**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**Washington,D. C. 20549

**FORM 10-K**

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

**For the Fiscal Year Ended March 31,2006**

**Commission File Number 0-146-02**

## **CYANOTECH CORPORATION**(Exact name of registrant as specified in its charter)

| **Nevada**                                            |   | **91-1206026**       |
|-------------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of                      |   | (I. R. S. Employer   |
|  incorporation or organization)                  |   | Identification  No.) |
| **73-4460 Queen Kaahumanu Highway,  Suite 102,** |   | ** **           |
| **Kailua-Kona,  Hawaii**                              |   | **96740**            |
| (Address of  principal executive offices)             |   | (Zip Code)           |

Registrant’stelephone number, including area code:  **(808) 326-1353**

| Securities registered pursuant to  Section 12(b) of the Act: |   | Name of each exchange  on which registered: |
|------------------------------------------------------------------------|--------|---------------------------------------------|
| **None**                                                               |   | **NASDAQ  Capital Market**                  |

Securities registered pursuant to Section 12(g) ofthe Act:

**CommonStock, $.005 par value**(Title of Class)

Indicate by check mark if theregistrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act.    o Yes    x No

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act.    o Yes    x No

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.    x Yes    o No

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 ofRegulation S-K (§229.405 of this chapter) is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K.    o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):

| Large accelerated filer o |   | Accelerated  filer o |   | Non-accelerated  filer x |
|--------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicated by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act). o Yes    x No

The aggregate market value of the Registrant’s CommonStock held by non-affiliates of the Registrant on June 19, 2006 wasapproximately $11,425,700 based on the closing sale price of the Common Stockon the NASDAQ Capital Market on that date.

Number of shares outstanding of Registrant’s CommonStock at June 19, 2006 was 20,928,265.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portionsof the Registrant’s Definitive Proxy Statement for its 2006 Annual Meeting ofStockholders, to be filed with the Securities and Exchange Commission on orprior to July 18, 2006 and to be used in connection with the Annual Meetingof Stockholders expected to be held on August 24, 2006, are incorporatedby reference in Part III of this Form 10-K.

 

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**TABLEOF CONTENTS**

| Item       | ** ** | ** **                                                                                        | ** ** | ** ** | ** ** | **Page** | ** ** |
|------------|------------|---------------------------------------------------------------------------------------------------|------------|------------|------------|----------|------------|
|       |       | **PART I**                                                                                   |       |       |       |     |       |
| 1.         |       | Business                                                                                          |       |       | 3          |     |       |
| 1A.        |       | Risk Factors                                                                                      |       |       | 10         |     |       |
| 2.         |       | Properties                                                                                        |       |       | 14         |     |       |
| 3.         |       | Legal Proceedings                                                                                 |       |       | 14         |     |       |
| 4.         |       | Submission of  Matters to a Vote of Security Holders                                              |       |       | 14         |     |       |
| ** ** |       | **PART II**                                                                                  |       |       |       |     |       |
| 5.         |       | Market for  Registrant’s Common Equity and Related Stockholder Matters.                      |       |       | 15         |     |       |
| 6.         |       | Selected Financial  Data                                                                          |       |       | 16         |     |       |
| 7.         |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations  |       |       | 16         |     |       |
| 7A.        |       | Quantitative  and Qualitative Disclosures About Market Risk                                       |       |       | 26         |     |       |
| 8.         |       | Financial  Statements and Supplementary Data                                                      |       |       | 27         |     |       |
| 9.         |       | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure             |       |       | 46         |     |       |
| 9A.        |       | Controls and  Procedures.                                                                         |       |       | 47         |     |       |
| 9B.        |       | Other  Information                                                                                |       |       | 47         |     |       |
| ** ** |       | **PART III**                                                                                 |       |       |       |     |       |
| 10.        |       | Directors and  Executive Officers of the Registrant                                               |       |       | 47         |     |       |
| 11.        |       | Executive  Compensation                                                                           |       |       | 47         |     |       |
| 12.        |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters   |       |       | 47         |     |       |
| 13.        |       | Certain  Relationships and Related Transactions                                                   |       |       | 47         |     |       |
| 14.        |       | Principal  Accountant Fees and Services.                                                          |       |       | 47         |     |       |
| ** ** |       | **PART IV**                                                                                  |       |       |       |     |       |
| 15.        |       | Financial  Statement Schedules and Exhibits.                                                      |       |       | 48         |     |       |
| 16.        |       | Signatures                                                                                        |       |       | 52         |     |       |

 

 

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**PART I**

**Item 1. Business**

**General**

CyanotechCorporation is a world leader in the production of high value natural productsderived from microalgae.  Incorporated in1983, the Company is guided by the principle of providing beneficial, qualitymicroalgal products for human and animal nutrition in a sustainable, reliableand environmentally sensitive operation. We are ISO 9001:2000 compliant,reinforcing our commitment to quality in our products, to quality in ourrelationships (with our customers, suppliers, co-workers and the communities welive in), and to quality of the environment we work in. The Company’s productsinclude:

·       *BioAstin®*natural astaxanthin is apowerful dietary antioxidant with expanding applications as a humannutraceutical and functional food ingredient, shown to support and maintain thebody’s natural inflammatory response, to enhance skin, muscle and joint health.

·       *NatuRose*ânatural astaxanthin, is used as a feed ingredient for the aquaculture feedindustry, specifically providing natural pigmentation to aquaculture-raisedshrimp, salmon, yellowtail tuna and “tai” (red sea bream), and for the animalfeed industry such as in poultry feed formulations to naturally pigment theyolk of chicken eggs;

·       *Spirulina**Pacifica*â,is a nutrient-rich dietary supplement used for extra energy, a strengthenedimmune system and as a source of antioxidant carotenoids;

·       Naturalphycobiliproteins are highly fluorescent pigments used as tags or markers inmany kinds of biological assays in the immunological diagnostics market.

Microalgae are a diverse group of microscopic plantsthat have a wide range of physiological and biochemical characteristics andcontain, among other things, high levels of natural protein, amino acids,vitamins, pigments and enzymes. Microalgae have the following properties thatmake commercial production attractive: (1) microalgae  grow much faster than land grown plants,often up to 100 times faster; (2) microalgae have uniform cell structurewith no bark, stems, branches or leaves, permitting easier extraction ofproducts and higher utilization of the microalgae cells; and (3) thecellular uniformity of microalgae makes it practical to manipulate and controlgrowing conditions in order to optimize a particular cell characteristic. Efficientcultivation of microalgae requires consistent light, warm temperature, lowrainfall and proper chemical balance in a very nutrient-rich environment. Ifthe chemical composition of a pond changes from its required balance,contamination can occur from the growth of unwanted organisms.

Since 1983, we have designed, developed andimplemented proprietary production and harvesting technologies, systems andprocesses, thereby eliminating many of the stability and contamination problemsfrequently encountered in the production of microalgae. Our production of theseproducts at the 90-acre facility on the Kona Coast of Hawaii providessignificant advantages. We selected the Keahole Point location in order to takeadvantage of the consistent warm temperatures, abundant sunshine and low levelsof rainfall needed for optimal cultivation of microalgae. This location alsooffers us access to cold deep ocean water, drawn from an offshore depth of2,000 feet, which we use in our patented *Ocean-ChillDrying*system to eliminate the oxidative damage caused by standarddrying techniques and as a source of trace nutrients for microalgal cultures. Webelieve that our technology, systems, processes and favorable growing locationpermit year-round harvest of our microalgal products in a cost-effectivemanner.

Unless otherwiseindicated, all references in this report to the “Company,” “we,” “us,” “our,”and “Cyanotech” refer to Cyanotech Corporation and its wholly ownedsubsidiaries, Nutrex Hawaii, Inc. (“Nutrex Hawaii” or “Nutrex”), a Hawaiicorporation, and Cyanotech Japan YK (“Cyanotech Japan” or “CJYK”), a Japancorporation.

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**Cyanotech’sBusiness**

The Company operatesentirely in one operating segment, the cultivation and production of microalgaeinto high-value, high-quality natural products. The Company cultivates, on alarge-scale basis, two microalgal species from which our two major productlines, spirulina products and natural astaxanthin products, are derived. Cyanotechrecords revenue and cost of sales information by product category but does notrecord operating expenses by such product category. The following table setsforth, for the three years ended March 31, 2006, the net sales contributedby each of the Company’s product lines (in thousands):

| ** **                         | ** ** | **Net Sales** | ** ** |
|------------------------------------|------------|--------------------|------------|
| ** **                         | ** ** | **2006**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Spirulina products:                |       |               |       |   |   |   |   |
| *Spirulina  Pacifica*              |       | $                  | 6,517      |   | $ | 6,626 |   | $ | 6,511 |   |
| Natural astaxanthin  products:     |       |               |       |   |   |   |   |
| *NatuRose*                         |       | 1,403              |       | 1,817 |   | 2,545 |   |
| *BioAstin*                         |       | 2,967              |       | 2,855 |   | 2,388 |   |
| Other including  phycobiliproteins | * *   | 244                |       | 147 |   | 138 | * * |
| Total                              | ** ** | $                  | 11,131     |   | $ | 11,445 |   | $ | 11,582 | ** ** |

*** ***

***Spirulina Products***

Since 1985, Cyanotech has been producing a strain ofspirulina microalgae marketed as *SpirulinaPacifica.*Accounting for 59%, 58% and 56% of net sales for the yearsended March 31, 2006, 2005, and 2004, respectively, *Spirulina Pacifica*provides avegetable-based, highly absorbable source of protein, natural beta-carotene,mixed carotenoids, B vitamins, gamma linolenic acid, essential amino acids andother phytonutrients.  *Spirulina Pacifica*is produced in threeforms:  powder, flake and tablets.  Powder is used as an ingredient in nutritionalsupplements and health food drinks while flakes are used as a seasoning onvarious foods.  Tablets are consumed as adaily dietary supplement.  All threeforms are sold as raw material in bulk quantities and as packaged consumerproducts under the Nutrex Hawaii label.

Beginning in 1994, we have produced two grades of *Spirulina Pacifica*:  an all-natural grade cultivated by usingconventional agricultural fertilizers and an organic grade that is cultivatedusing only organic fertilizers. Our organic *SpirulinaPacifica* was grown and processed in accordance with the NationalOrganic Program of the United States Department of Agriculture (“USDA”)effective October 2002.  Prior tothe establishment of the USDA organic standard, our organic standard was theCalifornia Organic Food Act of 1990. Our organic cultivation and processingmethods were certified annually by Quality Assurance International of SanDiego, California, a leading third-party agency. In its 2002 decision, the USDANational Organics Standards Board (“NOSB”) allowed the use of certainfertilizers in organic Spirulina cultivation through October 2005, afterwhich all cultivators must find alternate sources of key nutrients in order toretain organic certification. The Company determined that although alternativefertilizers exist, their costs are prohibitive and their use would lead tolower quality Spirulina products. Other cultivators in the United States havereached similar conclusions. The USDA-NOSB did not extend the use of certainfertilizers for organic Spirulina cultivation at its October 2005 meetingand the Company discontinued cultivating organic Spirulina and has convertedall Spirulina cultivation to “all natural”. The Company does not expect thisdecision to have a material effect on overall sales of our Spirulina Pacificaproducts. The Company’s all natural *SpirulinaPacifica*is certified Kosher by Organized Kashrus Laboratories ofBrooklyn, New York and is cultivated without the use of herbicides orpesticides.

In March 2003, Cyanotech and EarthriseNutritionals, Inc. of Petaluma, California submitted a joint notice to theUnited States Food and Drug Administration (“FDA”) reporting theirdetermination, through scientific procedures, that the spirulina cultivated byboth companies is GRAS (generally 

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recognized as safe) foraddition to a variety of foods. In November 2003, the FDA concluded thenotification procedure by written response that it had no questions about thecompanies’ determination that spirulina is GRAS for addition to a variety offoods.

Our *SpirulinaPacifica* is cultivated in a combination of fresh water and a meteredamount of nutrient-rich deep ocean water (containing essential trace elements),drawn from a depth of 2,000 feet below sea level. This water mixture issupplemented with the other major required nutrients such as sodium bicarbonate(baking soda) and infused with carbon dioxide.  With the exception of deep ocean water, theraw materials and nutrients required in our Spirulina production are availablefrom multiple sources; however, there can be no assurance that the pricing froma new source will be comparable to current pricing.  In the case of deep ocean water, althoughabundantly available at this location, the facility to pump and deliver thewater to the Company is owned by the State of Hawaii. The facility isconstructed of two separately located pump stations providing redundancy shouldone station fail. The State of Hawaii sets the price for deep ocean waterannually based on its cost to deliver the water.  If the pricing for a critical raw material ornutrient significantly increases, this could have a material adverse effect onour business, financial condition and results of operations. The ability of theCompany’s suppliers to meet performance and quality specifications and deliveryschedules is also important to operations.

Continuing the production process, the Spirulina cropin each pond is circulated by paddlewheels to keep an even blend of nutrientsin suspension and a uniform exposure of the algae to sunlight. Our ponds areengineered to maintain the right media depth for sunlight to permeate each cropcompletely, facilitating rapid growth. The design of our cultivation pondspromotes efficient growing conditions, allowing the *Spirulina Pacifica* algae to reproduce rapidly. Each pond canbe harvested, on average, in six days. As sunlight is a major component ofcultivation, production can be impacted from seasonality changes during thewinter months, with shortened daylight hours and potential inclement weather.

Once ready for harvest, some 70% of the Spirulinaalgae is pumped from a pond through underground pipes to our processingbuilding where the crop is separated from the culture media by stainless steelscreens. The remaining culture serves as an inoculum for the next growth cycle.Harvested Spirulina is washed with fresh water and vacuum filtered beforemoving to the drying stage. Culture media separated from Spirulina algae duringprocessing is conserved and recycled. Recycled media is refortified withnutrients before being returned to the culture ponds for another cycle ofcultivation. Our *Integrated Culture BiologyManagement*(“ICBM”) technology for microalgae cultivation has provento be a reliable and stable operating environment, allowing us to grow andharvest Spirulina without significant contamination by unwanted microorganismsand without associated loss of productivity.

*SpirulinaPacifica* powder is dried via our patented low-oxygen *Ocean-Chill Drying* process, therebypreserving high levels of antioxidant carotenoids and other nutrients sensitiveto heat and oxygen. This process also allows us to recover carbon dioxide fromour drying system gas to be reused as a raw material back in our growing ponds.The drying process takes about six seconds and results in a dark green powder. Spirulinapowder is difficult to form into tablets. Most tablet manufacturers either addhigh amounts (from 10% to 30%) of inert substances to “glue” the tablettogether or use a heat granulation process that destroys nutrients. Incontrast, our *Spirulina Pacifica*tabletscontain a maximum of 2% of such substances and are produced in cold presscompression tablet-making machines. Our *SpirulinaPacifica* flakes are produced by combining freshly harvested *Spirulina Pacifica*with food-gradelecithin and drying this blend in a proprietary system.

Each production lot of *Spirulina Pacifica* is sampled and subjected to thoroughquality control analyses including testing for moisture, carotenoids, minerals,color and taste, among others. Further, each lot of our *Spirulina Pacifica* undergoes a prescribedset of microbiological food product tests, including total aerobic bacteria,coliform bacteria and E. coli. The *SpirulinaPacifica* powder, tablets and flakes are vacuum-sealed inoxygen-barrier foil laminate bags along with a packet of oxygen absorbent. This

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packaging ensures productfreshness and extends the shelf life of bulk *SpirulinaPacifica*products. The Company’s packaged consumer products arebottled and labeled by two contractors in California. These contractors areKosher certified and subject to regular government inspections. Such packagingservices are readily available from multiple sources.

The majority of our bulk Spirulina sales are to healthfood manufacturers and formulators with their own Spirulina product lines, manyof whom identify and promote Cyanotech’s Hawaiian *Spirulina Pacifica*in their products. Such customerspurchase bulk powder or bulk tablets and package these products under theirbrand label for sale to the health and natural food markets. Many of the brandsproduced by these customers are marketed and sold domestically in directcompetition with the packaged consumer products sold through our Nutrex Hawaiisubsidiary. Nutrex Hawaii packaged consumer products are sold through anestablished health food distribution network in the domestic market and shippedthrough one of our wholesale distributors. In selected foreign markets, we haveexclusive sales distributors for both our bulk and packaged consumer products.

Our *SpirulinaPacifica* products compete with a variety of vitamins, dietarysupplements, other algal products and similar nutritional products available toconsumers. The nutritional products market is highly competitive and includesinternational, national, regional and local producers and distributors, many ofwhom have greater resources than Cyanotech and many of whom offer a greatervariety of products. Our direct competition in the Spirulina market iscurrently from Dainippon Ink and Chemical Company’s Earthrise facility inCalifornia and several farms in China. Other competitors include numeroussmaller farms in China, India, Thailand, Taiwan, Cuba, South Africa and SouthAmerica. The market for Spirulina is mature with slow growth expected in futureperiods. In this mature market, the Company has experienced increased pricecompetition due to more Spirulina suppliers as well as a larger portion ofsales coming from bulk product orders whose customers generally treat theseproducts as commodities with price being the major determining factor drivingtheir purchasing decision. As one of the largest producers of Spirulina, ourchallenge is to increase our market share among customers who seek thehigh-quality products we produce while concurrently adjusting our product mixto meet our revenue targets.

As of March 31, 2006, the backlog of orders forall Spirulina products totaled approximately $448,000 and such orders areexpected to be filled in the first quarter of fiscal 2007. Such backlogs at theend of fiscal 2005 and 2004 were $661,000 and $334,000 respectively.

***Natural Astaxanthin******Products***

The Company commenced commercial production of naturalastaxanthin in early 1997 with the introduction of *NatuRose* to the aquaculture market.  Astaxanthin is a red pigment used in theaquaculture market primarily to impart a pink to red color to the flesh ofcommercially raised fish and shrimp but also has been found to be essential fortheir proper growth and survival. Since its introduction, several feedingtrials have been performed by our customers and potential customers that provethe efficacy of *NatuRose*as analternative to the petrochemical-based synthetic astaxanthin presently used bymost aquaculture companies. The appeal of our product is that it is derivedfrom a natural source and produces results that are comparable, or in somecases superior, to synthetic astaxanthin. Sold in bulk quantities as a powder, *NatuRose*sales accounted for 13%, 16% and22% of net sales for the years ended March 31, 2006, 2005 and 2004,respectively.

In 1999, our natural astaxanthin product for the humannutrition market, *BioAstin,*wasintroduced. *BioAstin*salesaccounted for 27%, 25% and 21% of net sales for the years ended March 31,2006, 2005 and 2004, respectively. *BioAstin*isproduced in three forms: a liquid lipid extract, gelcaps and microencapsulated “beadlets”with all three forms sold in bulk quantities.  *BioAstin*gelcapsare also sold in packaged consumer form under the Nutrex Hawaii label. Agrowing body of scientific literature is suggesting that the beneficialantioxidant properties of natural astaxanthin may surpass many of theantioxidant properties of vitamin C, vitamin E, beta-carotene and othercarotenoids. Independent 

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scientific studiesindicate that in certain models, natural astaxanthin has up to 550 times theantioxidant activity of vitamin E and 10 times the antioxidant activity ofbeta-carotene.

