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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

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)

Registrant’s telephone number, including area code:  (410) 740-0081

None

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x  Yes  o  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  o  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 company” in 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).  oYes  x No

The number of shares of Common Stock outstanding as of March 8, 2010 was 33,309,034.

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MARTEK BIOSCIENCES CORPORATION

FORM 10-Q

For The Quarterly Period Ended January 31, 2010

INDEX

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

MARTEK BIOSCIENCES CORPORATION

CONSOLIDATED BALANCE SHEETS

See accompanying notes.

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MARTEK BIOSCIENCES CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

See accompanying notes.

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MARTEK BIOSCIENCES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes.

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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, 2010 are not necessarily indicative of the results that may be expected for the year ending October 31, 2010.  The accompanying unaudited financial statements and these notes should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended October 31, 2009.

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 Company’s consolidated financial statements and accompanying notes. On an ongoing basis, the Company evaluates its estimates and judgments, which are based on historical and anticipated results and trends and on various other assumptions that the Company believes to be reasonable under the circumstances. By their nature, estimates are subject to an inherent degree of uncertainty and, as such, actual results may differ from the Company’s estimates.

Segment Information The Company currently operates in one material business segment, the development and commercialization of high value nutritional products from microbial sources, including algae, 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.

Revenue Recognition The Company derives revenue from three sources: product sales, contract manufacturing and collaborations. The Company recognizes product sales revenue when persuasive evidence of an arrangement exists, the fee is fixed or determinable, collectibility is probable, the product is shipped and title and risk of loss are transferred. A number of 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. The consideration from these contracts is allocated based on the relative fair values of the separate elements. Revenue is recognized on product sales when goods are shipped and all other conditions for revenue recognition are met. If volume pricing discounts are deemed to be a separate element, revenue on related product shipments is recognized using the estimated average price to the customer over the term of the discount period, which requires an estimation of total production shipments over that time frame.  Amounts billed in excess of the estimated average price are recorded as deferred revenue.  Conversely, a receivable is recorded for the excess of the estimated average price over amounts billed. Estimates of average prices are reviewed and, if necessary, adjusted periodically based on updated estimates of product shipments during each contract year.  The Company’s historical estimates of product shipments have approximated actual results.  Amounts recorded as either deferred revenue or a receivable are settled at the end of each contract year, which generally is December 31.  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.  The Company’s terms of sale allow for limited rights of return with such rights based solely on compliance with agreed-upon customer product specifications.  The Company tests the product for compliance with customer product specifications prior to shipment. Such returns have not been material.

Royalty income is recorded when earned, based on information provided by the Company’s customers.  Royalty income was not material in the three months ended January 31, 2010 and 2009.

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.

Revenue earned from collaboration work may come from stand-alone arrangements for certain discrete development work or multiple deliverable arrangements that include such development work followed by larger-scale manufacturing efforts. Revenue is recognized based on the nature of the arrangements, with each of the multiple deliverables in a given arrangement having distinct and separate fair values. Fair values are determined via consistent pricing between stand-alone arrangements and multiple deliverable arrangements, as well as a competitive bidding process. Collaborations may be performed on a time and materials basis or fixed fee basis. For time and materials arrangements, revenue is recognized as services are performed and billed. For fixed fee arrangements where customer delivery and acceptance provisions are substantive, revenue is recognized upon completion and acceptance by the customer.

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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 $800,000 in the three months ended January 31, 2010 and $700,000 in the three months ended January 31, 2009.

Income Taxes 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 Company’s estimate of its annual effective income tax rate.  In determining the estimated annual effective income tax rate, the Company analyzes various factors, including projections of the Company’s annual earnings and taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes and the ability of the Company to use tax credits and net operating loss carryforwards.

The Company recognizes the benefits of tax positions in the financial statements if such positions are more likely than not to be sustained upon examination by the taxing authority and satisfy the appropriate measurement criteria.  If the recognition threshold is met, the tax benefit is generally measured and recognized as the tax benefit having the highest likelihood, in management’s judgment, of being realized upon ultimate settlement with the taxing authority, assuming full knowledge of the position and all relevant facts.  The Company also recognizes interest and penalties accrued related to unrecognized tax benefits in the provision for income taxes.  The Company believes appropriate provisions for all outstanding issues have been made for all jurisdictions and all open tax years.  It is reasonably possible that the total amount of unrecognized tax benefits as of January 31, 2010 will decrease within the next 12 months as various uncertainties are resolved.  The Company cannot reasonably estimate the range of potential outcomes.

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 are highly effective cash flow hedges and qualify for hedge accounting.  Consequently, the resulting unrealized gains and losses are recorded as a component of other comprehensive income until the related product is sold.  As of January 31, 2010, there were no outstanding forward contracts.  Amounts recorded due to hedge ineffectiveness have not been material.

Advertising Advertising costs are expensed as incurred.  Advertising costs, including print, television and internet-based advertising, were approximately $500,000 in the three months ended January 31, 2010 and $300,000 in the three months ended January 31, 2009.

