CYANOTECH CORPORATION
                               1998 ANNUAL REPORT

                  MICROALGAE: ORGANIC FACTORIES OF THE FUTURE.



<PAGE>

                             SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                         Years ended March 31,
----------------------------------------------------------------------------------------------
<S>                                     <C>         <C>         <C>          <C>          <C>
(in thousands, except per share data)   1998        1997        1996         1995         1994
==============================================================================================

Results of Operations
Net sales                           $  7,627   $  11,399   $   8,081    $   4,150     $  2,697
Gross profit                           3,137       6,809       4,563        1,875        1,202
Income (loss) from operations           (300)      3,751       2,571          718          220
Net income (loss)                       (300)      4,159       2,509          769          204
Net income (loss) per common share
   Basic                            $  (0.05)  $    0.31   $    0.22    $    0.05     $  (0.02)
   Diluted                          $  (0.05)  $    0.25   $    0.17    $    0.05     $  (0.02)

Average shares outstanding
   Basic                              12,909      12,583       9,583        8,895        8,602
   Diluted                            12,909      16,598      14,502        8,895        8,602

Selected Balance Sheet Data
Cash and investment securities      $  1,397   $   6,729   $   9,409   $      496    $     866
Total assets                          25,667      26,015      19,716        6,212        5,132
Long-term debt and
   capital lease obligations             129         559         838          184          109
Stockholders' equity               $  23,174   $  23,335   $  17,316   $    5,104    $   4,160
</TABLE>

                                   CYANOTECH

Cyanotech is harnessing the vast  potential of microalgae to produce  high-value
natural products for important market applications worldwide.
   The  Company's  products  include  Spirulina  Pacifica(TM),  a  nutrient-rich
dietary  supplement;  NatuRose(TM), a natural  astaxanthin  product  used in the
worldwide aquaculture  industry;  and  phycobiliproteins,  which are fluorescent
pigments  used in the  immunological  diagnostics  market.  The  Company is also
developing  microalgae-based  products for the biopesticide markets and, through
an exclusive license agreement with The Scripps Research  Institute,  a patented
aldolase catalytic antibody with potential  applications in industrial synthesis
for  the  manufacture  of  pharmaceuticals,   fine  chemicals  and  agricultural
products.
   Cyanotech's technologies,  systems,  processes and favorable growing location
on the Kona coast of Hawaii  permit  year-round  growing and  harvesting  of its
products in a cost-effective  manner. Its production system operates without the
use of pesticides and herbicides, and does not create erosion, fertilizer runoff
or water pollution.
   Cyanotech  is  the  only  microalgae  company  in the  world  to be  ISO-9002
registered.
   Cyanotech  markets  its  products in the United  States and  foreign  markets
through  retail,   wholesale  and  private  label  channels.   Nutrex,  Inc.,  a
wholly-owned  subsidiary,   produces  and  markets  spirulina-based  nutritional
products for the retail market.
   Additional  company and product  information  is available  on  Cyanotech's
World Wide Web site at www.cyanotech.com.
<PAGE>



The wide range of products Cyanotech is beginning to produce -- from nutritional

supplements and animal feed ingredients to industrial  enzymes and biopesticides

-- is proving the Company's  concept of microalgae  as broadly  capable  organic

factories for  high-value,  diverse  applications.  
                                                    


                  CYANOTECH PRODUCT PIPELINE: ROBUST AND VARIED
<TABLE>
<CAPTION>
<S>                                                                                  <C>                 <C>
PRODUCT                                                                              INTRODUCED          MARKETS
------------------------------------------------------------------------------------------------------------------------------------
Spirulina Pacifica(TM)                                                                  1985             Health & Natural Foods
A nutrient-rich  dietary supplement,  CYAN's unique strain is a vegetable-based,                         Over $30 million at
highly absorbable  source of natural beta carotene,  mixed carotenoids and other                         wholesale 
phytonutrients,  B vitamins,  gamma linolenic acid (GLA),  protein and essential                         (CYAN $7.1 million sales in
amino acids.                                                                                              FY98)
------------------------------------------------------------------------------------------------------------------------------------
Phycobiliproteins                                                                       1988             Immunological Diagnostics
Fluorescent pigments used for medical testing.                                                           Nominal
                                                                                                         (CYAN $250,000 sales
                                                                                                          in FY98)
-----------------------------------------------------------------------------------------------------------------------------------
NatuRose(TM) Natural Astaxanthin                                                        1997             Aquaculture/Animal
A red pigment used primarily in the aquaculture  industry to impart color to the                         Feed/Pigments
flesh of pen-raised fish and shrimp.  Competes with synthetic  astaxanthin  made                         Over $150 million 
from petrochemicals.                                                                                     (one supplier)      
                                                                                                         (CYAN $250,000 sales 
                                                                                                          in FY98)
------------------------------------------------------------------------------------------------------------------------------------
Aldolase Catalytic Antibody                                                             1998             Industrial Enzymes
Genetically  engineered  antibody may have numerous  applications  in industrial                         Undefined  
synthesis,  including  certain  anti-cancer  compounds.  Has efficiency rate and                         (varied industrial/
operative  mechanism  equal  to  natural  enzyme,  but with a  broader  scope of                          pharmaceutical 
reactivity.  Exclusive  license  from  The  Scripps  Research  Institute.  First                          applications)
commercially  available  aldolase  catalytic  antibody.
------------------------------------------------------------------------------------------------------------------------------------
Mosquitocide                                                                            1999             Biopesticides  
CYAN is genetically engineering a natural toxin from Bacillus thuringiensis var.                         Over $500 million 
israelensis (Bti) into the blue-green algae, Synechococcus,  a food for mosquito                         (worldwide need enormous)
larvae. When applied to a  mosquito-infested  body of water, the algae could act
as an  effective  and  environmentally  safe means of control.  
------------------------------------------------------------------------------------------------------------------------------------
Other Products                                                                          2000+            Undefined
CYAN plans to develop other  high-value  products from  microalgae.  These could
include    genetically-engineered    pharmaceuticals,     nutraceuticals,    and
poly-unsaturated fatty acids.
------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
                                       1

<PAGE>
TO OUR STOCKHOLDERS

Fiscal 1998 was a profound  disappointment  for Cyanotech  after years of steady
growth.  But it was  principally  attributable  to  reduced  sales  to a  single
Spirulina purchaser,  which had been the Company's largest customer,  accounting
for 34% of total  sales in FY97 vs.  5% in FY98.  These  figures  show  both the
opportunity  and the problem of relying on a single  product and  customer.  The
customer is a network  marketer  whose sales in China were halted by the Chinese
government  for much of the past fiscal  year along with all  network  marketers
there, then banned altogether. As a result,  Cyanotech's sales decreased to $7.6
million in FY98 from $11.4  million in FY97 with a net loss of  $300,000 in FY98
vs. net  income of $4.2  million in FY97.  To return to  profitability  at lower
demand  levels,  we  reduced  our  workforce  by 25% in the fourth  quarter.  By
contrast, fiscal 1999 and future years look more positive due to the variety and
potential of products on the market and under development.

SPIRULINA PACIFICA(TM)
         With the reduced sales to China,  we worked hard during FY98 to broaden
our customer base for  Spirulina.  An indicator of progress is our  relationship
with the General  Nutrition  Center (GNC) chain of retail  stores in the U.S. We
are now selling our branded Nutrex(TM) Spirulina Pacifica products through 1,000
GNC stores nationwide, up from 200 stores at the beginning of FY98. We also have
increased marketing efforts in Hawaii, signed additional  distributors overseas,
and are  investigating  new markets,  such as in poultry feed where  preliminary
studies indicate that Spirulina  contributes to a significantly  improved immune
system in poultry with the possibility of eliminating antibiotics. The Spirulina
market  overall is not large,  but we are working to increase our already strong
share.

NATUROSE(TM) ASTAXANTHIN
         We hoped that NatuRose would be used by the  aquaculture  industry from
its  introduction  in March 1997,  but we did not account for the close customer
relationships  in a market  characterized  by a single  supplier and the caution
shown in  accepting a new  product.  During  FY98,  prospective  customers in 12
countries  engaged in more than 30 feeding trials of NatuRose with all completed
studies to date showing positive results. Although we only sold trial quantities
of astaxanthin  during the fiscal year,  commercial  order flow has begun in the
first  quarter  of  FY99.  We  also  have  signed  a  Letter  of  Intent  with a
multi-national  life  sciences  company ($15 billion in annual sales to 150-plus
countries) to distribute  NatuRose,  initially to its  aquaculture  customers in
Europe.

MOSQUITOCIDE
         Once NatuRose was launched in 1997, we turned our development attention
to the  promising  potential  mosquitocide  we had  licensed  in FY 96 from  the
University  of  Memphis.  In the  summer  of 1997,  we hired a senior  molecular
biologist  experienced  in  natural  bacterial  toxins to lead the  mosquitocide
effort.  The original genetically engineered microalgae we had licensed included
only one of the four BTI toxins,  all of which are harmless to humans but deadly

                                       2
<PAGE>

to mosquito  larvae.  We are currently  focused on adding up to three additional
Bti toxins to  significantly  increase the product's  toxicity and to lessen the
risk of mosquito larvae evolving a resistance to a single-toxin product. We plan
to have the mosquitocide in limited commercial  production for worldwide testing
by the end of the current fiscal year.  The market  potential is unknown at this
time, but the need for safe-for-human  biopesticides is growing as the incidence
of  mosquito-borne  malarial and other diseases is increasing in both developing
and developed countries.

SCRIPPS ALDOLASE ANTIBODY
         In April  1998,  we  signed an  exclusive  agreement  with The  Scripps
Research  Institute  to produce  the  Institute's  patented  aldolase  catalytic
antibody 38C2 in microalgae.  Previously, the antibody has only been produced in
small quantities in animal cells in the laboratory. We have long maintained that
microalgae  provide an  excellent  vehicle for the genetic  engineering  of many
products due to their ease of genetic manipulation,  short generation cycles and
cellular   uniformity.   This  product  with  potential  for   applications   in
pharmaceuticals, fine chemicals and agriculture exemplifies our thesis.