The Company produces natural astaxanthin from *Haematococcus pluvialis* microalgae grownin fresh water supplemented with nutrients. As these algae are extremelysusceptible to contamination by unwanted algae, protozoa and amoebae, theCompany developed a proprietary system known as the *PhytoDome Closed Culture System*or *PhytoDome CCS*to overcome this problem*.*Using these large-scalephotobioreactors, we are able to grow consistently large volumes ofcontaminant-free *Haematococcus*culture. Raw materials and nutrients for our natural astaxanthin productionshare the same sourcing constraints and pricing risks as those existing in ourSpirulina production. Fresh water is critical to the production of our naturalastaxanthin and is supplied by the County of Hawaii.  While the Company has not experienced anyconstraint on fresh water availability to date, availability could be impactedby a significant population growth in the region as well as throughputconstraints on the water delivery infrastructure.  The Company has met with officials of theCounty of Hawaii to assess the fresh water situation and evaluate theprobability of future risks. The Company recycles fresh water in its productionprocess where possible and continues to explore further recycling opportunities.However, there is no guarantee that these efforts will result in significantchanges to our fresh water utilization.

For the final stage of cultivation, the *Haematococcus*algae is transferred to openponds where an environmental stress is applied causing the algae to form sporeswhich accumulate high levels of astaxanthin. Once ready for harvest, the mediacontaining these spores is transported through underground pipes to ourastaxanthin processing building where the culture media and algal spores areseparated. Fresh water recovered from this stage of processing may be recycledfor further use in cultivation. The harvested algal spores are dried to a finepowder. During processing, the spores are cracked in a proprietary system toassure high bioavailability of astaxanthin. Each production lot of astaxanthinis sampled and tested for astaxanthin concentration. Finally the bulk powder isvacuum-sealed in oxygen-barrier foil laminate bags along with a packet ofoxygen absorbent.

Unlike Spirulina, astaxanthin is produced in abatch-mode and each cultivation pond must be completely drained and thoroughlycleaned between cycles. While the entire astaxanthin production cycle takes atotal of four weeks, each stage of the four-step process is staggered andcontinuously feeds the next stage of cultivation. As a result, we are currentlyable to produce a new crop of astaxanthin from each of our 500,000 literculture ponds approximately once per week.  Pond cultivation can be negatively impactedseasonally with shortened daylight hours and potential inclement weather inwinter months.

Natural astaxanthin for human consumption is processedfurther utilizing a high-pressure extraction process. The resulting product isa lipid extract insoluble in water used for the production of gelcaps. Thisproduct can also be micro-encapsulated into “beadlets” which our customers usein other formulations. All natural astaxanthin products destined for humanconsumption undergo a prescribed set of microbiological food product tests toensure safety and quality. The Company uses third party contractors for theextraction services, the production of gelcaps and the production of beadlets. Althoughthese services are available only from a limited number of sources, we have theability to use other parties if any of the current contractors becomeunavailable; however, there is no assurance that the pricing from a newcontractor will be comparable to current negotiated pricing. In addition, a newcontractor would have to pass the Company’s qualification process ensuringquality standards can be met or exceeded. If the pricing, for any of theseservices, significantly increases, this could have a material adverse effect onour business, financial condition and results of operations.

*NatuRose*is sold through a network of agents and distributorsprimarily to feed manufacturers and farmers in the aquaculture industry. Japanis one of our primary markets for the application of *NatuRose*in aquaculture and was a major factor in ourdecision to establish CJYK as a channel of distribution. In addition, *NatuRose*is sold to poultry feedformulators as a natural pigment for the yolk of chicken eggs and 

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also to formulators offeeds for commercial breeding of high-value tropical fish. As our product is anatural astaxanthin, many of these formulators identify *NatuRose* by name as a component of theirfeed.

The animal nutrition astaxanthin market is currentlydominated by Royal DSM of the Netherlands (“Royal DSM”). Royal DSM purchased F.Hoffmann-LaRoche’s division of vitamins and fine chemicals, including theirsynthetic astaxanthin operation, in 2003. *NatuRose*competes with the synthetic astaxanthin products derived frompetrochemicals as well as other natural astaxanthin products derived from othernatural sources such as *Phaffia*yeastand Paracoccus bacteria. Although synthetic astaxanthin has widespread use as apigmentation source in commercial aquaculture, independent scientific analysisand feeding trials have shown that the molecular structure of the astaxanthin derivedfrom the *Haematococcus* microalgamore closely resembles the astaxanthin obtained naturally by fish in the wild. Withthe continued growth in the world aquaculture industry and the growingpropensity towards “natural” alternatives, we believe *NatuRose*can compete against otherproducts on the basis of its natural state, performance and price.

While the positive effects of astaxanthin inaquaculture have been recognized for years, the potential benefits ofastaxanthin to human health are still emerging. As natural astaxanthin is oneof the most potent and bioactive biological antioxidants found in nature, thenumber of potential roles of natural astaxanthin for human health is growing. Muchresearch has been published in recent years on the beneficial roles ofantioxidants in our health, in the aging process and on specific healthconditions.  The full efficacy of *BioAstin*as a human nutraceuticalsupplement requires further significant clinical study. The Company, to containcosts, did not spend significant amounts on clinical trials over the past twofiscal years. Independent antioxidant research and prior clinical trials showpromising human applications. The Company holds three United States patentsrelating to the usage of *BioAstin*inthe treatment of Carpal Tunnel Syndrome, the treatment of canker/cold sores andfor its use as a topical and oral sunscreen.

*BioAstin*is sold in liquid lipid form as a raw ingredient todietary supplement manufacturers, health food formulators and cosmeticmanufacturers and *BioAstin*gelcapsand beadlets are sold in bulk quantities to distributors. *BioAstin*gelcaps are also sold as apackaged consumer product through Nutrex Hawaii directly to natural productdistributors, retailers and consumers. *BioAstin*competes directly with similar products marketed by othermanufacturers including Fuji Chemical of Japan, Algatechnologies of Israel, andValensa (formally U.S. Nutraceuticals), and Mera Pharmaceuticals in the UnitedStates. In the general category of nutritional supplements, *BioAstin*also competes with a variety ofvitamins, dietary supplements and other antioxidant products available toconsumers. The nutritional products market is highly competitive and includesinternational, national, regional and local producers and distributors, many ofwhom have greater resources than Cyanotech and many of whom offer a greatervariety of products.

As of March 31, 2006,the backlog of orders for all Natural Astaxanthin products totaledapproximately $257,000 and such orders are expected to be filled in the firstquarter of fiscal 2007. Such backlogs at the end of fiscal 2005 and 2004 were$74,000 and $389,000, respectively.

***Phycobiliprotein******Products***

The Company also producesphycobiliproteins for sale to the medical and biotechnology research industries.Phycobiliproteins are highly fluorescent pigments derived from microalgae. Theirspectral properties make them useful as tags or markers in many kinds ofbiological assays, such as flow cytometry, fluorescence immunoassays andfluorescence microscopy. We do not anticipate that phycobiliproteins willrepresent a significant component of total sales in future periods.

**Major Customers**

Approximately $1,285,000or 12% of net sales for the year ended March 31, 2006 were to SpirulinaInternational B. V., a Spirulina marketing and distribution company based inthe Netherlands.  Sales to 

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thiscustomer amounted to $1,130,000 or 10% of net sales for the fiscal year 2005and $1,560,000 or 13% of net sales for the fiscal year 2004.  We believe that sales to this customer willcontinue to represent a significant portion of total net sales in futureperiods and any significant reduction in demand from this customer could have amaterial adverse effect on our business, financial condition and results of operations.

**Research andDevelopment**

Cyanotech’s expertise is in the development ofefficient, stable and cost-effective production systems for microalgal products.Our researchers investigate each specific microalga identified in thescientific literature for potentially marketable products and then strive todevelop the technology to grow such microalgae on a commercial scale. Successfulmicroalgal product development is highly uncertain and is dependent on numerousfactors, many beyond the Company’s control. Products that appear promising inearly phases of development may be found to be ineffective, may be uneconomicalbecause of manufacturing costs or other factors, may be precluded fromcommercialization due to the proprietary rights of other companies, or may failto receive necessary regulatory approvals.

The Company had researchand development expenditures of $192,000, $257,000 and $149,000 in fiscal years2006, 2005 and fiscal 2004, respectively. The Company reduced investment inscientific clinical trials during the first two quarters of fiscal 2006 as partof our effort to contain costs, but plans to increase investment in such trialsin future periods.  Fiscal 2006 expensesincluded those for the initiation of clinical trials aimed at increasing productionyields and improving the quality and stability of such products. The Companycontinues to explore customer sponsored research and development as a potentialopportunity in the future. Amounts spent on customer-sponsored research werenot material in each of the three years ended March 31, 2006.

**Patents, Trademarksand Licenses**

Cyanotech has receivedfive United States patents:  two onaspects of our production methods and three relating to usage of our *BioAstin*products.  The Company views its proprietary rights asimportant, but believes that a loss of such rights is not likely to have amaterial adverse effect on the Company’s present business as a whole. TheCompany’s operations are not dependent upon any single trademark, although sometrademarks are identified with a number of the Company’s products and are ofimportance in the sale and marketing of such products.

**Regulations andEnvironmental Matters**

In 2002, the Company was issued under the EndangeredSpecies Act (“ESA”) an Incidental Take Permit (“ITP”) by the United StatesDepartment of Interior Fish and Wildlife Service (“FWS”).  The ESA defines “incidental take” as “incidentalto, and not the purpose of, the carrying out of an otherwise lawful activity.”  This permit authorizes incidental take of theendangered Hawaiian stilt (*Himantopusmexicanus knudseni)* that is anticipated to occur as a result ofongoing operations and maintenance at the Company’s Kona facility.  As a mandatory component for the issuance ofsuch permit, the Company submitted and maintains a Habitat Conservation Plan (“HCP”)to ensure that the effects of the permitted action on listed species areadequately minimized and mitigated.

The HCP called for the creation of a nesting andbreeding ground for the Hawaiian stilt to offset any take activity.  The Company has complied with theserequirements since 2002.  The breedingprogram was so successful that the increase in the Hawaiian stilt population inthe area became a potential hazard for the adjacent State airport facility.  The Company disassembled the stilt habitat andis mitigating “take” by using standard non-lethal hazing devices to discouragenesting and breeding.

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A requirement of the ITPis to provide insurance coverage for funding the project for the term of theITP.  The Company’s insurance broker wasunable to locate an underwriter who would provide such a bond. As permitted bylaw, the FWS waived this requirement recognizing that this HCP did not involvea significant capital expenditure. However, under Hawaii state law, no waiverprovision is available.  In lieu ofinsurance, the Company provided a refundable deposit of approximately $89,000to the State of Hawaii. In May 2006, this deposit was refunded to theCompany.  The ITP, which expired on March 17,2005, was renewed by the Company for an additional year. In October, 2005 theCompany submitted a new ten-year HCP to the FWS and the State of HawaiiDivision of Forestry and Wildlife (DOFAW). Because of high work loads at thesegovernment agencies, we have not received a new ITP but continue to operateunder the conditions of the old ITP and HCP with concurrence from FWS and DOFAW.We expect a new ITP to be issued during fiscal 2007.

**Employees**

As of March 31, 2006,the Company employed 62 people on a full-time basis.  Of the total, 44 are involved in harvestingand production, 2 in research and development, and the remainder in sales,administration and support. Management believes that its relations withemployees are good. We currently are experiencing some difficulty in attractingentry-level operations personnel due to increased wage competition for workersstemming from the growth in the State’s construction industry. None of ouremployees are subject to collective bargaining agreements.

**InternetInformation**

Our Internet address iswww.cyanotech.com. There we make available, free of charge, copies of Cyanotechdocuments, news releases and financial statements issued in the last 12 months.Included there are updated copies of the Company’s Code of Conduct and Ethics,the Nominating and Corporate Governance Committee Charter, and the Charter andPowers of the Audit Committee. The information found on our Web site, unlessotherwise indicated, is not part of this or any other report we file with orfurnish to the Securities and Exchange Commission. *Spirulina Pacifica*and *BioAstin*are sold directly online through the Company’s website, www.nutrex-hawaii.com,as well as through resellers in over 40 countries worldwide. Technicalinformation for the Company’s phycobiliproteins products is available atwww.phycobiliprotein.com. Corporate data, product information and charters ofour Board committees are also available at www.cyanotech.com.

**Item 1A. RiskFactors**

You should carefullyconsider the risks described below which we believe are significant but not theonly ones we face. Any of the following risks could have a material adverseeffect on our business, financial condition and operating results. You shouldalso refer to the other information contained in this report, including ourfinancial statements and the related notes.

**A Significant or Prolonged Economic Downturn CouldHave a Material Adverse Effect on Our Results of Operations**

Our results of operationsare affected by the business activity of our customers who in turn are affectedby the level of economic activity in the industries and markets that they serve.A decline in the level of business activity of our clients could have amaterial adverse effect on our revenues and profit margin.

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**Our Quarterly Operating Results May Vary FromQuarter to Quarter, Which May Result in Increased Volatility of OurShare Price**

We haveexperienced, and may in the future continue to experience, fluctuations in ourquarterly operating results. These fluctuations could reduce the market priceof our Common Stock. Factors that may cause our quarterly operating results tovary include, but are not limited to:

·       thebusiness decisions of our customers regarding orders for our products;

·       increasedenergy costs;

·       increasedraw material costs;

·       productiondifficulties;

·       weather-relatedcultivation difficulties;

·       contaminationof our cultivation and production facilities;

·       theeffect of weather on customer demand patterns;

·       theintroduction of new products by us or our competitors;

·       changesin our pricing policies or those of our competitors;

·       seasonaltrends in our customers’ buying patterns

·       changesin government regulation, both domestic and foreign;

·       fluctuationin foreign currency exchange rates;

·       globaleconomic and political conditions and related risks, including acts ofterrorism; and

·       otherfactors beyond our control.

A significant portion of our expense levels arerelatively fixed and the timing of increases in expense levels is based inlarge part on our forecasts of future sales. If net sales are belowexpectations in any given period, the adverse impact on results of operationsmay be magnified by our inability to adjust expenses quickly enough tocompensate for the sales shortfall.

**Market Price forOur Common Stock Has Been Unpredictable; Potential Delisting.**

On December 1, 2005 the Company received noticefrom Nasdaq that the bid price of the Company’s stock closed below the minimum$1.00 per share requirement for the last 30 consecutive business days asrequired by NASDAQ Marketplace Rule 4310(c)(4). However, the Company wasprovided 180 calendar days, or until May 30, 2006, to regain compliance byvirtue of the bid price closing at $1.00 per share or more for a minimum of 10days. Compliance was not demonstrated by May 30, 2006, but the Nasdaqstaff determined and communicated to the Company in a letter dated May 31,2006 that the Company:

“... met all initial inclusion criteria for The NasdaqCapital Market set forth in Marketplace Rule 4310(c) (except for thebid price). As a result, the Company has been provided an additional 180calendar day compliance period or until November 27, 2006 to regaincompliance with respect to the bid price deficiency. Marketplacerule 4310(c)(8)(E) states that: Nasdaq may, in its discretion,require an issuer to maintain a bid price of at least $1.00 per share for aperiod in excess of ten consecutive business days, but generally no more than20 consecutive business days, before determining that the issuer hasdemonstrated an ability to maintain long-term compliance. In determiningwhether to monitor bid price beyond ten business days, Nasdaq will consider thefollowing four factors: (i) margin of compliance (the amount by which theprice is above the $1.00 minimum standard); (ii) trading volume (a lack oftrading volume may indicate a lack of bona fide market interest in the securityat the 

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posted bid price); (iii) the market maker montage(the number of market makers quoting at or above $1.00 and the size of theirquotes); and, (iv) the trend of the stock price (is it up or down).”

**Our Global Operations Expose Us to Complex Management,Foreign Currency, Legal, Tax and Economic Risks, Which WeMay Not Be Able to Address Adequately**

We conduct businessin a number of countries around the world. For the year ended March 31,2006, approximately 52% of our net sales were from sales to foreign customers.As a result, we are subject to a number of risks which include, but are notlimited to:

·       theburden of complying with a wide variety of national and local laws;

·       potentiallylonger payment cycles for foreign sales;

·       multipleand possibly overlapping and conflicting tax laws;

·       coordinatinggeographically separated locations;

·       restrictions(government and otherwise) on the movement of cash;

·       theabsence in some jurisdictions of effective laws protecting our intellectualproperty rights;

·       changesin government regulations, both domestic and foreign;

·       globaleconomic and political conditions and related risks, including acts ofterrorism; and

·       fluctuations in foreigncurrency exchange rates.

**Competition in OurIndustry is Intense**

The nutritional productsmarket is highly competitive. In includes international, national, regional andlocal producers and distributors, many of whom have greater resources thanCyanotech and many of whom offer a greater variety of products. Increasedcompetition in our industry could result in price reductions, reduced grossprofit margin or loss of market share, any of which could have a materialeffect on our business, results of operations and financial condition.

**Our Revenues Could Be Adversely Affected By the Lossof a Significant Customer or the Failure to Collect a Large AccountsReceivable**

We have in the past derived, and may continue in thefuture to derive, a significant portion of our revenues from a relativelylimited number of major customers. From quarter to quarter, revenues from oneor more individual customers may exceed 10% of our revenues for the quarter.During the year ended March 31, 2006, sales to one customer, a Europeandistributor of natural products, were approximately 12% of net sales. If salesto this customer or other such major customer decrease significantly, this maymaterially affect our results of operations. In addition, if we fail to collectlarge accounts receivable from such major customers, we could be subject tosignificant financial exposure.

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**If We Are Unable to Protect Our Intellectual PropertyRights or if We Infringe Upon the Intellectual Property Rights of OthersOur Business May Be Harmed**

Cyanotech has receivedfive United States patents:  two onaspects of our production methods and three for use of our BioAstinâproducts. Although we regard our proprietary technology, trade secrets,trademarks and similar intellectual property as important, we rely on acombination of trade secret, contract, patent, copyright and trademark law toestablish and protect our rights in our products and technology. There can beno assurance that we will be able to protect our technology adequately or thatcompetitors will not be able to develop similar technology independently. Inaddition, the laws of certain foreign countries may not protect the Company’sintellectual property rights to the same extent as the laws of the UnitedStates. Litigation in the United States or abroad may be necessary to enforceour patent or other intellectual property rights, to protect our trade secrets,to determine the validity and scope of the proprietary rights of others or todefend against claims of infringement. Such litigation, even if successful,could result in substantial costs and diversion of resources and could have a materialadverse effect on our business, results of operations and financial condition. Additionally,if any such claims are asserted against us, we may seek to obtain a licenseunder the third party’s intellectual property rights. There can be no assurance,however, that a license would be available on terms acceptable or favorable tous, if at all.

**We May Need toRaise Additional Capital in the Future Which May Not Be Available**

At March 31, 2006,the Company’s working capital was $5,525,000. Cash equivalents and short-terminvestments at March 31, 2006 totaled $2,535,000. Our cash requirementswill depend on numerous factors, including: demand for products; normalrequirements to maintain and upgrade facilities and equipment; whetheropportunities emerge in either new markets or in research and developmentactivities; or, in the event we need to expand or contract our production ordistribution infrastructure. We believe our current cash, cash equivalents andshort-term investments, and cash provided from operations will be sufficient tomeet our capital requirements for at least the next 12 months. If we need toraise additional funds, we may not be able to secure funding on acceptableterms, or not at all. If we raise additional funds through the issuance ofequity or convertible debt securities, the percentage ownership of our thencurrent stockholders may be reduced. If we raise additional funds through theissuance of convertible debt securities, or through additional debt or similarinstruments, such securities, debt, or similar instruments could have rightssenior to those of our common stockholders and such instruments could containprovisions restricting our operations. If adequate funds are not available tosatisfy either short-term or long-term capital requirements, we may be requiredto limit operations with adverse results.