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 designated as cash flow hedges in other comprehensive income in the Consolidated Statement of Stockholders’ Equity.

Investments The Company has classified investments at January 31, 2010 and October 31, 2009 as either trading or 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 issuer’s future earnings potential; the near term prospects for recovery of the market value of a security; the intent of the Company to sell the impaired security; and whether the Company will be required to sell the security prior to the anticipated recovery in market value.  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 does not intend to sell the investment prior to a recovery of amortized cost, are assumed to be temporary. If management determines that an other-than-temporary impairment exists, the carrying value of the investment will be reduced to the current fair value of the investment.  An other-than-temporary impairment resulting from credit-related matters is recognized as a charge in the consolidated statements of income equal to the amount of the carrying value reduction. Other-than-temporary impairment write-downs resulting from non-credit-related matters are recognized in other comprehensive income.

The fair value option for financial assets and liabilities 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 short-term investments at January 31, 2010. The Put Agreement is the only instrument of its nature or type held by the Company and for which the Company has elected the fair value option. See Note 3 for further discussion.

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The Company classifies its investments as either current or long-term based upon the investments’ contractual maturities and the Company’s 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, accounts receivable, accounts payable, notes payable and long-term debt, to approximate the fair value of the respective assets and liabilities at January 31, 2010 and October 31, 2009.  See Note 4 for further discussion of the Company’s fair value measurements.

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 maintained or 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 Goodwill is tested for impairment annually, on August 1, or more frequently when events occur or circumstances change that would more likely than not reduce the fair value of the asset below its carrying amount.  The Company operates as one reporting unit and determines fair value of the reporting unit using the market approach.

Purchased intangible assets other than goodwill are amortized over their useful lives unless these lives are determined to be indefinite. The Company’s 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 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.

Recently Issued Accounting Pronouncements In December 2007, the FASB issued Statement No. 141(R), “Business Combinations”, which has principally been codified in FASB Accounting Standards Codification (“ASC”) Topic 805, “Business Combinations” (“ASC 805”).  ASC 805 establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. ASC 805 also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. ASC 805 was effective for the Company beginning with the first quarter of fiscal 2010. As further described in Note 13, the Company acquired Charter Amerifit LLC and all of its subsidiaries (“Amerifit”) in February 2010. The adoption of ASC 805 did not have a cumulative effect upon adoption; however, ASC 805 will be material to the Company’s financial condition and results of operations.  Specifically, the adoption of ASC 805 required the immediate expensing of acquisition-related costs and additional impacts of ASC 805 are anticipated as the total purchase price is allocated to Amerifit’s net tangible and intangible assets based on their estimated fair values on the date of acquisition.

2. DSM SUPPLY AND LICENSE AGREEMENT

In July 2009, the Company entered into the First Amended and Restated ARA Alliance, Purchase, and Production Agreement (the “Restated Agreement”) with DSM. The Restated Agreement, which extends the original supply term through December 31, 2023,  amended, consolidated and restated all existing agreements between the two parties governing the cross-licensing, purchase, supply and production of ARA. While, subject to certain limited exceptions, Martek is committed to purchasing all of its ARA requirements from DSM through the term of the Restated Agreement, the Restated Agreement also set minimum ARA purchase quantities for Martek in calendar years 2010 and 2011.  As of January 31, 2010, the value of the remaining calendar year 2010 and full calendar year 2011 minimum purchase requirements are approximately $88.4 million and $87.1 million, respectively. These minimum purchase quantities approximate the amounts expected to be procured by Martek in the normal course of business. Under certain circumstances, either Martek or DSM may terminate the Restated Agreement after 2012. Upon early termination by Martek, Martek would be required to make a payment to DSM with the value of such payment decreasing over the remaining term of the Restated Agreement and being dependent upon DSM’s physical infrastructure at the early termination date. A termination payment by Martek as of January 1, 2013 would currently range from $15 million to $20 million and a termination payment as of January 1, 2016 would currently range from less than $1 million to $7 million.

3. INVESTMENTS

At January 31, 2010 and October 31, 2009, the Company had investments consisting of auction rate securities (“ARS”), the underlying assets of which 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 17 to 38 years. Since February 2008, as a result of negative conditions in the global credit markets, the large majority of the auctions for the Company’s investment in these securities have failed to settle, resulting in Martek continuing to hold such securities. Consequently, the investments are not currently liquid and the Company will not be able to access these funds, except as noted below, until a future auction of these investments is successful, a buyer is found outside of the auction process or the investments reach their contractual maturity date.

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.

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In November 2008, the Company executed a Put Agreement with a financial institution that 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 Company’s ARS holdings to which this relates have a cost basis of approximately $7.3 million and a fair value at January 31, 2010 of approximately $6.1 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.  Therefore, the Company has classified such investments as “trading”.  Net gains associated with these ARS during the three months ended January 31, 2010 were not material.  In the three months ended January 31, 2009, the Company recognized a $1.7 million impairment charge on these ARS, which was recognized in interest and other income in the consolidated statements of income.  The impairment charge consisted of $1.0 million of unrealized losses reclassified from other comprehensive income and $700,000 of unrealized fair value declines occurring after such reclassification.

