Martek Biosciences 10-Q 2009
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the Quarterly Period Ended January 31, 2009
For the Transition Period From to
COMMISSION FILE NUMBER 0-22354
MARTEK BIOSCIENCES CORPORATION
(Exact name of registrant as specified in its charter)
6480 Dobbin Road, Columbia, Maryland 21045
(Address of principal executive offices)
Registrants telephone number, including area code: (410) 740-0081
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting companyin Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
o Yes þ No
The number of shares of Common Stock outstanding as of March 4, 2009 was 33,154,575.
MARTEK BIOSCIENCES CORPORATION
For The Quarterly Period Ended January 31, 2009
PART I FINANCIAL INFORMATION
Item 1. Financial Statements.
MARTEK BIOSCIENCES CORPORATION
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
MARTEK BIOSCIENCES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes.
MARTEK BIOSCIENCES CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
See accompanying notes.
MARTEK BIOSCIENCES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation The accompanying unaudited consolidated financial statements of Martek Biosciences Corporation (the Company or Martek) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended January 31, 2009 are not necessarily indicative of the results that may be expected for the year ending October 31, 2009. For further information, refer to the consolidated financial statements and footnotes thereto included in Martek Biosciences Corporations Annual Report on Form 10-K for the year ended October 31, 2008.
Consolidation The consolidated financial statements include the accounts of Martek and its wholly-owned subsidiaries, Martek Biosciences Boulder Corporation and Martek Biosciences Kingstree Corporation, after elimination of all significant intercompany balances and transactions.
Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the Companys 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 Companys 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. Certain 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 the Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, the consideration from these contracts is allocated based on the relative fair values of the separate elements. Revenue is recognized on product sales when goods are shipped and all other conditions for revenue recognition are met. 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 Companys licensees. Royalty income was approximately $300,000 and $800,000 in the three months ended January 31, 2009 and 2008, 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 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 revenues. Shipping and handling costs were approximately $700,000 and $500,000 in the three months ended January 31, 2009 and 2008, respectively.
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 a portion of purchases of arachidonic acid (ARA) from DSM Food Specialties B.V. (DSM), which are denominated in euros.
The Company periodically enters 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. Consequently, the resulting unrealized gains and losses are recorded as a component of other comprehensive income until exercise of the forward contracts, at which time realized gains or losses are recorded as a component of inventory until the related product is sold. As of January 31, 2009, outstanding forward contracts had notional values aggregating approximately 19.4 million euros (equivalent to $24.8 million at January 31, 2009), which mature by November 2009. Amounts recorded due to hedge ineffectiveness have historically not been material.
Research and Development Research and development costs are charged to operations as incurred. These costs include internal labor, materials and overhead expenses associated with the Companys ongoing research and development activity as well as third-party costs for contracted work and clinical trials.
Advertising Advertising costs are expensed as incurred. Advertising costs, including print, television and internet-based advertising, were approximately $300,000 and $500,000 in the three months ended January 31, 2009 and 2008, respectively.
Other Operating Expenses Other operating expenses relate primarily to internal production and contract manufacturing start-up costs, including materials, training and other such costs, incurred in connection with the expansion of the Companys internal manufacturing operations and costs incurred in connection with qualification of certain third-party manufacturers. 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 basis and the tax basis 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 in the tax jurisdictions in which the deferred tax assets are located. Valuation allowances are provided to reduce such deferred tax assets to amounts more likely than not to be ultimately realized.
Income tax provision or benefit includes U.S. federal, state and local income taxes and is based on pre-tax income or loss. The interim period provision or benefit for income taxes is based upon the Companys estimate of its annual effective income tax rate. In determining the estimated annual effective income tax rate, the Company analyzes various factors, including projections of the Companys annual earnings and taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes and the ability of the Company to use tax credits and net operating loss carryforwards.
The Company adopted Financial Accounting Standards Boards Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48), effective November 1, 2007. FIN 48 defines the threshold for recognizing the benefits of tax positions in the financial statements as more likely than not to be sustained upon examination by the taxing authority. If the recognition threshold is met, the tax benefit is generally measured and recognized as the tax benefit having the highest likelihood, in the Companys judgment, of being realized upon ultimate settlement with the taxing authority, assuming full knowledge of the position and all relevant facts. Pursuant to FIN 48, the Company recognizes interest accrued related to unrecognized tax benefits and penalties in the provision for income taxes. The Company is subject to U.S. federal income tax as well as state and local tax in various jurisdictions. Because the Companys 2006 U.S. federal income tax return used net operating loss carryforwards dating, in part, back to fiscal 1991, some elements of income tax returns back to fiscal 1991 are subject to examination. The Company believes appropriate provisions for all outstanding issues have been made for all jurisdictions and all open years. It is reasonably possible that the total amount of unrecognized tax benefits will change within the next 12 months as various uncertainties are resolved. The Company cannot reasonably estimate the range of potential outcomes.
Equity-Based Compensation The Company records compensation cost for all equity-based payments based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R). The Company utilizes the straight-line method for allocating compensation cost by period.
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 restricted stock units using the treasury stock method.
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 as well as changes in the market value of exchange rate forward contracts in other comprehensive income in the Consolidated Statement of Stockholders Equity.
Cash and Cash Equivalents Cash equivalents consist of highly liquid investments with an original maturity from date of purchase of three months or less.
Investments and Marketable Securities The Company has classified investments and marketable securities at January 31, 2009 as both trading and available-for-sale and at October 31, 2008 as available-for-sale. Unrealized gains and losses on available-for-sale securities are reported as accumulated other comprehensive income, which is a separate component of stockholders equity. Unrealized gains and losses on trading securities and realized gains and losses on both types of securities are included in other income as incurred based on the specific identification method.
The Company periodically evaluates whether any declines in the fair value of its available-for-sale 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 issuers 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.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (SFAS 159). SFAS 159 permits an entity to elect to measure eligible items at fair value (fair value option) including many financial instruments. The decision to elect the fair value option is made individually for each instrument and is irrevocable once made. Changes in fair value for the selected instruments are recorded in earnings. The Company has elected the fair value option for the auction rate securities rights agreement (the Put Agreement), which is recorded within long-term investments. The Put Agreement is the only instrument of its nature/type that we hold and for which we have elected the fair value option under SFAS No. 159. See Note 3 for further discussion.
The Company classifies its investments as either current or long-term based upon the investments contractual maturities and the Companys ability and intent to convert such instruments to cash within one year.
Fair Value of Financial Instruments The Company considers the carrying cost of its financial assets and liabilities, which consist primarily of cash and cash equivalents, 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 January 31, 2009 and October 31, 2008. See Note 4 for further discussion of the Companys fair value measurements.
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 managements 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 managements expectations.
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 production 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:
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. Certain external legal and related costs are incurred in connection with patent applications. If a future economic benefit is anticipated from the resulting patent or an alternate future use is available to the Company, such costs are capitalized and amortized over the expected life of the patent. The Company also capitalizes 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 In accordance with SFAS No.142, Goodwill and Other Intangible Assets (SFAS 142), goodwill is tested for impairment on an annual basis and between annual tests when indicators of potential impairment are identified, using a fair value-based approach. The Companys annual impairment test date is August 1 of each fiscal year. The Company has one reporting unit and determines fair value of the reporting unit using the market and income approach. 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. The Companys intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, generally ten to seventeen years.
Impairment of Long-Lived Assets In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, 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. Assets are grouped and evaluated for impairment at the lowest level for which there is identified cash flows. The Company deems an asset to be impaired if a forecast of undiscounted cash flows is less than its carrying amount. The impairment to be recognized is measured by the amount by which the carrying amount of assets exceeds the fair value of the assets. The Company generally measures fair value by discounting projected future cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
2. 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 Companys nutritional oils that it sells to its infant formula licensees. Among other things, this agreement provided 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. Under the agreement, annual ARA unit pricing is calculated utilizing a cost-plus approach that is based on the prior years actual costs incurred adjusted primarily for current year volume and cost expectations and, to a limited extent, adjusted for certain current year actual expenses.
In February 2006, the Company and DSM entered into an amendment to the original agreement (the 2006 Amendment). The 2006 Amendment established the overall economics associated with DSMs expansion at both its Belvidere, New Jersey and Capua, Italy production facilities. In July 2007, the companies entered into a second amendment to the original agreement (the 2007 Amendment). Among other things, the 2007 Amendment established the parameters and methodologies for the calculation of ARA pricing for calendar years 2008, 2009 and, if certain criteria are met, 2010. As part of the 2006 Amendment, Martek guaranteed the recovery of certain costs incurred by DSM in connection with the Belvidere, New Jersey and Capua, Italy expansions, up to $40 million. In May 2008, the Company and DSM entered into an amendment to the payment terms of the guarantee. In connection with this amendment, it was agreed that in full satisfaction of the guarantee, Martek will commit to purchasing certain minimum quantities of ARA during the period January 1, 2009 through September 30, 2009. As of January 31, 2009, the value of the remaining calendar 2009 minimum purchase quantities is approximately $63.2 million with such minimum volumes approximating the amounts expected to be purchased by Martek in the normal course of business.