**Our InsuranceLiability Coverage is Limited**

In the ordinary course ofbusiness, the Company purchases insurance coverages (e.g., property andliability coverages) to protect itself against loss of or damage to itsproperties and claims made by third parties and employees for property damageor personal injuries. However, the protection provided by such insurance islimited in significant respects and, in some instances, the Company has nocoverage and certain of the Company’s insurance has substantial “deductibles”or has limits on the maximum amounts that may be recovered. For example, if ahurricane or other uninsured catastrophic natural disaster should occur, theCompany may not be able to recover all facility restoration costs and revenueslost from business interruption. In addition, the Company maintains productliability insurance in limited amounts for all of its products involving humanconsumption; however, broader product liability coverage is prohibitivelyexpensive. Insurers have also introduced new exclusions or limitations ofcoverage for claims related to certain perils including, but not limited to,mold and terrorism. If a series of losses occurred, such as from a series oflawsuits in the ordinary course of business each of which were subject to thedeductible amount, or if the maximum limit of the available insurance weresubstantially exceeded, the Company could incur 

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lossesin amounts that would have a material adverse effect on its result ofoperations and financial condition.

**Our Ability to Develop and Market New Products orModify Existing Products and Production Methods May beAdversely Affected If we Lose the Services of or Cannot Replace CertainEmployees Knowledgeable in Advanced Scientific and Other Fields**

The Company’s products arederived from and depend on proprietary and non-proprietary processes andmethods founded on advanced scientific knowledge, skills, and expertise. If theservices of employees knowledgeable in these fields are lost and cannot bereplaced in a reasonable time frame at reasonable costs, the Company’s abilityto develop and market new products or modify existing products and productionmethods would be adversely impacted. At the same time, regulatory compliancesurrounding the Company’s products and financial matters generally requiresminimum levels of knowledge and expertise related to production, qualityassurance, and financial control. If the Company loses the services or cannotreasonably replace employees who have the necessary knowledge and expertise theCompany’s ability to remain in regulatory compliance could be adverselyaffected.

**Item 2. Properties**

The Company’s principal facility and corporateheadquarters is located at the Natural Energy Laboratory of Hawaii Authority (“NELHA”)at Keahole Point in Kailua-Kona, Hawaii. It encompasses approximately 90 fullydeveloped acres containing microalgal cultivation ponds, processing facilities,research and quality control laboratories, and sales and administrative offices.The property is leased from the State of Hawaii under a 30-yearcommercial lease expiring in 2025. We believe that there is sufficientavailable land at NELHA to meet anticipated needs if a revised NELHA lease canbe negotiated with acceptable terms. Under the terms of the existing NELHAlease, the Company could be required to remove improvements at the end of thelease term. Based upon analysis pursuant to Statement of Financial AccountingStandards No. 143 and FASB Interpretation No. 47, we do not believethe projected cost for such removal to be material to the consolidatedfinancial statements, or likely, given historical experience. However,conditions could change in the future. It is not possible to predict suchchanges or estimate any impact thereof.

The Company also rentswarehouse space near NELHA and also in San Dimas, California and office spacein Tokyo, Japan.

**Item 3. LegalProceedings**

From time to time theCompany may become party to lawsuits and claims that arise in the ordinarycourse of business relating to employment, intellectual property, and othermatters. There were no significant legal matters outstanding at March 31,2006.

**Item 4. Submissionof Matters to a Vote of Security Holders**

No matters were submittedto a vote of stockholders during the fourth quarter of fiscal 2006.

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**PART II**

**Item 5. Market forRegistrant’s Common Equity and Related Stockholder Matters**

The Company’s common stockis traded on the NASDAQ SmallCap Market under the symbol “CYAN”. The closingprice of our common stock on such market at June 19, 2006 was $0.68. As ofJune 19, 2006, there were 20,928,265 registered holders of record of ourcommon stock. The high and low selling prices as reported by the NASDAQ StockMarket were as follows:

| **Quarter Ended:**        | ** ** | ** ** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** | **March 31** | ** ** |
|--------------------------------|------------|------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|-------------------|------------|
| Fiscal 2006                    |       |       |       |             |       |                  |       |                 |       |              |       |   |   |   |   |   |   |
| Common stock  price per share: |       |       |       |             |       |                  |       |                 |       |              |       |   |   |   |   |   |   |
| High                           |       |       | $          | 1.24             |       |                  |       | $                    | 1.21       |              |       |   | $ | 1.06 |   |   |   | $ | 0.88 |   |   |
| Low                            |       |       | $          | 0.80             |       |                  |       | $                    | 0.73       |              |       |   | $ | 0.51 |   |   |   | $ | 0.55 |   |   |
| Fiscal 2005                    |       |       |       |             |       |                  |       |                 |       |              |       |   |   |   |   |   |   |
| Common stock  price per share: |       |       |       |             |       |                  |       |                 |       |              |       |   |   |   |   |   |   |
| High                           |       |       | $          | 1.65             |       |                  |       | $                    | 1.85       |              |       |   | $ | 1.70 |   |   |   | $ | 1.53 |   |   |
| Low                            |       |       | $          | 1.10             |       |                  |       | $                    | 1.00       |              |       |   | $ | 1.10 |   |   |   | $ | 1.20 |   |   |

 

On December 1, 2005 the Company received noticefrom Nasdaq that the bid price of the Company’s stock closed below the minimum$1.00 per share requirement for the last 30 consecutive business days asrequired by NASDAQ Marketplace Rule 4310(c)(4). However, the Company wasprovided 180 calendar days, or until May 30, 2006, to regain compliance byvirtue of the bid price closing at $1.00 per share or more for a minimum of 10days. Compliance was not demonstrated by May 30, 2006, but the Nasdaqstaff determined and communicated to the Company in a letter dated May 31,2006 that the Company:

“... met all initial inclusion criteria for The NasdaqCapital Market set forth in Marketplace Rule 4310(c) (except for thebid price). As a result, the Company has been provided an additional 180calendar day compliance period or until November 27, 2006 to regaincompliance with respect to the bid price deficiency. Marketplace rule 4310(c)(8)(E) statesthat: Nasdaq may, in its discretion, require an issuer to maintain a bid priceof at least $1.00 per share for a period in excess of ten consecutive businessdays, but generally no more than 20 consecutive business days, beforedetermining that the issuer has demonstrated an ability to maintain long-termcompliance. In determining whether to monitor bid price beyond ten businessdays, Nasdaq will consider the following four factors: (i) margin ofcompliance (the amount by which the price is above the $1.00 minimum standard);(ii) trading volume (a lack of trading volume may indicate a lack of bonafide market interest in the security at the posted bid price); (iii) themarket maker montage (the number of market makers quoting at or above $1.00 andthe size of their quotes); and, (iv) the trend of the stock price (is itup or down).”

The Company is prohibitedfrom declaring any common stock dividends without the prior written consent ofa lender per the conditions of an existing term loan agreement with such lender.The Company has never declared or paid cash dividends on its common stock. Wecurrently intend to retain all of our earnings for use in the business and donot anticipate paying any cash dividends on common stock in the foreseeablefuture.

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**Item6. Selected Financial Data**

| ** **                                       | ** ** | **Years ended March 31,**                           | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                       | ** ** | **(In thousands, except per share data)** | ** ** |
| **Results of Operations**                        | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                        | ** ** | $                                                                  | 11,131     |   | $ | 11,445 | ** ** | $ | 11,582 | ** ** | $ | 8,951 |   | $ | 8,235 |   |
| Gross profit                                     | ** ** | 3,299                                                              |       | 3,818 | ** ** | 3,940 | ** ** | 2,895 |   | 1,562 |   |
| Income (loss)  from operations                   | ** ** | (107                                                               | )          | 562 | ** ** | 729 | ** ** | (1,210 | ) | (2,185 | ) |
| Net income (loss)                                | ** ** | (268                                                               | )          | 486 | ** ** | 399 | ** ** | (1,775 | ) | (2,589 | ) |
| Net income (loss)  per common share—diluted | ** ** | (0.01                                                              | )          | 0.02 | ** ** | 0.02 | ** ** | (0.10 | ) | (0.15 | ) |
| **Selected Balance Sheet Data**                  | ** ** |                                                               |       |   | ** ** |   | ** ** |   |   |   |   |
| Cash and  investment securities                  | ** ** | 2,535                                                              |       | 3,005 | ** ** | 2,531 | ** ** | 579 |   | 1,051 |   |
| Working capital                                  | ** ** | 5,525                                                              |       | 5,102 | ** ** | 4,083 | ** ** | 2,352 |   | 1,008 |   |
| Total assets                                     | ** ** | 17,473                                                             |       | 18,542 | ** ** | 18,357 | ** ** | 17,482 |   | 18,400 |   |
| Long-term debt,  excluding current maturities    | ** ** | 1,387                                                              |       | 1,743 | ** ** | 2,093 | ** ** | 3,694 |   | 2,765 |   |
| Stockholders’ equity                        | ** ** | 14,817                                                             |       | 15,080 | ** ** | 14,440 | ** ** | 12,273 |   | 13,191 |   |
|                                                  |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

*The following discussion should be read in conjunctionwith the Company’s consolidated financial statements and accompanying notesincluded in Part II. Item 8. Financial Statements and Supplementary Data. Fora more comprehensive description of the Company’s products and markets for suchproducts, see Part I. Item 1. Business.*

**Overview**

Cyanotech Corporation’s core competency is cultivatingand processing microalgae into high-value, high-quality natural products forthe human and animal nutrition markets. Our products are sold in bulkquantities to manufacturers, formulators and distributors in the health foods,nutritional supplements and animal nutrition markets and as packaged consumerproducts to distributors, retailers, and direct consumer sales. The Companymanufactures its products in Hawaii but markets them worldwide, generating 52%,49% and 58% of its revenues outside of the United States for each of the yearsended March 31, 2006, 2005 and 2004, respectively. Competing in a globalmarketplace, the Company is influenced by the general economic conditions ofthe countries in which its customers operate, including adherence to itscustomers’ local governmental regulations and requirements. The Companycurrently has no material foreign exchange exposure.

The Company reported a net loss of $268,000, or($0.01) per diluted share for fiscal 2006 compared to net income of $486,000,or $0.02 per diluted share for fiscal 2005. Cash, cash equivalents andshort-term investment balances at March 31, 2006 were $2,535,000, down$470,000 from a year ago. Working capital improved 8% to $5,525,000 at March 31,2006 from working capital of $5,102,000 a year ago, primarily due to increasedinventory balances and decreased accounts payable balances.

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The following tabledetails selected financial data highlighting three key areas (dollars inthousands):

| ** **                                   | ** ** | **Year Ended March 31,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales:                                   |       |                                    |       |   |   |   |   |
| Spirulina products                           |       | $                                       | 6,517      |   | $ | 6,626 |   | $ | 6,511 |   |
| Natural astaxanthin products                 |       | 4,370                                   |       | 4,672 |   | 4,933 |   |
| Other products                               |       | 244                                     |       | 147 |   | 138 |   |
|                                         |       | $                                       | 11,131     |   | $ | 11,445 |   | $ | 11,582 |   |
| Gross profit as a percentage of sales        |       | 30                                      | %          | 33 | % | 34 | % |
| Operating expenses as a  percentage of sales |       | 31                                      | %          | 28 | % | 28 | % |

 

Net sales for fiscal 2006 were $11,131,000, or 3%lower than the $11,445,000 reported for the prior fiscal year. During fiscal2006, the Company continued to experience a reduction of NatuRose sales to theworldwide aquaculture market due to reduced Sea Bream sales, growers using lessnatural astaxanthin in their feed, and heightened competition in other markets.We now feel that this condition is likely to persist. The Company has takenaction to diversify its market for NatuRose in selected markets in Europe andnew aquaculture markets in Japan. While we expect to experience the results ofthese efforts in the next fiscal year, there can be no guarantee that ourefforts will expand the market for NatuRose. The Company’s emphasis is on firstgrowing the market for its BioAstin products followed by market growth forNatuRose. The Company will continue to contain discretionary operating spendingbut may invest in focused expenditures particularly in advertising and clinicaltrials in the human nutrition and cosmetics markets. Externally, the Company isalso working with industry-leading manufacturers in these markets to integrate *BioAstin*into their products. The Companyintends to emphasize market acceptance of its natural astaxanthin products asincreased competition from other producers of natural and synthetic astaxanthinmay result in the decline of margins generated by its natural astaxanthinproducts.  Management cannot predictwhether the outcomes of any of these strategies will be successful.

As depicted in the preceding table, the Company’sgross profit margin as a percentage of net sales decreased to 30% for thefiscal year ended March 31, 2006, down from 33% for fiscal 2005 and 34%for fiscal 2004. The decrease in gross margin between fiscal 2006 and 2005 wasin part the result of production variances associated with decreasedastaxanthin production in response to lower orders for NatuRose. In addition,the company experienced increased chemical (primarily nutrient) and electricalcosts, with the latter also serving to increase the cost of water. The increasein chemical (primarily nutrient) costs is due to several factors includingincreased consumption due to weather and production variables as well asincreased raw material prices. The decrease in gross profit margin percentagebetween fiscal 2005 and 2004 was primarily due to a change in sales mixstemming from reduced NatuRose Natural Astaxanthin sales. As noted in thepreceding paragraph, the Company will continue to contain discretionaryspending, and will take advantage of opportunities to minimize the use of rawmaterials, including chemicals and utilities.

Management expects the Company’s gross profit marginpercentages to remain essentially consistent with the results reported forfiscal 2006; however there are many factors which could materially diminishgross profit. These include, but are not limited to, sales volume and mix,increases in the cost of raw materials and raw material freight costs,production volumes above and below normal capacity in response to customaryproduction variables (such as weather) and significant changes in demand forthe Company’s products. This includes the allocation of production resources,principally the factors impacting Astaxanthin and Spirulina biomass productionlevels and production rates based on the variables just mentioned.

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To offset increased coststhe Company continues to strive to increase production efficiencies in volumeyield, potency, and quality consistent with the Company’s commitment to producehigh-value, high-quality products. However, these efforts cannot be guaranteedto achieve the desired results.

**Results ofOperations**

***Revenues***   Netsales for fiscal 2006 was $11,131,000, a 3% decrease from net sales of$11,445,000 in fiscal 2005 and a decrease of 4% from net sales of $11,582,000reported in fiscal 2004. The following is a discussion of revenues by majorproduct category.

***Spirulina******  ***The Company has beenproducing *Spirulina Pacifica*, astrain of Spirulina microalga, since 1985. Revenues generated from the Company’sSpirulina products are a significant portion of total revenues, amounting to$6,517,000, $6,626,000 and $6,511,000 for the years ended March 31, 2006,2005 and 2004 respectively. Although the Company believes that Spirulina is amature product in a highly competitive market, the dollar amount of revenues hasremained relatively consistent over the three year period. As a percentage oftotal revenues, spirulina product sales represented 59% in 2006, 58% in 2005and 56% in 2004 reflecting product mix changes. Approximately $1,285,000 or 12%of net sales for the year ended March 31, 2006 were to SpirulinaInternational B. V., a Spirulina marketing and distribution company based inthe Netherlands.  Sales to this customeramounted to $1,130,000 or 10% of net sales for the fiscal year 2005 and$1,560,000 or 13% of net sales for the fiscal year 2004.  We believe that sales to this customer willcontinue to represent a significant portion of total net sales in futureperiods and any significant reduction in demand from this customer could have amaterial adverse effect on our business, financial condition and results ofoperations. 

The Company has experienced increased competition forits Spirulina products resulting from an increasing number of suppliers ofSpirulina as well as from a larger portion of our sales coming from bulkproduct orders whose customers generally treat these products as commoditieswith price being the major determining factor driving their purchasing decision.We expect this competitive pricing pressure to continue in future periods andin response have focused on improving the quality of our Spirulina products insupport of customers who demand higher quality raw materials for theirformulations. However, fiscal 2006 Spirulina sales saw average unit pricesdecrease approximately 3% as compared to the prior year, with a slight increasein the number of units sold during the 2006 fiscal year. At March 31, 2006our backlog of Spirulina orders decreased from the previous year by $213,000,due primarily to the timing of orders from our customers. In fiscal 2005, wehad experienced an increase in average unit price of approximately 5% ascompared to the prior year with a slight increase in the number of units sold.

***Natural Astaxanthin***   Infiscal 2006, the Company’s sales of its natural astaxanthin products were$4,370,000 a decrease of 6% from $4,672,000 in fiscal 2005, and a decrease of11% from $4,933,000 in fiscal 2004. The decrease in natural astaxanthin saleswere primarily due to decreased market demand for NatuRose in the Japanaquaculture market during fiscal 2006, which was partially offset by increasedunit sales of higher-priced BioAstin into the human nutritional market. At March 31,2006 our backlog of orders for all natural astaxanthin products was $257,000,an increase of $183,000 from that of a year ago. The Company believes that thefindings of clinical trials undertaken in prior years and in this fiscal yearby the Company, its customers and other unaffiliated parties, takenindividually and on a cumulative basis, is generating  growing consumer awareness of the beneficialantioxidant and anti-inflammatory properties of astaxanthin. Validation ofnatural astaxanthin benefits identified in such scientific studies has helpedto spur demand for our natural astaxanthin products in the human nutritionmarket and could provide the basis for proprietary intellectual property. TheCompany completed and issued reports on two positive scientific clinical trialson natural astaxanthin during fiscal 2006. One study demonstrated that naturalastaxanthin could lower levels of C-Reactive Protein, an indicator of systemicinflammation and the second study showed that grip strength could be increasedin those suffering from tennis elbow by consumption of 

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natural astaxanthin.  The Company plans to continue expenditures ontargeted scientific trials in the future in accordance with its strategy toincrease sales of natural astaxanthin products.

***Cost of Sales******  ***Our cost ofsales, as a percentage of net sales, was at 70%, 67% and 66% for fiscal years2006, 2005, and 2004, respectively. Cost of sales includes the cost ofnutrients and materials, direct labor and manufacturing overhead costs, anddepreciation and amortization of production equipment, buildings and leaseholdimprovements specific to the production process.

The cost of sales percentage increased between fiscal2006 and 2005 in part due to the result of production variances associated withdecreased astaxanthin production in response to lower orders for NatuRose. Inaddition, the company experienced increased chemical (primarily nutrient) andelectrical costs, with the latter also serving to increase the cost of water.The increase in chemical (primarily nutrient) costs is due to several factorsincluding increased usage due to weather and production variables as well asincreased raw material prices.

For fiscal 2007, with the rising cost of fuel oil, theCompany could incur higher electrical utility costs dependent upon theregulated public utility’s ability to obtain approval for rate increases. Ifelectrical utility costs were to double from fiscal 2006 costs, the Companyestimates that the cost to manufacture its products could increase by as muchas 15% above prior year costs.

Fresh water is critical for our natural astaxanthinproduction and while the Company has not experienced any constraint on freshwater availability, future availability could be negatively impacted bysignificant growth in the local population as well as by throughput constraintson the water delivery infrastructure owned by the County of Hawaii. Given thecriticality of fresh water to our operations and the community, the Companyrecycles fresh water where possible and has developed additional waterrecycling systems during fiscal 2006 in its efforts to utilize fresh water efficiently.

For the production of *BioAstin,*the Company’s natural astaxanthin product for the human nutritionmarket, two third party contractors are utilized for the processes ofextraction, and a sole third party contractor is utilized for each of theencapsulation (for gelcaps) and micro-encapsulation (for beadlets), Althoughthese services are available only from a limited number of sources, we have theability to use other parties if any of the current contractors becomeunavailable. If pricing for any of these services significantly increases,there could be a material adverse effect on our business, financial conditionand results of operations. There have not been any significant changes in thecost of extraction or encapsulation services and none are now anticipated.