The Company has recorded the Put Agreement at its fair value, which as of January 31, 2010 is approximately $1.2 million. The Company elected to adopt the fair value option 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.  Due to the Company’s intent to sell its ARS covered by the Put Agreement to the financial institution on June 30, 2010, the fair value of such ARS along with the fair value of the Put Agreement are classified as short-term investments in the accompanying consolidated balance sheet as of January 31, 2010.  Net losses associated with the Put Agreement during the three months ended January 31, 2010 were not material.  In the three months ended January 31, 2009, the Company recognized a gain of $1.6 million related to the Put Agreement, which was recognized in interest and other income in the consolidated statements of income.

As of January 31, 2010, the Company’s ARS holdings not covered by the Put Agreement have a cost basis of approximately $5.6 million and a fair value of approximately $4.6 million. The total decline in fair value of $1.0 million has been recorded as a net reduction to other comprehensive income. 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, the intent of the Company to sell the impaired security, and whether the Company will be required to sell the security prior to the anticipated recovery in market value.  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.  Due to the underlying maturities of these investments and the Company’s belief that the market for the ARS not covered by the Put Agreement may take in excess of twelve months to fully recover, the fair value of such ARS is classified as long-term investments in the accompanying consolidated balance sheet as of January 31, 2010.  Net unrealized gains associated with these ARS during the three months ended January 31, 2010 were not material.  In the three months ended January 31, 2009, the Company recognized $900,000 as a reduction to other comprehensive income related to the temporary unrealized losses for the Company’s ARS not covered by the Put Agreement.

4. FAIR VALUE MEASUREMENTS

The Company has adopted the provisions of guidance codified as ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC 820”) for financial instruments. ASC 820 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 ASC 820 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.

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 ASC 820 hierarchy.

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As of January 31, 2010, the Company held certain assets that are required to be measured at fair value on a recurring basis.  These financial assets were as follows (in thousands):

(1)  Included in long-term investments in the accompanying consolidated balance sheets.

(2)  Included in short-term investments in the accompanying consolidated balance sheets.

(3)  Included in cash and cash equivalents in the accompanying consolidated balance sheets.

The table below provides a reconciliation of the beginning and ending balances of the Company’s investments measured at fair value using significant unobservable inputs (Level 3) for the three months ended January 31, 2010 and 2009 (in thousands):

(1) See Note 3 for discussion of Auction Rate Securities and related Put Agreement.

(1) See Note 3 for discussion of Auction Rate Securities and related Put Agreement.

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Some of the inputs into the discounted cash flow models from which the Company bases its Level 3 valuations for the ARS 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, the expected term of each security and the credit-adjusted rate of the counterparty to the Put Agreement. 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 the Company. The expected term for the Put Agreement was based on the earliest date on which the Company can exercise the Put Agreement rights.

5.  INVENTORIES

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 $32.9 million and $34.4 million at January 31, 2010 and October 31, 2009, respectively.  Depreciation as well as certain other fixed costs related to such idle assets is recorded as cost of product sales in the accompanying consolidated statements of income.

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7.  GOODWILL AND OTHER INTANGIBLE ASSETS

Intangible assets and related accumulated amortization consist of the following (in thousands):

In February 2009, Martek entered into a license agreement with an international food company for certain patented technology expected to be used in the production of Martek’s life’sDHA™ for certain applications. 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, including certain minimum royalty payments of approximately $2.0 million, the timing of which is also subject to the successful completion of the development goals.  The license fees paid in connection with this arrangement are being amortized over 10 years. 

Most of the amortization associated with the Company’s intangible assets is reflected in amortization of intangible assets in the accompanying consolidated statements of income.  Included in amortization of intangible assets is approximately $1.2 million in the three months ended January 31, 2010 and approximately $1.6 million in the three months ended January 31, 2009 related to assets supporting the Company’s commercial products and approximately $200,000 in the three months ended January 31, 2010 and January 31, 2009 related to assets supporting the Company’s research and development initiatives.

8.  NOTES PAYABLE AND LONG-TERM DEBT

In January 2010, the Company entered into a Credit Agreement (the “Credit Agreement”) that includes a $75 million term loan (the “Term Loan”) and a $50 million secured revolving credit facility (the “Revolver”).  The Credit Agreement replaced the existing $135 million credit facility (the “Former Facility”). The proceeds from the Term Loan were received by, and the funds under the Revolver became available to, Martek on February 12, 2010, coincident with the closing of the Company’s acquisition of Amerifit (see further discussion in Note 13).

The Term Loan and the Revolver are collateralized by certain of the Company’s and its subsidiaries’ assets, including accounts receivable, deposit accounts, inventory and certain software, general intangibles and records pertaining to the foregoing as well as a pledge of 100% of its domestic subsidiaries’ equity.  The Revolver, which may be increased during the term of the facility by up to an additional $50 million subject to certain conditions, expires in February 2013.  The Term Loan matures in February 2013. Martek is required to make quarterly installment payments on the Term Loan of $3,750,000 beginning April 2010 plus additional annual repayments on January 31 of each year based on consolidated excess cash flow, as defined in the Credit Agreement, of the preceding fiscal year.