At January 31, 2009 and October 31, 2008, the Company had investments consisting of auction rate securities (ARS) whose underlying assets are student loans originated under the Federal Family Education Loan Program (FFELP). FFELP student loans are guaranteed by state guarantors who have reinsurance agreements with the U.S. Department of Education. These ARS are intended to provide liquidity via an auction process that resets the applicable interest rate approximately every 30 days and allows the Company to either roll over its holdings or gain immediate liquidity by selling such investments at par. The underlying maturities of these investments range from 18 to 39 years. Since February 2008, as a result of negative conditions in the global credit markets, the large majority of the auctions for the Companys investment in these securities have failed to settle, resulting in Marteks continuing to hold such securities. Consequently, the investments are not currently liquid and the Company will not be able to access these funds until a future auction of these investments is successful or a buyer is found outside of the auction process.
While Martek continues to receive interest payments on these investments involved in failed auctions, the Company believes that the estimated fair value of these ARS no longer approximates par value. Such fair value was estimated by the Company and considers, among other items, the creditworthiness of the issuer, the collateralization underlying the securities and the timing of expected future cash flows. Based upon these fair value estimates, as of January 31, 2009, Martek has recorded temporary impairments of $1.7 million and other-than-temporary impairments of $1.7 million on such ARS whose original cost basis totals $13.1 million (see below for discussion of the accounting for such impairments). In addition, due to the Companys belief that the market for these ARS may take in excess of twelve months to fully recover, the Company has classified these investments as long-term on the accompanying consolidated balance sheet as of January 31, 2009.
As of October 31, 2008, all ARS were classified as available-for-sale and all declines in value were recognized in other comprehensive income. In November 2008, the Company executed a Put Agreement with a financial institution which provides Martek the ability to sell certain of its ARS to the financial institution and allows the financial institution, at its sole discretion, to purchase such ARS at par during the period June 30, 2010 through July 2, 2012. The Companys ARS holdings to which this relates have a cost basis of approximately $7.5 million and a fair value at January 31, 2009 of approximately $5.8 million. Upon execution of the Put Agreement, the Company no longer had the intent or unilateral ability to hold the ARS covered by the Put Agreement to maturity and therefore, the Company classified such investments as trading and recognized $1.7 million as an other-than-temporary impairment during the quarter ended January 31, 2009. This $1.7 million impairment charge, which was recorded in other income in the accompanying consolidated statements of income, includes $1.0 million of unrealized losses reclassified from other comprehensive income and $700,000 of unrealized fair value declines occurring after such reclassification. Due to the classification as trading, future changes in fair value to these ARS will be recorded in earnings.
For the quarter ended January 31, 2009, the Company recorded the Put Agreement at its fair value of approximately $1.6 million and recognized a gain equal to this amount, in other income within the accompanying consolidated statements of income. The Company elected to adopt the fair value option as permitted by SFAS 159 for the Put Agreement so that future changes in the fair value of this asset will largely offset the fair value movements of the related ARS. The Company believes that the accounting for the Put Agreement will then match its purpose as an economic hedge to the changes in the fair value of the related ARS. The ability of the Put Agreement to act as an economic hedge is subject to the continued expected performance by the financial institution of its obligations under the agreement. The fair value of the Put Agreement considers, among other things, the creditworthiness of the issuer and the liquidity of the financial instrument.
As of January 31, 2009, the Companys ARS holdings not covered by the Put Agreement have a cost basis of approximately $5.6 million and a fair value of approximately $3.9 million. The total decline in fair value of $1.7 million includes approximately $900,000 which was recorded as a reduction to other comprehensive income during the quarter ended January 31, 2009. The Company believes that the unrealized losses on these ARS are temporary. In making this determination, Martek primarily considered the financial condition of the issuers, collateralization underlying the securities and our ability and intent to hold these investments until recovery in market value occurs. The Company continues to monitor the market for ARS and consider its impact, if any, on the fair value of these investments. If the Company determines that any valuation adjustment is other than temporary, the Company would record an impairment charge to earnings.
4. FAIR VALUE MEASUREMENTS
As of November 1, 2008, the Company adopted the provisions of SFAS No. 157, Fair Value Measurements (SFAS 157) for financial instruments. SFAS 157 defines fair value, establishes a fair value hierarchy for assets and liabilities measured at fair value and requires expanded disclosures about fair value measurements. The adoption of SFAS 157 did not have a material impact on the Companys financial condition, results of operations, or cash flows; however, the additional disclosures required by SFAS 157 are presented below. The SFAS 157 hierarchy ranks the quality and reliability of inputs, or assumptions, used in the determination of fair value and requires assets and liabilities carried at fair value to be classified and disclosed in one of the following three categories:
Level 1 quoted prices in active markets for identical assets and liabilities;
Level 2 inputs other than Level 1 quoted prices that are directly or indirectly observable; and
Level 3 unobservable inputs that are not corroborated by market data.
In October 2008, the FASB issued Staff Position No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active (FSP 157-3). FSP 157-3 clarifies the application of SFAS 157 to financial assets for which an active market does not exist. Specifically, FSP 157-3 addresses the following SFAS 157 application issues: (1) how a reporting entitys own assumptions should be considered in measuring fair value when observable inputs do not exist; (2) how observable inputs in inactive markets should be considered when measuring fair value; and (3) how the use of market quotes should be considered when assessing the relevance of inputs available to measure fair value. FSP 157-3 applies to financial assets within the scope of accounting pronouncements that require or permit fair value measurements in accordance with SFAS 157 and was effective upon issuance. Adoption of FSP 157-3 did not materially affect the Companys methodology for determining Level 3 pricing as discussed below.
The Company evaluates financial assets and liabilities subject to fair value measurements on a recurring basis to determine the appropriate level at which to classify them for each reporting period. This determination requires highly subjective judgments as to the significance of inputs used in determining fair value and where such inputs lie within the SFAS 157 hierarchy.
As of January 31, 2009, the Company held certain assets that are required to be measured at fair value on a recurring basis. These financial assets and liabilities were as follows (in thousands):
The table below provides a reconciliation of the beginning and ending balances of the Companys investments measured at fair value using significant unobservable inputs (Level 3) for the three month period ended January 31, 2009 (in thousands):
Some of the inputs into the discounted cash flow models from which the Company bases its Level 3 valuations for the auction rate securities and put agreement are unobservable in the market and have a significant effect on valuation. The assumptions used in preparing the models include, but are not limited to, periodic coupon rates, market required rates of return and the expected term of each security. The coupon rate was estimated using implied forward rate data on interest rate swaps and U.S. treasuries, and limited where necessary by any contractual maximum rate paid under a scenario of continuing auction failures. Assumptions regarding required rates of return were based on risk-free interest rates and credit spreads for investments of similar credit quality. The expected term for the ARS was based on a weighted probability-based estimate of the time the principal will become available to us. The expected term for the Put Agreement was based on the earliest date on which we can exercise the Put Agreement rights.
Inventories consist of the following (in thousands):
Inventory levels are evaluated by management based upon anticipated product demand, shelf-life, future marketing plans and other factors. Reserves for obsolete and slow-moving inventories are recorded for amounts that may not be realizable.
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following (in thousands):
Assets available for commercial use that were not in productive service had a net book value of $37.2 million and $38.2 million at January 31, 2009 and October 31, 2008, respectively. Depreciation as well as certain other fixed costs related to such idle assets is recorded as idle capacity costs and included within cost of product sales in the accompanying consolidated statements of income.
7. GOODWILL AND OTHER INTANGIBLE ASSETS
Intangible assets and related accumulated amortization consist of the following (in thousands):
Core technology and current products relate to the value assigned to the products purchased as part of the OmegaTech acquisition in fiscal 2002. All amortization associated with the Companys intangible assets is reflected in amortization of intangible assets in the accompanying consolidated statements of income. Included in amortization of intangible assets is approximately $1.6 million and $1.5 million in the three months ended January 31, 2009 and 2008, respectively, related to assets supporting the Companys commercial products. Included in amortization of intangible assets is approximately $200,000 and $100,000 in the three months ended January 31, 2009 and 2008, respectively, related to assets supporting the Companys research and development initiatives.