To offset increased costs, the Company seeks ways toincrease production efficiencies in volume yield, potency, and qualityconsistent with the Company’s commitment to produce high-value, high-qualityproducts. However, these efforts cannot be guaranteed to achieve the desiredresults.

The Company will adopt SFAS No. 151 effective April 1,2006. The provisions of SFAS No. 151 “Inventory Costs—an amendment ofAccounting Research Bulletin No. 43, Chapter 4” require that abnormalamounts of freight, handling costs and wasted material (spoilage) be recognizedas current-period charges and fixed production overhead costs be allocated toinventory based on the normal capacity of production facilities. Normal capacityis defined as “the production expected to be achieved over a number of periodsor seasons under normal circumstances, taking into account the loss of capacityresulting from planned maintenance.” Companies will no longer be permitted to capitalize inventory costs onthe balance sheet when the production defect rate varies significantly from theexpected defect rate. SFAS No. 151 is effective for inventory costsincurred during fiscal years beginning after June 15, 2005.

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Adoption of the provisions of SFAS No. 151 is notexpected to have a material impact on the Company’s future financial condition,results of operations, or liquidity. However, unforeseen changes in any of thefactors surrounding the estimates imbedded in the determination of inventoryvalues and cost of sales could have a material impact on cost of sales underSFAS No. 151. Such changes in factors and estimates include but are notlimited to: production levels and capacity, changes in the prices paid for rawmaterials, supplies, and labor, changes in yield, potency, and quality ofbiomass, and changes in processing or production methods.

***Gross Profit Margin******  ***The Company’sgross profit margin as a percentage of net sales decreased to 30% for thefiscal year ending March 31, 2006, down from 33% for fiscal 2005 and 34%for fiscal 2004 as previously described.

Management expects the Company’s gross profit marginpercentages to remain essentially consistent with the results reported forfiscal 2006; however there are many factors which could materially diminishgross profit. These include, but are not limited to, sales volume and mix,increases in the cost of raw materials and raw material freight costs, andproduction volumes above and below normal capacity in response to customaryproduction variables (such as weather) and significant changes in demand forthe Company’s products, and the allocation of production resources, principallythe factors impacting Astaxanthin and Spirulina biomass production levels andrates based on the variabilities just mentioned.

***Operating Expenses***   Operatingexpenses as a percentage of net sales were 31% for fiscal 2006 and 28% forfiscal 2005 and 2004. During fiscal 2006, sales and marketing expenses andgeneral and administrative expenses increased. These increases were partiallyoffset by decreased research and development expenses. The Company is committedto ongoing cost containment aimed at controlling its level of operatingexpenses but may increase some discretionary spending in future periods asdictated by the needs of the business.  The following is a discussion of spending byfunctional areas.

Our research and development costs decreased to$192,000, down 25% from $257,000 in fiscal 2005 and up 29% from $149,000 infiscal 2004.  The major expenditures inresearch and development were for initiation of new scientific clinical trials,costs related to product registration and work aimed at increasing productionyields and continually improving the quality and stability of such products.

Our sales and marketing costs were $1,331,000,$1,202,000 and $1,239,000 in fiscal 2006, 2005 and 2004, respectively.  Fiscal 2006 expenses were 11% higher than infiscal 2005 primarily due to increased advertising expenditures for bulkBioAstin and NatuRose products.

Our general and administrative costs were $1,883,000,$1,797,000 and $1,823,000 in fiscal 2006, 2005 and 2004, respectively. Comparedto fiscal 2005, fiscal 2006 expenses increased by 5% due to increased personnelcosts and increased regulatory compliance reporting costs. Fiscal 2005 expensesdecreased from fiscal 2004 primarily due to elimination of a royalty paymentobligation which ended in fiscal 2004, reduced contract services expenses and areduction in bad debt expense, offset in part by increased personnel expenses.

The Company expects operating expense spending toremain consistent with or moderately increased from fiscal 2006 levels.Increases may be necessary in research and development as new opportunitiesarise. However, the Company will continue to seek additional leverage fromcustomer supported research where and as practicable. Increases in sales andmarketing expenses may become necessary as the Company seeks new and increasedmarkets and market share. Whether sales and marketing expenses increase overfiscal year 2006 levels will be based on customer demand levels, customerresponse, and customer and market opportunities that may arise. Finally, asnoted under general and administrative costs, the cost of regulatory complianceactivities—including financial, international standards (ISO), US food and drugmanufacturing practice (GMP), and other regulatory compliance areas—continue to

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increase. In addition, theCompany must remain competitive in the labor market, and this may lead tofurther increases in general and administrative costs.

***Other Expense******  ***The followingdetails the amounts included in other expense (dollars in thousands):

| ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest expense  on Term Loan Agreement(1)    |       | $        | 175        |     | $          | 158      |       | $ | 160 |   |
| Interest expense  on convertible debentures(2) |       | —   |       | —   |       | 119      |       |
| Other interest  expense                        |       | 5        |       | 5        |       | 7        |       |
| Other income, net(3)                           | * *   | (36      | )          | (46      | )          | (31      | )          |
| Total other expense                            |       | $        | 144        |     | $          | 117      |       | $ | 255 |   |

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(1)          The principal balance onthe Term Loan was $1,751,000, $2,098,000 and $2,439,000 as of March 31,2006, 2005 and 2004 respectively. The interest rate under the Term Loan is 1%above the prime rate.  The prime rate asof March 31, 2006, 2005 and 2004 was 7.25%, 5.25% and 4.0% respectively.Interest expense includes amortization of debt issue costs.

(2)          In December 2003,the convertible debentures were voluntarily converted into common stock (seeNote 5 of Notes to Consolidated Financial Statements Part II. Item 8.).

(3)          Other income, netincludes interest earned on certain cash and cash equivalents balances andgains arising from exchange rate fluctuations on transactions of the Company’sJapan subsidiary.

***Income Taxes***   Forfiscal 2006, the Company recorded income tax expense of $17,000 primarilyrelated to Hawaii State income taxes. For fiscal 2005, estimated Federal andHawaii State income tax benefit of $68,000 was recorded partially offset byincome taxes of $27,000 related to our Japan operations. For fiscal 2004, aprovision for income taxes of $75,000 was recorded for taxes relating to ouroperations in Japan partially offset by a state tax refund. At March 31,2006 the Company had Federal and Hawaii state net operating loss carryforwardsof approximately $13,804,000 and $9,101,000, respectively. These net operatingloss benefits have been fully reserved as their utilization is not assured.

**Liquidity andCapital Resources**

***Financial Condition******  ***At March 31,2006, the Company’s working capital was $5,525,000 an increase of $423,000compared to $5,102,000 at March 31, 2005. Cash equivalents and short-terminvestments at March 31, 2006 totaled $2,535,000 a decrease of $470,000from $3,005,000 at March 31, 2005. The increase in working capital anddecrease in cash and cash equivalents and short term investments are primarilydue to increased inventory balances and decreased accounts payable balances.Working capital at March 31, 2004 was $4,083,000.

The Company has a Term Loan Agreement (“Term Loan”)with a lender providing up to $3.5 million in credit facilities, secured bysubstantially all the assets of the Company. The outstanding balance under theTerm Loan as of March 31, 2006 is approximately $1,751,000. The Term Loanhas a maturity date of May 1, 2010 and is payable in 120 equal monthlyprincipal and interest payments of approximately $40,000. The interest rateunder the Term Loan, in absence of a default under the agreement, is the primerate, as defined, in effect as of the close of business on the first day ofeach calendar quarter, plus 1% (the prime rate was 7.25% at March 31,2006). The Company is in compliance with all restrictive covenants of the TermLoan. The Company is prohibited by the Term Loan from declaring any cashdividends without the lender’s prior written consent. A $250,000 restrictedcash deposit is held in an interest-bearing restricted cash account per theterms of the Term Loan and is included in Other Assets in the consolidatedbalance sheets at March 31, 2006 and 2005.

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The following tablepresents the Company’s debt and lease obligations at March 31, 2006 (inthousands):

| ** **       | ** ** | **Less Than  1 Year** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After  Years** | ** ** | **Total** | ** ** |
|------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|------------------|------------|-----------|------------|
| Term Loan        |       |                            | $          | 364                |       |               |       | $                | 830        |      |       |   | $ | 557 |   |   | $ | — |   | $ | 1,751 |   |
| Operating leases |       |                            | 234        |               |       |               | 417        |             |       |      | 299        |   |   | 2,183 |   | 3,133 |   |
| Total            |       |                            | $          | 598                |       |               |       | $                | 1,247      |      |       |   | $ | 856 |   |   | $ | 2,183 |   | $ | 4,884 |   |

*** ***

***Cash Flows******  ***Our cash, cashequivalents and short-term investments were $2,535,000, $3,005,000 and$2,531,000 at March 31, 2006, 2005 and 2004, respectively. At March 31,2006, $700,000 of this amount represents short-term investments in certificatesof deposit.

During fiscal years 2006, 2005 and 2004, the Companygenerated cash from operating activities of $179,000, $1,328,000 and $1,966,000,respectively. Reduced cash from operations in fiscal year 2006 compared tofiscal year 2005 is primarily due to the net loss reported in fiscal 2006 of$268,000 compared to net income of $486,000 in fiscal year 2005 and $399,000 infiscal year 2004. Additionally, in fiscal 2006 cash was used to reducepayables, both in the ordinary course of business and to take advantage ofavailable supplier discounts, and to increase inventories. Cash generated fromoperations in 2005 reflected the Company’s profitability and improvedcollection of trade accounts receivable. 

Net cash of $11,000used in investing activities during fiscal 2006 was due to $311,000 ofinvestment in equipment and leasehold improvements net of $300,000 generatedfrom the maturity of short-term investments. In 2005, net cash of $1,649,000was used in investing activities. This included $1,000,000 invested inshort-term investments. Investments in equipment and leasehold improvementswere $649,000 and $413,000 in fiscal years 2005 and 2004.  The capital expenditures for all periodspresented pertained primarily to improvements in cultivation and processingfacilities. For fiscal 2006, such expenditures continued to be aimed towardcapital projects enhancing or maintaining our ability to respond to marketdemand. Depreciation and amortization expense was $1,321,000, $1,319,000 and$1,346,000 for the years ended March 31 2006, 2005 and 2004, respectively.For fiscal 2007 management expects to continue to invest in equipment upgradesand leasehold improvements tied to market requirements and productionefficiency. These amounts are expected to aggregate up to $500,000 in fiscal2007.

During fiscal 2006, cash used in financing activitiesamounted to $338,000, representing principal payments on long-term debt of$347,000, offset in part by proceeds from the exercise of stock optionstotaling $9,000. For fiscal 2005, financing activities used cash of $205,000,representing principal payments on long-term debt of $341,000, offset in partby proceeds from issuance of common stock and from the exercise of stockoptions and warrants totaling $136,000.  Fiscal 2004 financing activities provided cashof $399,000 consisted primarily of the following:  (1) net proceeds received from theexercise of warrants and stock options totaling $477,000 (2) the partialrelease of a restricted deposit held in connection with the Term Loan of$250,000 and (3) principal payments on long-term debt of $328,000.

Management expectsliquidity in fiscal 2007 to be generated primarily from operating cash flows,but funds may also be generated through capital lease or debt sources if andwhen the use of such funding sources becomes beneficial. Management anticipatessufficient liquidity in fiscal 2007 to fund normal operations, capitalexpenditures, and debt service.

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**Variability ofResults**

The following selectedquarterly financial data (unaudited) as of and for the periods presentedhighlights the significant fluctuations in operating results and financialcondition that the Company has experienced in the past  three fiscal years (dollars in thousands):

| ** **         | ** ** | **4**th Quarter | ** ** | **3**rd Quarter | ** ** | **2**nd Quarter  | ** ** | **1**st Quarter   | ** ** |
|--------------------|------------|----------------------|------------|----------------------|------------|-----------------------|------------|------------------------|------------|
| **Ended**          | ** ** | ** **           | ** ** | **March 31,**   | ** ** | **December 31,** | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
| Fiscal 2006:       |       |                 |       |                 |       |                  |       |                   |       |   |   |   |   |   |   |   |   |
| Net sales          |       |                 | $          | 3,252                |       |                  |       | $                      | 2,333      |   |   |   | $ | 2,517 |   |   |   | $ | 3,029 |   |   |
| Cost of sales      |       |                 | 2,180      |                 |       |                  | 1,712      |                   |       |   | 1936 |   |   |   | 2,004 |   |   |
| Operating expenses |       |                 | 853        |                 |       |                  | 857        |                   |       |   | 879 |   |   |   | 817 |   |   |
| Net income (loss)  |       |                 | 194        |                 |       |                  | (294       | )                      |       |   | (321 | ) |   |   | 153 |   |   |
| Working capital    |       |                 | 5,525      |                 |       |                  | 5,196      |                   |       |   | 5,312 |   |   |   | 5,471 |   |   |
| Fiscal 2005:       |       |                 |       |                 |       |                  |       |                   |       |   |   |   |   |   |   |   |   |
| Net sales          |       |                 | $          | 2,560                |       |                  |       | $                      | 3,180      |   |   |   | $ | 2,998 |   |   |   | $ | 2,707 |   |   |
| Cost of sales      |       |                 | 1,846      |                 |       |                  | 2,017      |                   |       |   | 1,944 |   |   |   | 1,820 |   |   |
| Operating expenses |       |                 | 804        |                 |       |                  | 845        |                   |       |   | 881 |   |   |   | 726 |   |   |
| Net income (loss)  |       |                 | (74        | )                    |       |                  | 326        |                   |       |   | 121 |   |   |   | 113 |   |   |
| Working capital    |       |                 | 5,102      |                 |       |                  | 4,991      |                   |       |   | 4,474 |   |   |   | 4,274 |   |   |
| Fiscal 2004:       |       |                 |       |                 |       |                  |       |                   |       |   |   |   |   |   |   |   |   |
| Net sales          |       |                 | $          | 3,290                |       |                  |       | $                      | 3,024      |   |   |   | $ | 2,840 |   |   |   | $ | 2,428 |   |   |
| Cost of sales      |       |                 | 2,099      |                 |       |                  | 1,840      |                   |       |   | 1,979 |   |   |   | 1,724 |   |   |
| Operating expenses |       |                 | 736        |                 |       |                  | 892        |                   |       |   | 829 |   |   |   | 754 |   |   |
| Net income (loss)  |       |                 | 441        |                 |       |                  | 109        |                   |       |   | (10 | ) |   |   | (141 | ) |   |
| Working capital    |       |                 | 4,083      |                 |       |                  | 3,141      |                   |       |   | 2,921 |   |   |   | 2,436 |   |   |
|                    |            |                      |            |                      |            |                       |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company’s results of operations and financialcondition can be affected by numerous factors, many of which are beyond itscontrol and could cause future results of operations to fluctuate materially asit has in the past. Future operating results may fluctuate as a result ofchanges in sales volumes to our largest customers, weather patterns, increasedcompetition, increased materials, nutrient and energy costs, foreign currencyexchange fluctuations, governmental regulations and other factors beyond ourcontrol. In addition, the Company maintains product liability insurance only inlimited amounts for products involving human consumption because broaderproduct liability coverage is cost prohibitive.

A significant portion ofour expense levels are relatively fixed, so the timing of increases in expenselevels is based in large part on forecasts of future sales. If net sales arebelow expectations in any given period, the adverse impact on results ofoperations may be magnified by our inability to adjust spending quickly enoughto compensate for the sales shortfall. We may also choose to reduce prices orincrease spending in response to market conditions, which may have a materialadverse effect on financial condition and results of operations.

**Effect of RecentlyIssued Accounting Standards and Estimates**

In December 2005, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (Revised 2004) (SFAS No. 123R),“Share-Based Payment”, which is a revision of FASB Statement No. 123 “Accountingfor Stock-Based Compensation.”  SFAS No. 123Rrequires an entity to measure the cost of employee services received inexchange for an award. If an award vests or becomes exercisable based on theachievement of a condition other than service, performance or market condition,the award is liability-classified. Liability-classified awards are remeasuredto fair value at each balance sheet date until the award is settled. Equity-classifiedawards, including grants of employee stock options, are measured at thegrant-date fair value of the award and are not subsequently remeasured. Thecost of equity-classified 

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awards is recognized inthe income statement over the period during which an employee is required toprovide the service in exchange for the award. Currently the company accountsfor its employee and non-employee director stock options under the intrinsicvalue provision of APB Opinion No. 25.  The Company is required to adopt theprovisions for SFAS No. 123R as of the beginning of the first annualreporting period that begins after June 15, 2005, although earlieradoption is permitted.  Management haselected to adopt the provisions of SFAS No. 123R, “Share-Based Payment,”for its share-based compensation plans effective April 1, 2006 using theModified Prospective method of accounting.

In November 2004, the FASB issued SFAS No. 151“Inventory Costs—an amendment of Accounting Research Bulletin No. 43,Chapter 4”. SFAS No. 151 requires that abnormal amounts of freight,handling costs and wasted material (spoilage) be recognized as current-periodcharges and fixed production overhead costs be allocated to inventory based onthe normal capacity of production facilities. Normal capacity is defined as “theproduction expected to be achieved over a number of periods or seasons undernormal circumstances, taking into account the loss of capacity resulting fromplanned maintenance.”  Companies will nolonger be permitted to capitalize inventory costs on the balance sheet when theproduction defect rate varies significantly from the expected defect rate. SFASNo. 151 is effective for inventory costs incurred during fiscal yearsbeginning after June 15, 2005.  TheCompany will adopt SFAS No. 151 effective April 1, 2006. Adoption ofthe provisions of SFAS No. 151 is not expected to have a material impacton the Company’s financial condition, results of operations, or liquidity.However, unforeseen changes in any of the factors surrounding the estimatesimbedded in the determination of inventory values and cost of sales could havea material impact on cost of sales under SFAS No. 151. Such changes infactors and estimates include but are not limited to: production levels andcapacity, changes in the prices paid for raw materials, supplies, and labor,changes in yield, potency, and quality of biomass, and changes in processing orproduction methods

In December 2004, the FASB issued SFAS No. 153,“Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29, ‘Accountingfor Nonmonetary Transactions.’”  SFAS No. 153 is based on theprinciple that exchange of nonmonetary assets should be measured based on thefair market value of the assets exchanged. SFAS No. 153 eliminates theexception of nonmonetary exchanges of similar productive assets and replaces itwith a general exception for exchanges of nonmonetary assets that do not havecommercial substance. SFAS No. 153 is effective for nonmonetary assetexchanges in fiscal periods beginning after June 15, 2005. The Companywill adopt SFAS No. 153 effective April 1, 2006. Adoption of theprovisions of SFAS No. 153 is not expected to have a material impact onthe Company’s financial condition, results of operations, or liquidity.

In March 2005, the FASB issued FASB InterpretationNo. 47 (“FIN 47”), “Accounting for Conditional Asset RetirementObligations—an interpretation of FASB Statement No. 143.”  FIN 47clarifies that the term “conditional asset retirement obligation” as used inFASB Statement No. 143, “Accounting for Asset Retirement Obligations,”refers to a legal obligation to perform an asset retirement activity in whichthe timing and (or) method of settlement are conditional on a future event thatmay or may not be within the control of the entity. Accordingly, an entity isrequired to recognize a liability for the fair value of a conditional assetretirement obligation if the fair value of the liability can be reasonablyestimated. FIN 47 is effective for fiscal years ending after December 15,2005. The Company adopted the provisions of FIN 47 effective April 2005. Adoptionof the provisions of FIN 47 had no material impact on the Company’s financialcondition, results of operations or liquidity.