ROBUST PRODUCT PIPELINE
         There  are over  30,000  species  of  microalgae,  many of  which  have
natural,  beneficial  properties  that can be  extracted  to produce  high-value
products,   while  many  more  can  act  effectively  as  vehicles  for  genetic
engineering to produce other products.  Our challenge is to remain focused as we
explore  the  wealth of  possibilities  and to  dedicate  our  efforts  to those
products with the clear and present  potential of success for the benefit of our
stockholders.  Cyanotech's product pipeline,  as shown on page 1 of this report,
is truly  robust  and varied -- a major  advance  from just a few years ago when
Spirulina was our only major  product.  Now Spirulina is among the products with
lesser  potential  in terms of overall  market  size and  possible  sales in the
future.

LOOKING AHEAD
         The hardest thing we had to do in fiscal 1998 was to lay off 25% of our
dedicated workforce in Kona. We deeply appreciate their  under-standing and look
forward to resuming our role as a steady employer in the region.  We commend the
fine work of all our  associates,  past and  present,  in helping run a reliable
operation with excellent  quality  control while  developing the significant new
products in our  pipeline.  We thank our  stockholders  for their  understanding
during a difficult period and our Board of Directors for supportive  counsel. In
brief,  we have  proven  the  process  of  producing  high-value  products  from
microalgae and are  developing a promising line of products.  We look forward to
increased sales and a return to our traditionally higher margins.

Gerald R. Cysewski, Ph.D.
Chairman, President and Chief Executive Officer
June 18, 1998

                                       3
<PAGE>


CHARTS

Net Sales
$ millions
94--$2,697
85--$4,150
96--$8,081
97--$11,399
98--$7,627

Gross Profit
$ millions
94--$1,202
95--$1,875
96--$4,563
97--$6,809
98--$3,137

Net Income (Loss)
$ millions
94--$204
95--$769
96--$2,509
97--$4,159
98--$(300)
<PAGE>
MANAGEMENT'S  DISCUSSION  AND  ANALYSIS  OF  FINANCIAL  CONDITION AND RESULTS OF
OPERATIONS

RESULTS OF OPERATIONS

                  The following table  sets forth certain consolidated statement
of operations data as a percentage of net sales for the periods indicated:
<TABLE>
<CAPTION>
<S>               <C>                                                 <C>         <C>         <C> 
                  Year Ended March 31,                                1998        1997        1996
                  ================================================================================

                  Net sales                                          100.0%      100.0%      100.0%
                     Cost of sales                                    58.9        40.3        43.5
                  --------------------------------------------------------------------------------
                  Gross profit                                        41.1        59.7        56.5
                  --------------------------------------------------------------------------------
                  Operating expenses:
                     Research and development                          8.8         5.1         4.4
                     General and administrative                       17.3        12.6        14.8
                     Sales and marketing                              18.9         9.1         5.5
                  --------------------------------------------------------------------------------
                      Total operating expenses                        45.0        26.8        24.7
                  --------------------------------------------------------------------------------
                      Income (loss) from operations                   (3.9)       32.9        31.8
                  --------------------------------------------------------------------------------
                  Other income (expense):
                     Interest income                                   2.6         3.9         0.3
                     Interest expense                                 (0.4)       (0.4)       (1.1)
                     Other income, net                                 0.1         0.1          --
                  --------------------------------------------------------------------------------
                      Total other income (expense)                     2.3         3.6        (0.8)
                  --------------------------------------------------------------------------------
                  Income (loss) before income taxes                   (1.6)       36.5        31.0
                  Income taxes                                        (2.3)         --          --
                  --------------------------------------------------------------------------------
                      Net income (loss)                               (3.9)%      36.5%       31.0%
                  ================================================================================
</TABLE>

Fiscal 1998 Compared to Fiscal 1997

                           Net Sales
                  Net sales for the year ended March 31, 1998 were $7,627,000, a
                  decrease of 33.1% from net sales of  $11,399,000  for the year
                  ended March 31,  1997.  The  decrease in net sales  during the
                  year ended March 31, 1998 is  primarily  due to lower sales of
                  Spirulina  packaged consumer products to our largest customer,
                  a Hong Kong-based  network  marketing  company which purchased
                  our packaged  consumer products for sale under a private label
                  through their  marketing  organization,  primarily in mainland
                  China.  This  customer  experienced  a  delay  in  its  annual
                  recertification  process  by the  Chinese  government  and was
                  restricted by local governmental  authorities from hosting any
                  large  scale  distributor  meetings  from March  1997  through
                  September 1997. These regulatory  factors  adversely  impacted
                  our  customer's  ability  to  sell  and,  consequently,   this
                  customer's  need  for  our  packaged   consumer  products  was
                  severely  reduced.  For the year ended  March 31,  1998,  this
                  customer  accounted for less than 5% of Cyanotech's net sales,
                  down from  approximately 34% and 29% of net sales in the years
                  ended March 31, 1997 and 1996, respectively. Subsequent to the
                  end of fiscal 1998,  the Chinese  government  imposed a ban on
                  all network market  organizations,  effective October 1, 1998.
                  Future sales to this customer are expected to be minimal. Also
                  contributing  to the decline were lower  shipments (11% lower)
                  and lower average selling prices (2% lower) for bulk Spirulina
                  powder.

                           Gross Profit
                  Gross profit represents net sales less the cost of goods sold,
                  which includes the cost of materials,  manufacturing  overhead
                  costs,    direct   labor   expenses   and   depreciation   and
                  amortization. Gross profit decreased to 41.1% of net sales for
                  the year ended March 31, 1998, from 59.7% of net sales for the
                  year ended March 31, 1997.  This decrease in gross profit from
                  the prior  year is  primarily  attributable  to a shift in the
                  product mix to greater  sales of lower  priced bulk  Spirulina
                  products  (78% of net sales in fiscal 1998, up from 58% of net
                  sales in fiscal 1997), Spirulina production inefficiencies due
                  to  decreased   production  beginning  December  1997  through
                  February 1998 which resulted in additional  charges to Cost of
                  Sales of  approximately $264,000 during that period, and lower
                  average selling prices for bulk Spirulina.

                                       4
<PAGE>
                           Operating Expenses
                  Operating expenses increased by $379,000, an increase of 12.4%
                  over  the  prior   year,   primarily   because  of   increased
                  expenditures for sales and marketing.

                      Research and  Development.  Expenditures  for research and
                  development  increased  15.3% to $677,000,  for the year ended
                  March 31, 1998,  from  $587,000,  for the year ended March 31,
                  1997. The increase from the prior year is primarily the result
                  of  research  and  ongoing   development   work  done  on  the
                  mosquitocide  project  and  on  optimizing  production  of the
                  natural  astaxanthin  product.  Research and development costs
                  are  expected to  increase  further  during  fiscal 1999 as we
                  continue to optimize the PhytoMax PCS technology, increase the
                  research activities  directed at the mosquitocide  project and
                  begin development work to produce Aldolase  Catalytic Antibody
                  38C2 as a result of our exclusive  license  agreement with The
                  Scripps Research Institute which was signed in April 1998.

                     General  and  Administrative.  General  and  administrative
                  expenses  decreased  8.3% to  $1,318,000,  for the year  ended
                  March 31, 1998, from $1,437,000,  for the year ended March 31,
                  1997.  The decrease  from the prior year is  primarily  due to
                  reduced  associate  incentive bonuses which are indexed to the
                  Company's  profitability,  partially  offset by an increase in
                  personnel costs.

                     Sales and Marketing. Sales and marketing expenses increased
                  39.5% to $1,442,000,  for the year ended March 31, 1998,  from
                  $1,034,000,  for the year ended March 31,  1997.  The increase
                  from the  prior  year is  primarily  due to  higher  personnel
                  costs,  and  increased  domestic and  international  marketing
                  efforts  associated  with  the  introduction  of the  NatuRose
                  product.


                           Other Income (Expense)
                  Other  income  decreased  by 57.1% to  $175,000,  for the year
                  ended March 31, 1998, from $408,000,  for the year ended March
                  31,  1997.  The  decrease  from the  prior  year is  primarily
                  related to  decreased  earnings on lower  balances of cash and
                  investment securities.

                           Income Taxes
                  The  provision  for income  taxes was  $175,000,  for the year
                  ended  March  31,  1998.  This  is due to an  increase  in the
                  allowance  for deferred tax assets,  offset in part by current
                  income tax benefits.

                           Net Income (Loss)
                  For the year ended March 31, 1998 and for the first time since
                  1991,  the  Company  recorded a net loss.  The fiscal 1998 net
                  loss of $300,000,  compares with net income of $4,159,000, for
                  the year ended March 31, 1997.  The net loss is primarily  the
                  result of lower sales of Spirulina bulk and packaged  consumer
                  products due to a reduction  in orders from a single  customer
                  in China that had previously  accounted for a large percentage
                  of sales of packaged  consumer  Spirulina  Pacifica  products,
                  lower  average  selling  prices for bulk  Spirulina  products,
                  Spirulina   production   inefficiencies   due   to   decreased
                  production  during  December 1997 through  February 1998 which
                  resulted  in  an  additional   charge  to  Cost  of  Sales  of
                  approximately $264,000 during the third and fourth quarters of
                  1998, and start-up costs associated with  commercialization of
                  NatuRose, our natural astaxanthin product.
                     In February  1998,  the Company  reduced its  workforce  by
                  approximately  25% in order to  better  align  resources  with
                  sales  levels.  The  workforce   reduction  was  part  of  the
                  Company's  plans to enhance its competitive  position  through
                  improvements of operational  productivity and cost reduction -
                  specifically   more   effecient   utilization  of  assets  and
                  employees.  Production  operations,  sales, and administrative
                  functions were restructured and downsized by this action.


Fiscal 1997 Compared to Fiscal 1996

                           Net Sales
                  Net sales for the year ended March 31, 1997 were  $11,399,000,
                  a 41.1%  increase  over net sales of  $8,081,000  for the year
                  ended March 31,  1996.  The  increase in net sales  during the
                  year ended March 31,  1997 is  attributable  to  significantly
                  higher  production  and  sales of bulk  Spirulina  powder  and
                  tablets  and  increased  sales of packaged  consumer  products
                  which carry a higher sales price than bulk Spirulina  Pacifica
                  products.  The increased production is the result of Spirulina
                  production  expansions  that were  completed  in February  and
                  November 1996.