In February 2009, Martek entered into a license agreement with General Mills for certain patented technology expected to be used in the production of Marteks lifesDHA. Under the agreement, Martek was granted a perpetual and generally exclusive license to the technology. As consideration for this license, Martek paid an upfront license fee of $1.0 million and will pay, subject to the successful completion by the licensor of certain development goals related to the licensed technology, additional fees of up to approximately $5.0 million. In addition, Martek will be required to pay royalties of up to 4.5% of sales of products produced using the licensed technology.
Based on the current amount of intangible assets subject to amortization, including the February 2009 license noted above, the estimated total amortization expense for fiscal 2009, fiscal 2010, fiscal 2011, fiscal 2012 and fiscal 2013 will be approximately $5.6 million, $4.6 million, $4.0 million, $3.1 million and $3.0 million respectively. As of January 31, 2009, the weighted average remaining useful lives of the Companys patents, current products and licenses are 8 years, 8 years and 12 years, respectively.
8. NOTES PAYABLE AND LONG-TERM DEBT
The Company has a $135 million secured revolving credit facility that is collateralized by accounts receivable, inventory and all capital stock of the Companys subsidiaries and expires in September 2010. There were no amounts outstanding under the credit facility in the three months ended January 31, 2009. The weighted average annual commitment fee rate on unused amounts was approximately 0.1% for the three months ended January 31, 2009 and 2008. The commitment fee rate is based on LIBOR and the Companys 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 January 31, 2009, the Company was in compliance with all of these debt covenants.
Interest expense incurred by the Company during the three months ended January 31, 2009 and 2008 was not material.
The carrying amounts of notes payable at January 31, 2009 and October 31, 2008 approximate their fair values based on instruments of similar terms available to the Company.
9. COMMITMENTS AND CONTINGENCIES
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.
In May 2008, the Company entered into a collaboration agreement with a global biotechnology company to jointly develop and commercialize a canola seed that produces DHA. Martek and its co-collaborator anticipate a multi-year effort to produce this oil. The Companys financial commitments associated with this development initiative are subject to the successful completion of identified milestones. As of January 31, 2009, the Companys financial commitment, primarily through internal research efforts, to the first projected milestone date totals approximately $1.1 million. Commitments thereafter, also primarily through internal research efforts, assuming successful achievement of all identified milestones, total approximately $5.6 million.
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, Nutrinovas 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 the defendants infringed all the asserted claims of three Martek patents and that these patents were valid. It also found that the defendants willfully infringed one of these patents. In October 2007, the judge upheld the October 2006 jury verdict that the defendants infringed all of the asserted claims of U.S. Patent Nos. 5,340,594 and 6,410,281 and that these patents were not invalid. The judge has granted a permanent injunction against the defendants with respect to those two patents. The judge also upheld the jury verdict that the defendants had acted willfully in their infringement of U.S. Patent No. 6,410,281. Regarding the third patent involved in the case, U.S. Patent No. 6,451,567, the judge reversed the jury verdict and found that the asserted claims of this patent were invalid. Marteks request to the judge to reconsider his ruling on the third patent was denied. Martek and the defendants have appealed aspects of the judges final decision. The appeal hearing before the U.S. Court of Appeals for the Federal Circuit is scheduled for April 2009. The two patents where the infringement was upheld, U.S. Patent Nos. 5,340,594 and 6,410,281, are scheduled to expire in July 2009 and August 2011, respectively.
In January 2004, the Company filed a patent infringement lawsuit in Germany against Nutrinova and Celanese Ventures GmbH. Lonza Ltd. and a customer of Nutrinova have also been added to this lawsuit. The complaint alleges infringement of Marteks European patent relating to DHA-containing oils. A hearing was held in a district court in Dusseldorf in September 2007 and the court issued its decision in October 2007, ruling that Marteks patent was infringed by the defendants. The defendants have appealed, and the appeal is expected to be heard in 2009.
In connection with these patent lawsuits, the Company has incurred and capitalized significant external legal costs. As of January 31, 2009, the patents being defended had a net book value of approximately $5.5 million, including capitalized legal costs, which will be amortized over a weighted average remaining period of approximately four years.
These lawsuits are further described in Item 1 of Part II of this Form 10-Q, 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 Companys results of operations or financial condition.
10. STOCKHOLDERS EQUITY
The Company recognized approximately $800,000 and $600,000 in the three months ended January 31, 2009 and 2008, respectively, in compensation cost related to employee stock plans. Such costs were recorded approximately 75%, 15% and 10% as selling, general and administrative expenses, research and development expenses and cost of revenues, respectively, in both periods.
The Company granted 263,238 restricted stock units during the three months ended January 31, 2009, which vest over 62 months from the date of grant. The total fair value of the restricted stock units granted of $7.2 million was based on fair market value on the date of grant.
As of January 31, 2009, there was approximately $15.4 million remaining in unrecognized compensation cost related to restricted stock units. The cost is expected to be recognized through fiscal 2014 with a weighted average recognition period of approximately two years.
As of January 31, 2009, there was approximately $300,000 of unrecognized compensation cost related to unvested stock options. The cost is expected to be recognized through fiscal 2011 with a weighted average recognition period of approximately one year.
11. 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 restricted stock units 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):
Stock options to purchase approximately 1.8 million shares were outstanding but were not included in the computation of diluted net income per share for the three months ended January 31, 2009, and stock options to purchase approximately 1.7 million shares were outstanding but were not included in the computation of diluted net income per share for the three months ended January 31, 2008, because the effects would have been antidilutive.
12. COMPREHENSIVE INCOME
Comprehensive income and its components for the three months ended January 31, 2009 and 2008 were as follows (in thousands):
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.
This Managements 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:
Forward-looking statements include those statements containing words such as the following:
All of these forward-looking statements involve risks and uncertainties. They and other forward-looking statements in this Form 10-Q are all made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. We wish to caution you that our actual results may differ significantly from the results we discuss in our forward-looking statements. We discuss some of the risks that could cause such differences in Part II, Item 1A. Risk Factors in this report on Form 10-Q and in our various other filings with the Securities and Exchange Commission. Our forward-looking statements speak only as of the date of this document, and we do not intend to update these statements to reflect events or circumstances that occur after that date.
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 lifesDHA, a vegetarian source of the omega-3 fatty acid DHA (docosahexaenoic acid), for use in infant formula, pregnancy and nursing products, foods and beverages, dietary supplements and animal feed, and lifesARA, a vegetarian source of the omega-6 fatty acid ARA (arachidonic acid), for use in infant formula. We sell oils containing these fatty acids as lifesDHA, DHASCO®, Neuromins®, ARASCO® and lifesARA. 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 Alzheimers disease, dementia and increased cardiovascular problems. Further research is underway to assess the role of supplementation with our DHA on mitigating a variety of health risks.
We have entered into license agreements with over 30 infant formula manufacturers, who collectively represent approximately 75% of the estimated $15 billion worldwide retail market for infant formula and nearly 100% of the estimated $4.5 billion U.S. retail market for infant formula, including the retail value of Women, Infants & 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 Danone (formerly Numico), each of whom is selling infant formula supplemented with our nutritional oils. Our licensees are now selling infant formula products containing our oils collectively in over 75 countries. Supplemented infant formulas from Mead Johnson Nutritionals, Abbott Laboratories, PBM Products, Nestle, Hain Celestial and Nutricia North America are currently being sold in the United States. In addition, certain infant formula licensees are selling products in the United States and abroad that contain our nutritional oils and target the markets for children ages nine months to seven years of age and older, and one infant formula licensee, Mead Johnson Nutritionals, is selling a product that contains our oils for pregnant and nursing women.
We are continuing to aggressively pursue further penetration of our DHA oils, both domestically and internationally, in the food and beverage, pregnancy and nursing, nutritional supplements and animal feed markets. We are in discussions with many companies to sell products containing our DHA oils for cognitive function, cardiovascular health and other applications. To date, over 100 domestic and international companies have launched non-infant formula products that contain lifesDHA, most of which remain on the market and are believed to be meeting customer expectations. Certain of our DHA license and supply agreements with major consumer food products companies establish Martek, subject to certain exceptions, as their exclusive supplier of DHA for minimum periods of time. We, along with our customers and certain third parties, are developing other DHA delivery methods, including powders and emulsions, to facilitate further entry into the non-infant formula markets. Management believes that over the next few years, the non-infant formula markets will continue to expand and could ultimately represent a larger opportunity than infant formula.
For the three months ended January 31, 2009, we generated approximately $9.6 million of net income on revenues of $87.4 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:
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.