The Term Loan will bear interest at the election of Martek at either LIBOR plus up to 3.375% or a base rate plus up to 1.25% depending upon the consolidated leverage ratio during each preceding fiscal quarter. The Revolver will bear interest at the election of Martek at either LIBOR plus up to 3.00% or a base rate plus up to 1.00% depending upon the consolidated leverage ratio during each preceding fiscal quarter.  The base rate is the higher of the lender’s prime rate, the federal funds rate plus 0.50% or LIBOR plus 1.50%.  LIBOR is the greater of 1.50% per annum or LIBOR at the time of such determination.

There were no amounts outstanding under the Former Facility in the three months ended January 31, 2010.  The weighted average annual commitment fee rate on unused amounts was approximately 0.1% for the three months ended January 31, 2010 and 2009, all of which was applicable to the Former Facility.  The commitment fee rate under the Credit Agreement of up to 0.50% on the Revolver is based on the Company’s consolidated leverage ratio during each preceding fiscal quarter. Among other things, the Credit Agreement contains restrictions on future debt, the payment of dividends and the further encumbrance of assets. In addition, the Credit Agreement requires that the Company comply with specified financial ratios and tests, including minimum coverage ratios and maximum leverage ratios.

In connection with the January 2010 financing, the Company incurred debt issuance costs totaling approximately $3.3 million. Such amounts were allocated to the Term Loan and the Revolver on a pro-rata basis. Amounts allocated to the Term Loan are amortized using the effective interest method and amounts allocated to the Revolver are amortized using the straight-line method.

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The carrying amounts of notes payable at January 31, 2010 and October 31, 2009 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 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 Company’s financial commitments associated with this development initiative are subject to the successful completion of identified milestones.  As of January 31, 2010, the Company’s financial commitment, primarily through internal research efforts, to the first projected milestone date totals approximately $500,000.  Commitments thereafter, also primarily through internal research efforts, assuming successful achievement of all identified milestones, total approximately $5.6 million.

In August 2009, the Company entered into a collaboration agreement with BP for the joint development of biofuels from microbial oils. Under the terms of the agreement, Martek and BP will work together to establish proof of concept for large-scale, cost-effective microbial biodiesel production through fermentation. In connection with this agreement, BP has agreed to contribute up to $10 million to the initial phases of the collaboration, which utilizes Martek’s significant expertise in microbial oil production and BP’s production and commercialization experience in biofuels as the platform for the joint development effort. Martek will perform the biotechnology research and development associated with the initial phases and receive fees from BP for such efforts.  All intellectual property owned prior to the execution of the collaboration agreement will be retained by each respective company, and all intellectual property developed during the collaboration period will be owned by BP, with an exclusive license to Martek for commercialization in nutrition, cosmetic and pharmaceutical applications. Additionally, each party is entitled to certain commercial payments from the counterparty for commercialization of the technology in the other party’s fields of use.

Patent Infringement Litigation In September 2003, the Company filed a patent infringement lawsuit in the U.S. District Court in Delaware against Nutrinova Nutrition Specialties & Food Ingredients GmbH (“Nutrinova”) and others alleging infringement of certain of our U.S. patents.  In December 2005, Nutrinova’s DHA business was sold to Lonza Group LTD, a Swiss chemical and biotechnology group, and the parties agreed to add Lonza to the U.S. lawsuit.  In October 2006, the infringement action in the United States was tried, and a verdict favorable to Martek was returned.  The jury found that 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.  Martek’s request to the judge to reconsider his ruling on the third patent was denied.  Martek and the defendants appealed aspects of the judge’s final decision and a hearing was held before the U.S. Court of Appeals in April 2009.  In September 2009, the Court of Appeals ruled in Martek’s favor on all of the patents that were the subject of the appeal, which included U.S. Patent Nos. 5,340,594, 6,410,281, 6,451,567 noted above and 5,698,244, which was included in Martek’s appeal as a result of the trial court’s decision at a pre-trial hearing on the meaning and scope of the patent claims in dispute. With respect to U.S. Patent No. 5,698,244, the Court of Appeals reversed the trial court’s interpretation of certain claim language and remanded this patent to the trial court for further proceedings.  U.S. Patent Nos. 5,340,594 and 6,454,567 have expired and U.S. Patent Nos. 6,410,281 and 5,698,244 are scheduled to expire in August 2011 and December 2014, respectively.  The defendants requested a rehearing with the Court of Appeals on the decision, but their request was denied.  Additionally, the defendants have requested reexamination of U.S. Patent Nos. 6,410,281 and 5,698,244 in the U.S. Patent and Trademark Office.

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 Martek’s 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 Martek’s patent was infringed by the defendants.  The defendants have appealed, and the appeal is expected to be heard in 2010 or 2011.  This patent is scheduled to expire in February 2011.