                                       5
<PAGE>
                           Gross Profit
                  Gross  profit  increased  to 59.7% of net  sales  for the year
                  ended  March  31,  1997  from  56.5% of net sales for the year
                  ended March 31,  1996.  The  increase in gross profit from the
                  prior year is  primarily  attributable  to  economies of scale
                  related to the  production of both bulk and packaged  consumer
                  Spirulina Pacifica products, but was partially offset by lower
                  average selling prices (18% lower) for bulk products.

                           Operating Expenses
                  Operating expenses  increased by $1,066,000,  with significant
                  increases in all three components.

                     Research and  Development.  Expenditures  for research and
                  development  increased  67.2% to $587,000,  for the year ended
                  March 31, 1997,  from  $351,000,  for the year ended March 31,
                  1996. The increase from the prior year is primarily the result
                  of  the  development  work  done  on the  natural  astaxanthin
                  product  and  the  research  work  done  on  the  mosquitocide
                  project.

                     General  and  Administrative.  General  and  administrative
                  expenses  increased  20.2% to  $1,437,000,  for the year ended
                  March 31, 1997, from $1,196,000,  for the year ended March 31,
                  1996.   The   increase   is   due  to   higher   staff-related
                  expenditures,  the  accrual  of  associate  incentive  bonuses
                  indexed to the Company's  profitability  during the year ended
                  March 31, 1997, and higher insurance costs.

                     Sales and Marketing. Sales and marketing expenses increased
                  132.4% to $1,034,000,  for the year ended March 31, 1997, from
                  $445,000, for the year ended March 31, 1996. The increase from
                  the  prior  year  is  primarily  due to  higher  staff-related
                  expenditures,   and  increased   domestic  and   international
                  marketing  efforts  associated  with higher  sales of packaged
                  consumer  products and with the  introduction  of the NatuRose
                  product.

                           Other Income (Expense)
                  Other income  increased to $408,000,  for the year ended March
                  31, 1997,  from other  expense of $62,000,  for the year ended
                  March 31, 1996.  The increase from the prior year is primarily
                  related to  increased  earnings on larger cash and  investment
                  securities balances.

                           Net Income
                  Net income  increased to $4,159,000,  for the year ended March
                  31, 1997, from $2,509,000,  for the year ended March 31, 1996.
                  The  increase in net income is primarily a result of increased
                  production and sales of bulk and packaged  consumer  Spirulina
                  Pacifica products.
                     Inflation  during  the years ended March 31, 1998, 1997 and
                  1996  did  not  have  a  material  impact  on  the   Company's
                  operations.


Variability of Results

                  Cyanotech  Corporation  was  formed in 1983 and did not become
                  profitable  on an annual  basis until  fiscal 1992 (the twelve
                  month  period  ended  December  31,  1992).  From  fiscal 1992
                  through  fiscal  1997,  the  Company  had  total  net sales of
                  $29,401,000,  and total net  income of  $7,931,000.  In fiscal
                  1998,  the Company had net sales of $7,627,000  and a net loss
                  of $300,000. As of March 31, 1998, our accumulated deficit was
                  $761,000.   There  can  be  no  assurance   that  we  will  be
                  consistently  profitable  on either a  quarterly  or an annual
                  basis. We have experienced quarterly fluctuations in operating
                  results and anticipate that these fluctuations may continue in
                  future periods.  Future  operating  results may fluctuate as a
                  result of changes in sales  levels to our  largest  customers,
                  new product introductions,  production  difficulties,  weather
                  patterns,  the mix between sales of bulk products and packaged
                  consumer   products,   start-up  costs   associated  with  new
                  facilities,  expansion  into new  markets,  sales  promotions,
                  competition,  increased  energy  costs,  the  announcement  or
                  introduction  of new products by our  competitors,  changes in
                  our customer mix,  overall  trends in the market for Spirulina
                  and astaxanthin products and other factors beyond our control.
                  While  a  significant   portion  of  our  expense  levels  are
                  relatively  fixed,  and the  timing of  increases  in  expense
                  levels  is based  in large  part on our  forecasts  of  future
                  sales,  if net  sales  are  below  expectations  in any  given
                  period,  the adverse  impact on results of  operations  may be
                  magnified by our inability to adjust  spending  quickly enough
                  to compensate for the sales  shortfall.  We may also choose to
                  reduce  prices or  increase  spending  in  response  to market
                  conditions,  which may have a material  adverse  effect on our
                  results of operations.

                                       6
<PAGE>

New Accounting Standards

                  In  June  1996,  the  Financial   Accounting  Standards  Board
                  ("FASB") issued  Statement of Financial  Accounting  Standards
                  ("SFAS") No. 125,  "Accounting  for Transfers and Servicing of
                  Financial Assets and Extinguishments of Liabilities". SFAS No.
                  125  generally is effective  for  transfers  and  servicing of
                  financial assets and extinguishments of liabilities  occurring
                  after December 31, 1996,  and is to be applied  prospectively.
                  This Statement provides accounting and reporting standards for
                  transfers    and    servicing   of   financial    assets   and
                  extinguishments of liabilities based on consistent application
                  of a financial-components approach that focuses on control. It
                  distinguishes  transfers  of  financial  assets that are sales
                  from  transfers  that are secured  borrowings.The  adoption of
                  SFAS No. 125 did not have a material  effect on the  Company's
                  reported   financial   position,   results  of  operations  or
                  liquidity.
                     In February 1997,  the FASB issued SFAS No. 128,  "Earnings
                  per Share".  SFAS No. 128 is  effective  for both  interim and
                  annual periods  ending after  December 15, 1997.  SFAS No. 128
                  requires  the  presentation  of  "Basic"  earnings  per share,
                  representing income available to common  shareholders  divided
                  by the weighted  average  number of common shares  outstanding
                  during the period,  and  "Diluted"  earnings per share,  which
                  reflects the potential dilution that could occur if securities
                  or other contracts to issue Common Stock shares were exercised
                  or  converted  into  Common  Stock  shares or  resulted in the
                  issuance  of  Common  Stock  shares  that  then  shared in the
                  earnings of the Company.  SFAS No. 128 requires restatement of
                  all prior period per share data presented. The Company adopted
                  SFAS No. 128 for the quarter  ended  December 31, 1997 and has
                  restated all prior period earnings per share data presented.
                     Also during  February  1997,  the FASB issued SFAS No. 129,
                  "Disclosure of  Information  about Capital  Structure,"  which
                  lists required  disclosures  about capital  structure that had
                  been  included in a number of previously  existing  statements
                  and  opinions.  SFAS No. 129 is effective  for periods  ending
                  after December 15, 1997. The Company adopted the provisions of
                  SFAS No. 129 as of December 31, 1997. The adoption of SFAS No.
                  129 did not have a material  effect on the Company's  reported
                  financial information.
                     In June 1997,  the FASB  issued  SFAS No.  130,  "Reporting
                  Comprehensive  Income,"  which  establishes  standards for the
                  reporting  and  display  of   comprehensive   income  and  its
                  components  in  a  full  set  of   general-purpose   financial
                  statements.  SFAS  No.  130  is  effective  for  fiscal  years
                  beginning  after  December  15,  1997.  SFAS No. 130  requires
                  reclassification  of financial  statements for earlier periods
                  provided for comparative purposes.  The Company will adopt the
                  provisions of SFAS No. 130 for the fiscal year beginning April
                  1, 1998.
                     Also  during  June  1997,  the FASB  issued  SFAS No.  131,
                  "Disclosures  about  Segments  of an  Enterprise  and  Related
                  Information," which establishes  standards for public business
                  enterprises to report  information about operating segments in
                  annual   financial   statements   and   requires   that  those
                  enterprises   report  selected   information  about  operating
                  segments in interim  financial reports issued to shareholders.
                  SFAS No. 131 is  effective  for fiscal years  beginning  after
                  December  15,  1997.  SFAS No.  131  requires  restatement  of
                  comparative  information  presented for earlier  periods.  The
                  Company  will  adopt the  provisions  of SFAS No.  131 for the
                  quarter  beginning  April 1, 1998.  Management does not expect
                  adoption  of SFAS No. 131 will have a  material  effect on the
                  Company's reported financial information.
                     In February 1998, the FASB issued SFAS No. 132, "Employers'
                  Disclosures about Pensions and Other Postretirement Benefits,"
                  which  amends  the  disclosure  requirements  of SFAS No.  87,
                  "Employers' Accounting for Pensions," SFAS No. 88, "Employers'
                  Accounting for Settlements and Curtailments of Defined Benefit
                  Pension Plans and for Termination  Benefits" and SFAS No. 106,
                  "Employers' Accounting for Postretirement  Benefits Other Than
                  Pensions." SFAS No. 132 addresses disclosure only and does not
                  change  any  of  the  measurement  or  recognition  provisions
                  provided  for in SFAS  Nos.  87,  88 or 106.  SFAS No.  132 is
                  effective for fiscal years  beginning  after December 15, 1997
                  and requires restatement of comparative  information presented
                  for earlier periods.  The Company will adopt the provisions of
                  SFAS No.  132 for the  fiscal  year  beginning  April 1, 1998.
                  Management  does not expect adoption of SFAS No. 132 will have
                  a  material  effect  on  the  Company's   reported   financial
                  information.
                     In March 1998, the American  Institute of Certified  Public
                  Accountants ("AICPA") Accounting Standards Executive Committee
                  issued Statement of Position ("SOP") 98-1, "Accounting for the
                  Costs of Computer Software  Developed or Obtained for Internal
                  Use," which  requires that certain  costs,  including  certain
                  payroll  and   payroll-related   costs,   be  capitalized  and
                  amortized over the estimated useful life of the software.  The
                  provisions   of  SOP  98-1  are  effective  for  fiscal  years
                  beginning  after  December  15,  1998.  The  Company  has  not
                  determined when it will adopt SOP 98-1.  Management  estimates
                  that the adoption of SOP 98-1 will not have a material  effect
                  on the Company's financial condition, results of operations or
                  liquidity.