New Product Launches During the first quarter of fiscal 2009, several new products containing Marteks lifesDHA were launched as follows:
New Microencapsulation Technology In-licensed for Certain Food Applications In February 2009, Martek entered into a license agreement with General Mills for a patented microencapsulation technology. Microencapsulation is a process widely used in food manufacturing that protects the integrity of food ingredients and helps maintain the nutritional value, shelf-life and flavor of the finished food or beverage product. This technology is expected to expand the range of food and beverage products that can incorporate lifesDHA and enhance Marteks ability to produce high-quality, cost-effective DHA powders. Martek is granted a perpetual and generally exclusive license to the technology for use with DHA and other polyunsaturated fatty acids, while General Mills retains the right to this technology for its own use and exclusively for uses within certain of its core businesses.
New Data Published on Benefits of DHA The benefits of DHA supplementation were recently discussed in the following publications.
Martek expects total revenues for the second quarter of fiscal 2009 to be between $87 million and $92 million with second quarter infant formula revenue projected to be between $76 million and $80 million and second quarter non-infant formula nutritional revenue projected to be between $7 million and $9 million. Second quarter gross margin is expected to be approximately 42.5%. Net income for the second quarter is projected to be between $8.9 million and $10.3 million, and diluted earnings per share are projected to be between $0.27 and $0.31.
For the full fiscal year 2009, consistent with previous guidance, the Company continues to expect moderate growth of both revenues and profitability over fiscal 2008 with profitability continuing to grow at a higher rate than revenues primarily due to improvements in gross profit margins. However, if the current worldwide economic recession remains deep and prolonged, there is greater uncertainty with respect to the Companys ability to attain its forecasted operating results.
We manufacture oils rich in DHA at our production facilities located in Winchester, Kentucky and Kingstree, South Carolina. 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. Both manufacturing facilities have received favorable ratings by the American Institute of Baking, an independent auditor of food manufacturing facilities, and have obtained the ISO 14001 Environmental Management System (EMS) International Standard, the most recognized EMS standard in the world. Also, the National Oceanic and Atmospheric Administration has granted Marteks Winchester plant, the Companys primary shipping location, a health certificate, which is required for import of products into many countries, including China and neighboring countries in the Pacific Rim. In October 2006, we restructured our plant operations following a review of the Companys production and cost structure. Under the restructuring, a substantial portion of production formerly taking place in Winchester was transferred to Kingstree. 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 if required by customer demand.
Over 90% of our ARA oils are purchased from DSM as manufactured at its Capua, Italy and Belvidere, New Jersey plants. Because DSM is a third-party manufacturer, we have only limited control over the timing and level of its Capua and Belvidere production volumes. The balance of our ARA requirements is produced at our Kingstree facility.
Under our agreement with DSM, annual ARA unit pricing is calculated utilizing a cost-plus approach that is based on the prior years actual costs incurred adjusted primarily for current year volume and cost expectations and, to a limited extent, adjusted for certain current year actual expenses. In February 2006, we and DSM entered into an amendment to the original agreement (the 2006 Amendment). The 2006 Amendment established the overall economics associated with DSMs expansion at both its Belvidere, New Jersey and Capua, Italy production facilities. In July 2007, we and DSM entered into a second amendment to the original agreement (the 2007 Amendment). Among other things, the 2007 Amendment established the parameters and methodologies for the calculation of ARA pricing for calendar years 2008, 2009 and, if certain criteria are met, 2010. As part of the 2006 Amendment, we guaranteed the recovery of certain costs incurred by DSM in connection with these expansions, up to $40 million. In May 2008, we and DSM entered into an amendment to the payment terms of the guarantee. In connection with this amendment, it was agreed that in full satisfaction of the guarantee, we will commit to purchasing certain minimum quantities of ARA during the period January 1, 2009 through September 30, 2009. As of January 31, 2009, the value of the remaining calendar 2009 minimum purchase quantities is approximately $63.2 million with such minimum volumes approximating the amounts expected to be purchased by Martek in the normal course of business.
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 ARA in our plants; however, our current manufacturing capacity would not permit us to produce ARA quantities sufficient to meet current demand without impacting our production of DHA. 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 DSMs 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, collectively, to the infant formula, pregnancy and nursing, food and beverage, dietary supplement and animal feed 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 routine basis and at a commercially acceptable cost. Our success will also be somewhat dependent on our ability to align our production with customer demand, which is inherently uncertain. There can also be no assurance that we will be able to continue to comply with applicable regulatory requirements, including the Food and Drug Administrations good manufacturing practice (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 discuss accounting policies and assumptions that involve a higher degree of judgment and complexity than others in our Managements Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report to shareholders on Form 10-K for the year ended October 31, 2008. Other than the adoption of SFAS No. 157, Fair Value Measurements (SFAS 157) as discussed below (see also Note 4 to the consolidated financial statements), there have been no significant changes in the Companys critical accounting policies since October 31, 2008.
Fair Value Measurements As of November 1, 2008, the Company adopted the provisions of SFAS 157 for financial instruments. SFAS 157 defines fair value, establishes a fair value hierarchy for assets and liabilities measured at fair value and requires expanded disclosures about fair value measurements. The SFAS 157 hierarchy ranks the quality and reliability of inputs, or assumptions, used in the determination of fair value and requires assets and liabilities carried at fair value to be classified and disclosed as either a Level 1, 2 or 3 fair value instrument. Different from Levels 1 and 2, Level 3 instruments are valued using unobservable inputs that are not corroborated by market data. At January 31, 2009, we had Level 3 assets of $11.3 million which include both auction rate securities and an auction rate securities rights agreement (the Put Agreement). Of this amount, fair value changes in assets totaling $7.4 million would be recorded through earnings and changes in the remainder would be recorded through other comprehensive income. Some of the unobservable inputs into the discounted cash flow models from which we base our Level 3 valuations include, but are not limited to, periodic coupon rates, market required rates of return and the expected term of each security. Changes to the inputs used as of January 31, 2009 would cause fluctuations to the fair value of the affected instruments and such fair value changes could be material.
RESULTS OF OPERATIONS
The following table presents revenues by category (in thousands):
Product sales increased $5.4 million or 6.9% in the three months ended January 31, 2009 as compared to the three months ended January 31, 2008. Product sales were comprised of the following (in thousands):
Sales to the infant formula market during the three months ended January 31, 2009 increased as compared to the three months ended January 31, 2008 due primarily to growth in international infant formula markets. Launches of new products and increased market penetration of existing products containing lifesDHA also resulted in higher sales to the food and beverage market in the three months ended January 31, 2009 compared to the same period of the prior fiscal year. In addition, sales into the pregnancy and nursing, nutritional supplements and animal feeds markets increased in the three months ended January 31, 2009 due to a continued expansion of Marteks customer base in these markets.
Approximately 80% of our product sales in the three months ended January 31, 2009 were generated by sales to Mead Johnson Nutritionals, Abbott Laboratories, Nestle, Wyeth and Danone (formerly Numico). 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 55% of our sales to infant formula licensees for the three months ended January 31, 2009 and 2008 relate to sales in the U.S. As of January 31, 2009, we estimate that formula supplemented with our oils had penetrated almost all of the U.S. infant formula market.
Although we anticipate that annual product sales will continue to grow, our future sales growth is subject to quarter-to-quarter fluctuations and is dependent to a significant degree upon the following factors: (i) the 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 and the success in the marketplace of such launches; (iii) the timing and extent of stocking and destocking of inventory by our customers; (iv) the levels of inclusion of our oils in infant formula; (v) the timing and extent of our customers production campaigns and plant maintenance shutdowns; and (vi) the availability and use by our customers and others of competitive products.
Contract manufacturing sales revenues, totaling approximately $3.3 million and $4.3 million in the three months ended January 31, 2009 and 2008, respectively, relate mainly to fermentation work performed for various third parties at our Kingstree, South Carolina facility. The decrease in contract manufacturing revenues in the three months ended January 31, 2009 as compared to the three months ended January 31, 2008 was primarily due to lower revenues from one customer. During fiscal 2009, we anticipate continuing to reduce the scope of our contract manufacturing activities, focusing more of our resources on our higher margin nutritional oils business.
As a result of the above, total revenues increased by $4.5 million or 5.4% in the three months ended January 31, 2009 as compared to the three months ended January 31, 2008.
Cost of Revenues
The following table presents our cost of revenues (in thousands):
Cost of product sales as a percentage of product sales improved to 56% in the three months ended January 31, 2009 from 57% in the three months ended January 31, 2008. The decrease in the comparative three months was due primarily to reductions in our DHA costs generated from improved productivity yields and increased production capacity utilization.