In connection with these patent lawsuits, the Company has incurred and capitalized significant external legal costs. As of January 31, 2010, the patents being defended in the Lonza matter had a net book value of approximately $4.1 million, including capitalized legal costs, which is being amortized over a weighted average remaining period of approximately five years.  This amount is subject to future impairment, in whole or in part, pending the outcome of these patent lawsuits.

These lawsuits are further described in Item 1. “Legal Proceedings” of Part II of this Form 10-Q.

Other The Company is involved in various other legal actions.  Management believes that these actions, either individually or in the aggregate, will not have a material adverse effect on the Company’s results of operations or financial condition.

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10.  STOCKHOLDERS’ EQUITY

The Company recognized approximately $900,000 in the three months ended January 31, 2010 and approximately $800,000 in the three months ended January 31, 2009 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 all periods.

The Company granted 384,926 restricted stock units during the three months ended January 31, 2010, which generally 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, 2010, there was approximately $18.1 million remaining in unrecognized compensation cost related to restricted stock units. The cost is expected to be recognized through fiscal 2015 with a weighted average recognition period of approximately two years.

Unrecognized compensation cost related to unvested stock options as of January 31, 2010 is not material.

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 2.1 million shares were outstanding but were not included in the computation of diluted net income per share for the three months ended January 31, 2010, and 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, because the effects would have been antidilutive.

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12. COMPREHENSIVE INCOME

Comprehensive income and its components for the three months ended January 31, 2010 and 2009 were as follows (in thousands):

13. SUBSEQUENT EVENT — ACQUISITION OF CHARTER AMERIFIT LLC

On February 12, 2010, Martek completed the acquisition of the Charter Amerifit LLC and all of its subsidiaries (“Amerifit”). Amerifit develops, markets and distributes branded consumer health and wellness products and holds leading brand positions in all of its key product categories. Amerifit products are sold in most major mass, club, drug, grocery and specialty stores and include: Culturelle®, a leading probiotic supplement; AZO®, the leading OTC brand addressing symptom relief, detection and prevention of urinary tract infections; and ESTROVEN®, the leading all-natural nutritional supplement brand addressing the symptoms of menopause.

Upon the closing of the acquisition, Martek paid for the benefit of Amerifit’s equity holders total cash consideration of approximately $201 million, net of cash acquired, of which amount $27 million was placed into an escrow that secures certain post-closing adjustment obligations and certain indemnification obligations.  The consideration included approximately $1 million related to the effects of the preliminary determinations of Amerifit’s net debt level and net working capital, both of which are subject to adjustment based on the final determinations of Amerifit’s net debt level and net working capital at closing.  To finance the Amerifit acquisition, Martek utilized existing cash of approximately $115 million along with the proceeds from the $75 million Term Loan and $11 million drawn from the Revolver.  See Note 8 for additional discussion of these debt instruments.

In addition to the Company’s expectation that the Amerifit acquisition will be financially accretive, Martek expects to be able to use Amerifit’s marketing platform to commercialize and distribute the nutritional health and wellness products that Martek is currently developing.

Under the acquisition method of accounting, the total purchase price will be allocated to Amerifit’s net tangible and intangible assets based on their estimated fair values as of the February 12, 2010 closing date of the acquisition. The final purchase price will be determined following completion of the closing balance sheet and post-closing adjustments and valuation report of acquired intangible assets. Martek has made a preliminary allocation of the estimated purchase price using estimates. We are in the process of completing our assessment of the fair value of the assets acquired and liabilities assumed and finalizing our calculation of the final purchase price. The completion of the valuation report of acquired intangible assets and final purchase price may result in material revisions to the fair values noted below.

The table below summarizes the preliminary estimated fair values of assets acquired and liabilities assumed based on management’s current best estimates.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements concerning our business and operations, including, among other things, statements concerning the following:

·                  expectations regarding future revenue, revenue growth, gross margin, operating cash flow and profitability of Martek and its newly-acquired subsidiary, Charter Amerifit LLC and all of its subsidiaries (“Amerifit”);

·                  expectations regarding product introductions and growth in nutritional product sales;

·                  expectations regarding Martek’s ability to use the marketing platform of Amerifit to commercialize products under development;

·                  expectations regarding potential collaborations and acquisitions;

·                  expectations regarding demand for products with our nutritional oils;

·                  expectations regarding sales to and by our infant formula customers and supplemented infant formula market penetration levels;

·                  expectations regarding marketing of our oils by our infant formula customers;

·                  expectations regarding future agreements with, and revenues from, companies in the food and beverage, pregnancy and nursing, nutritional supplement and animal feed markets;

·                  expectations regarding future revenues from contract manufacturing customers;

·                  expectations regarding future revenues from collaborations;

·                  expectations regarding growing consumer recognition of the key health benefits of DHA and ARA;

·                  expectations regarding competitive products;

·                  expectations regarding future efficiencies and improvements in manufacturing processes and the cost of production of our nutritional oils;

·                  expectations regarding future purchase volumes and costs of third-party manufactured oils;

·                  expectations regarding the amount of production capacity and our ability to meet future demands for our nutritional oils;

·                  expectations regarding the amount of inventory held by us or our customers;

·                  expectations regarding production capacity utilization and the effects of excess production capacity;

·                  expectations regarding future selling, general and administrative and research and development costs;

·                  expectations regarding future capital expenditures;

·                  expectations regarding levels of consumption through governmental programs of infant formula products containing our nutritional oils; and

·                  expectations regarding our ability to maintain and protect our intellectual property.