On March 29, 2005, the Securities and ExchangeCommission (SEC) staff issued Staff Accounting Bulletin No. 107, “Share-BasedPayment” (SAB No. 107), which expressed the SEC staff’s views on SFAS No. 123R,but did not modify any of SFAS No. 123R’s provisions. The views expressedby the SEC in SAB No. 107 in conjunction with its assessment of SFAS No. 123Rare, for this Company’s purposes, consistent with the requirements of SFAS No. 123Rwhich the Company will, as explained above, adopt effective April 1, 2006.

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In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections, areplacement of APB Opinion No. 20 and FASB Statement No. 3.”  SFAS No. 154 requires retrospectiveapplication for voluntary changes in accounting principle unless it isimpracticable to do so. In addition, indirect effects of a change in accountingprinciple should be recognized in the period of the accounting change. SFAS No. 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. The Company will adopt SFAS No. 154effective April 1, 2006. The impact of adopting SFAS No. 154 cannotbe determined.

**Application ofCritical Accounting Policies and Estimates**

The Company’s discussion and analysis of its financialcondition and results of operations are based upon the Company’s consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. The preparation offinancial statements in conformity with those accounting principles requiresmanagement to make judgments and estimates that affect the amounts reported inthe consolidated financial statements and accompanying notes. Actual resultscould differ from those estimates. The Company regularly re-evaluates itsjudgments and estimates which are based upon historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances. The Company believes that of its significant accountingpolicies, policies that may involve a higher degree of judgment and complexityare inventory valuations, valuation of equipment and leasehold improvements andlong-lived assets, and income taxes.

The Company recognizes revenues when goods are shipped(FOB shipping point) and when significant risks and benefits of ownership aretransferred.

The Company is required to state inventories at thelower of cost or market. Cost is defined as the sum of the applicableexpenditures and charges directly or indirectly incurred in bringinginventories to their existing condition and location. Cost for inventorypurposes may be determined under any one of several assumptions as to the flowof cost factors, such as first-in, first-out; average cost; and last-in,first-out. Our inventories are stated at the lower of cost, which approximatesfirst-in, first-out, or market. Inventory values are subject to many criticalestimates, and unforeseen changes in any of the factors surrounding theestimates imbedded in the determination of inventory values and cost of salescould have a material impact on the Company’s results. Such changes in factorsand estimates include but are not limited to: production levels and capacity,changes in the prices paid for raw materials, supplies, and labor, changes inyield, potency, and quality of biomass, changes in processing or productionmethods, and changes in the carrying value of our inventories resulting fromthe prices our customers are willing to pay for our products.

Equipment and leasehold improvements are reported atcost. Self-constructed leasehold improvements include design, construction andsupervision costs. These costs are recorded in construction in progress and aretransferred to equipment and leasehold improvements when construction iscompleted and the facilities are placed in service. If the Company experiencesimpairment to its equipment or leasehold improvement, we would account for theimpairment in accordance with SFAS No. 144. Pursuant to SFAS No. 144,long-lived assets, such as property, plant and equipment and purchasedintangibles subject to amortization shall be reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. Recoverability of assets to be held and used ismeasured by a comparison of the carrying amount of an asset to the estimatedundiscounted future cash flows expected to be generated by the asset. If thecarrying amount of an asset exceeds its estimated future cash flows, animpairment charge is recognized to the extent that the carrying amount exceedsthe asset’s fair value. The development of estimated future cash flows includesmany significant assumptions which are subject to change.

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Income taxes are accountedfor under the asset and liability method. The asset and liability methodrequires the recognition of deferred tax assets and liabilities for theexpected future tax consequences attributable to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir tax bases and operating loss and tax credit carryforwards. Deferred taxassets and liabilities are measured using enacted income tax rates applicableto the period in which the deferred tax assets or liabilities are expected tobe recovered or settled. The Company records a valuation allowance to reduceits deferred tax assets to the amount that it believes is more likely than notto be realized. Judgment is required in assessing the need for the valuationallowance. The ultimate realization of deferred tax assets is dependent uponthe generation of future taxable income during the periods in which thosetemporary differences become deductible. Should the Company generate sustainedtaxable income in the future, management may conclude that a portion or all ofthe existing valuation allowance is no longer required.

**Item 7A. Quantitativeand Qualitative Disclosures About Market Risk**

We have never entered into any transactions usingderivative financial instruments or derivative commodity instruments andbelieve that our exposure to market risk associated with other financialinstruments is not material.

We have a term loanagreement which adjusts quarterly based on the prime rate. As such we areexposed to the interest rate risk whereby a 1% increase in the prime rate wouldlead to an increase of approximately $16,000 in interest expense for the yearending March 31, 2007 (based on March 31, 2006 amounts outstanding).

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**Item8. Financial Statements and Supplementary Data**

**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors andStockholdersCyanotech Corporation:

We have audited the accompanying consolidated balancesheets of Cyanotech Corporation and subsidiaries (the Company) as of March 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity and comprehensive income (loss), and cash flows for eachof the years in the three-year period ended March 31, 2006. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidatedfinancial statements referred to above present fairly, in all materialrespects, the financial position of Cyanotech Corporation and subsidiaries asof March 31, 2006 and 2005, and the results of their operations and theircash flows for each of the years in the three-year period ended March 31,2006, in conformity with U.S. generally accepted accounting principles.

/s/ KPMG LLP

Honolulu, HawaiiJune 16, 2006

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**CYANOTECH CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSMarch 31, 2006 and 2005**

| ** **                                                                                                                                        | ** ** | **2006**                                              | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|----------|------------|
| ** **                                                                                                                                        | ** ** | **(in thousands,  except share data)** | ** ** |
| ASSETS                                                                                                                                            |       | ** **                                            | ** ** |
| Current assets:                                                                                                                                   |       |                                                  |       |     |       |
| Cash and cash  equivalents                                                                                                                        |       | $                                                     | 1,835      |     | $          | 2,005 |   |
| Short-term investments                                                                                                                            |       | 700                                                   |       | 1,000    |       |
| Accounts receivable, net  of allowance for doubtful accounts of $25 in 2006 and $46 in 2005                                                       |       | 2,209                                                 |       | 2,069    |       |
| Refundable income taxes                                                                                                                           |       | 16                                                    |       | 97       |       |
| Inventories                                                                                                                                       |       | 1,935                                                 |       | 1,565    |       |
| Prepaid expenses and  other current assets                                                                                                        |       | 99                                                    |       | 85       |       |
| Total current assets                                                                                                                              |       | 6,794                                                 |       | 6,821    |       |
| Equipment and leasehold  improvements, net                                                                                                        |       | 10,164                                                |       | 11,174   |       |
| Other assets                                                                                                                                      |       | 515                                                   |       | 547      |       |
| Total assets                                                                                                                                      |       | $                                                     | 17,473     |     | $          | 18,542 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                         |       |                                                  |       |     |       |
| Current liabilities:                                                                                                                              |       |                                                  |       |     |       |
| Current maturities of  long-term debt                                                                                                             |       | $                                                     | 364        |     | $          | 355 |   |
| Accounts payable                                                                                                                                  |       | 485                                                   |       | 977      |       |
| Accrued expenses                                                                                                                                  |       | 420                                                   |       | 387      |       |
| Total current  liabilities                                                                                                                        |       | 1,269                                                 |       | 1,719    |       |
| Long-term debt,  excluding current maturities                                                                                                     |       | 1,387                                                 |       | 1,743    |       |
| Total liabilities                                                                                                                                 |       | 2,656                                                 |       | 3,462    |       |
| Stockholders’ equity:                                                                                                                        |       |                                                  |       |     |       |
| Common stock of $.005 par  value, authorized 30,000,000 shares; issued and outstanding 20,928,265 shares  for 2006 and 20,896,265 shares for 2005 |       | 105                                                   |       | 104      |       |
| Additional paid-in  capital                                                                                                                       |       | 27,330                                                |       | 27,298   |       |
| Accumulated other  comprehensive income (loss)—foreign currency translation adjustments                                                      |       | (1                                                    | )          | 27       |       |
| Accumulated deficit                                                                                                                               |       | (12,617                                               | )          | (12,349  | )          |
| Total stockholders’  equity                                                                                                                  |       | 14,817                                                |       | 15,080   |       |
| Total liabilities and stockholders’ equity                                                                                                   |       | $                                                     | 17,473     |     | $          | 18,542 |   |

 

See accompanying notes to consolidated financial statements.

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**CYANOTECHCORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSYears ended March 31, 2006, 2005 and 2004**

| ** **                                                  | ** ** | **2006**                                                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                  | ** ** | **(in thousands, except  per share data)** | ** ** |
| Net sales                                                   |       | $                                                              | 11,131     |     | $          | 11,445   |       | $ | 11,582 |   |
| Cost of sales                                               |       | 7,832                                                          |       | 7,627    |       | 7,642    |       |
| Gross profit                                                |       | 3,299                                                          |       | 3,818    |       | 3,940    |       |
| Operating expenses:                                         |       |                                                           |       |     |       |     |       |
| Research and development                                    |       | 192                                                            |       | 257      |       | 149      |       |
| Sales and marketing                                         |       | 1,331                                                          |       | 1,202    |       | 1,239    |       |
| General and administrative                                  |       | 1,883                                                          |       | 1,797    |       | 1,823    |       |
| Total operating expense                                     |       | 3,406                                                          |       | 3,256    |       | 3,211    |       |
| Income (loss) from operations                               |       | (107                                                           | )          | 562      |       | 729      |       |
| Other income (expense):                                     |       |                                                           |       |     |       |     |       |
| Interest income                                             |       | 46                                                             |       | 31       |       | 6        |       |
| Interest expense                                            |       | (180                                                           | )          | (163     | )          | (286     | )          |
| Other income (expense), net                                 |       | (10                                                            | )          | 15       |       | 25       |       |
| Total other expense, net                                    |       | (144                                                           | )          | (117     | )          | (255     | )          |
| Income (loss) before income taxes                           |       | (251                                                           | )          | 445      |       | 474      |       |
| Income tax expense (benefit)                                |       | 17                                                             |       | (41      | )          | 75       |       |
| Net income (loss)                                           |       | $                                                              | (268       | )        | $          | 486      |       | $ | 399 |   |
| Net income (loss)  per share:                               |       |                                                           |       |     |       |     |       |
| Basic                                                       |       | $                                                              | (0.01      | )        | $          | 0.02     |       | $ | 0.02 |   |
| Diluted                                                     |       | $                                                              | (0.01      | )        | $          | 0.02     |       | $ | 0.02 |   |
| Shares used in  calculation of net income (loss) per share: |       |                                                           |       |     |       |     |       |
| Basic                                                       |       | 20,904                                                         |       | 20,784   |       | 18,971   |       |
| Diluted                                                     |       | 20,904                                                         |       | 20,979   |       | 19,111   |       |

 

See accompanying notes to consolidated financial statements.

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**CYANOTECHCORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (LOSS)**

**Years endedMarch 31, 2006, 2005 and 2004**

| ** **                                                                | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** **     | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **             | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|------------|------------|----------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                | ** ** | **Common**                                                | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **      | ** ** | **Comprehensive** | ** ** | **Other**              | ** ** | **Total**              | ** ** |
| ** **                                                                | ** ** | **Stock**                                                 | ** ** | **Common** | ** ** | **Paid-in**    | ** ** | **Accumulated** | ** ** | **Income**        | ** ** | **Comprehensive**      | ** ** | **Stockholders’** | ** ** |
| ** **                                                                | ** ** | **Shares**                                                | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit**     | ** ** | **(Loss)**        | ** ** | **Income (Loss)** | ** ** | **Equity**             | ** ** |
| ** **                                                                | ** ** | **(in thousands, except share data)** | ** ** |
| Balances at March 31, 2003                                           |       | 18,316,701                                                |       |       | $          | 92             |       |            |       | $                 | 25,418     |                   |       |                   | $          | (13,234 | ) |   |   | $ | — |   |   |   | $ | (3 | ) |   |   | $ | 12,273 |   |   |
| Conversion of debentures to common stock                                  |       | 1,923,076                                                 |       |       | 10         |           |       |            | 1,240      |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 1,250 |   |   |
| Issuances of  common stock for:                                           |       |                                                      |       |       |       |           |       |            |       |              |       |                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Exercise of stock options for cash                                        |       | 45,800                                                    |       |       | —     |           |       |            | 43         |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 43 |   |   |
| Exercise of warrants for cash, net of costs $19                           |       | 429,234                                                   |       |       | 2          |           |       |            | 451        |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 453 |   |   |
| Third party services, at fair value                                       |       | 10,000                                                    |       |       | —     |           |       |            | 5          |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 5 |   |   |
| Non-employee directors’ services, at fair value                      |       | 6,000                                                     |       |       | —     |           |       |            | 3          |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 3 |   |   |
| Common stock purchased at fair value and cancelled                        |       | (16,565                                                   | )          |       | —     |           |       |            | (19        | )                 |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | (19 | ) |   |
| Comprehensive  income:                                                    |       |                                                      |       |       |       |           |       |            |       |              |       |                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | 399        |                   |       |   | 399 |   |   |   | — |   |   |   | 399 |   |   |
| Other comprehensive income—foreign currency  translation adjustments |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | —     |                   |       |   | 33 |   |   |   | 33 |   |   |   | 33 |   |   |
| Comprehensive income                                                      |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | —     |                   |       |   | 432 |   |   |   | — |   |   |   | — |   |   |
| Balances at March 31, 2004                                           |       | 20,714,246                                                |       |       | 104        |           |       |            | 27,141     |              |       |                   | (12,835    | )                      |       |   | — |   |   |   | 30 |   |   |   | 14,440 |   |   |
| Issuances of  common stock for:                                           |       |                                                      |       |       |       |           |       |            |       |              |       |                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Exercise of stock options for cash                                        |       | 36,019                                                    |       |       | —     |           |       |            | 32         |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 32 |   |   |
| Exercise of warrants for cash                                             |       | 132,000                                                   |       |       | —     |           |       |            | 104        |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 104 |   |   |
| Non-employee directors’ services, at fair value                      |       | 14,000                                                    |       |       | —     |           |       |            | 15         |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 15 |   |   |
| Issuance of stock options for third party services,  at fair value        |       | —                                                    |       |       | —     |           |       |            | 6          |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 6 |   |   |
| Comprehensive  income:                                                    |       |                                                      |       |       |       |           |       |            |       |              |       |                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | 486        |                   |       |   | 486 |   |   |   | — |   |   |   | 486 |   |   |
| Other comprehensive loss—foreign currency translation  adjustments   |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | —     |                   |       |   | (3 | ) |   |   | (3 | ) |   |   | (3 | ) |   |
| Comprehensive income                                                      |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | —     |                   |       |   | 483 |   |   |   | — |   |   |   | — |   |   |
| Balances at March 31, 2005                                           |       | 20,896,265                                                |       |       | 104        |           |       |            | 27,298     |              |       |                   | (12,349    | )                      |       |   | — |   |   |   | 27 |   |   |   | 15,080 |   |   |
| Issuances of  common stock for:                                           |       |                                                      |       |       |       |           |       |            |       |              |       |                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Exercise of stock options for cash                                        |       | 14,500                                                    |       |       | 1          |           |       |            | 8          |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 9 |   |   |
| Non-employee directors’ services, at fair value                      |       | 17,500                                                    |       |       | —     |           |       |            | 14         |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 14 |   |   |
| Compensation expense for accelerated vesting of stock  options            |       | —                                                    |       |       | —     |           |       |            | 10         |              |       |                   | —     |                   |       |   | — |   |   |   | — |   |   |   | 10 |   |   |
| Comprehensive  loss:                                                      |       |                                                      |       |       |       |           |       |            |       |              |       |                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                  |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | (268       | )                      |       |   | (268 | ) |   |   | — |   |   |   | (268 | ) |   |
| Other comprehensive loss—foreign currency translation  adjustments   |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | —     |                   |       |   | (28 | ) |   |   | (28 | ) |   |   | (28 | ) |   |
| Comprehensive loss                                                        |       | —                                                    |       |       | —     |           |       |            | —     |              |       |                   | —     |                   |       |   | (296 | ) |   |   | — |   |   |   | — |   |   |
| Balances at  March 31, 2006                                          |       | 20,928,265                                                |       |       | $          | 105            |       |            |       | $                 | 27,330     |                   |       |                   | $          | (12,617 | ) |   |   | $ | — |   |   |   | $ | (1 | ) |   |   | $ | 14,817 |   |   |

 

See accompanying notes to consolidated financial statements.

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**CYANOTECHCORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSYears ended March 31, 2006, 2005 and 2004**

| ** **                                                                            | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                                            | ** ** | **(in thousands)** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                |       |                    |       |     |       |     |       |
| Net income (loss)                                                                     |       | $                       | (268       | )        | $          | 486      |       | $ | 399 |   |
| Adjustments to reconcile  net income (loss) to cash provided by operating activities: |       |                    |       |     |       |     |       |
| Depreciation and amortization                                                         |       | 1,321                   |       | 1,319    |       | 1,346    |       |
| Amortization of debt issue costs and other assets                                     |       | 37                      |       | 27       |       | 65       |       |
| Issuance of common stock and stock options in exchange  for services                  |       | 14                      |       | 21       |       | 8        |       |
| Compensation expense for accelerated vesting of  stock options                        |       | 10                      |       | —   |       | —   |       |
| Provision for (reduction of) allowance for doubtful  accounts                         |       | (8                      | )          | 50       |       | 36       |       |
| Net (increase)  decrease in assets:                                                   |       |                    |       |     |       |     |       |
| Accounts receivable                                                                   |       | (132                    | )          | 92       |       | (408     | )          |
| Refundable income taxes                                                               |       | 81                      |       | (86      | )          | (2       | )          |
| Inventories                                                                           |       | (370                    | )          | (466     | )          | 301      |       |
| Prepaid expenses and other assets                                                     |       | (47                     | )          | (1       | )          | (65      | )          |
| Net increase  (decrease) in liabilities:                                              |       |                    |       |     |       |     |       |
| Accounts payable                                                                      |       | (492                    | )          | 103      |       | 71       |       |
| Accrued expenses                                                                      |       | 33                      |       | (217     | )          | 215      |       |
| Net cash provided by operating activities                                             |       | 179                     |       | 1,328    |       | 1,966    |       |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                |       |                    |       |     |       |     |       |
| (Purchase)  Maturity of short-term investments                                        |       | 300                     |       | (1,000   | )          | —   |       |
| Investment in  equipment and leasehold improvements                                   |       | (311                    | )          | (649     | )          | (413     | )          |
| Net cash used in  investing activities                                                |       | (11                     | )          | (1,649   | )          | (413     | )          |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                |       |                    |       |     |       |     |       |
| Proceeds from issuance  of common stock and exercise of stock options                 |       |                    |       |     |       |     |       |
| and warrants, net of issuance costs                                                   |       | 9                       |       | 136      |       | 477      |       |
| Release of restricted  cash deposit                                                   |       | —                  |       | —   |       | 250      |       |
| Principal  payments on long-term debt                                                 |       | (347                    | )          | (341     | )          | (328     | )          |
| Net cash provided by (used in) financing activities                                   |       | (338                    | )          | (205     | )          | 399      |       |
| Net increase (decrease) in cash and cash equivalents                                  |       | (170                    | )          | (526     | )          | 1,952    |       |
| Cash and cash  equivalents at beginning of year                                       |       | 2,005                   |       | 2,531    |       | 579      |       |
| Cash and cash equivalents at end of year                                              |       | $                       | 1,835      |     | $          | 2,005    |       | $ | 2,531 |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                    |       |                    |       |     |       |     |       |
| Cash paid during the  year for:                                                       |       |                    |       |     |       |     |       |
| Interest                                                                              |       | $                       | 148        |     | $          | 132      |       | $ | 260 |   |
| Income taxes                                                                          |       | $                       | —     |     | $          | 178      |       | $ | 17 |   |
| Supplemental  disclosure of non-cash financing activities:                            |       |                    |       |     |       |     |       |
| Conversion of  debentures to common stock                                             |       | $                       | —     |     | $          | —   |       | $ | 1,250 |   |

 

 

See accompanying notes to consolidated financial statements.