Cost of contract manufacturing sales, totaling $3.4 million and $3.7 million in the three months ended January 31, 2009 and 2008, respectively, are the costs related to the fermentation work performed for various third parties at our Kingstree, South Carolina facility. Our contract manufacturing margins vary between periods primarily due to contract mix and volume.
See Management Outlook for discussion of expected overall profit margins for the remainder of fiscal 2009.
The following table presents our operating expenses (in thousands):
Research and Development Our research and development costs increased $800,000 or 13% in the three months ended January 31, 2009 as compared to the three months ended January 31, 2008. The increase in the comparable three months is due to the timing of certain outside clinical services performed and additional internal resources dedicated to our research and development projects. Our research and development efforts continue to focus on: (i) broadening the scientific evidence supporting the benefits of lifesDHA throughout life; (ii) improving manufacturing processes to improve production efficiencies and versatility of our oils; and (iii) developing new products to expand our market offerings. We expect to continue to experience quarter-to-quarter fluctuations in research and development expenses primarily due to the timing of outside services, including third-party clinical trial services.
Selling, General and Administrative Our selling, general and administrative costs increased $100,000 or 1% in the three months ended January 31, 2009 as compared to the three months ended January 31, 2008.
Amortization of Intangible Assets We capitalize patent application and patent defense costs in addition to certain other external costs related to our intellectual property portfolio to the extent that we anticipate a future economic benefit or an alternate future use is available to us from such expenditures. We amortize these costs over the expected life of the respective assets. We recorded amortization expense related to our intangible assets of $1.8 million and $1.7 million in the three months ended January 31, 2009 and 2008, respectively. See Item 1 of Part II of this Form 10-Q, Legal Proceedings for further discussion of certain patent matters.
Other Operating Expenses We incurred other operating expenses of $200,000 in both quarters ended January 31, 2009 and 2008. These costs in fiscal 2009 and 2008 primarily include contract manufacturing and third-party production trials.
Interest and Other Income, Net
Interest and other income, net, decreased by $100,000 in the three months ended January 31, 2009 as compared to the three months ended January 31, 2008, due primarily to the other than temporary impairment of certain long-term securities. See Note 3 to the consolidated financial statements for further discussion.
Interest expense decreased by $100,000 in the three months ended January 31, 2009 as compared to the three months ended January 31, 2008 as certain notes payable were repaid in full during fiscal 2008. Since October 31, 2007, there have been no amounts outstanding under our revolving credit facility.
Income Tax Provision
The provision for income taxes reflected an effective tax rate of 37.7% in the three months ended January 31, 2009 and 35.9% in the three months ended January 31, 2008. Increases to the Companys effective tax rate during fiscal 2009 were caused by higher state income taxes.
As of October 31, 2008, we had net operating loss carryforwards for Federal income tax purposes of approximately $121 million, which expire at various dates between 2014 and 2025. The timing and manner in which U.S. net operating loss carryforwards may be utilized may be limited if we incur a change in ownership as defined under Section 382 of the Internal Revenue Code. Although we have net operating losses available to offset future taxable income, we will likely be subject to Federal alternative minimum taxes.
As a result of the foregoing, net income was $9.6 million in the three months ended January 31, 2009 as compared to net income of $8.7 million in the three months ended January 31, 2008.
LIQUIDITY AND CAPITAL RESOURCES
Since fiscal 2006, we have financed our operations primarily from the following sources:
At January 31, 2009, our primary sources of liquidity were our cash and cash equivalents totaling $107.3 million as well as the $135 million available under our revolving credit facility. Cash and cash equivalents increased $4.8 million since October 31, 2008. During the three months ended January 31, 2009, we generated $8.6 million in cash from operating activities due primarily to earnings in the period. Capital expenditures during the three months ended January 31, 2009 were $2.5 million. In general, we believe that our current production infrastructure can accommodate our short- and medium-term growth objectives in all material respects. We expect that capital expenditures for fiscal 2009 will not exceed $25 million.
At January 31, 2009, our long-term investments had a fair value of $11.3 million and consisted primarily of auction rate securities (ARS) whose underlying assets are student loans originated under the Federal Family Education Loan Program (FFELP). FFELP student loans are guaranteed by state guarantors who have reinsurance agreements with the U.S. Department of Education. These ARS are intended to provide liquidity via an auction process that resets the applicable interest rate approximately every 30 days and allows investors to either roll over their holdings or gain immediate liquidity by selling such investments at par. The underlying maturities of these investments range from 18 to 39 years. Since February 2008, as a result of negative conditions in the global credit markets, the large majority of the auctions for our investment in these securities have failed to settle, resulting in Marteks continuing to hold such securities. Consequently, the investments are not currently liquid and we will not be able to access these funds until a future auction of these investments is successful or a buyer is found outside of the auction process. To this end, in November 2008, we executed an auction rate securities rights agreement (the Put Agreement) with a financial institution which provides us the ability to sell certain of our ARS to the financial institution and allows the financial institution, at its sole discretion, to purchase such ARS at par during the period June 30, 2010 through July 2, 2012. Our ARS holdings to which this relates have a cost basis of approximately $7.5 million and a fair value at January 31, 2009 of approximately $5.8 million. The Put Agreement, which is deemed a discrete long-term investment, has a recorded fair value of approximately $1.6 million. We based our valuation of these ARS and the Put Agreement on discounted cash flow models that include various unobservable inputs. Changes to the inputs used as of January 31, 2009 would cause fluctuations to the fair value of the affected instruments and such fair value changes could be material.
The following table sets forth our future minimum payments under contractual obligations at January 31, 2009:
We have a $135 million secured revolving credit facility that is collateralized by accounts receivable, inventory and all capital stock of our subsidiaries and expires in September 2010. There were no amounts outstanding under the revolving credit facility during the three months ended January 31, 2009. The weighted average annual commitment fee rate on unused amounts was approximately 0.1% for the three months ended January 31, 2009. 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 January 31, 2009, we were in compliance with all of these debt covenants.
We believe that the revolving credit facility, when combined with our cash and cash equivalents of $107.3 million on-hand at January 31, 2009, and anticipated operating cash flows, will provide us with adequate capital to meet our obligations for at least the next 12 to 18 months. Nonetheless, we may require additional capital to fund, among other things, our research and development, product testing and marketing activities. The ultimate amount of additional funding that we may require will depend, among other things, on one or more of the following factors:
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.
Item 3. Quantitative and Qualitative Disclosures about Market Risk.
We are subject to market risk associated with changes in foreign currency exchange rates and interest rates.
A portion of the ARA we buy from DSM is denominated in euros, which exposes us to risks related to changes in exchange rates between the U.S. dollar and the euro. We expect that for fiscal 2009, approximately 25% of our ARA received from DSM will be subject to currency risk. We enter into foreign currency cash flow hedges to reduce the related market risk on our payment obligations. We do not enter into foreign currency cash flow hedges for speculative purposes. At January 31, 2009, we had unrealized losses on such hedge instruments totaling approximately $1.7 million, net of income taxes. To the extent not covered by these hedge instruments, fluctuations between the U.S. dollar and the euro will impact our cost of ARA oil and gross margins. We estimate that a 5% change in the exchange rate would impact gross margins of our infant formula products by less than 0.5%.
We are subject to risk from adverse changes in interest rates, primarily relating to variable-rate borrowings used to maintain liquidity; however, at January 31, 2009, there was no variable-rate debt outstanding.
We have long-term investments at January 31, 2009 with a fair value of $11.3 million, which consist primarily of auction rate securities (ARS). These ARS are intended to provide liquidity via an auction process that resets the applicable interest rate approximately every 30 days and allows investors to either roll over their holdings or gain immediate liquidity by selling such investments at par. Since February 2008, as a result of negative conditions in the global credit markets, the large majority of the auctions for our investment in these securities have failed to settle, resulting in our continuing to hold such securities. Based on the estimated fair value of the ARS, during fiscal 2008 and fiscal 2009, we recorded unrealized losses on these securities totaling approximately $3.4 million ($2.1 million, net of income tax benefit), reflecting the decline in the estimated fair value of these securities. We continue to monitor the market for auction rate securities and consider its impact, if any, on the fair value of these investments. If current market conditions deteriorate further, the Company may be required to record additional write-downs. In November 2008, we executed an auction rate securities rights agreement (the Put Agreement) with a financial institution which provides us the ability to sell certain of our ARS to the financial institution and allows the financial institution, at its sole discretion, to purchase such ARS at par during the period June 30, 2010 through July 2, 2012. Our ARS holdings to which this relates have a cost basis of approximately $7.5 million and a fair value at January 31, 2009 of approximately $5.8 million. The Put Agreement, which is deemed a discrete long-term investment, has a recorded fair value of $1.6 million. The benefits of the Put Agreement are subject to the continued expected performance by the financial institution of its obligations under the agreement. We based our valuation of these ARS and the Put Agreement on discounted cash flow models that include various unobservable inputs. Changes to the inputs used as of January 31, 2009 would cause fluctuations to the fair value of the affected instruments and such fair value changes could be material.