Forward-looking statements include those statements containing words such as the following:

·                  “will,”

·                  “should,”

·                  “could,”

·                  “anticipate,”

·                  “believe,”

·                  “plan,”

·                  “estimate,”

·                  “expect,”

·                  “intend,” and other similar expressions.

All of these forward-looking statements involve risks and uncertainties. They and other forward-looking statements in this Form 10-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.

GENERAL

Martek was founded in 1985. We are a leader in the innovation, development, production and sale of high-value products from microbial sources that promote health and wellness through nutrition.  Our technology platform consists of our core expertise, broad experience and proprietary technology in areas such as microbial biology, algal genomics, fermentation and oil processing.  This technology platform has resulted in our development of a number of products including our flagship product, life’sDHA™, a sustainable and vegetarian source of algal DHA (docosahexaenoic acid) important for brain, heart and eye health throughout life for use in infant formula, pregnancy and nursing products, foods and beverages and dietary supplements. We also produce life’sARA™ (arachidonic acid), an omega-6 fatty acid, for use in infant formula and growing-up milks.  On February 

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12, 2010, we acquired Amerifit.  Amerifit develops, markets and distributes branded consumer health and wellness products and holds leading brand positions in all of its key product categories. Amerifit products are sold in most major mass, club, drug, grocery and specialty stores and include: Culturelle®, a leading probiotic supplement; AZO®, the leading OTC brand addressing symptom relief, detection and prevention of urinary tract infections; and ESTROVEN®, the leading all-natural nutritional supplement brand addressing the symptoms of menopause. We currently have a number of nutritional health and wellness products under development that we plan to commercialize and distribute through Amerifit’s marketing platform. See “Recent Highlights” below for further discussion of Amerifit.

We sell oils containing these fatty acids as life’sDHA™, DHASCO®, Neuromins®, ARASCO® and life’sARA™. We derive DHA from microalgae and ARA from fungi, using proprietary processes.  Cell membranes throughout the body contain these fatty acids, and they are particularly concentrated in the brain, central nervous system, retina and heart.  Research has shown that DHA and ARA may enhance mental and visual development in infants.  In addition, research has shown that DHA may play a pivotal role in brain function throughout life and may reduce the risk of cardiovascular disease. Low levels of DHA in adults have been linked to a variety of health risks, including Alzheimer’s disease, dementia, cardiovascular problems and various other neurological and visual disorders. Further research is underway to assess the role of supplementation with our DHA on mitigating a variety of health risks.

We are supplying over 35 infant formula customers with our nutritional oils.  These companies 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 and 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 customers include infant formula market leaders Mead Johnson Nutritionals, Nestle, Abbott Nutrition, Pfizer and Danone, each of whom is selling infant formula supplemented with our nutritional oils.  Our customers are now selling infant formula products containing our oils collectively in over 75 countries.  Supplemented infant formulas from Mead Johnson Nutritionals, Abbott Nutrition, PBM Products, Nestle, Hain Celestial and Nutricia North America are currently being sold in the United States. In addition, certain infant formula customers 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.

We are currently marketing and selling life’sDHA™, either directly or through distributors, for food and beverage, supplement and animal feed applications to both U.S. and international companies. To date, over 200 domestic and international companies have launched non-infant formula products that contain life’sDHA™, most of which remain on the market.  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.  Certain of these agreements establish the customer as the exclusive customer of life’sDHA™ in a particular food or beverage category or categories or geographic region.  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.

Although we anticipate future growth in annual sales of our nutritional oils, we are likely to continue to experience quarter-to-quarter and year-to-year fluctuations in our future operating results, some of which may be significant. The timing and extent of future oils-related revenues are largely dependent upon the following factors:

·                  the timing of international infant formula market introductions by our customers;

·                  the timing of our customers’ ordering patterns;

·                  the timing and extent of stocking and de-stocking of inventory by our customers;

·                  the timing and extent of our customers’ production campaigns and plant maintenance shutdowns;

·                  the timing and extent of introductions of DHA into various child and/or adult applications and the marketplace success of such applications;

·                  the levels of inclusion of our oils in infant formula;

·                  the continued acceptance, and extent thereof, of products containing our oils under WIC and other regulatory programs in the U.S.;

·                  the continued acceptance of these products by consumers and continued demand by our customers;

·                  the ability of our customers to incorporate our oils into various foods and beverages;

·                  our ability to protect against competitive products through our patents;

·                  competition from alternative sources of DHA and ARA; and

·                  agreements with other future third-party collaborators to market our products or develop new products.