                                       7
<PAGE>
                     In April 1998,  the AICPA  Accounting  Standards  Executive
                  Committee issued SOP 98-5, "Reporting on the Costs of Start-up
                  Activities."   SOP  98-5   requires  that  costs  of  start-up
                  activities,  including  organization  costs,  be  expensed  as
                  incurred.  The provisions of SOP 98-5 are effective for fiscal
                  years   beginning   after   December   15,  1998  and  earlier
                  application is encouraged. The Company has not determined when
                  it will adopt SOP 98-5. Management does not expect adoption of
                  SOP  98-5  will  have  a  material  effect  on  the  Company's
                  financial condition, results of operations or liquidity.

Liquidity and Capital Resources

                  Cyanotech's   cash   and   investment   securities   decreased
                  $5,332,000  to  $1,397,000  during the fiscal year ended March
                  31, 1998. The decrease is primarily  attributable to increased
                  capital expenditures for equipment and leasehold improvements.
                     Cash flows provided by operating  activities  were $988,000
                  in 1998, down from $2,860,000 in 1997 because of the reduction
                  in net  income.  The  primary  sources of 1998 cash flows from
                  operating   activities   were  a  decrease  in  net   accounts
                  receivable, offset in large part by an increase in inventories
                  and decreases in accounts payable and accrued expenses.
                     Cash flows used in investing  activities were $1,927,000 in
                  1998 compared to $10,962,000 in 1997. The primary uses of cash
                  flows in  investing  activities  during  1998 were for capital
                  expenditures totaling $5,881,000,  offset by proceeds from the
                  sale  and   maturities  of  investment   securities   totaling
                  $3,954,000.
                     Cash flows used in financing  activities  were  $439,000 in
                  1998 compared to cash flow provided by financing activities of
                  $1,468,000  in  1997.  The  primary  uses  of  cash  flows  in
                  financing  activities were for principal  payments of $401,000
                  on long-term  debt and $130,000 on capital lease  obligations,
                  offset  somewhat by  proceeds  received  from the  exercise of
                  common stock options and warrants.
                     As of March 31, 1998,  we had no  significant  construction
                  commitments.  However,  we  have  agreed  with a  construction
                  contractor to resume work on a culture pond expansion  project
                  by January 1, 1999 in a  reasonable  and  customary  manner in
                  accordance  with the  terms of the  contract  and at a minimum
                  billable rate of $150,000 per month. The remaining  balance on
                  the construction  contract is approximately  $1.9 million.  If
                  work does not  resume by  January 1,  1999,  and  continue  as
                  agreed  because  of  the  Company's  inability  to  fund  such
                  construction, then the contract may be considered to have been
                  terminated  by Cyanotech.  Assertion by the  contractor of its
                  termination rights could have a material adverse effect on the
                  Company's  financial  condition,   results  of  operations  or
                  liquidity.  Total  costs  incurred  as of March 31,  1998 with
                  respect  to this  expansion  project  approximate  $2,643,000.
                  Management  expects to resume work on the project on or before
                  January 1, 1999.
                     We presently  estimate that our existing capital  resources
                  and  anticipated  cash flows from  future  operations  will be
                  sufficient  to fund current  operations.  However,  we plan to
                  spend,  subject  to  available  financing,  approximately  $11
                  million on capital  expenditures  during the next three fiscal
                  years,   primarily  to  continue  the  expansion  of  NatuRose
                  production  on the newly  leased 93  acres.  Existing  capital
                  resources and  anticipated  cash flows from future  operations
                  will not be sufficient to fund these capital expenditures. Our
                  bank credit line of $1,000,000 expired on January 31, 1998 and
                  was not  renewed.  Another  $1,000,000  bank line  expired  on
                  February 7, 1998 when the  underlying  certificate  of deposit
                  matured.  As of March  31,  1998,  the  Company  was  actively
                  pursuing  additional credit facilities to meet any anticipated
                  shortfall in cash flow,  but there is no  assurance  that such
                  facilities  will  be  obtained  at the  amount  required  at a
                  reasonable cost to the Company.


Year 2000 Compliance

                  The  Company  has  completed  a  comprehensive  review  of its
                  computer  systems  to  identify  the  systems  that  could  be
                  affected  by the  "Year  2000"  issue  and  has  developed  an
                  implementation  plan,  to be  completed  by the end of  fiscal
                  1999,  to  resolve  the  issue.  The Year 2000  problem is the
                  result of computer  programs  being  written  using two digits
                  rather  than four to define the  applicable  year.  Any of the
                  Company's  programs  that  have  time-sensitive  software  may
                  recognize  a date using "00" as the year 1900  rather than the
                  year 2000.  This  could  result in a major  system  failure or
                  miscalculations. The Company believes that, with modifications
                  to existing software and converting to new software,  the Year
                  2000 problem will not pose  significant  operational  problems
                  for  the  Company's   computer  systems  as  so  modified  and
                  converted. The costs of such modifications and conversions are
                  not expected to be material.  However,  if such  modifications
                  and conversions are not completed in a timely manner, the Year
                  2000 problem may have a material  impact on the  operations of
                  the Company.

                                       8
<PAGE>

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
<S>         <C>                                                                              <C>         <C>
                                                                                                 At March 31,
            -------------------------------------------------------------------------------------------------
            (in thousands, except share data)                                                1998        1997
            =================================================================================================
            ASSETS

Current assets:
            Cash and cash equivalents                                                     $ 1,397    $  2,775
            Investment securities                                                              --       3,954
            Accounts receivable, net of allowance for doubtful
                receivables of $10 in 1998                                                  1,246       2,791
            Inventories                                                                     2,229       1,138
            Prepaid expenses                                                                   88         155
            Deferred tax assets                                                                --         373
            -------------------------------------------------------------------------------------------------
                    Total current assets                                                    4,960      11,186
            Equipment and leasehold improvements, net                                      20,544      14,666
            Other assets                                                                      163         163
            -------------------------------------------------------------------------------------------------
                    Total assets                                                          $25,667    $ 26,015
            =================================================================================================

            LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
            Current maturities of long-term debt                                          $    50    $    150
            Note payable                                                                      975          --
            Current maturities of capital lease obligations                                   129         130
            Accounts payable                                                                  938       1,508
            Accrued expenses and other                                                        272         333
            -------------------------------------------------------------------------------------------------
                    Total current liabilities                                               2,364       2,121
            Long-term debt, excluding current maturities                                       62         363
            Obligations under capital lease, excluding current maturities                      67         196
            -------------------------------------------------------------------------------------------------
                    Total liabilities                                                       2,493       2,680
            -------------------------------------------------------------------------------------------------

Stockholders' equity:
            Cumulative  preferred  stock,  Series  C, of $.001  par  value
               (aggregate  involuntary  liquidation $2,975 ($5 per share),
               plus unpaid  cumulative  dividends).  Authorized  5,000,000
               shares; issued and outstanding 595,031 shares in 1998 and 
               734,977 shares in 1997                                                          1           1
            Common stock of $.005 par value,  authorized  25,000,000  shares  at
               March 31, 1998 and 1997; issued and outstanding 13,599,572 shares
               at March 31, 1998 and 12,712,682 shares at March 31, 1997                      68          63
            Additional paid-in capital                                                    23,866      23,732
            Accumulated deficit                                                             (761)       (461)
            ------------------------------------------------------------------------------------------------
                    Total stockholders' equity                                            23,174      23,335
            Commitments and contingencies
            ------------------------------------------------------------------------------------------------
                    Total liabilities and stockholders' equity                          $ 25,667    $ 26,015
            ================================================================================================
</TABLE>
            See accompanying notes to consolidated financial statements.

                                       9
<PAGE>
                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                                        Years ended March 31,
            -------------------------------------------------------------------------------------------------
            <S>                                                               <C>         <C>        <C>
            (in thousands, except per-share data)                                1998        1997        1996
            =================================================================================================

            Net sales                                                         $ 7,627     $11,399    $  8,081
            Cost of sales                                                       4,490       4,590       3,518
            -------------------------------------------------------------------------------------------------
                Gross profit                                                    3,137       6,809       4,563
            -------------------------------------------------------------------------------------------------

Operating expenses:
            Research and development                                              677         587         351
            General and administrative                                          1,318       1,437       1,196
            Sales and marketing                                                 1,442       1,034         445
            -------------------------------------------------------------------------------------------------
                Total operating expenses                                        3,437       3,058       1,992
            -------------------------------------------------------------------------------------------------
                Income (loss) from operations                                    (300)      3,751       2,571
            -------------------------------------------------------------------------------------------------

Other income (expense):
            Interest income                                                       202         443          32
            Interest expense, net of interest costs capitalized of $114 in 1998,
              $23 in 1997 and nil in 1996                                         (35)        (47)        (90)
            Other income (expense), net                                             8          12          (4)
            -------------------------------------------------------------------------------------------------
            Total other income (expense)                                          175         408         (62)
            -------------------------------------------------------------------------------------------------
                Income (loss) before income taxes                                (125)      4,159       2,509
                Income taxes                                                     (175)         --          --
            -------------------------------------------------------------------------------------------------
                Net income (loss)                                             $  (300)    $ 4,159    $  2,509
            =================================================================================================
            Net income (loss) per common share
                   Basic                                                      $ (0.05)    $  0.31    $   0.22
            =================================================================================================
                   Diluted                                                    $ (0.05)    $  0.25    $   0.17
            =================================================================================================
            Weighted average number of common shares outstanding
                   Basic                                                       12,909      12,583       9,583
            =================================================================================================
                   Diluted                                                     12,909      16,598      14,502
            =================================================================================================
</TABLE>
                  See accompanying notes to consolidated financial statements.