Item 4. Controls and Procedures.
PART II OTHER INFORMATION
Item 1. Legal Proceedings.
Aventis S.A. and Nagase & Co. Ltd. are challenging our European patent covering our DHA-containing oils. At a hearing in October 2000, the Opposition Division of the European Patent Office (EPO) revoked our patent on the grounds that it was not novel. We immediately appealed this ruling, and in July 2002 we received a positive ruling from an Appeal Board of the EPO, setting aside the prior decision to revoke this patent. 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 hearing has been scheduled for March 2009. Claim 1 of this patent is the basis of the patent infringement suit against Nutrinova and Lonza in Germany, discussed below. In the event Martek were to lose this appeal, this DHA patent would be revoked. The revocation of this patent would result in the dismissal of the patent infringement suit against Nutrinova and Lonza in Germany, discussed below, and patent protection for Marteks DHA-containing oils for use in infant formula would be compromised in Europe. Currently, annual sales of Marteks DHA for use in infant formula in Europe to companies other than those with whom Martek has or expects to have an exclusive supply agreement are less than $1 million. Such exclusive agreements generally run through 2011. An adverse decision would not impact Marteks ARA patent position in Europe. Moreover, the outcome of this appeal will not affect the patent infringement lawsuit against Lonza in the U.S., as the U.S. lawsuit is based on a different family of patents.
In April 2007, the EPO granted another patent to Martek for ARA oil made from Marteks microbial source for use in infant formula. This divisional ARA patent strengthens Marteks intellectual property position by providing commercially significant protection through the expiration date of the original patent, January 22, 2012. Suntory, N.V. Nutricia and Cargill filed oppositions against this divisional ARA patent. N.V. Nutricia has withdrawn from the opposition. The Opposition Division hearing has been scheduled for June 2009.
Prior to our purchase of OmegaTech, Aventis Research and Technologies GmbH & Co. KG, and Nagase Limited challenged OmegaTechs 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. In a November 2007 hearing, the Opposition Division upheld claims that are narrower than the claims originally granted but broader than the claims that were previously upheld in the December 2000 Opposition Division hearing. Martek and Aventis have appealed. The appeal process is not expected to be completed before 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. Nutrinova Nutrition Specialties & Food Ingredients GmbH is the only opponent, and they appealed. The appeal hearing was held in October 2008 and the patent was upheld in modified form. The modified patent claims are directed to processes for fermenting Thraustochytrium and Schizochytrium in a medium containing sodium sulfate and less than 120 milligrams per liter of chloride.
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. Lonza Ltd. was added to 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. In October 2007, the judge upheld the October 2006 jury verdict that the defendants infringed all of the asserted claims of U.S. Patent Nos. 5,340,594 and 6,410,281 and that these patents were not invalid. The judge has granted a permanent injunction against the defendants with respect to those two patents. The judge also upheld the jury verdict that the defendants had acted willfully in their infringement of U.S. Patent No. 6,410,281. Regarding the third patent involved in the case, U.S. Patent No. 6,451,567, the judge reversed the jury verdict and found that the asserted claims of this patent were invalid. Marteks request to the judge to reconsider his ruling on the third patent was denied. Martek and the defendants have appealed aspects of the judges final decision. The appeal hearing before the U.S. Court of Appeals for the Federal Circuit is scheduled for April 2009. The two patents where the infringement was upheld, U.S. Patent Nos. 5,340,594 and 6,410,281, are scheduled to expire in July 2009 and August 2011, respectively.
We also filed a patent infringement suit involving Nutrinova Nutrition Specialties & Food Ingredients GmbH and Celanese Ventures GmbH in Germany in January 2004. Lonza Ltd. and a customer of Nutrinova have also been added to this lawsuit. The complaint alleges infringement of our European patent relating to DHA-containing oils. A hearing was held in a district court in Dusseldorf in September 2007 and the court issued its decision in October 2007, ruling that Marteks patent was infringed by the defendants. The defendants have appealed, and an appeal hearing was scheduled for February 2009. Martek and the defendants requested that the appeal hearing be delayed until the Appeal Board of the EPO decides whether to uphold Marteks European patent covering our DHA-containing oils. As discussed above, this EPO Appeal Board hearing is scheduled for March 2009. In December 2008 Martek requested that the court expand the appeal to include Lonzas production of DHA in Germany, based on evidence discovered in October 2008.
We filed a patent infringement suit involving Lonza Ltd AG and Capsugel France in France in November 2008. The complaint alleges infringement of our European patent relating to DHA-containing oils.
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 ruled against Martek. Martek appealed. The appeal brief was filed in February 2007 and Suntory responded in August 2007. The Korean Intellectual Property Office ruled against Martek in September 2007, and we appealed to the Patent Court in October 2007. The Patent Court held hearings in August 2008 and September 2008. The Patent Court ruled against Martek in November 2008, and we appealed to the Korean Supreme Court in December 2008. The Korean Supreme Court issued a summary dismissal of our appeal in February 2009, resulting in this Korean ARA patent being finally revoked.
Suntory also initiated an invalidation case against one of our blended oil patents 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 ruling against Martek was issued in February 2007. Martek appealed to the Patent Court in April 2007. The Patent Court ruled against Martek, and we appealed to the Korean Supreme Court in August 2008. The Korean Supreme Court issued a summary dismissal of our appeal in December 2008, resulting in this Korean blended oil patent being finally revoked. The revoked patent covered a blend of fish oil DHA and microbial oil ARA. Sales of our oils during fiscal 2008 to licensees in South Korea with whom we do not have a sole source supply arrangement were less than $1.0 million.
Martek is opposing two of Suntorys low sterol ARA oil patents in Europe and one in Australia. The patents are generally directed to processes for producing microbial ARA oil having a low ratio of certain sterols, the resulting oil and its use in infant formula. Martek believes that the patents are invalid for a number of reasons, including prior art that anticipates the claims relevant to Martek. An Opposition Division hearing on the first European patent was held in April 2008, and the Opposition Division revoked the Suntory patent. Suntory has appealed, during which time the patent will remain in full force and effect. Hearings on the other European patent and on the Australian patent are expected in 2009.
Third parties have filed Requests for Reexamination (Requests) of eleven of Marteks U.S. patents. Eight of these Requests were filed by Lonza with respect to eight of Marteks DHA patents which are not relevant to Marteks infant formula business. Three of these patents have now expired and another is likely to expire before the initial Reexamination process is complete. Additionally, an anonymous party filed the other three Requests with respect to two of Marteks blended oils patents and one ARA patent. The U.S. Patent Office has granted all eleven of the Requests to initiate a Reexamination process. As a result of these Reexaminations, the claims of the subject patents may be upheld in their current form, narrowed, abandoned, or revoked, or the term of a patent may be shortened. Not all of the claims of the patents are subject to Reexamination. With respect to the ARA patent, which is scheduled to expire in 2014, and the non-infant formula DHA patents, we have received initial adverse office actions from the patent examiner, which is standard if a Request is granted, to which we have responded. We anticipate further proceedings with the patent examiner and if unfavorable decisions are received, we plan to appeal. The ARA patent as well as those DHA patents that have not expired will remain in full force and effect during the appeal process. Additionally, we have received second adverse office actions from the patent examiner for the two blended oils patents which are scheduled to expire in 2011. If we are unable to overcome these office actions, we plan to appeal within the U.S Patent and Trademark Office, and in the event of a negative outcome, we will have an opportunity to further appeal to the federal courts. These patents will remain in full force and effect during the appeal process, which is likely to extend beyond the 2011 term of these patents. However, if the appeals are not successful or are not pursued, some claims of these patents could be revoked or the patents, including the ARA patent with the 2014 expiration date, could have their terms shortened from their original expiration dates.
There are additional intellectual property proceedings pending against Martek or that Martek has pending against third parties that are not considered material.
In addition, from time to time, Martek is a party to additional litigation or administrative proceedings relating to claims arising from its operations in the normal course of business. Management believes that the ultimate resolution of any such additional litigation or administrative proceedings currently pending against Martek is unlikely, either individually or in the aggregate, to have a material adverse effect on Marteks results of operations or financial condition.
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.
Current economic and market conditions could adversely affect our revenue and profitability.