As such, the likelihood, timing and extent of future profitability are largely dependent on factors such as those mentioned above, as well as others, over which we have limited or no control.

RECENT HIGHLIGHTS

·                  Acquisition of Charter Amerifit LLC — On February 12, 2010, we completed the acquisition of Amerifit. Amerifit develops, markets and distributes branded consumer health and wellness products and holds leading brand positions in all of its key product categories. Amerifit

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products are sold in most major mass, club, drug, grocery and specialty stores and include: Culturelle®, a leading probiotic supplement; AZO®, the leading OTC brand addressing symptom relief, detection and prevention of urinary tract infections; and ESTROVEN®, the leading all-natural nutritional supplement brand addressing the symptoms of menopause.

Upon the closing of the acquisition, we paid for the benefit of Amerifit’s equity holders total cash consideration of approximately $201 million, net of cash acquired, of which amount $27 million was placed into an escrow that secures certain post-closing adjustment obligations and certain indemnification obligations.  The consideration included approximately $1 million related to the effects of the preliminary determinations of Amerifit’s net debt level and net working capital, both of which are subject to adjustment based on the final determinations of Amerifit’s net debt level and net working capital at closing.  To finance the Amerifit acquisition, we utilized existing cash of approximately $115 million along with the proceeds from the $75 million Term Loan and $11 million drawn from the Revolver.  See Note 8 to the consolidated financial statements for additional discussion of these debt instruments.

In addition to our expectation that the Amerifit acquisition will be financially accretive, we expect to be able to use Amerifit’s marketing platform to commercialize and distribute the nutritional health and wellness products that we are currently developing.

·                  Non-Infant Formula Product Launches — Products with Martek’s life’sDHA™ were recently launched in the United States including Natelle®One (Azur Pharma Ltd)  prescription prenatal vitamin with 250 mg life’sDHA™, Algal-900 DHA Softgels (CVS/Pharmacy®) with 900 mg life’sDHA™, Spring Valley® Algal-900 DHA (Wal-Mart) with 900 mg life’sDHA™, Horizon™ Organic Lowfat Chocolate Milk Plus DHA Omega-3 (WhiteWave Foods), Sara Lee® Soft & Smooth Plus Bread (Sara Lee) and Francesco Rinaldi® ToBe Healthy pasta sauces (LiDestri Foods).

·                  Extension of Danone Multi-Year Sole-Source License and Supply Agreement — In March 2010, Martek announced that it has extended its multi-year sole-source license and supply agreement with Danone, a leading worldwide producer of infant nutrition products.  Under the terms of the amended agreement, Martek will be Danone’s exclusive supplier of ARA for all of its infant formula and growing-up milk products through at least December 31, 2014, which is an extension of Martek’s current exclusive ARA supply position with Danone by three years.  As with the current agreement, Danone may continue to use non-microbial DHA sources.  In most cases, Martek will continue to serve as Danone’s global supplier for its microbially-derived DHA needs for infant formula. This is an amendment to the 2007 agreement between Martek and Numico and contains certain limited termination rights.  Martek has supplied DHA and ARA to Numico, which was acquired by Danone in 2008, for infant formula products since 1994.

·                  New Scientific Data Published on DHA and ARA — The benefits of DHA and ARA supplementation were recently discussed in the following publications:

·                  The American Journal of Clinical Nutrition (online, February 2010) published results of a study investigating DHA supplementation on brain function.  Thirty-three healthy boys, 8-10 years of age, were supplemented with 400 or 1200 mg/day DHA or placebo for 8 weeks and tested during an activity of continuous performance.  The results showed that the DHA level in red blood cells was positively correlated with brain function and inversely correlated with reaction time during the activity. These results demonstrate the important role that DHA plays in regulation of brain activity.  Martek provided financial support and life’sDHA™ for this study.

·                  The American Journal of Clinical Nutrition (online, February 2010)  published the results of a study in which 343 term infants were fed formula containing no long-chain polyunsaturated fats or formula supplemented with 0.32% DHA, 0.64% DHA, or 0.96% DHA throughout the first year of life.  All DHA-supplemented formula also contained 0.64% ARA.  Visual evoked potential (VEP) was measured at 1.5, 4, 9, and 12 months.  At 12 months, all DHA-supplemented infants scored significantly better in VEP visual acuity than those given an unsupplemented formula.  There were also no significant differences in VEP visual acuity between the three DHA-supplemented groups.  The authors state that these subtle changes in vision are important “because they suggest diet-related modifications in the developmental course of structure and function in the brain and/or retina” and that “dietary supply of DHA during infancy may have long-lasting effects on brain function.”  Martek’s life’sDHA™ and life’sARA™ were used in the study.

PRODUCTION

We manufacture oils rich in DHA at our production facilities located in Kingstree, South Carolina and Winchester, Kentucky.  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 achieved compliance with 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 Martek’s Winchester plant, the Company’s 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.