                                       10
<PAGE>
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
                                                                                           Years ended March 31, 1998, 1997 and 1996
------------------------------------------------------------------------------------------------------------------------------------

                                                                                                                              Total
                                              Preferred stock         Common stock   Additional                              Stock-
                                                          Par                  Par      paid-in   Accumulated   Treasury   holders'
(in thousands, except share data)              Shares   value       Shares   value      capital       deficit      stock     equity
====================================================================================================================================
<S>                                         <C>         <C>       <C>        <C>       <C>          <C>           <C>       <C>
Balances at March 31, 1995                  1,997,477      $2     9,051,325    $  45   $  12,216    $  (7,129)    $  (30)   $ 5,104
Exercise of common stock warrants
  for cash                                         --      --       891,200        5         507           --         --        512
Exercise of stock options for cash                 --      --        82,625       --          76           --         --         76
Issuance of common stock to nonemployee
  directors for services                           --      --         8,000       --          40           --         --         40
Exchange of Series A preferred stock for
  common stock                             (1,250,000)     (1)      250,000        1          --           --         --         --
Exchange of Series B preferred stock for
  common stock                                (12,500)     --         2,500       --          --           --         --         --
Retirement of treasury stock                       --      --       (30,000)      --         (30)          --         30         --
Common stock issued for cash, net of
  costs of $556                                    --      --     1,500,000        8       9,067           --         --      9,075
Net income                                         --      --            --       --          --        2,509         --      2,509
-----------------------------------------------------------------------------------------------------------------------------------

Balances at March 31, 1996                    734,977       1    11,755,650       59      21,876       (4,620)        --     17,316
Exercise of common stock warrants
  for cash                                         --      --       668,120        3         298           --         --        301
Exercise of stock options for cash                 --      --        57,912       --          49           --         --         49
Issuance of common stock options for
  other assets                                     --      --            --       --          80           --         --         80
Issuance of common stock to nonemployee
  directors for services                           --      --         6,000       --          37           --         --         37
Common stock issued for cash, net of
  costs of $51                                     --      --       225,000        1       1,392           --         --      1,393
Net income                                         --      --            --       --          --        4,159         --      4,159
-----------------------------------------------------------------------------------------------------------------------------------

Balances at March 31, 1997                    734,977       1    12,712,682       63      23,732         (461)        --     23,335
Exercise of common stock warrants
  for cash                                         --      --       107,880        1          43           --         --         44
Exercise of stock options for cash                 --      --        84,750        1         102           --         --        103
Common stock purchased from
  employees and canceled                           --      --       (13,470)      --         (55)          --         --        (55)
Issuance of common stock to
  nonemployee directors for services               --      --         8,000       --          47           --         --         47
Exchange of Series C preferred stock for
  common stock                               (139,946)     --       699,730        3          (3)          --         --         --
Net loss                                           --      --            --       --          --         (300)        --       (300)
-----------------------------------------------------------------------------------------------------------------------------------

Balances at March 31, 1998                    595,031      $1    13,599,572   $   68   $  23,866    $    (761)        --   $ 23,174
===================================================================================================================================
</TABLE>
See accompanying notes to consolidated financial statements.

                                       11
<PAGE>
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                                                                              Years ended March 31,
                  ------------------------------------------------------------------------------------------------------------------

                   (in thousands)                                                                      1998        1997        1996
                  ==================================================================================================================
Cash flows from operating activities:
<S>                                                                                                 <C>         <C>        <C>     
                  Net income (loss)                                                                 $  (300)    $ 4,159    $  2,509
                  Adjustments to reconcile net income (loss) to net cash provided by
                    operating activities:
                      Deferred income taxes                                                             373        (373)         --
                      Depreciation and amortization                                                     978         691         499
                      Decrease (increase) in accounts receivable, net                                 1,545      (1,503)       (640)
                      Increase in inventories                                                        (1,091)       (644)       (119)
                      Decrease (increase) in prepaid expenses and other assets                           67         (62)       (118)
                      Increase (decrease) in accounts payable                                          (570)        656         223
                      Increase (decrease) in accrued expenses and other                                 (61)       (101)        204
                      Other                                                                              47          37          40
                  ----------------------------------------------------------------------------------------------------------------- 
                         Net cash provided by operating activities                                      988       2,860       2,598
                  -----------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
                  Investment in equipment and leasehold improvements                                 (5,881)     (7,008)     (3,910)
                  Purchases of investment securities                                                     --     (10,827)         --
                  Proceeds from sales and maturities of investment securities                         3,954       6,873          --
                  -----------------------------------------------------------------------------------------------------------------
                         Net cash used in investing activities                                       (1,927)    (10,962)     (3,910)
                  -----------------------------------------------------------------------------------------------------------------

Cash flows from financing activities:
                  Proceeds from issuance of common stock and exercise of stock options
                    and warrants, net of issuance costs                                                  92       1,743       9,663
                  Proceeds from issuance of long-term debt                                               --          --         750
                  Principal payments on long-term debt                                                 (401)       (150)        (94)
                  Principal payments on capital lease obligations                                      (130)       (125)        (94)
                  -----------------------------------------------------------------------------------------------------------------
                         Net cash provided by (used in) financing activities                           (439)      1,468      10,225
                  -----------------------------------------------------------------------------------------------------------------
                  Net increase (decrease) in cash and cash equivalents                               (1,378)     (6,634)      8,913
                  Cash and cash equivalents at beginning of year                                      2,775       9,409         496
                  -----------------------------------------------------------------------------------------------------------------
                  Cash and cash equivalents at end of year                                          $ 1,397     $ 2,775    $  9,409
                  =================================================================================================================

Supplemental disclosure of cash flow information:
                  Cash paid during the year for interest, net of amounts capitalized                $    35     $    36    $     73
                  =================================================================================================================
                  Cash paid during the year for income taxes                                        $    56     $   355    $     --
                  =================================================================================================================
                  Non-cash investing and financing activities:
                      Issuance of note payable for construction in progress                         $   975     $    --    $     --
                      Equipment leased under capital lease obligations                                   --          --         303
                      Issuance of common stock and options for services and other assets                 47         117          40
                  =================================================================================================================
</TABLE>
                  See accompanying notes to consolidated financial statements.

                                       12

<PAGE>

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



          (all amounts in thousands, except share data)

Note 1    Description of Business and Summary of Accounting Policies

                    a. Description of Business
          Cyanotech  Corporation  (Company) develops and  commercializes natural
          products from microalgae.The Company is currently producing microalgae
          products for the nutritional supplement, aquaculture feed/pigments and
          immunological diagnostics  markets  and is also developing microalgae-
          based  products  for  the  biopesticide,  chiral  chemistry  and  food
          coloring markets.
               Substantially   all   of   the  Company's  net  sales  have  been
          attributable  to  its   Spirulina  Pacifica(TM)  products.   Sales  of
          Spirulina Pacifica   products accounted for  approximately  95% of the
          Company's net sales for the year  ended  March 31, 1998  and  98%  for
          the  years ended March 31, 1997 and 1996.

                    b. Principles of Consolidation
          The Company consolidates enterprises  in  which  it  has a controlling
          financial interest. The accompanying consolidated financial statements
          include  the  accounts  of  Cyanotech  Corporation,  its  wholly owned
          subsidiaries,  Nutrex, Inc. and Cyanotech International FSC, Inc.  All
          significant  intercompany   balances   and   transactions  have   been
          eliminated in consolidation.
               Cyanotech  International  FSC, Inc., was formed on  April 1, 1997
          as a foreign sales corporation under the Internal Revenue Code.

                    c. Cash and Cash Equivalents
          For purposes of the consolidated statements of cash flows, the Company
          considers all highly liquid debt securities purchased with original or
          remaining  maturities of three months or less to be cash equivalents.

                    d. Investment Securities
          Investment  securities at March 31,  1997  consisted  of U.S.Treasury,
          mortgage-backed, and other interest bearing securities.   The  Company
          classifies its debt and equity securities in one of three  categories;
          trading, available-for-sale, or  held-to-maturity.  Trading securities
          are bought  and held  principally  for the  purpose of selling them in
          the near term.  Held-to-maturity  securities are  those  securities in
          which  the  Company   has  the  ability   and   intent  to   hold  the
          security until maturity.  All other securities not included in trading
          or held-to-maturity are classified as available-for-sale.
               Trading and available-for-sale securities  are  recorded  at fair
          value.   Held-to-maturity securities are  recorded  at amortized cost,
          adjusted  for  the amortization or accretion of premiums or discounts.
          Unrealized holding gains and losses on trading securities are included
          in earnings.   Unrealized holding gains and losses, net of the related
          tax  effects,  on  available-for-sale  securities  are  excluded  from
          earnings  and  are  reported as a separate  component of stockholders'
          equity  until  realized.  Realized  gains  and losses from the sale of
          held-to-maturity and available-for-sale securities are determined on a
          specific identification basis.
               A decline in the market value of any  available-for-sale or held-
          to-maturity  security  below  cost  that  is  deemed  to be other than
          temporary results in a reduction in carrying amount to fair value. The
          impairment  is  charged  to  earnings  and  a  new  cost basis for the
          security is  established.  Premiums  and discounts  are  amortized  or
          accreted over the life of the related held-to-maturity  security as an
          adjustment to yield using the effective interest method.  Dividend and
          interest income are recognized when earned.

                    e. Inventories
          Inventories  are stated at the lower of cost which approximates first-
          in, first-out)  or  market.   Market  is  determined by net realizable
          value.

                    f. Equipment and Leasehold Improvements
          Owned  equipment  and  leasehold  improvements  are  stated  at  cost.
          Equipment  under  capital  lease is stated at the lower of the present
          value of minimum lease payments or fair value of the equipment  at the
          inception of the lease.  Depreciation  and  amortization  are provided
          using the straight-line  method over  the  estimated  useful lives for
          equipment  and furniture and fixtures  and the  shorter  of the  lease
          terms  or  estimated  useful  lives  for  leasehold  improvements  and
          equipment under capital lease as follows:

                                       13
<PAGE>
          Equipment                                                3 to 10 years
          Leasehold improvements           remaining lease term (10 to 28 years)
          Furniture and fixtures                                         7 years
          Equipment under capital lease                lease term (3 to 5 years)

          Amortization   of  equipment  under  capital  lease  is   included  in
          depreciation and amortization expense in the accompanying consolidated
          financial statements.
          