The United States economy and the global economy have entered a severe recession. Due to factors such as uncertainties in consumer spending, a regional and/or global economic downturn may reduce the demand for our nutritional oils. If demand for our oils declines, our revenue and profitability will be adversely affected. Furthermore, challenging economic conditions also may impair the ability of our customers to pay for products they have purchased and may impair the ability of our vendors to supply us with items critical to the operation of our business. Any of these negative occurrences could adversely impact our operating results, financial condition or business, in general.
A substantial portion of our nutritional oil products sales is made to five 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 five of our existing customers. Approximately 80% of our product sales revenue during the three months ended January 31, 2009 was generated by sales of DHA and ARA to five customers: Mead Johnson Nutritionals, Abbott Laboratories, Nestle, Wyeth and Danone (formerly Numico). 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 fluctuations in our quarter-to-quarter revenues and cash flows. 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.
Our major customers are part of either the pharmaceutical or food and beverage industries. Mergers and acquisitions are prevalent in both industries. If one of our major customers or divisions thereof are acquired, as there are no minimum purchase requirements in our license agreements with them, there is no guarantee that the acquirer will continue purchasing our oils at current levels or continue selling infant formula at all. An acquisition of one of our major customers could have a material effect on future revenues.
Our major customers also employ differing strategies with respect to the timing of their inventory and raw material purchases. To the extent that these strategies change (i.e., further advancements to a just-in-time procurement process), our revenues in the quarter of such change could be materially affected by this modification in customer ordering patterns. In addition, our major customers use varying inclusion levels of DHA and ARA in their infant formulas. If significant changes in their market shares occur, we could experience material changes in our infant formula revenues.
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. Potential competitors include companies such as BASF AG, DSM, Cargill Inc., Suntory Limited, Archer Daniels Midland Company, Lonza Group LTD, Nagase & Co. Ltd., Ocean Nutrition and Monsanto. Many of these companies 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/or 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.
In addition to the Lonza and Nutrinova matters described below, 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:
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 ingredients in 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. Furthermore, breastfeeding advocacy groups challenge the benefits of infant formulas whether or not they contain our nutritional oils. Some experts 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 supplemented 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.
We are aware that in Asia as well as other international markets, certain infant formula manufacturers incorporate very low levels or, at times, no ARA in their supplemented infant formulas. Furthermore, in most countries, there are significant disparities amongst infant formula manufacturers as to the levels of DHA and ARA in their respective products. A failure by one or more regulatory authorities to enact guidelines for minimum levels of DHA and/or ARA for supplementation of infant formula products or the issuance of regulatory guidelines that establish targeted levels of DHA and/or ARA in infant formula that are lower than levels currently being used 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 that permit inclusion of DHA and ARA ingredients containing higher levels of EPA than covered in Marteks patents could also reduce the market opportunity for Marteks DHA and ARA ingredients in affected countries. While the Codex Alimentarius Infant Formula Standard and the European Union and Australia/ New Zealand regulations all permit the optional addition of DHA and ARA in infant formula, there are no existing regulations in any country requiring the addition of DHA and ARA.
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 largely dependent 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 65 U.S. patents, covering various aspects of our technology, which will expire on various dates between 2009 and 2024. Our core infant formula-related U.S. patents expire between 2011 and 2014. We have been granted U.S. patents covering food and beverage products containing Marteks DHA oil which expire by 2009, and granted U.S. patents covering certain processes for producing DHA-containing oil that may be used in foods and beverages which expire between 2009 and 2024. We have filed, and intend to file, applications for additional patents covering both our products and processes as appropriate. Currently, we have over 350 issued patents and over 500 pending patent applications worldwide.
There can be no assurance that (i) any patent applications filed by, assigned to or licensed to us will be granted; (ii) we will develop additional products that are patentable; (iii) any patents issued to or licensed by us will provide us with any competitive advantages or adequate protection for inventions; (iv) any patents issued to or licensed by us will not be challenged, invalidated or circumvented by others; or (v) 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, United States and Asian patent authorities have not adopted a consistent policy regarding the breadth of claims allowed for health and bioscience patents. Our products might infringe the patent rights of others, whether existing now or in the future. Similarly, the products of others could infringe our patent rights. The defense and prosecution of patent claims are both costly and time consuming, even if the outcome is ultimately in our favor. An adverse outcome in infringement actions by Martek against third parties could reduce or eliminate any competitive advantage provided by the affected Martek patent rights. An adverse outcome in infringement actions by third parties against Martek could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties and/or require us to cease selling the affected products.
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 (through patent expiration or otherwise) 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 our oils and may have a material adverse effect on our results of operations, especially on 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. Furthermore, even if our licensees continue to use our oils, direct competition could force us to reduce the price of our products, which could materially affect future revenues and product margins.
There are a number of intellectual property proceedings pending against Martek or that Martek has pending against third parties, including:
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 or we may be forced to reduce the price of our products, which could also cause decreases in future revenues as well as product margins. Specifically, the revocation of our European DHA patent or ARA 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, license disputed rights from third parties and/or cease selling the affected products. 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 January 31, 2009, the net book value of our patent assets totaled $15.2 million, which includes approximately $5.5 million of costs related to our patent defenses in the Nutrinova/ Lonza matters discussed above, which will be amortized over a weighted average remaining period of approximately four 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. We also expect that in the future, third parties may allege that Martek infringes their intellectual property rights, which could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties and/or require us to cease selling the affected products.
If our non-infant formula customers do not introduce products containing our nutritional oils on a broad scale into the marketplace and consumers do not purchase such products, our sales to these markets will be limited.
We are continuing to aggressively pursue further penetration of our DHA oils in the food and beverage, pregnancy and nursing, nutritional supplements and animal feed markets. To this end, we have signed license and supply agreements with several consumer products companies. Our success in penetrating this market, however, is dependent upon these customers introducing products that contain our nutritional oils into the marketplace and is further dependent upon the end consumer purchasing such products. Although some of our customers have launched products containing our oils, we cannot control whether our existing customers or potential new customers will continue to do so in the future, nor can we control whether our current or future customers will follow through with their planned launches of products containing our oils. Furthermore, as a broad scale product launch by our customers is likely dependent on actual or perceived consumer demand, which is inherently uncertain, we cannot control whether our customers will broadly distribute such DHA-enriched products or offer them beyond niche products or line extensions. To date, our non-infant formula customers have launched approximately 175 products containing our oils. Of the products launched, some have failed, but most remain on the market and are believed to be meeting customer expectations. Despite this fact, industry averages, particularly food and beverage, would continue to suggest that many of these products will not ultimately be successful in the marketplace. As such, the introduction of a product by our customers does not guarantee that the product will remain on the market. If our non-infant formula customers do not introduce products containing our nutritional oils on a broad scale into the marketplace and end consumers do not purchase such products, our sales to the food and beverage, pregnancy and nursing, nutritional supplements and animal feed markets would 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 and nutritional supplements markets.
Due to the sensitivity of our oils to oxidation, it is possible that our oils may vary over time in such a way as to negatively affect the taste, smell and/or shelf stability of food and beverage applications. While we believe that the food and beverage market could be a large market for DHA supplementation with our DHA-S oil, the potential in this market would be limited if methods are not developed that allow incorporation of the oil into various foods and beverages with, among other things, acceptable flavor, odor and texture for the duration of the shelf life of the food and beverage products. Furthermore, while DHA-enriched food and beverage products with acceptable flavor and stability have been developed, risks exist for other finished food and beverage products, including cereals, shelf-stable beverages and certain types of nutritional bars for which DHA supplementation 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 and distribution processes, including the packaging, storage and handling of such products. To facilitate this, our customers may require us to meet certain enhanced specifications and standards, our compliance with which cannot be assured. 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, production and distribution issues over which we have little or no control.
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.
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, including increased cardiovascular problems, Alzheimers disease and dementia and various other neurological and visual disorders. 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 USDAs organic seal on certain products that contain our oils. In some instances, such products have been further reviewed and the authorization to use Marteks oils has been explicitly ratified by the USDA. Certain advocacy groups, however, have challenged these authorizations and ratifications. 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 approximately 3% of the total U.S. food sales in 2006; 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 a 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. Moreover, these consumer sensitivities are further heightened during periods of economic uncertainty and downturn. 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 our customers delaying or suspending product launches, or, at a minimum, may lead to price pressure on us. If our food and beverage customers delay product launches or we have to reduce our prices, our sales and/or profitability relative to the food and beverage market may be adversely impacted.
If we are unable to gain broad regulatory approvals for the incorporation of our oils into foods and beverages worldwide, our future revenues in the food and beverage market may be limited.