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**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**Note 1 Descriptionof Business and Summary of Accounting Policies**

**Description ofBusiness**

Cyanotech Corporation (theCompany) cultivates and produces high-value, high-quality natural productsderived from microalgae. The Company currently cultivates, on a large-scalebasis, two microalgal species from which its two major product lines arederived. The Company is currently producing microalgal products for thenutritional supplement, animal feed/pigments and immunological diagnosticsmarkets. The Company manufactures all of its products in the United States andsells its products worldwide. As the Company’s operations are solely related tomicroalgae-based products, management of the Company considers its operations tobe in one industry segment. Correspondingly, the Company records revenue andcost of sales information by product category but does not record operatingexpenses by such product category.

**Principles ofConsolidation**

The accompanyingconsolidated financial statements include the accounts of Cyanotech Corporationand its wholly owned subsidiaries, Nutrex Hawaii, Inc. (“Nutrex Hawaii” or“Nutrex”) and Cyanotech Japan YK (“Cyanotech Japan” or “CJYK”). All significantintercompany balances and transactions have been eliminated in consolidation.

**Estimates andAssumptions**

The preparation of theconsolidated financial statements requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities and thedisclosure of any contingent assets and liabilities as of the date of thefinancial statements and the reported amounts of revenues and expenses duringthe period reported. Management reviews theses estimates and assumptionsperiodically and reflects the effect of revisions in the period that they aredetermined to be necessary. Actual results could differ significantly fromthose estimates and assumptions.

**Foreign CurrencyTranslation and Risk**

The Japanese Yen is thefunctional currency for Cyanotech Japan. As such, Cyanotech Japan’s assets andliabilities are translated at the exchange rate on the balance sheet date andrevenues and expenses are translated at average rates of exchange prevailingduring the year. Translation adjustments are charged or credited to accumulatedother comprehensive income (loss) in stockholders’ equity. Certain transactionsfor Cyanotech Japan are exposed to foreign currency risk. The Company activelymonitors and manages the balances subject to foreign currency risk. Currently,we do not hedge any of our foreign currency risk through the use of derivativefinancial instruments.

**FinancialInstruments**

Cash and cash equivalents consist of cash and highlyliquid debt instruments such as commercial paper and certificates of depositwith maturities of three months or less from the date of purchase. Short-terminvestments are certificates of deposits maturing between three and nine monthsfrom the purchase date and are stated at cost. Interest earned on short-terminvestments is deposited monthly into an accessible cash account and istherefore classified as cash and cash equivalents. The Company’s practice is toinvest cash with financial institutions that have acceptable credit ratings andto limit the amount of credit exposure to any one financial institution.

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Statement of Financial Accounting Standards (“SFAS”) No. 107,“Disclosures About Fair Value of Financial Instruments,” defines the fair valueof a financial instrument as the amount at which the instrument could beexchanged in a current transaction between willing parties. Management appliesthe following methods and assumptions in estimating the fair value of eachclass of financial instruments for all periods presented.

*Cashand Cash Equivalents, Short-Term Investments, Accounts Receivable and AccountsPayable*   Due to the short-term nature of theseinstruments, management believes that the carrying amounts approximate fairvalue.

*Long-Term Debt*   Thecarrying amount of long-term debt approximates fair value as interest ratesapplied to the underlying debt are adjusted quarterly to market interest rateswhich approximates current interest rates for similar debt instruments ofcomparable maturities.

**Trade AccountsReceivable and Allowance for Doubtful Accounts**

Trade accounts receivableare recorded at the invoiced amount and do not accrue interest. The allowancefor doubtful accounts reflects management’s best estimate of probable creditlosses inherent in the accounts receivable balance. The Company determines theallowance based on historical experience, specifically identified nonpayingaccounts and other currently available evidence. The Company reviews itsallowance for doubtful accounts monthly with focus on significant individualpast due balances over 90 days. All other balances are reviewed on a pooledbasis. Account balances are charged off against the allowance after all meansof collection have been exhausted and the potential for recovery is consideredremote. The Company does not have any off-balance sheet credit exposure relatedto its customers.

**Inventories**

Inventories are stated atthe lower of cost (which approximates first-in, first-out) or market.

**Equipment andLeasehold Improvements and Long-Lived Assets**

Equipmentand leasehold improvements are stated at cost. Depreciation and amortizationare provided using the straight-line method over the estimated useful lives forequipment and furniture and fixtures, or the shorter of the land lease term(see Note 3) or estimated useful lives for leasehold improvements as follows:

| Equipment              |   | 3 to  10 years |
|------------------------|--------|----------------|
| Furniture and fixtures |   | 7  years       |
| Leasehold improvements |   | 10 to 20 years |

 

The Company accounts for impairment of its equipmentor leasehold improvements in accordance with SFAS No. 144. Pursuant toSFAS No. 144, long-lived assets, such as property, plant and equipment andpurchased intangibles subject to amortization shall be reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be held andused is measured by a comparison of the carrying amount of an asset to theestimated undiscounted future cash flows expected to be generated by the asset.If the carrying amount of an asset exceeds its estimated future cash flows, animpairment charge is recognized to the extent that the carrying amount exceedsthe asset’s fair value.

Assets to be disposed of and related liabilities wouldbe separately presented in the consolidated balance sheet. Assets to bedisposed of would be reported at the lower of the carrying value or fair valueless costs to sell and would not be depreciated.

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SFAS No. 143 “Accountingfor Asset Retirement Obligations” requires the fair value of a liability for anasset retirement obligation to be recognized in the period in which it isincurred if a reasonable estimate of fair value can be made. The associatedasset retirement costs would be capitalized as part of the carrying amount ofthe long-lived asset and depreciated over the life of the asset. The liabilityis accreted at the end of each period through charges to operating expense. Ifthe obligation is settled for other than the carrying amount of the liability,the Company will recognize a gain or loss on settlement.

**Revenue Recognition**

The Company recognizes revenueswhen goods are shipped (FOB shipping point) and when significant risks andbenefits of ownership are transferred.

**Research andDevelopment and Advertising**

Research and developmentand advertising costs are expensed as incurred.

**Income Taxes**

Income taxes are accountedfor under the asset and liability method. The asset and liability methodrequires the recognition of deferred tax assets and liabilities for theexpected future tax consequences attributable to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir tax bases and operating loss and tax credit carryforwards. Deferred taxassets and liabilities are measured using enacted income tax rates applicableto the period in which the deferred tax assets or liabilities are expected tobe recovered or settled. The effect on deferred tax assets and liabilities of achange in tax rates is recognized in income in the period that includes theenactment date.

**Stock Option Plans**

The Company applies the intrinsic value-based methodof accounting prescribed by Accounting Principle Board (“APB”) Opinion No. 25,“Accounting for Stock Issued toEmployees”, and related interpretations, in accounting for its fixedplan stock options issued to employees, including non-employee directors. Assuch, compensation expense would be recorded on the date of grant only if thecurrent market price of the underlying stock exceeded the exercise price. TheCompany applies the fair value-based method of accounting prescribed by SFAS No. 123,“Accounting for Stock-BasedCompensation”, and Emerging Issues Task Force (“EITF”) Issue No. 96-18,“Accounting for Equity Instruments That Are Issued to Other Than Employees forAcquiring, or in Conjunction with Selling, Goods or Services” in accounting forits fixed plan stock options issued to outside third parties other thannon-employee directors. As such, expenses representing the fair value ofstock-based awards on the date of grant are recognized over the vesting period.

As allowed by SFAS No. 123, for the fiscal yearended March 31, 2006 the Company has elected to continue to apply theintrinsic value-based method of accounting for employee based stock options andadopted only the disclosure requirements of SFAS No. 123.

On March 23, 2006, in response to SFAS No. 123(R),the Compensation and Stock Option Committee of the Company’s Board of Directorsapproved accelerating the vesting of all outstanding unvested employeeincentive stock options under the provisions of APB Opinion No. 25, and relatedinterpretations. Options held by non-employees and directors were not includedin the vesting acceleration since all such options were already fully vested.The decision to accelerate vesting of all outstanding unvested employeeincentive stock options was made to avoid recognizing, pursuant to the Company’sApril 1, 2006 adoption of SFAS No. 123(R), the non-cash compensationcost related to unvested Employee Incentive Stock Options. These wouldotherwise have been unvested as of March 31, 2006 and would have beenreflected as a non-cash expense in future statements of operations.

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Due to the Company having fewer than 100 employees, itwas deemed prudent to accelerate the vesting of all outstanding employeeincentive stock options as noted above. This resulted in the companyrecognizing non-cash compensation expense of approximately $10,000 for the yearended March 31, 2006, representing the estimated benefit of acceleratedvesting for those unvested incentive options with exercise prices less than thefair market value of the Company’s stock on March 23, 2006. It isestimated that the total future compensation expense that will be avoided infuture years is approximately $78,000, before tax, based on the March 23,2006 acceleration date. The foregoing amount would have primarily impactedfiscal years ending March 31, 2007 through March 31, 2009.

Due to the Company’s tax net operating loss carryforward position, no tax benefits are received or are expected to be receivedover the remaining life of the 2005 Stock Plan. Accordingly, Stock Plan amountsare the same both before and after tax.

At the effective vesting acceleration date of March 23,2006, there were 20,000 unvested employee incentive stock options outstandingunder the company’s 1995 and 2005 Stock Plans, and 162,855 unvested employeeincentive stock options outstanding under the company’s 1994 and 2004 StockPlans. Of the outstanding incentive stock options, 76,492 had exercise priceswhich were greater than the $0.68 per share fair market value of the Company’scommon stock on March 23, 2006. The remaining 106,363 options had exerciseprices less than or equal to the $0.68 fair market value of the Company’s stockon March 23, 2006. As of the effective vesting acceleration date, exerciseprices were $1.10 per incentive option for the 76,492 options with exerciseprices greater than $0.68, and ranging from $0.50 to $0.65 per incentive optionfor the 106,363 options with exercise prices less than or equal to $0.68.

Thefollowing table illustrates the effect on net income (loss) and net income(loss) per common share if the Company had applied the fair-value method underSFAS No. 123 to its employee stock options:

| ** **                                                                                              | ** ** | **2006**                                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                              | ** ** | **(in thousands, except  per share amounts)** | ** ** |
| Net income  (loss), as reported                                                                         |       | $                                                                 | (268       | )        | $          | 486      |       | $ | 399 |   |
| Reverse  accelerated vesting expense recognized under intrinsic value method                            |       | 10                                                                |       | —   |       | —   |       |
| Deduct  stock-based employee compensation expense determined under fair-value method  for all awards(1) |       | (135                                                              | )          | (90      | )          | (82      | )          |
| Pro forma net  income (loss)                                                                            |       | $                                                                 | (393       | )        | $          | 396      |       | $ | 317 |   |
| Net income (loss)  per common share                                                                     |       |                                                              |       |     |       |     |       |
| —Basic and  Diluted:                                                                               |       |                                                              |       |     |       |     |       |
| As reported                                                                                             |       | $                                                                 | (0.01      | )        | $          | 0.02     |       | $ | 0.02 |   |
| Pro forma                                                                                               |       | $                                                                 | (0.02      | )        | $          | 0.02     |       | $ | 0.02 |   |

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(1)          Forthe year ended March 31, 2006, the amount includes the impact ofaccelerated vesting of unvested employee stock options on March 23, 2006amounting to $78,000.

**New AccountingPronouncements**

In December 2005, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (Revised 2004) (SFAS No. 123R),“Share-Based Payment”, which is a revision of FASB Statement No. 123 “Accountingfor Stock-Based Compensation.” SFAS No. 123R requires an entity to measurethe cost of employee services received in exchange for an award. If an awardvests or becomes exercisable based on the achievement of a condition other thanservice, performance or market condition, the award is liability-classified. Liability-classifiedawards are remeasured to fair value at each balance sheet date until the awardis settled. Equity-classified awards, including grants of employee stockoptions, are measured at the grant-date fair value of the award and are notsubsequently remeasured. The cost of equity-classified awards is recognized inthe income statement over the period during which an employee is required to 

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provide the service inexchange for the award. Currently the company accounts for its employee andnon-employee director stock options under the intrinsic value provision of APBOpinion No. 25. The Company is required to adopt the provisions for SFAS No. 123Ras of the beginning of the first annual reporting period that begins after June 15,2005, although earlier adoption is permitted. Management has elected to adoptthe provisions of SFAS No. 123R, “Share-Based Payment,” for itsshare-based compensation plans effective April 1, 2006 using the ModifiedProspective method of accounting.

SFAS No. 123R offers several alternatives forimplementation, among them the Modified Prospective Method of accounting forcompensation costs related to “Share Based Payments.” In the Company’s case itsEmployee Incentive Options are “plain vanilla,” as defined by the SEC in SAB No. 107,normally vesting over a five year period and exercisable under the terms of theCompany’s Stock Plan up to ten years from date of grant. The Company hasdetermined that a Black-Scholes-Merton model will be most reflective of thefair value of option grants. The Company’s methodology will incorporatevolatility measurements derived from the actual trading history of the Company’spublicly traded shares and will incorporate exercise, forfeiture, and otherrequired measurements derived from actual results.

Because the Company’s future Employee Incentive StockOptions are expected to be “plain vanilla” in the same sense the term is usedby the SEC in SAB No. 107, they will be reflected only in the Company’sEquity and Compensation Expense accounts. At present the Company does not haveany unvested Employee Incentive Stock Options subject to measurement andrecording under the requirements of SFAS No. 123R, “Share-Based Payment.”If Stock Options are granted in the future the impact on the Company’scompensation expense and net income will depend on many variables, andassumptions, including those previously discussed. Because there are nounvested employee incentive options as of April 1, 2006 the Company doesnot expect to record any share-based payment expense for currently outstandingemployee incentive options in fiscal 2007. Future employee incentive options,if granted, will be recognized and expensed under the provisions of SFAS No. 123R

In November 2004, the FASB issued SFAS No. 151“Inventory Costs—an amendment of Accounting Research Bulletin No. 43,Chapter 4”. SFAS No. 151 requires that abnormal amounts of freight,handling costs and wasted material (spoilage) be recognized as current-periodcharges and fixed production overhead costs be allocated to inventory based onthe normal capacity of production facilities. Normal capacity is defined as “theproduction expected to be achieved over a number of periods or seasons undernormal circumstances, taking into account the loss of capacity resulting fromplanned maintenance.” Companies will no longer be permitted to capitalizeinventory costs on the balance sheet when the production defect rate variessignificantly from the expected defect rate. SFAS No. 151 is effective forinventory costs incurred during fiscal years beginning after June 15, 2005.The Company will adopt SFAS No. 151 effective April 1, 2006. Adoptionof the provisions of SFAS No. 151 is not expected to have a materialimpact on the Company’s financial condition, results of operations, orliquidity. However, unforeseen changes in any of the factors surrounding theestimates imbedded in the determination of inventory values and cost of salescould have a material impact on cost of sales under SFAS No. 151. Suchchanges in factors and estimates include but are not limited to: productionlevels and capacity, changes in the prices paid for raw materials, supplies,and labor, changes in yield, potency, and quality of biomass, and changes inprocessing or production methods.

In December 2004, the FASB issued SFAS No. 153,“Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29, ‘Accountingfor Nonmonetary Transactions.’” SFAS No. 153 is based on the principlethat exchange of nonmonetary assets should be measured based on the fair marketvalue of the assets exchanged. SFAS No. 153 eliminates the exception ofnonmonetary exchanges of similar productive assets and replaces it with ageneral exception for exchanges of nonmonetary assets that do not havecommercial substance. SFAS No. 153 is effective for nonmonetary assetexchanges in fiscal periods beginning after June 15, 2005. The Companywill adopt SFAS No. 153 effective April 1, 2006. Adoption of 

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the provisions of SFAS No. 153is not expected to have a material impact on the Company’s financial condition,results of operations, or liquidity.

In March 2005, the FASB issued FASBInterpretation No. 47 (“FIN 47”), “Accounting for Conditional AssetRetirement Obligations—an interpretation of FASB Statement No. 143.” FIN 47clarifies that the term “conditional asset retirement obligation” as used inFASB Statement No. 143, “Accounting for Asset Retirement Obligations,”refers to a legal obligation to perform an asset retirement activity in whichthe timing and (or) method of settlement are conditional on a future event thatmay or may not be within the control of the entity. Accordingly, an entity isrequired to recognize a liability for the fair value of a conditional assetretirement obligation if the fair value of the liability can be reasonablyestimated. FIN 47 is effective for fiscal years ending after December 15,2005. The Company adopted the provisions of FIN 47 effective April 2005. Adoptionof the provisions of FIN 47 had no material impact on the Company’s financialcondition, results of operations or liquidity.

On March 29, 2005, the Securities and ExchangeCommission (SEC) staff issued Staff Accounting Bulletin No. 107, “Share-BasedPayment” (SAB No. 107), which expressed the SEC staff’s views on SFAS No. 123R,but did not modify any of SFAS No. 123R’s provisions. . The viewsexpressed by the SEC in SAB No. 107 in conjunction with its assessment ofSFAS No. 123R are, for this Company’s purposes, consistent with therequirements of SFAS No. 123R which the Company will, as explained above,adopt effective April 1, 2006.

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections, areplacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154requires retrospective application for voluntary changes in accountingprinciple unless it is impracticable to do so. In addition, indirect effects ofa change in accounting principle should be recognized in the period of theaccounting change. SFAS No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. The Company will adopt SFAS No. 154 effective April 1, 2006.The impact of adopting SFAS No. 154 cannot be determined.