               g. Earnings Per Share
          In February 1997,  the  Financial Accounting Standards  Board ("FASB")
          issued  Statement of Financial Accounting  Standards ("SFAS") No. 128,
          Earnings per Share.  SFAS No. 128  is effective  for both  interim and
          annual periods  ending after December 15, 1997.  SFAS No. 128 requires
          the  presentation of "Basic" earnings per share,  representing  income
          available to  common  shareholders  divided  by  the  weighted average
          number of common shares outstanding  for  the  period,  and  "Diluted"
          earnings  per  share, which reflects the potential dilution that could
          occur  if  securities  or other contracts to issue Common Stock shares
          were  exercised or  converted  into Common Stock shares or resulted in
          the issuance of Common Stock shares that then  shared in the  earnings
          of the Company.  SFAS No. 128 requires restatement of all prior period
          earnings per share data  presented.  The Company adopted SFAS No.  128
          for the quarter  ended  December  31, 1997 and has  restated all prior
          period earnings per share data presented.
               For  the  year  ended  March 31, 1998,  warrants  and  options to
          purchase Common Stock shares of the Company and  convertible preferred
          stock were outstanding,  but were not included in the 1998 computation
          of Diluted net loss per common share because the  inclusion  of  these
          securities would have had  an antidilutive  effect on the net loss per
          common  share.  As of March 31, 1998,  warrants  and options to aquire
          431,725  shares  of  the  Company's  common  stock and preferred stock
          convertible into 2,975,155 shares of the Company's common  stock  were
          outstanding.
               Following is a reconciliation of the numerators  and denominators
          of  the  Basic  and  Diluted  net  income  (loss)  per  Common   Share
          computations  for  the  periods  presented  (in thousands except share
          data):
<TABLE>
<CAPTION>
          <S>                                                               <C>                     <C>                  <C>     
          Years ended March 31,                                                   1998                   1997                  1996
          =========================================================================================================================

          Basic Earnings per share
          -------------------------------------------------------------------------------------------------------------------------
          Net income (loss)                                                 $     (300)             $    4,159           $    2,509
          Less: Requirement for Preferred Stock dividends                         (289)                   (294)                (354)
          -------------------------------------------------------------------------------------------------------------------------
          Income (loss) available to Common stockholders                    $     (589)             $    3,865           $    2,155
          =========================================================================================================================
          Weighted average Common Shares outstanding                        12,909,000              12,583,000            9,583,000
          =========================================================================================================================
          Net income (loss) per Common Share                                $    (0.05)             $     0.31           $     0.22
          =========================================================================================================================
          Diluted Earnings Per Share
          Income (loss) avaliable to Common stockloders                     $     (589)             $    3,865           $    2,155
          Plus: Requirement for Preferred Stock dividends                           --                     294                  354
          -------------------------------------------------------------------------------------------------------------------------
          Net income (loss) available to Common stockholders as adjusted    $     (589)             $    4,159           $    2,509
          =========================================================================================================================
          Weighted average Common Shares outstanding                        12,909,000              12,583,000            9,583,000
          Effect of dilutive securities
               Stock options and warrants                                           --                 340,000              994,000
               Convertible perferred stock                                          --               3,675,000            3,925,000
          -------------------------------------------------------------------------------------------------------------------------
          Weighted average Common Shares outstanding as adjusted            12,909,000              16,598,000           14,502,000
          =========================================================================================================================
          Net income (loss) per common share                                $    (0.05)             $     0.25           $     0.17
</TABLE>
                    h. Research and Development
          Research and development costs are expensed as incurred.  Research and
          development  costs  amounted to  $677, $587 and $351 in 1998, 1997 and
          1996 respectively.

                    i. Income Taxes
          Deferred tax assets and liabilities are recognized  for the future tax
          consequences   attributable  to  differences   between  the  financial
          statement  carrying  amounts of existing assets  and  liabilities  and
          their  tax  bases  and  operating  

                                       14
<PAGE>

          loss carryforwards.  Deferred tax assets and liabilities  are measured
          using  enacted  income tax rates applicable  to the  period  in  which
          the   deferred   tax assets or liabilities are expected to be realized
          or settled.  As changes in tax laws or rates are enacted, deferred tax
          assets and  liabilities  are adjusted through the provision for income
          taxes.

                    j. Stock Option Plan
          Prior to April 1, 1996,  the  Company  accounted  for its stock option
          plan in accordance with the  provisions of Accounting Principles Board
          ("APB") Opinion No. 25, Accounting for Stock Issued to Employees,  and
          related  interpretations.  As such,  compensation expense was recorded
          on  the  date  of  grant  only if  the  current  market  price for the
          underlying stock exceeded the exercise price. Effective April 1, 1996,
          the   Company   adopted   SFAS  No. 123,  Accounting  for  Stock-Based
          Compensation, which permits  entities  to  recognize  as expense  over
          the  vesting  period  the fair  value of all stock-based awards on the
          date of grant.
               Alternatively,  SFAS No. 123  also allows entities to continue to
          apply  the provisions of APB Opinion No. 25 and  provide pro forma net
          income and pro forma net  income  per  common  share  disclosures  for
          employee stock option grants made in fiscal year 1996 and future years
          as if the  fair-value-based  method  defined in SFAS No. 123 had  been
          applied.  The Company has elected to continue to apply the measurement
          provisions  of  APB  No.  25  and  provide  the  pro forma disclosures
          required by SFAS No. 123.

                    k. Impairment  of  Long-Lived  Assets  and Long-Lived Assets
          to Be Disposed Of
          The Company adopted the provisions of SFAS No. 121, Accounting for the
          Impairment  of  Long-Lived  Assets  and  for  Long-Lived Assets  to Be
          Disposed Of, effective April 1, 1996. SFAS No. 121 requires that long-
          lived  assets  and certain  identifiable intangibles  be reviewed  for
          impairment whenever  events or changes in circumstances  indicate that
          the carrying amount of an asset may not be recoverable. Recoverability
          of  assets  to  be held  and used is measured by a  comparison  of the
          carrying amount of an asset to future net cash  flows  expected  to be
          generated by the asset.  If such assets are considered to be impaired,
          the impairment to be recognized is measured as the amount the carrying
          amount of the assets exceeds  the fair value of the assets.  Assets to
          be  disposed  of  are  reported at the lower of the carrying amount or
          fair value less costs to sell.  Adoption  of SFAS No. 121 did not have
          a material  impact  on  the  Company's financial position,  results of
          operations or liquidity.

                    l.  Transfers  and   Servicing   of   Financial  Assets  and
          Extinguishments of Liabilities
          In June 1996, the FASB issued SFAS No. 125,  Accounting  for Transfers
          and Servicing of Financial Assets and Extinguishments of  Liabilities.
          SFAS No. 125  generally  is  effective  for transfers and servicing of
          financial  assets and extinguishments of liabilities  occurring  after
          December 31, 1996 and is to be applied prospectively.  This  Statement
          provides   accounting   and  reporting  standards  for  transfers  and
          servicing of financial assets and extinguishments of liabilities based
          on  consistent  application  of  a  financial-components approach that
          focuses on  control.  It distinguishes transfers of  financial  assets
          that are sales  from transfers that are secured  borrowings.  Adoption
          of SFAS No.  125 did  not  have a  material  impact  on the  Company's
          financial position, results of operations or liquidity.

                    m. Use of Estimates
          The  preparation of financial statements in conformity  with generally
          accepted  accounting  principles requires management to make estimates
          and  assumptions  that  affect  the  reported  amounts  of  assets and
          liabilities and disclosure of contingent assets and liabilities at the
          date of the financial statements, and the reported amounts of revenues
          and expenses during the reporting period.  Actual results could differ
          significantly from those estimates.

                    n. New Accounting Pronouncements 
          In  February  1997,  the  FASB  issued  SFAS  No. 129,  Disclosure  of
          Information about Capital Structure,  which lists required disclosures
          about  capital  structure  that  had  been  included  in  a  number of
          previously existing statements and opinions. SFAS No. 129 is effective
          for periods ending after  December 15, 1997.  The Company  adopted the
          provisions  of  SFAS No. 129 as of December 31, 1997.  The adoption of
          SFAS No. 129 did not have  a material effect on the Company's reported
          financial information. 
               In   June  1997,   the   FASB  issued  SFAS  No.  130,  Reporting
          Comprehensive Income, which establishes standards  for  the  reporting
          and display of comprehensive  income  and its components in a full set
          of general-purpose financial statements. SFAS No. 130 is effective for
          fiscal years beginning after December 15, 1997.  SFAS No. 130 requires
          reclassification of financial  statements for earlier periods provided
          for  comparative  purposes.  The  Company will adopt the provisions of
          SFAS  No.  130  for  the  fiscal  year  beginning  April  1, 1998.  
               In June 1997,  the  FASB also issued SFAS  No.  131,  Disclosures
          about  Segments  of  an  Enterprise  and  Related  Information,  which
          establishes  standards  for  public  business  enterprises  to  report
          information  about 

                                       15
<PAGE>

          operating  segments in annual financial statements and  requires  that
          those enterprises report selected information about operating segments
          in  interim  financial reports  issued  to shareholders.  SFAS No. 131
          is  effective  for fiscal years  beginning  after  December  15, 1997.
          SFAS No. 131 requires restatement of comparative information presented
          for  earlier  periods.  The Company will adopt the provisions of  SFAS
          No. 131 for the quarter beginning April 1, 1998.  Management does  not
          expect adoption of SFAS No. 131 will have  a  material  effect  on the
          Company's  reported  financial information.  
               In February 1998,  the  FASB  issued   SFAS  No.  132, Employers'
          Disclosures about Pensions and  Other  Postretirement Benefits,  which
          amends  the  disclosure  requirements  of  SFAS  No.  87,   Employers'
          Accounting  for  Pensions,  SFAS  No.  88,  Employers'  Accounting for
          Settlements and Curtailments of Defined Benefit Pension  Plans and for
          Termination  Benefits  and  SFAS  No. 106,  Employers'  Accounting for
          Postretirement  Benefits  Other Than Pensions.  SFAS No. 132 addresses
          disclosure  only  and  does  not  change  any  of  the  measurement or
          recognition provisions provided for in SFAS Nos. 87, 88 or 106.   SFAS
          No. 132 is effective for fiscal  years  beginning   after December 15,
          1997 and requires restatement of comparative information presented for
          earlier periods. The Company will adopt the provisions of SFAS No. 132
          for  the  fiscal  year  beginning  April 1, 1998.  Management does not
          expect  adoption  of  SFAS No. 132 will have a material  effect on the
          Company's  reported  financial information.   
               In  March  1998,  the  American  Institute  of  Certified  Public
          Accountants  ("AICPA") Accounting Standards Executive Committee issued
          Statement of  Position  ("SOP")  98-1,  Accounting  for the  Costs  of
          Computer  Software  Developed  or  Obtained for  Internal  Use,  which
          requires that certain costs, including certain  payroll  and  payroll-
          related costs, be capitalized  and amortized over the estimated useful
          life of the software.  The provisions of SOP 98-1  are  effective  for
          fiscal years  beginning after  December 15, 1998.  The Company has not
          determined when it will adopt SOP 98-1.  Management estimates that the
          adoption of SOP 98-1 will not have a material effect on the  Company's
          financial  condition,  results of operations or  liquidity.  
               In April 1998, the AICPA Accounting Standards Executive Committee
          issued SOP 98-5,  Reporting  on  the  Costs  of  Start-up  Activities.
          SOP  98-5  requires  that  costs  of  start-up activities,   including
          organization costs, be  expensed  as  incurred.  The provisions of SOP
          98-5 are effective for fiscal years beginning  after December 15, 1998
          and earlier application is encouraged.  The Company has not determined
          when it will adopt SOP 98-5.  Management does not expect  adoption  of
          SOP 98-5  will  have  a  material  effect  on the Company's  financial
          condition,  results of operations or liquidity.