To date, our DHA-S oil has received regulatory approval or is accepted for inclusion in foods and beverages, with certain country-specific limitations, in Argentina, Australia, Canada, Chile, China, Israel, Japan, Malaysia, Mexico, New Zealand, the Philippines, the European Community, Taiwan and the United States. With respect to approvals in Europe and Israel, the use of our DHA-S is authorized 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. We have been working to extend approval in Europe 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. 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 and dietary supplements markets.
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 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 are eligible 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 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 cardiovascular benefits, then our penetration of the food and beverage and dietary supplements markets may be limited.
If the FDA finalizes its proposed rule to prohibit nutrient content claims for DHA and EPA, our penetration of the food and beverage and dietary supplements markets may be limited.
In November 2007, the FDA issued a proposed rule that would prohibit the nutrient content claims for DHA and EPA that had been authorized in three previously submitted Food and Drug Administration Modernization Act (FDAMA) notifications. The FDA is proposing to prohibit the DHA and EPA nutrient content claims because the agency does not believe they are based on an authoritative statement. The FDA specifically acknowledged that it did not conduct an independent review of the scientific evidence when evaluating these nutrient content claims. In addition to other stakeholders, we have submitted comments in opposition to this proposed rule. It is unclear when the FDA will issue a final rule. In the event the proposed rule becomes final, the potential health benefits of consuming DHA and EPA still may be communicated through the use of a qualified health claim and/or structure/function claims that are made consistent with applicable FDA requirements and/or quantitative claims. Nonetheless, our penetration of the food and beverage and dietary supplements markets may be limited if this proposed rule is implemented.
If the FDA narrowly interprets certain sections of the Food and Drug Administration Amendments Act of 2007, such an interpretation could have a material adverse effect on our business and financial condition.
In July 2008, the FDA issued a notice and request for comments on section 912 of the Food and Drug Administration Amendments Act of 2007, titled Prohibition Against Food to Which Drugs or Biological Products Have Been Added. This section of the Act prohibits the use in food of certain authorized drugs and biological substances, including certain such substances that have been the subject of substantial clinical investigations that have been made public. The prohibition applies unless companies first marketed the substance in food prior to the FDA authorization and before the substantial clinical investigations had been instituted. We have submitted comments to the FDA in which we assert that the implementation of section 912 should be based on the intended purpose of the clinical investigation rather than on the mere existence of such an investigation. A more restrictive interpretation of the implementation of section 912 could not only discourage companies from sponsoring clinical research for new food ingredients, but could also bar the continued marketing of some food ingredients and dietary supplements already on the market. Such an interpretation by the FDA could have a material adverse effect on our results of operations and financial condition.
If we or our customers fail to secure authorized nutrition and health claims within the European Union, future revenues from sales within the European Union could be adversely affected.
In December 2006, the European Parliament and Council issued regulation EC No 1924/2006 on nutrition and health claims made on foods. Implementation of this regulation is currently scheduled for January 2010, although the review of claim applications under the regulation is currently underway. Until January 2010, claims that have been in use in Member States prior to January 2006 may continue to be used. After January 2010, only claims listed in the regulation and those that have received European Union (EU) authorization shall be permitted on foods and dietary supplements within the EU. Our failure, and that of our customers, to secure authorized claims for our DHA and ARA could adversely impact future market penetration of products containing our DHA and ARA in the EU.
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 DSMs 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.
Market fluctuations in the availability and cost of raw materials and energy are beyond our control and may adversely impact our business.
Raw material and energy costs are a significant operating expense of our production facilities and we are dependent on outside suppliers for nearly all of our key raw material and energy needs. The prices and availability of raw materials and energy can be volatile and are susceptible to rapid and substantial changes due to factors beyond our control such as changing economic conditions, weather conditions and supply and demand considerations. A substantial decrease in the availability of raw materials and/or energy from the Companys suppliers, the loss of a key supplier or a substantial increase in the cost of our raw materials and/or energy could adversely impact the Companys results of operations.
If customer demand for our nutritional oils requires us or our major suppliers to increase production beyond current levels, we may experience certain risks associated with the ramp-up of commercial manufacturing that could have a material adverse effect on our business, financial condition, and/or results of operations.
When combining our current DHA production capabilities in Winchester and Kingstree with DSMs 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, collectively, to the infant formula market and pregnancy and nursing, food and beverage, dietary supplement and animal feed markets. Our and DSMs ability to maintain commercial production at these higher levels has not been successfully tested.
As we and our major suppliers increase our production, we may encounter many risks associated with our commercial manufacturing such as:
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. As of January 31, 2009, the Company had $37.2 million of production assets that are currently idle and are being held for future use. 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 meet such demand and to ensure the existence of dual-plant manufacturing redundancy. 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.
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 or if the amount of infant formula offered to participants is reduced.
We estimate that of the total current annual U.S. market opportunity for sales of supplemented infant formula, approximately half represents Women, Infants 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 50 states and the District of Columbia offer term and 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. Further, in December 2007, the USDA, the federal agency which governs WIC, issued an interim final rule which included a reduction in the amount of infant formula to be offered through WIC. State WIC agencies have until August 2009 to implement this change and the USDA is accepting comments on this interim final rule through February 2010. If there is a permanent reduction in the amount of infant formula offered through WIC, then our future infant formula revenues could be materially affected.
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) regulations as required by the FDA. GMP regulations specify production and process controls, component and product testing standards, quality control and quality assurance requirements, and records and other documentation controls. As a manufacturer of DHA and ARA that are marketed as dietary supplements and used as ingredients in infant formulas and foods and beverages sold in the United States, 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 food and beverage, 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 pollutants. If we fail to properly handle these hazardous materials and/or emissions, substantial costs and harm to our business could result.
In connection with our research and development and manufacturing activities, we utilize some hazardous materials and emit regulated pollutants. We are subject to federal, state and local laws and regulations governing the use, storage, handling, discharge, management and disposal of hazardous materials and the emission of regulated pollutants. The cost of compliance with these laws and regulations could be significant, and our ability to comply with certain emission requirements 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 our 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 natural resource damages 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.
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 and 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. With respect to infant formula, customer recall could result from such things as contamination, spoilage, product misbranding or product tampering, whether real or perceived. 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. Insurance coverage for such risks is expensive and difficult to obtain, and we may be unable to obtain coverage in the future on acceptable terms, if at all. 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, negative publicity and the resulting inability to effectively market our products.
Concerns with the safety and quality of our nutritional oils could cause customers to avoid our products.
Recent adverse publicity about the safety of certain foods due to the actual or potential existence of certain compounds therein has heightened the sensitivities of many consumers. These safety and quality issues, whether real or perceived, may discourage customers from buying products containing or perceived to contain the compounds which give rise to such concerns. We could be adversely affected if our customers or the ultimate consumers of our products lose confidence in the safety and quality of our nutritional oils. Any negative change in customer perceptions about the safety and quality of our products could adversely affect our business and financial condition.
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 January 31, 2009, we had approximately $107.3 million in cash and cash equivalents as well as $135 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 may 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. Furthermore, 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.
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 January 31, 2009, our common stock traded between $39.60 and $22.47 per share. During the fifty-two week period ending January 31, 2008, our common stock traded between $34.70 and $19.64 per share. The following are examples of items that may significantly impact the market price for our common stock:
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 January 31, 2009, we had 33,154,575 shares of common stock outstanding. The average daily trading volume in our common stock during the fifty-two week period ending January 31, 2009 was approximately 500,000 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 January 31, 2009, we had 33,154,575 shares of common stock and approximately 600,000 unvested restricted stock units outstanding, as well as stock options outstanding to purchase an aggregate of approximately 2.6 million shares of common stock. Of the stock options, substantially all were exercisable at March 4, 2009, and approximately 400,000 had exercise prices that were below the market price on this date. The restricted stock units will vest and common stock will issue at various dates through 2014. To the extent that these options for our common stock are exercised, restricted stock units vest 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 future 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.
Changes in foreign currency exchange rates or interest rates could reduce profitability.
A portion of the ARA we buy from DSM is denominated in euros. We expect that for fiscal 2009, approximately 25% of our ARA received from DSM will be subject to currency risk. 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. Furthermore, these contracts have inherent levels of counterparty risk over which we have no control. We have entered into foreign currency forward contracts with outstanding notional values aggregating approximately 19.4 million euros at January 31, 2009. We estimate that a 5% change in the exchange rate would impact gross margins of our infant formula products by less than 0.5%.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Item 3. Defaults Upon Senior Securities.
Item 4. Submission of Matters to a Vote of Security Holders.
Item 5. Other Information.
Item 6. Exhibits.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.