**Note 2 Inventories**

Inventoriesconsist of the following as of March 31, 2006 and 2005:

| ** **      | ** ** | **2006**                | ** ** | **2005** | ** ** |
|-----------------|------------|-------------------------|------------|----------|------------|
| ** **      | ** ** | **(in thousands)** | ** ** |
| Raw materials   |       | $                       | 228        |     | $          | 246 |   |
| Work in process |       | 260                     |       | 243      |       |
| Finished goods  |       | 1,323                   |       | 957      |       |
| Supplies        |       | 124                     |       | 119      |       |
|            |       | $                       | 1,935      |     | $          | 1,565 |   |

 

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**Note 3 Equipment and Leasehold Improvements, Net**

Equipment and leasehold improvements consists of thefollowing as of March 31, 2006 and 2005:

| ** **                                      | ** ** | **2006**                | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| Equipment                                       |       | $                       | 10,461     |     | $          | 10,241 |   |
| Leasehold  improvements                         |       | 14,642                  |       | 14,603   |       |
| Furniture and  fixtures                         |       | 86                      |       | 86       |       |
|                                            |       | 25,189                  |       | 24,930   |       |
| Less accumulated  depreciation and amortization |       | (15,327                 | )          | (14,006  | )          |
| Construction  in-progress                       |       | 302                     |       | 250      |       |
|                                            |       | $                       | 10,164     |     | $          | 11,174 |   |

 

**Note 4 AccruedExpenses**

Componentsof accrued expenses as of March 31, 2006 and 2005 are as follows:

| ** **                        | ** ** | **2006**                | ** ** | **2005** | ** ** |
|-----------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                        | ** ** | **(in thousands)** | ** ** |
| Wages,  commissions and royalties |       | $                       | 181        |     | $          | 158 |   |
| Professional fees                 |       | 104                     |       | —   |       |
| Freight                           |       | 26                      |       | 88       |       |
| Other accrued  expenses           |       | 109                     |       | 141      |       |
|                              |       | $                       | 420        |     | $          | 387 |   |

 

**Note 5 Long-TermDebt**

Long-termdebt consists of the following as of March 31, 2006 and 2005:

| ** **                                    | ** ** | **2006**                | ** ** | **2005** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                    | ** ** | **(in thousands)** | ** ** |
| Term loan                                     |       | $                       | 1,751      |     | $          | 2,098 |   |
| Less current  maturities                      |       | (364                    | )          | (355     | )          |
| Long-term debt,  excluding current maturities |       | $                       | 1,387      |     | $          | 1,743 |   |

 

At March 31,2006, the aggregate maturities of long-term debt are as follows:

| **Year ending March 31:** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** |
|------------------------------------------|------------|------------|------------|-------------------------|------------|
| 2007                                     |       |       | $          | 364                     |       |   |
| 2008                                     |       |       | 397        |                    |       |
| 2009                                     |       |       | 434        |                    |       |
| 2010                                     |       |       | 474        |                    |       |
| 2011                                     |       |       | 82         |                    |       |
|                                     |       |       | $          | 1,751                   |       |   |

 

*Term Loan Agreement*

In April 2000, the Company executed a Term LoanAgreement (“Term Loan”) with a lender providing for $3.5 million in aggregatecredit facilities, secured by the Company’s assets. The Term Loan has amaturity date of May 1, 2010 and is payable in 120 equal monthly principaland interest payments. The interest rate under this Term Loan, in the absenceof a default under the agreement, is the prime rate, in effect as of the closeof business on the first day of each calendar quarter, plus 1%. As of March 31,2006 

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and 2005, the prime ratewas 7.25% and 5.25%, respectively. The Company is in compliance with allrestrictive covenants of the Term Loan as of March 31, 2006. The Companyis prohibited from declaring any common stock dividends without the lender’sprior written consent. A warrant to purchase 20,000 shares of the Company’scommon stock was issued in conjunction with this Term Loan. The warrant expiresin April 2011 and has an exercise price of $2.55 per share. The warrantmay only be exercised after the Company has repaid the Term Loan in full.

Of the loan proceeds,$500,000 had been deposited in an interest-bearing restricted cash account perthe terms of the Term Loan. In July 2003, the Company received $250,000 ofcash previously held as a restricted deposit. The remaining $250,000 restrictedcash deposit continues to be held in the restricted cash account and isincluded in Other Assets in the accompanying consolidated Balance Sheets at March 31,2006 and 2005.

**Note 6 Leases**

The Company leases facilities, equipment and landunder operating leases expiring between 2006 and 2025. The land lease providesfor contingent rentals in excess of minimum rental commitments based on apercentage of the Company’s sales. Contingent rental for the years ended March 31,2006, 2005 and 2004 was $55,000, $88,000 and $39,000, respectively.

Futureminimum lease payments under non-cancelable operating leases at March 31,2006 are as follows:

| **Year ending March 31:** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** |
|------------------------------------------|------------|------------|------------|-------------------------|------------|
| 2007                                     |       |       | $          | 234                     |       |   |
| 2008                                     |       |       | 227        |                    |       |
| 2009                                     |       |       | 190        |                    |       |
| 2010                                     |       |       | 151        |                    |       |
| 2011                                     |       |       | 148        |                    |       |
| Thereafter  through 2025                 |       |       | 2,183      |                    |       |
| Total minimum  lease payments            |       |       | $          | 3,133                   |       |   |

 

Rent expense underoperating leases amounted to $316,000, $338,000 and $271,000 for the yearsended March 31, 2006, 2005 and 2004, respectively.

**Note 7 StockOptions and Warrants**

*Stock Options*

On August 22, 2005, the stockholders approved the2005 Stock Option Plan (the “2005 Plan”). 800,000 shares of common stock werereserved for issuance under the ten year term of the 2005 Plan. As of March 31,2006 780,000 options remained available for grant under the 2005 Plan. Underthe 2005 Plan, eligible employees and certain independent consultants may begranted options to purchase shares of the Company’s Stock. The shares issuableunder the 2005 Plan will either be shares of the Company’s authorized but previouslyunissued common stock or shares reacquired by the Company, including sharespurchased on the open market.

Options under the 2005 Plan are granted, and arevested and exercisable as determined by the Board of Directors or the StockOption and Compensation Committee of the Board in accordance with theprovisions of the 2005 Stock Option Plan. The number of options granted andvesting, exercise, and other conditions are set forth in a Stock OptionAgreement evidencing each grant. No option can have a life in excess of ten (10) years.

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All shares granted in the form of options under the2005 Plan will reduce, on a share for share basis, the number of sharesavailable for subsequent grants. Option grants which forfeit under the terms ofthe 2005 Plan will return to the pool of reserved shares and be available forsubsequent grants under the terms of the 2005 Plan.

On August 16, 2004, the stockholders approved theIndependent Director Stock Option and Stock Grant Plan (the “2004 Plan”). 300,000shares of common stock are reserved for issuance under the 2004 Plan. As of March 31,2006 278,000 options remained available for grant under the 2004 Plan. Underthe 2004 Plan, upon election to the Board of Directors, a newly electednon-employee director is granted a ten-year option to purchase 4,000 shares ofthe Company’s common stock at a fair market value on the date of grant. Allsuch options are granted at Fair Market Value of Shares subject to the optionon the date of grant. Options granted vest and become exercisable six monthsfrom the date of grant. In addition, on the date of each Annual Meeting ofStockholders, each non-employee director continuing in office is automaticallygranted, without payment, 3,500 shares of common stock, non-transferable forsix months following the date of grant. Concurrent with the 2004 Plan approval,the 1994 Non-Employee Director Stock Option and Stock Grant Plan was terminatedexcept for the outstanding options issued thereunder.

Previously under the terminated 1994 Plan, uponelection to the Board of Directors, non-employee directors were granted aten-year option to purchase 3,000 shares of the Company’s common stock at fairmarket value on the date of grant. In addition, on the date of each AnnualMeeting of Stockholders, each non-employee director continuing in office wasgranted, without payment, 2,000 shares of common stock, non-transferable forsix months following the date of grant. Expense recognized from the 2004 Planand the 1994 Plan grants of shares of common stock for the years ended March 31,2006, 2005 and 2004 was $14,000, $15,000 and $3,000, respectively.

At March 31,2006, there were 780,000 shares available under the 2005 Plan and no remainingshares available under previous Plans. The per share weighted average fairvalue of stock options granted during 2006, 2005 and 2004 was $0.65, $0.80 and$0.38, respectively, on the date of grant using a Black Scholes option pricingmodel with the following weighted average assumptions:

| ** **               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected dividend  yield |       |     | 0          | %        |       |     | 0          | % |   |   | 0 | % |   |
| Risk-free  interest rate |       |     | 4.3        | %        |       |     | 4.5        | % |   |   | 4.5 | % |   |
| Expected  volatility     |       |     | 107        | %        |       |     | 104        | % |   |   | 97 | % |   |
| Expected life in years   |       |     | 4.5        |     |       |     | 4.0        |   |   |   | 5.0 |   |   |

 

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Activity for stock optionsoutstanding during the periods indicated was as follows:

| ** **                      | ** ** | ** **         | ** ** | **Weighted**            | ** ** |
|---------------------------------|------------|--------------------|------------|-------------------------|------------|
| ** **                      | ** ** | **Number of** | ** ** | **Average**             | ** ** |
| ** **                      | ** ** | **Shares**         | ** ** | **Exercise Price** | ** ** |
| Balance at  March 31, 2003 |       |               | 758,696    |                    |       |   | $ | .1.46 |   |   |
| Granted                         |       |               | 190,400    |                    |       |   | 0.49 |   |   |
| Exercised                       |       |               | (45,800    | )                       |       |   | 0.95 |   |   |
| Expired                         |       |               | (75,900    | )                       |       |   | 3.13 |   |   |
| Forfeited                       |       |               | (171,700   | )                       |       |   | 1.31 |   |   |
| Balance at  March 31, 2004 |       |               | 655,696    |                    |       |   | 1.06 |   |   |
| Granted                         |       |               | 139,095    |                    |       |   | 1.10 |   |   |
| Exercised                       |       |               | (36,019    | )                       |       |   | 0.88 |   |   |
| Expired                         |       |               | (58,952    | )                       |       |   | 1.12 |   |   |
| Forfeited                       |       |               | (93,833    | )                       |       |   | 1.00 |   |   |
| Balance at  March 31, 2005 |       |               | 605,987    |                    |       |   | 1.09 |   |   |
| Granted                         |       |               | 20,000     |                    |       |   | 0.65 |   |   |
| Exercised                       |       |               | (14,500    | )                       |       |   | 0.53 |   |   |
| Expired                         |       |               | (103,600   | )                       |       |   | 1.69 |   |   |
| Forfeited                       |       |               | (38,964    | )                       |       |   | 0.82 |   |   |
| Balance at  March 31, 2006 |       |               | 468,923    |                    |       |   | 0.98 |   |   |

 

The following tablesummarizes the weighted average characteristics of outstanding stock options atMarch 31, 2006 for various exercise price ranges:

| ** **                                  | ** ** | **Outstanding Options** | ** ** | **Exercisable Options** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | **Number of**           | ** ** | **Remaining**                | ** ** | **Weighted** | ** ** | **Number of** | ** ** | **Weighted** | ** ** |
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Shares**                   | ** ** | **Life (Years)** | ** ** | **Average Price** | ** ** | **Shares** | ** ** | **Average Price** | ** ** |
| $0.46-$0.77                                 |       |                         | 253,425    |                         |       |   | 2.3 |   |   |   | $ | 0.56 |   |   |   | 251,363 |   |   |   | $ | 0.56 |   |   |
| $1.03-$1.63                                 |       |                         | 187,498    |                         |       |   | 1.9 |   |   |   | 1.09 |   |   |   | 177,748 |   |   |   | 1.09 |   |   |
| $3.69-$6.13                                 |       |                         | 28,000     |                         |       |   | 1.9 |   |   |   | 3.95 |   |   |   | 28,000 |   |   |   | 3.95 |   |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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*Warrants*

The Company hadissued warrants which allow the warrant holders rights to acquire an equivalentnumber of shares of common stock at a stated exercise price. Warrantsoutstanding during the periods indicated were as follows:

Warrants issued in connection with:

| ** **                      | ** ** | ** **             | ** ** | **50,000 Shares** | ** ** | ** **                 | ** ** | ** **                   | ** ** | ** ** | ** ** |
|---------------------------------|------------|------------------------|------------|------------------------|------------|----------------------------|------------|------------------------------|------------|------------|------------|
| ** **                      | ** ** | **3**rd Party     | ** ** | **Purchased by**  | ** ** | **Term Loan**         | ** ** | ** **                   | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Services**           | ** ** | **Stockholder**        | ** ** | **(See Note 5)** | ** ** | **Debentures**               | ** ** | ** ** | ** ** |
| **Grant date:**            | ** ** | **December 1999** | ** ** | **January 2000**  | ** ** | **April 2000**        | ** ** | **May 2000 &** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** **             | ** ** | ** **             | ** ** | ** **                 | ** ** | **May 2002**            | ** ** | ** ** | ** ** |
| **Expiration date:**       | ** ** | **December 2004** | ** ** | **January 2005**  | ** ** | **April 2011**        | ** ** | **May 2004**            | ** ** | ** ** | ** ** |
| **Exercise price:**        | ** ** | **$0.63**              | ** ** | **$1.00**              | ** ** | **$2.55**                  | ** ** | **$1.10**                    | ** ** | **Total**  | ** ** |
| Balance at March 31,  2003 |       |                   | 75,000     |                   |       |                       | 50,000     |                         |       |       | 20,000     |   |   |   | 454,734 |   |   | 599,734 |   |
| Exercises                       |       |                   | —     |                   |       |                       | —     |                         |       |       | —     |   |   |   | (429,234 | ) |   | (429,234 | ) |
| Balance at March 31, 2004  |       |                   | 75,000     |                   |       |                       | 50,000     |                         |       |       | 20,000     |   |   |   | 25,500 |   |   | 170,500 |   |
| Exercises                       |       |                   | (75,000    | )                      |       |                       | (50,000    | )                            |       |       | —     |   |   |   | (7,000 | ) |   | (132,000 | ) |
| Expired                         |       |                   | —     |                   |       |                       | —     |                         |       |       | —     |   |   |   | (18,500 | ) |   | (18,500 | ) |
| Balance at March 31, 2005  |       |                   | —     |                   |       |                       | —     |                         |       |       | 20,000     |   |   |   | — |   |   | 20,000 |   |
| Exercises                       |       |                   | —     |                   |       |                       | —     |                         |       |       | —     |   |   |   | — |   |   | — |   |
| Expired                         |       |                   | —     |                   |       |                       | —     |                         |       |       | —     |   |   |   | — |   |   | — |   |
| Balance at  March 31, 2006 |       |                   | —     |                   |       |                       | —     |                         |       |       | 20,000     |   |   |   | — |   |   | 20,000 |   |

 

**Note 8 Earnings PerShare**

Basic earnings per share is computed on the basis ofthe weighted average number of common shares outstanding. Diluted earnings pershare is computed on the basis of the weighted average number of common sharesoutstanding plus the potentially dilutive effect of outstanding stock optionsand warrants using the “treasury stock” method and convertible securities usingthe “if-converted” method.

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Reconciliationsbetween the numerator and the denominator of the basic and diluted earnings pershare computations for the years ended March 31, 2006, 2005 and 2004 areas follows:

| ** **                                                             | ** ** | **Net Income**                                                   | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                                             | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                                                             | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Year ended  March 31, 2006:                                       |       |                                                                  |       |              |       |               |       |   |   |   |   |   |   |
| Basic earnings per share                                               |       |                                                                  | $          | (268              | )          |               |       | 20,904 |   |   |   | $ | (0.01 | ) |   |
| Effect of dilutive securities—  Common stock options and warrants |       |                                                                  | —     |              |       |               | —     |   |   |   |   |   |   |
| Diluted earnings per share                                             |       |                                                                  | $          | (268              | )          |               |       | 20.904 |   |   |   | $ | (0.01 | ) |   |
| Year ended  March 31, 2005:                                       |       |                                                                  |       |              |       |               |       |   |   |   |   |   |   |
| Basic earnings per share                                               |       |                                                                  | $          | 486               |       |               |       | 20,784 |   |   |   | $ | 0.02 |   |   |
| Effect of dilutive securities—  Common stock options and warrants |       |                                                                  | —     |              |       |               | 195        |   |   |   |   |   |   |
| Diluted earnings per share                                             |       |                                                                  | $          | 486               |       |               |       | 20,979 |   |   |   | $ | 0.02 |   |   |
| Year ended  March 31, 2004:                                       |       |                                                                  |       |              |       |               |       |   |   |   |   |   |   |
| Basic earnings per share                                               |       |                                                                  | $          | 399               |       |               |       | 18,971 |   |   |   | $ | 0.02 |   |   |
| Effect of dilutive securities—  Common stock options and warrants |       |                                                                  | —     |              |       |               | 140        |   |   |   |   |   |   |
| Diluted earnings  per share                                            |       |                                                                  | $          | 399               |       |               |       | 19,111 |   |   |   | $ | 0.02 |   |   |

 

Thefollowing securities were excluded from the calculation of diluted earnings pershare because their effect was antidilutive:

| ** **                       | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                       | ** ** | **(in thousands)** | ** ** |
| Debentures, prior  to conversion |       |                    | —     |     |       |     | —     |   |   | 1,329 |   |
| Stock options and  warrants      |       |                    | 489        |     |       |     | 158        |   |   | 441 |   |

 

**Note 9 ProfitSharing Plan**

The Company sponsors aprofit sharing plan for all employees not covered under a separate managementincentive plan. Under the profit sharing plan, 5% of pre-tax profits on aquarterly basis may be allocated to non-management employees based on grosswages. At management’s discretion, the profit sharing bonus may be distributedall in cash on an after-tax basis or distributed half in cash (on an after-taxbasis) and the remainder deposited in an employee’s 401(k) account on apre-tax basis with a five year vesting schedule, based on years of service withthe Company. All employees may make voluntary pre-tax contributions to their401(k) accounts; Company contributions are discretionary. For the yearsended March 31, 2006, 2005 and 2004 compensation expense relative to thisplan was approximately $18,000, $30,000 and $36,000, respectively.

43

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**Note 10 MajorCustomers and Geographic Information**

Netsales by product line for the years 2006, 2005 and 2004 are as follows:

| ** **                    | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                    | ** ** | **(in thousands)** | ** ** |
| Net sales:                    |       |                    |       |     |       |     |       |
| Spirulina products            |       | $                       | 6,517      |     | $          | 6,626    |       | $ | 6,511 |   |
| Natural  astaxanthin products |       |                    |       |     |       |     |       |
| NatuRose                      |       | 1,403                   |       | 1,817    |       | 2,545    |       |
| BioAstin                      |       | 2,967                   |       | 2,855    |       | 2,388    |       |
| Other products                |       | 244                     |       | 147      |       | 138      |       |
|                          |       | $                       | 11,131     |     | $          | 11,445   |       | $ | 11,582 |   |

 

Approximately $1,285,000, or 12% of our total netsales for the year ended March 31, 2006, was to a single customer. Salesto this customer for fiscal 2005 and 2004 were $1,130,000 (10% of net sales)and $1,560,000 (13% of net sales), respectively.

Thefollowing table presents sales for the years 2006, 2005 and 2004 by geographicregion:

| ** **      | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **      | ** ** | **(dollars in thousands)** | ** ** |
| Net sales(1):   |       |                                 |       |     |       |     |       |   |   |   |   |   |   |   |   |
| United States   |       | $                                    | 5,343      |     |       | 48       | %          |   | $ | 5,847 |   | 51 | % | $ | 4,918 |   | 42 | % |
| Japan           |       | 1,328                                |       |     | 12         | %        |       | 1,759 |   | 16 | % | 2,020 |   | 17 | % |
| The Netherlands |       | 1,300                                |       |     | 12         | %        |       | 1,180 |   | 10 | % | 1,562 |   | 14 | % |
| Other areas     |       | 3,160                                |       |     | 28         | %        |       | 2,659 |   | 23 | % | 3,082 |   | 27 | % |
|            |       | $                                    | 11,131     |     |       | 100      | %          |   | $ | 11,445 |   | 100 | % | $ | 11,582 |   | 100 | % |

----

(1)          Net sales are attributedto countries based on location of customer.

Substantially alllong-lived assets are located in the United States as of March 31, 2006and 2005.