Note 2    Investment Securities

          Investment securities held as  available-for-sale as of March 31, 1997
          were as follows (fair value approximates amortized cost):
<TABLE>
<CAPTION>
          <S>                                                           <C>
          U.S. Treasury securities                                      $  2,454
          Mortgage-backed securities                                         500
          Other interest bearing securities                                1,000
          ----------------------------------------------------------------------
                                                                        $  3,954
          ======================================================================
</TABLE>

          Proceeds  from  the  sales  and  maturities  of  investment securities
          classified as available for sale amounted to $3,954 in 1998 and $6,873
          in 1997.  Gross realized  gains on the disposal of  available-for-sale
          investment  securities  during  1998  and  1997  were   nil  and  $25,
          respectively.


Note 3    Inventories

          Inventories consists of the following as of March 31, 1998 and 1997:
<TABLE>
<CAPTION>
          <S>                                               <C>       <C>
                                                               1998        1997
          =====================================================================

          Raw materials                                     $   103    $    166
          Work in process                                       362         362
          Finished goods                                      1,524         346
          Supplies                                              240         264
          ---------------------------------------------------------------------
                                                            $ 2,229    $  1,138
          =====================================================================
</TABLE>
                                       16
<PAGE>

Note 4    Equipment and Leasehold Improvements, Net

          Equipment  and  leasehold improvements consists of the following as of
          March 31, 1998 and 1997:
<TABLE>
<CAPTION>
          <S>                                                                           <C>        <C>
                                                                                           1998        1997
          ==================================================================================================

          Equipment                                                                     $ 7,791    $  5,715
          Leasehold improvements                                                         13,285      10,935
          Furniture and fixtures                                                             94          67
          Equipment under capital lease                                                     569         602
          --------------------------------------------------------------------------------------------------
                                                                                         21,739      17,319
          Less accumulated depreciation and amortization                                 (4,707)     (3,729)
          Construction in-progress                                                        3,512       1,076
          -------------------------------------------------------------------------------------------------
               Equipment and leasehold improvements, net                                $20,544    $ 14,666
          =================================================================================================
</TABLE>

Note 5    Long-Term Debt and Note Payable

               Long term debt
          Long-term  debt  consists  of  the  following as of March 31, 1998 and
          1997:
<TABLE>
<CAPTION>
          <S>                                                                                                  <C>         <C> 
                                                                                                                   1998        1997
          =========================================================================================================================

          Notes payable at the London Interbank Offered Rate (LIBOR) plus 2%, adjusted quarterly;
             principal payments of $12.5 and $37.5 in 1998 and 1997, respectively, due quarterly,
             plus interest                                                                                    $   112     $    513
          Less current maturities of long-term debt                                                               (50)        (150)
          ------------------------------------------------------------------------------------------------------------------------
             Long-term debt, excluding current maturities                                                     $    62     $    363
          ========================================================================================================================
</TABLE>

          On  April  1,  1995,  the  Company  executed  a  $250 note, payable in
          principal  installments  of  $12.5 each quarter through April 1, 2000,
          plus  interest,  with  principal  and  interest  payments satisfied by
          delivering  to the lender an equivalent market value amount of salable
          product  or  cash (at the  lender's option).  The note  payable  bears
          interest at  LIBOR plus 2%,  adjusted  quarterly,  and is  secured  by
          certain  production  equipment.  For the quarter ended March 31, 1998,
          interest on this note was calculated at 7.97%.
               On  July 11, 1995,  the  Company executed a $500 note, payable in
          principal  installments of $25 each quarter through July 1, 2000, plus
          interest, with principal and interest payments satisfied by delivering
          to the lender an equivalent market value amount of salable product  or
          cash (at the lender's option). The note payable bore interest at LIBOR
          plus 2%, adjusted quarterly,  and was  secured  by  certain  leasehold
          improvements.  This note was satisfied, in its entirety, in 1998.

                    Note payable
          In March  1998,  the  Company  reached an  agreement  with its general
          contractor  to  convert  certain  trade  accounts  payable  to  a note
          payable.  Under  the  terms  of the agreement,  $975 of trade accounts
          payable to the contractor for work completed on an  expansion  project
          was converted  to a note  payable due December 31, 1998.  Terms of the
          note  call  for  a  principal and interest payment of $150 on April 1,
          1998,  monthly  principal  and  interest  payments  of  $100 beginning
          June 1, 1998,  and the  balance due on  December  31,  1998.  The note
          payable  bears interest at prime plus 2%,  beginning  January 1, 1998,
          and is  secured by all of the assets of the  Company.  As of March 31,
          1998, the interest rate was calculated at 10.5%.


Note 6    Leases
          The Company leases certain  equipment and a portable  building   under
          capital leases expiring between 1999 and 2000, and leases  facilities,
          equipment and  land under operating leases expiring  between  1999 and
          2025.  The Company has agreed in principle to the lease of  additional
          land under an operating lease expiring in 2027. At March 31, 1998, the
          net book value of equipment under the capital leases amounted to $399.

                                       17
<PAGE>
               Future  minimum  lease  payments  under non-cancelable  operating
          leases, including the effect of the aforementioned land lease expiring
          in  2027,  and  the  present  value  of  future  minimum capital lease
          payments  as of March 31, 1998 are as follows:
<TABLE>
<CAPTION>
          <S>                                                                               <C>                    <C>

          Year ending March 31:                                                      Capital leases        Operating leases
          =================================================================================================================

          1999                                                                              $   142                $    338
          2000                                                                                   68                     335
          2001                                                                                   --                     335
          2002                                                                                   --                     335
          2003                                                                                   --                     335
          Thereafter, through 2027                                                               --                   6,379
          -----------------------------------------------------------------------------------------------------------------
               Total minimum lease payments                                                     210                $  8,057
                                                                                                                   ========
          Less amount representing interest (at rates ranging from 7% to 9%)                    (14)
          -----------------------------------------------------------------------------------------
               Present value of net minimum capital lease payments                              196

          Less current maturities of capital lease obligations                                  129
          -----------------------------------------------------------------------------------------
               Obligations under capital lease, excluding current maturities                $    67
          =========================================================================================
</TABLE>
          Total rent expense under operating leases amounted to $211, $138,  and
          $89 for the years ended March 31, 1998, 1997, and 1996, respectively.
               The  land  leases  provide  for  contingent  rentals in excess of
          minimum  rental  commitments  based  on a percentage of  the Company's
          sales.  Contingent  rentals  for the years ended  March 31, 1998, 1997
          and 1996 were not significant.


Note 7    Series C Preferred Stock
          Series C preferred stock is convertible  into common stock at the rate
          of  one  share  of  preferred  stock  for five  shares of common stock
          through February 23, 2000,  after which date the conversion feature is
          no  longer applicable.  Series  C preferred stock  has  voting  rights
          equal  to  the  number  of  shares  of  common  stock into which it is
          convertible and has a preference in liquidation  over all other series
          of  preferred  stock of $5  per  share plus any accumulated but unpaid
          dividends.  Holders of Series C  preferred  stock are  entitled  to 8%
          cumulative annual dividends at the rate of $.40 per share;  cumulative
          dividends  in  arrears as of March 31,  1998  amount to $2,061 ($3.463
          per share).  Upon  conversion  of Series C preferred stock, cumulative
          dividends  in  arrears on converted shares are no longer payable.  The
          amount of cumulative dividends foregone due to  conversion  during the
          year ended March 31, 1998 was $457 (nil in 1997 and 1996). The consent
          of Series C preferred stockholders is required to modify their present
          rights or sell all or substantially all of the Company's assets.


Note 8    Stock Options and Warrants

               Stock options
          At   the   Company's   annual   meeting   held   on   August  9, 1995,
          the  stockholders  of  the  Company  approved the Company's 1995 Stock
          Option  Plan (the "1995  Plan"),  reserving a total of 400,000  shares
          of common stock for issuance  under the Plan.  At the Company's annual
          meeting  held on September  17,  1997,  the stockholders  approved  an
          amendment  to  the  1995  Plan  which  increased  the number of shares
          reserved for issuance under the Plan from 400,000 to 800,000. The 1995
          Plan  provides for the issuance of both  incentive  and  non-qualified
          stock options.  Options  are to be granted at or above the fair market
          value of the Company's common stock at the date of grant and generally
          become exercisable over a five-year period.
               The  Company also has a  Non-employee  Director Stock Option  and
          Stock  Grant  Plan,  which was approved by  stockholders  in 1994 (the
          "1994 Plan").  Under the 1994 Plan, and upon election  to the Board of
          Directors,  non-employee  directors  are granted a ten-year  option to
          purchase 3,000 shares of the Company's common stock at its fair market
          value on the date of grant.  In  addition,  on the date of each Annual
          Meeting of  Stockholders in  each  year  that  the  1994  Plan  is  in
          effect,  each non-employee   director   continuing   in   office  will
          be  automatically  granted,  without  payment,  2,000 shares of common
          stock that is  non-transferable  for six months  following the date of
          grant.  Grants of 8,000,  6,000 and 8,000  shares of common stock were
          made under the 1994 Plan in  September  1997 and 1996 and August 1995,
          respectively.  Expense  recognized as  a result of these stock  grants
          amounted to $47,  $37 and $40 for  the  years ended  March  31,  1998,
          1997  and  1996, respectively.

