Biotech Values

[DewDiligence]

Martek’s Idle Assets Draw Questions

[The accounting issue per se ought to be irrelevant to any analyst who does more than a cursory examination the company’s financials. What is relevant, however, is that MATK’s business is in the doldrums, and this may be the reason for the aggressive accounting.]

http://online.wsj.com/article/SB117435300351442223.html

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Nondepreciation of Mothballed Plants
And Equipment Benefits Bottom Line

By DAVID REILLY
March 20, 2007

Like many businesses, Martek Biosciences Corp. believes its products will soon be the "next big thing." So it has ramped up its capacity to make food additives based on the omega-3 fatty acid found in fish.

The problem: Customers have yet to beat down the company's door, despite the company's belief that omega-3-based additives could improve mental and visual development in infants and cardiovascular health in adults. Martek is a leading seller of such additives to makers of infant formula. But it has struggled to crack the wider food market. These more-general sales account for less than 10% of revenue, while additives for infant formula account for about 90% of sales.

Martek's slow progress in increasing sales to food producers has some analysts and investors worried about the company's long-term growth. [They should be worried, IMO. Food sales are running about 1% of MATK’s product sales; they could quadruple and still be barely noticeable.] At the same time, one of its accounting methods has led to concerns that Martek is trying to make profits look more robust than they really are.

The bone of contention: Martek's treatment of what it calls "idle" assets. Martek noted in its fiscal-first-quarter results for the three months ended Jan. 31 that it has $94.3 million of property, plant and equipment -- or a third of these total assets -- "being held for future use." Martek doesn't depreciate assets designated this way. Such an approach is pretty rare; companies typically depreciate assets that they are either using or could be using.

Martek said its policies are in accordance with generally accepted accounting principles, are fully disclosed and have been signed off on by its auditor after thorough review and discussion. "We are very confident in our policies," said Peter Buzy, Martek's chief financial officer.

Defining 'Idle' Assets

Martek's approach lessens the bite that depreciation charges take out of net profit. In fiscal 2007, the move could boost net profit by about $3.9 million, or about 20%, according to a recent research report by proxy advisory and accounting-research firm Glass, Lewis & Co. A similar gain over the past year could have helped the company avoid two consecutive years of declining annual net profit.

Plus, if Martek was [the subjective “were” is proper here!] fully depreciating its assets and taking a bigger hit to profit, the company's share price would be an expensive 37 times expected fiscal 2007 earnings, as opposed to its current multiple of 30 times. Over the past 12 months the company's stock has dropped almost 39%.

Martek's designation of some assets as idle is not an unheard of approach. Accounting rules say assets in use should be depreciated, assets to be sold shouldn't be depreciated and assets that are to be abandoned should be quickly depreciated so their value is written down to zero. The rules don't address "temporarily idle" assets, except to say that they "shall not be accounted for as if abandoned."

Mr. Buzy said the company's approach rests on the principle that an asset shouldn't be depreciated if it is not being used and creating an economic benefit. There is "not a lot of real specific guidance," on the issue, he added.

Glass Lewis, in its recent report, said that even if there isn't a "bright-line rule" regarding temporarily idled assets, "The principle is clear: Once assets are ready for their intended use, companies should begin recognizing all expenses normally associated with them."

Testing an Asset's Value

Robert N. Freeman, an accounting professor at the University of Texas at Austin, said the company's approach may find support in accounting principles laid down in the early 1950s that say depreciation should occur when an asset is used. "You're in a gray area," he added.

Others find that approach troubling. If such an approach were widely used, "people would not be depreciating portions of their factory and equipment every quarter," said Jack Ciesielski, editor of the Analyst's Accounting Observer newsletter.

Mr. Ciesielski added that the assets' designation as idle should also raise concerns about whether they will be able to generate future cash flows to justify their value on the balance sheet, a circumstance known as "impaired."

Mr. Buzy said the assets are tested for impairment each quarter, although he said the company's view about impairment rests in part on management's optimistic view of the company's growth prospects. And if Martek is wrong? "We'll have a write-off," Mr. Buzy said. That would lead to a big charge against profit down the line.
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