Form 10-K, management has concluded that the material weakness surrounding depreciation of assets held for future use noted above has been fully remediated through the filing of the Company’s restated financial statements.
Management’s Report on Internal Control over Financial Reporting (as revised)
Martek is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rule 13a-15(f). Martek’s internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Martek’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect Martek’s transactions and dispositions of assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that Martek’s receipts and expenditures are being made only in accordance with authorizations of Martek’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of Martek’s assets that could have a material effect on the financial statements.
There are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or overriding of controls. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation.
On October 31, 2006, Martek’s management, including Martek’s principal executive and principal financial officers, evaluated Martek’s internal control over financial reporting and concluded that the internal control over financial reporting was effective. Subsequent to that date and in connection with the filing of this Amendment No. 1 to Martek’s Annual Report on Form 10-K to restate the Company’s financial statements and corresponding financial information for the year ended October 31, 2006, management re-evaluated the effectiveness of Martek’s internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Based on this re-evaluation, management identified one material weakness as of October 31, 2006. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The material weakness pertains to insufficient controls over the accounting for depreciation of assets held for future use. During fiscal 2006, Martek recorded depreciation of assets held for future use when such assets were placed in or returned to productive service. Upon review, Martek determined that, in accordance with our adopted straight-line depreciation policy, assets held for future use should have been depreciated when they were available for use, and depreciation should have been recognized evenly over the life of the asset without regard to whether the asset has been placed in productive service or is in commercial use. This correction, which was not identified by the Company’s existing controls over the calculation of depreciation, resulted in the restatement of the Company’s financial statements for the fiscal year ended October 31, 2006 and its unaudited quarterly financial information for the interim periods of fiscal 2006.
Because of this material weakness, management has concluded that the Company did not maintain effective internal control over financial reporting as of October 31, 2006, based on the criteria in COSO Internal Control — Integrated Framework.
Management’s assessment of the effectiveness of Martek’s internal control over financial reporting as of October 31, 2006 has been audited by Ernst & Young LLP, the Company’s independent registered public accounting firm, as stated in their report, which is included herein.
Remediation of Material Weakness
As part of the filing of this Amendment No. 1 to Form 10-K, management has concluded that the material weakness surrounding depreciation of assets held for future use noted above has been fully remediated through the filing of the Company’s restated financial statements.

45


 

PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a)(3) Exhibits
The Exhibits listed in the accompanying Exhibit Index are filed or incorporated by reference as part of this report.

46


 

SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Amendment No. 1 to the Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized on May 8, 2007.
         
  MARTEK BIOSCIENCES CORPORATION
 
 
  By   /s/ Steve Dubin    
    Steve Dubin   
    Chief Executive Officer and Director   
 

47


 

EXHIBIT INDEX
     
EXHIBIT    
NUMBER#   DESCRIPTION
 
   
23.01
  Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm.**
 
   
31.01
  Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).**
 
   
31.02
  Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).**
 
   
32.01
  Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. **
 
   
32.02
  Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
 
**   Filed herewith.

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