**Note 11 IncomeTaxes**

Income(loss) before income taxes consisted of:

| ** **                         | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                         | ** ** | **(in thousands)** | ** ** |
| United States                      |       | $                       | (165       | )        | $          | 375      |       | $ | 224 |   |
| Foreign                            |       | (86                     | )          | 70       |       | 250      |       |
| Income (loss)  before income taxes |       | $                       | (251       | )        | $          | 445      |       | $ | 474 |   |

 

44

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Incometax expense (benefit) for the years ended March 31, 2006, 2005 and 2004consisted of:

| ** **                    | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                    | ** ** | **(in thousands)** | ** ** |
| Current:                      |       |                    |       |     |       |     |       |   |   |
| Foreign                       |       |                    | $          | —   |       |     | $          | 11 |   | $ | 121 |   |
| Federal                       |       |                    | —     |     |       | (5       | )          | 5 |   |
| State                         |       |                    | 14         |     |       | (62      | )          | (33 | ) |
| Total current                 |       |                    | 14         |     |       | (56      | )          | 93 |   |
| Deferred:                     |       |                    |       |     |       |     |       |   |   |
| Foreign                       |       |                    | 3          |     |       | 15       |       | (18 | ) |
| Federal                       |       |                    | —     |     |       | —   |       | — |   |
| State                         |       |                    | —     |     |       | —   |       | — |   |
| Total deferred                |       |                    | 3          |     |       | 15       |       | (18 | ) |
| Income tax  expense (benefit) |       |                    | $          | 17       |       |     | $          | (41 | ) | $ | 75 |   |

 

Thefollowing table reconciles the amount of income taxes computed at the federalstatutory rate of 34%, for all periods presented, to the amount reflected inthe Company’s consolidated statement of operations for the years ended March 31,2006, 2005 and 2004:

| ** **                                                           | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                           | ** ** | **(in thousands)** | ** ** |
| Tax provision  (benefit) at federal statutory income tax rate        |       | $                       | (85        | )        | $          | 151      |       | $ | 161 |   |
| State income  taxes, net of federal income tax effect                |       | 9                       |       | (41      | )          | (22      | )          |
| Foreign income  taxes in excess of federal statutory income tax rate |       | —                  |       | 2        |       | 36       |       |
| Increase  (decrease) in valuation allowance for deferred tax assets  |       | 92                      |       | 55       |       | (188     | )          |
| Adjustment of  deferred tax assets                                   |       | (41                     | )          | (123     | )          | (180     | )          |
| Other, net                                                           |       | 42                      |       | (85      | )          | 268      |       |
| Income tax  expense (benefit)                                        |       | $                       | 17         |     | $          | (41      | )          | $ | 75 |   |

 

Thetax effects of temporary differences related to various assets, liabilities andcarryforwards that give rise to deferred tax assets and deferred taxliabilities as of March 31, 2006 and 2005 are as follows:

| ** **                                                                                                     | ** ** | **2006**                | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                                                                                     | ** ** | **(in thousands)** | ** ** |
| Deferred tax assets:                                                                                           |       |                    |       |     |       |
| Net operating loss carryforwards                                                                               |       | $                       | 5,239      |     | $          | 5,340 |   |
| Impairment loss on leasehold improvements for  financial reporting purposes                                    |       | 1,062                   |       | 1,062    |       |
| Tax credit carryforwards                                                                                       |       | 122                     |       | 115      |       |
| Other                                                                                                          |       | 204                     |       | 169      |       |
| Gross deferred tax assets                                                                                      |       | 6,627                   |       | 6,686    |       |
| Less valuation  allowance                                                                                      |       | (5,264                  | )          | (5,133   | )          |
| Net deferred tax assets                                                                                        |       | 1,363                   |       | 1,553    |       |
| Deferred tax  liability: Differences in depreciation and amortization on equipment and  leasehold improvements |       | (1,363                  | )          | (1,550   | )          |
| Net deferred tax  assets                                                                                       |       | $                       | —     |     | $          | 3 |   |

 

In assessing the realizability of deferred tax assets,management considers whether it is more likely than not that some portion orall of the deferred tax assets will not be realized. The ultimate realizationof deferred tax assets is dependent upon the generation of future taxableincome during the periods in which those temporary differences becomedeductible. Management considers the scheduled reversal of deferred 

45

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tax liabilities, projectedfuture taxable income and tax planning strategies in making this assessment. Basedupon the level of historical taxable income and projections for future taxableincome over the periods in which net deferred tax assets are deductible,management does not believe~~s~~ it is more likely than not the Company willrealize a portion of its gross deferred tax assets, and has thus established avaluation allowance to reflect its estimated realizability. The amount of thedeferred tax assets considered realizable, however, could change in the nearterm if estimates of future taxable income during the carryforward periodchange.

At March 31, 2006, the Company has net operatingloss carryforwards and tax carryfowards available to offset future federalincome tax as follows(in thousands):

| ** **                      | ** ** | ** **             | ** ** | **Research and** | ** ** |
|---------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **Net Operating** | ** ** | **Experimentation**   | ** ** |
| **Expires March 31,** | ** ** | ** **             | ** ** | **Losses**            | ** ** | **Tax Credits** | ** ** |
| 2011                            |       |                   | $          | —                |       |   |   | $ | 23 |   |   |
| 2012                            |       |                   | —     |                  |       |   | 9 |   |   |
| 2013                            |       |                   | 1,423      |                  |       |   | — |   |   |
| 2019                            |       |                   | 3,632      |                  |       |   | — |   |   |
| 2020                            |       |                   | 2,051      |                  |       |   | 7 |   |   |
| 2021                            |       |                   | 1,727      |                  |       |   | — |   |   |
| 2022                            |       |                   | 3,161      |                  |       |   | — |   |   |
| 2023                            |       |                   | 1,810      |                  |       |   | — |   |   |
|                            |       |                   | $          | 13,804                |       |   |   | $ | 39 |   |   |
|                                 |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 

In addition, at March 31, 2006, the Company hasalternative minimum tax credit carryforwards of approximately $83,000 availableto reduce future federal regular income taxes over an indefinite period.

At March 31, 2006,the Company has state tax net operating loss carryforwards of $9,101,000, whichexpire in March 31, 2019 through 2023, available to offset future Hawaiistate taxable income.

**Note 12 Selected Quarterly Financial Data (Unaudited)**

| ** **                                            | ** ** | **First**                                                          | ** ** | **Second**  | ** ** | **Third**   | ** ** | **Fourth**  | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|------------|------------|
| ** **                                            | ** ** | **Quarter**                                                        | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Year**   | ** ** |
| ** **                                            | ** ** | **(in thousands, except per share data)** | ** ** |
| 2006                                                  |       |                                                               |       |        |       |        |       |        |       |       |       |   |   |   |   |   |   |   |   |
| Net sales                                             |       |                                                               | $          | 3,029       |       |        |       | $           | 2,517      |       |       |   | $ | 2,333 |   |   |   | $ | 3,252 |   |   | $ | 11,131 |   |
| Gross profit                                          |       |                                                               | 1,025      |        |       |        | 581        |        |       |       | 621        |   |   |   | 1,072 |   |   | 3,299 |   |
| Net income (loss)                                     |       |                                                               | 153        |        |       |        | (321       | )           |       |       | (294       | ) |   |   | 194 |   |   | (268 | ) |
| Net income (loss)  per share—  Basic and Diluted |       |                                                               | 0.01       |        |       |        | (0.02      | )           |       |       | (0.01      | ) |   |   | 0.01 |   |   | (0.01 | ) |
| 2005                                                  |       |                                                               |       |        |       |        |       |        |       |       |       |   |   |   |   |   |   |   |   |
| Net sales                                             |       |                                                               | $          | 2,707       |       |        |       | $           | 2,998      |       |       |   | $ | 3,180 |   |   |   | $ | 2,560 |   |   | $ | 11,445 |   |
| Gross profit                                          |       |                                                               | 887        |        |       |        | 1,054      |        |       |       | 1,163      |   |   |   | 714 |   |   | 3,818 |   |
| Net income (loss)                                     |       |                                                               | 113        |        |       |        | 121        |        |       |       | 326        |   |   |   | (74 | ) |   | 486 |   |
| Net income (loss) per  share—  Basic and Diluted |       |                                                               | 0.01       |        |       |        | 0.01       |        |       |       | 0.02       |   |   |   | (0.00 | ) |   | 0.02 |   |

 

**Item 9. Changes inand Disagreements with Accountants on Accounting and Financial Disclosure**

Not applicable.

46

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**Item9A. Controls and Procedures**

Under the supervision andwith the participation of management, including the Chief Executive Officer andChief Financial Officer, we have evaluated the effectiveness of the design andoperation of our disclosure controls and procedures as of the end of the periodcovered by this report. Based on that evaluation, the Chief Executive Officerand Chief Financial Officer have concluded that these disclosure controls andprocedures are effective to ensure that the information required to bedisclosed by the Company is recorded, processed, summarized and reported inaccordance with Securities and Exchange Commission rules and forms. Subsequentto the date of our evaluation, there were no changes in our internal controlover financial reporting that have materially affected, or are reasonablylikely to materially affect, our internal controls over financial reporting.

**Item9B. Other Information**

Not applicable

**PART III**

**Item10. Directors and Executive Officers of the Registrant**

Information with respectto Directors may be found under captions “Proposal One: Election of Directors,”“Board Meetings and Committees,” “Director Compensation,” “Security Ownershipof Certain Beneficial Owners and Management” and “Compliance with Section 16(a) ofthe Exchange Act” contained in Cyanotech’s definitive 2006 Proxy Statement. Informationon Executive Officers may be found under the caption “Executive Officers”contained in Cyanotech’s definitive 2006 Proxy Statement. Such information isincorporated herein by reference.

We have adopted theCyanotech Code of Ethics for Chief Executive Officer and Senior FinancialOfficers (the “Code of Ethics”) included in our Code of Conduct. Our Code ofConduct and Ethics is publicly available on our website at www.cyanotech.com. Ifwe make any substantive amendments to or grant any waivers from such Coderelating to our Chief Executive Officer, Chief Financial Officer or Controller,we will disclose the nature of such amendment in a report on Form 8-Kand amend the website disclosure.

**Item11. Executive Compensation**

The information requiredby this Item is incorporated herein by reference from the sections captioned“Executive Compensation and Other Information,” ”Equity Compensation PlanInformation,” “Option Grants in Last Fiscal Year,” “Aggregated Option Exercisesin Last Fiscal Year and Fiscal Year-End Option Values,” and “Stockholder ReturnPerformance Graph” contained in Cyanotech’s definitive 2006 Proxy Statement.

**Item12. Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters**

The security ownershipinformation required by this Item is incorporated herein by reference from thesections captioned “Equity Compensation Plan Information” and “SecurityOwnership of Certain Beneficial Owners and Management” contained in Cyanotech’sdefinitive 2006 Proxy Statement.

**Item13. Certain Relationships and Related Transactions**

Not applicable.

**Item14. Principal Accountant Fees and Services**

Information concerningprincipal accountant fees and services appears in Cyanotech’s definitive 2006Proxy Statement under the heading “Independent Registered Public AccountingFirm’s Fees” and is incorporated herein by reference.

47

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**PART IV**

**Item 15. FinancialStatement Schedules and Exhibits**

(a)          FinancialStatements and Schedules

·        The following FinancialStatements of Cyanotech Corporation and subsidiaries and the Report ofIndependent Registered Public Accounting Firm are included in Item 8 of thisreport:

| Consolidated Balance Sheets,  March 31, 2006 and 2005                                                                                    |   | 28 |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|----|
| Consolidated Statements  of Operations for the years ended March 31, 2006, 2005 and 2004                                                 |   | 29 |
| Consolidated Statements  of Stockholders’ Equity and Comprehensive Income (Loss) for the years ended  March 31, 2006, 2005 and 2004 |   | 30 |
| Consolidated Statements  of Cash Flows for the years ended March 31, 2006, 2005 and 2004                                                 |   | 31 |
| Notes to Consolidated Financial Statements                                                                                                    |   | 32 |

 

·        Thefollowing financial statement schedule is included in this report on the pages indicatedbelow:
| Schedule II—Valuation and  Qualifying Accounts      |   | 50 |
|----------------------------------------------------------|--------|----|
| Report of Independent Registered Public Accounting  Firm |   | 51 |

 

Financialstatement schedules not listed above have been omitted since they are eithernot required, not applicable or the information is included in the consolidatedfinancial statements or notes thereto.

48

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(b)         Exhibit Listing

| Exhibit Number | ** ** | **Document  Description**                                                                                                                                                                                                                                                                                                                                                  |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Restated Articles  of Incorporation (Incorporated by reference to  Exhibit 3.1 to the Company’s Quarterly Report on Form 10-QSB for  the quarter ended December 31, 1996, File No. 0-14602)                                                                                                                                                  |
| 3.2                 |       | Bylaws of the Registrant, as amended (Incorporated  by reference to Exhibit 3.1 to the Company’s Quarterly Report on  Form 10-QSB for the quarter ended December 31, 1996, File  No. 0-14602)                                                                                                                                                     |
| 4.1                 |       | Specimen Common Stock Certificate (Incorporated by  reference to Exhibit 4.1 to The Company’s Registration Statement on  Form SB-2 filed on February 28, 1996, File No. 333-00951)                                                                                                                                                                |
| 10.1                |       | 1994 Non-Employee Directors Stock Option and Stock  Grant Program (Incorporated by reference to Exhibit 10.7 to the  Company’s Annual Report on Form 10-KSB for the fiscal year ended March 31,  1994, File No. 0-14602)                                                                                                                          |
| 10.2                |       | 1995 Stock Option Plan for Cyanotech Corporation  dated August 9, 1995, as amended (Incorporated by reference to  Exhibit 4(c) to the Company’s Registration Statement on  Form S-8 filed on October 27, 1995, File No. 33-63789)                                                                                                       |
| 10.3                |       | Sub-Lease Agreement between the Company and Natural  Energy Laboratory of Hawaii Authority dated December 29, 1995  (Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly  Report on Form 10-QSB for the quarter ended December 31, 1995, File  No. 0-14602)                                                                 |
| 10.4                |       | Term Loan Agreement dated April 21, 2000  between the Company and B&I Lending, LLC (Incorporated by reference to  Exhibit 10.11 to the Company’s Annual Report on Form 10-K for the  year ended March 31, 2000, File No. 0-14602)                                                                                                        |
| 10.5                |       | 2005 Stock Option Plan for Cyanotech Corporation  dated August 22, 2005, incorporated by reference to Exhibit A of  the Company’s definitive Proxy Statement filed July 14, 2005, File  No. 0-14602                                                                                                                                               |
| 14.1                |       | Amended Code of Ethics for Chief Executive Officer and  Senior Financial Officers, which is included in the Code of Conduct and  Ethics. (Incorporated by reference to Exhibit 99.2 to the  Company’s Report on Form 8-K filed on December 19, 2005, and by  reference and attachment to the Company’s Internet address  www.cyanotech.com.) |
| 21.1                |       | Subsidiaries of the Company (Incorporated by  reference to Exhibit 21.1 to the Company’s Annual Report on  Form 10-K for the year ended March 31, 2003, File No. 0-14602)                                                                                                                                                                         |
| 23.1                |       | Consent of Independent Registered Public Accounting  Firm                                                                                                                                                                                                                                                                                                                  |
| 31.1                |       | Certifications of Chief Executive Officer Pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                  |
| 31.2                |       | Certifications of Chief Financial Officer Pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                  |
| 32.1                |       | Certifications of Chief Executive Officer Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                  |
| 32.2                |       | Certifications of Chief Financial Officer Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                  |

 

49

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**Schedule II**

**CyanotechCorporation and SubsidiariesValuation and Qualifying Accounts**

**Years Ended March 31,2006, 2005 and 2004(In Thousands)**

| ** **                           | ** ** | ** **          | ** ** | **Additions**       | ** ** | ** **          | ** ** | ** **   | ** ** |
|--------------------------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|--------------|------------|
| ** **                           | ** ** | **Balance at** | ** ** | **Charged to** | ** ** | **Charged to** | ** ** | ** **   | ** ** | **Balance at** | ** ** |
| ** **                           | ** ** | **Beginning**       | ** ** | **Costs and**  | ** ** | **Other**           | ** ** | ** **   | ** ** | **End of** | ** ** |
| **Description**                      | ** ** | ** **          | ** ** | **of Year**    | ** ** | **Expense**         | ** ** | **Accounts** | ** ** | **Deductions** | ** ** | **Year** | ** ** |
| Allowance for Doubtful  Receivables: |       |                |       |                |       |                |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 2006                                 |       |                | $          | 46                  |       |                |       | $            | (8         | ) |   |   | $ | — |   |   |   | $ | 13 |   |   |   | $ | 25 |   |   |
| 2005                                 |       |                | $          | 96                  |       |                |       | $            | 31         |   |   |   | $ | — |   |   |   | $ | 81 |   |   |   | $ | 46 |   |   |
| 2004                                 |       |                | $          | 60                  |       |                |       | $            | 37         |   |   |   | $ | — |   |   |   | $ | 1 |   |   |   | $ | 96 |   |   |
|                                      |            |                     |            |                     |            |                     |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

TheBoard of Directors and Stockholders

Cyanotech Corporation:

Under date of June 16, 2006, we reported on theconsolidated balance sheets of Cyanotech Corporation and subsidiaries (theCompany) as of March 31, 2006 and 2005, and the related consolidatedstatements of operations, stockholders’ equity and comprehensive income (loss),and cash flows for each of the years in the three-year period ended March 31,2006, which are included in the Company’s March 31, 2006 annual report on Form 10-K.In connection with our audits of the aforementioned consolidated financialstatements, we also audited the related financial statement schedule as listedin Item 15(a)(2). The financial statement schedule is the responsibility of theCompany’s management. Our responsibility is to express an opinion on thefinancial statement schedule based on our audits.

In our opinion, suchfinancial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly, in allmaterial respects, the information set forth therein.

/s/  KPMG LLP

Honolulu,Hawaii

June 16,2006

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on the 26th day of June, 2006.

|        | **CYANOTECH CORPORATION** |
|--------|---------------------------|
|   | By:                       | /s/  Gerald R. Cysewski, Ph. D. |
|   |                      | Gerald R.  Cysewski, Ph. D. |
|   |                      | *Chairman  of the Board, President* |
|   |                      | *and  Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

|                                | **Signatures** | ** **                                                          | ** ** |                    | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|--------------------------------|----------------|---------------------------------------------------------------------|------------|--------------------|-----------|------------|------------|--|----------|------------|
| /s/ Gerald R. Cysewski, Ph. D. |           | Chairman of the  Board, President and                               |       | June 26, 2006 |
| Gerald  R. Cysewski, Ph. D.    |           | Chief Executive Officer  (Principal Executive Officer and Director) |       |               |
| /s/ William R. Maris           |           | Chief Financial  Officer, Vice President—                      |       | June 26, 2006 |
| William  R. Maris              |           | Finance and  Administration, Secretary and Treasurer                |       |               |
| /s/ Michael A. Davis           |           | Director                                                            |       | June 26, 2006 |
| Michael  A. Davis              |           |                                                                |       |               |
| /s/ Gregg W. Robertson         |           | Director                                                            |       | June 26, 2006 |
| Gregg  W. Robertson            |           |                                                                |       |               |
| /s/ David I. Rosenthal         |           | Director                                                            |       | June 26, 2006 |
| David  I. Rosenthal            |           |                                                                |       |               |
| /s/ John T. Waldron            |           | Director                                                            |       | June 26, 2006 |
| John  T. Waldron               |           |                                                                |       |               |
| /s/ Paul C. Yuen               |           | Director                                                            |       | June 26, 2006 |
| Paul C. Yuen                   |           |                                                                |       |               |

 

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