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Over 90% of our ARA oils are purchased from DSM.  Because DSM is a third-party manufacturer, we have only limited control over the timing and level of its production volumes. The balance of our ARA requirements is produced at our Kingstree facility.  In July 2009, we entered into the First Amended and Restated ARA Alliance, Purchase, and Production Agreement (the “Restated Agreement”) with DSM. The Restated Agreement, which extends the original supply term through December 31, 2023,  amended, consolidated and restated all existing agreements between the two parties governing the cross-licensing, purchase, supply and production of ARA. While, subject to certain limited exceptions, Martek is committed to purchasing all of its ARA requirements from DSM through the term of the Restated Agreement, the Restated Agreement also set minimum ARA purchase quantities for Martek in calendar years 2010 and 2011.  As of January 31, 2010, the value of the remaining calendar year 2010 and full calendar year 2011 minimum purchase requirements are approximately $88.4 million and $87.1 million, respectively. These minimum purchase quantities approximate the amounts expected to be procured by us in the normal course of business.  Under certain circumstances, either we or DSM may terminate the Restated Agreement after 2012. Upon early termination by us, we would be required to make a payment to DSM with the value of such payment decreasing over the remaining term of the Restated Agreement and being dependent upon DSM’s physical infrastructure at the early termination date. A termination payment by us as of January 1, 2013 would currently range from $15 million to $20 million and a termination payment as of January 1, 2016 would currently range from less than $1 million to $7 million.

We have attempted to reduce the risk inherent in having a single supplier through certain elements of our supply agreement with DSM.  In connection with this agreement, we have the ability to produce, either directly or through an approved 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.  Although we currently produce ARA ourselves, our existing 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, this third-party facility provides us with multiple U.S. sites for the full downstream processing of ARA.

When combining our current DHA and ARA production capabilities in Kingstree and Winchester with DSM’s current ARA production capabilities, we have production capacity for DHA and ARA products in excess of $500 million in annualized sales, collectively, to the infant formula and non-infant formula 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 Administration’s “good manufacturing practice” (“GMP”) requirements. Under the terms of several of our agreements with infant formula customers, those customers may elect to manufacture these oils themselves. While our customers are not required to disclose to us that they have begun the process, we are currently unaware of any of our customers producing our oils or preparing to produce our oils, and estimate that it would take a customer 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 Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report to shareholders on Form 10-K for the year ended October 31, 2009.  There have been no significant changes in the Company’s critical accounting policies since October 31, 2009.

RESULTS OF OPERATIONS

Revenues

The following table presents revenues by category (in thousands):

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Product sales were essentially unchanged in the three months ended January 31, 2010 as compared to the three months ended January 31, 2009.  Product sales were comprised of the following (in thousands):

Sales to the infant formula market during the three months ended January 31, 2010 decreased as compared to the three months ended January 31, 2009 due primarily to normal fluctuations in product ordering patterns and declines in the U.S. infant formula market. Launches of new products and increased market penetration of existing products containing life’sDHA™, particularly in the food and beverage, pregnancy and nursing and nutritional supplements markets, resulted in higher sales to the non-infant formula nutritional markets in the three months ended January 31, 2010 compared to the same period of the prior fiscal year.  Approximately 70% of the increase in sales to the non-infant formula nutritional markets was to customers outside of the U.S.

Approximately 73% of our product sales in the three months ended January 31, 2010 were generated by sales to Mead Johnson Nutritionals, Abbott Nutrition, Nestle, Pfizer and Danone. 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 46% and 52% of our sales to infant formula customers for the three months ended January 31, 2010 and 2009, respectively, relate to sales in the U.S.  As of January 31, 2010, we estimate that formula supplemented with our oils had penetrated almost all of the U.S. infant formula market.

Our future nutritional oils sales are subject to quarter-to-quarter fluctuations and are 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 de-stocking 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 and services revenues totaled approximately $5.7 million in the three months ended January 31, 2010 and $3.3 million in the three months ended January 31, 2009.  Of the $5.7 million in the first quarter of fiscal 2010, approximately $4.6 million relates to contract manufacturing activities that we anticipate exiting, in large measure, over the course of fiscal 2010.  The remaining $1.1 million relates to the revenues associated with Martek’s joint development agreement with BP for work on microbial oils for use in biofuels, which began in late fiscal 2009 and is expected to continue through at least 2011.  The cessation of contract manufacturing activities is not expected to have any material impact on our financial condition or results of operations.

As a result of the above, total revenues increased by $2.4 million or 2.7% in the three months ended January 31, 2010 as compared to the three months ended January 31, 2009.

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 55% in the three months ended January 31, 2010 from 56% in the three months ended January 31, 2009. The decrease in the comparative three months was due to DHA productivity improvements and decreases in our overall cost of ARA.

Cost of contract manufacturing and services was $5.2 million in the three months ended January 31, 2010 and $3.4 million in the three months ended January 31, 2009.  Our contract manufacturing and services margins vary between periods primarily due to contract mix and volume.

See “Management Outlook” for discussion of expected revenue and gross profit margin growth for the second quarter of fiscal 2010.

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Operating Expenses

The following table presents our operating expenses (in thousands):