                                       18
<PAGE>
               In 1985,  the  Company  adopted  an  Incentive  Stock Option Plan
          (qualified stock option plan) and authorized 200,000 shares of  common
          stock to be set aside for grants to  officers and key employees of the
          Company.   In 1993,  the stockholders  approved an  amendment  to  the
          Incentive   Stock  Option  Plan  which increased  the number of shares
          reserved  for  issuance  under  this  plan  from  200,000  to 400,000.
          Options  were  granted  with  exercise  prices not lower than the fair
          market  value  of the  Company's  common  stock  at the date of grant.
          Options    generally   became   exercisable  in   four   equal  annual
          installments,  commencing  one year from the date of grant and expire,
          if not exercised, five years from the date of grant, unless stipulated
          otherwise by the Compensation and Stock Option Committee of the  Board
          of Directors.  The Incentive Stock Option Plan terminated on March 18,
          1995.  Options  granted  prior  to  the  plan termination date are not
          affected.
               At March 31, 1998, there were 466,500 additional shares available
          for grant under the 1995 Plan and 63,000  additional shares  available
          under  the  1994  Plan.   The  per  share weighted-average  fair value
          of stock options  granted  during 1998, 1997 and 1996 was $6.31, $6.02
          and $3.90, respectively, on the date of  grant  using a Black  Scholes
          option-pricing model with the following weighted-average  assumptions:
          1998 - expected dividend yield of 0%, risk-free interest rate of 6.6%,
          expected  volatility  of 99%,  and an expected life of 4.5 years; 1997
          expected  dividend  yield  of  0%,  risk-free  interest  rate of 6.6%,
          expected volatility of 130%, and an expected life of 4.1 years; 1996 -
          expected  dividend  yield  of  0%,  risk-free interest  rate  of 6.2%,
          expected volatility of 110%, and an expected life of 4.3 years.
               The Company applies APB Opinion No. 25 in accounting for employee
          stock-based compensation and,  accordingly,  no  compensation cost has
          been  recognized for its employee stock  options  in the  accompanying
          financial  statements.  Had the Company determined  compensation  cost
          based on the estimated  fair value at the grant date for its  employee
          stock options under SFAS No. 123, the Company's net income  (loss) and
          net income (loss) per common share would have been as reflected in the
          pro forma amounts below:
<TABLE>
<CAPTION>
          <S>                                   <C>               <C>       <C>          <C>         <C>
                                                                               1998         1997        1996
          ==================================================================================================

          Net income (loss)                     As reported                 $  (300)     $ 4,159    $  2,509
                                                Pro forma                   $  (752)     $ 3,738    $  2,408
          Net income (loss) per common share    As reported       Basic     $ (0.05)     $  0.31    $   0.22
                                                                  Diluted   $ (0.05)     $  0.25    $   0.17
                                                Pro forma         Basic     $ (0.08)     $  0.27    $   0.21
                                                                  Diluted   $ (0.08)     $  0.23    $   0.17
</TABLE>
          Pro forma  net income  (loss) and net income  (loss) per common  share
          information reflect only options  granted  since 1996. Therefore,  the
          full impact of calculating compensation cost for stock  options  under
          SFAS No. 123  is  not reflected in the pro forma net income (loss) and
          net  income (loss)  per common share amounts  presented  above because
          compensation  cost is reflected  over the options'  vesting  period of
          5 years, and compensation  cost for options  granted prior to April 1,
          1995 is not considered.
               Stock option activity during the periods indicated is as follows:
<TABLE>
<CAPTION>
          <S>                                                                         <C>                <C>
                                                                                                          Weighted-
                                                                                    Number of               average
                                                                                       shares        exercise price
          =========================================================================================================
          Balance at March 31, 1995                                                   408,700            $     1.23
             Granted                                                                  101,000                  5.13
             Exercised                                                                (82,625)                  .92
             Forfeited                                                                 (7,375)                 1.03
          ---------------------------------------------------------------------------------------------------------

          Balance at March 31, 1996                                                   419,700                  2.24
             Granted                                                                  166,000                  7.30
             Exercised                                                                (57,912)                  .85
             Forfeited                                                               (107,400)                 1.31
          ---------------------------------------------------------------------------------------------------------

          Balance at March 31, 1997                                                   420,388                  4.42
             Granted                                                                  125,000                  6.31
             Exercised                                                                (84,750)                 1.21
             Forfeited                                                                (53,913)                 5.87
          ---------------------------------------------------------------------------------------------------------

          Balance at March 31, 1998                                                   406,725           $      5.48
          =========================================================================================================
</TABLE>

                                       19
<PAGE>


          The  following   table  summarizes  information  about  stock  options
          outstanding at March 31, 1998:
<TABLE>
<CAPTION>
          <S>                         <C>                      <C>                   <C>                  <C>             <C>

                                          Options Outstanding                              Options Exercisable
          -------------------------------------------------------------------------------------------------------------------------
              Range of     Number outstanding    Weighted-avg. remaining      Weighted-avg.    Number exercisable     Weighted-avg.
          exercise prices          at 3/31/98           contractual life     exercise price            at 3/31/98    exercise price
          =========================================================================================================================
            $.94 to $1.38              71,425                  1.5 years            $  0.95                54,319         $    0.96
           $5.13 to $7.63             335,300                  3.2 years            $  6.44                98,975         $    6.17
          -------------------------------------------------------------------------------------------------------------------------
            $.94 to $7.63             406,725                  2.9 years            $  5.48               153,294         $    4.32
          =========================================================================================================================
</TABLE>

                    Warrants
          At March 31,  1998,  the Company has warrants  outstanding  to acquire
          25,000 shares of the Company's common stock.  The warrants were issued
          in consideration for loans to the Company, in consideration for and in
          recognition  of  services  performed  and to certain  individuals  who
          guaranteed  notes payable by the Company.  Warrants granted for loans,
          services and guarantees  were granted with  exercise  prices not lower
          than the fair market  value of the  Company's common stock on the date
          of grant.  The warrants are exercisable at a price of  $1.00 per share
          and expire in September, 1999.  Warrants to acquire  107,880,  668,120
          and 891,200 shares of common stock were exercised at average prices of
          $.41, $.45 and $.57 in 1998, 1997 and 1996, respectively.


Note 10   Major Customers and Export Sales

          Sales to major customers for the years ended March 31, 1998,  1997 and
          1996 are summarized as follows  (percent of product sales):
<TABLE>
<CAPTION>
          <S>                                                                          <C>         <C>         <C>
                                                                                       1998        1997        1996
          =========================================================================================================

          Customer A                                                                      *%         34%         29%
          Customer B                                                                      *%          *%         11%
          ---------------------------------------------------------------------------------------------------------
                                                                                          *%         34%         40%
          =========================================================================================================
</TABLE>
          *Less than 10% of product sales.

          Net  product  sales  by geographic area for the years ended March 31,
          1998, 1997 and 1996 are summarized as follows:
<TABLE>
<CAPTION>
          <S>                                      <C>         <C>          <C>         <C>      <C>         <C>
                                                          1998                     1997                 1996
          =====================================================================================================
          United States                            $ 4,297     56%          $  4,303    38%      $ 3,614     45%
          Canada/South America                         404      5%               851     8%          896     11%
          Europe                                     1,284     17%             1,292    11%          747      9%
          China                                        358      5%             3,905    34%        2,375     29%
          Asia/Pacific, excluding China              1,284     17%             1,048     9%          449      6%
          -----------------------------------------------------------------------------------------------------
                                                   $ 7,627    100%          $ 11,399   100%      $ 8,081    100%
          =====================================================================================================
</TABLE>
          All foreign product sales transactions are consummated in U.S. dollars

                                       20
<PAGE>
Note 11   Income Taxes

          The  components  of  income  taxes  are as follows for the years ended
          March 31, 1998 and 1997:

<TABLE>
<CAPTION>
<S>                                                                                     <C>        <C> 
                                                                                           1998        1997
          =================================================================================================

          Current
             Federal                                                                    $   (13)   $    138
             State                                                                         (185)        235
          -------------------------------------------------------------------------------------------------
                                                                                           (198)        373
          -------------------------------------------------------------------------------------------------
          Deferred
             Federal                                                                        314        (352)
             State                                                                           59         (21)
          -------------------------------------------------------------------------------------------------
                                                                                            373        (373)
          -------------------------------------------------------------------------------------------------
                                                                                        $   175    $     --
          =================================================================================================
</TABLE>
          The  provision for income taxes for the years ended March 31, 1997 and
          1996   was   nil  due  to   the  utilization  of  net  operating  loss
          carryforwards.
               A  reconciliation  of  the amount of income taxes computed at the
          federal statutory rate of 34% to the amount reflected in the Company's
          consolidated  statements  of  operations  for  the  years  ended March
          31, 1998, 1997 and 1996 are as follows:
<TABLE>
<CAPTION>
          <S>                                                               <C>         <C>          <C>

                                                                               1998        1997        1996
          =================================================================================================
          Amount at the federal statutory income tax rate                   $   (43)    $ 1,414      $  853
          State income taxes, net of federal income tax effect                  (83)        141          --
          Benefit of operating loss carryforwards                                --      (1,328)       (853)
          Change in the beginning-of-the-year balance of the
               valuation allowance for deferred tax assets                      270        (213)         --
          Other                                                                  31         (14)         --
          -------------------------------------------------------------------------------------------------
                                                                            $   175     $    --      $   --
          =================================================================================================
</TABLE>
          The significant  components of deferred  income tax expense  (benefit)
          for the years ended March 31, 1998 and 1997 are as follows:
<TABLE>
<CAPTION>
          <S>                                                                                                 <C>        <C>
                                                                                                                 1998        1997
          =======================================================================================================================

          Deferred tax expense (benefit), exclusive of the change in beginnning-of-the-year valuation
             allowance balance                                                                                $   103    $   (160)
          Increase (decrease) in beginning-of-the-year balance of the valuation allowance for
             deferred tax assets                                                                                  270        (213)
          -----------------------------------------------------------------------------------------------------------------------
                                                                                                              $   373    $   (373)
          =======================================================================================================================
</TABLE>

                                       21
<PAGE>

          The tax effects of  temporary  differences  related to various assets,
          liabilities and carryforwards that  give  rise  to deferred tax assets
          and  deferred  tax  liabilities  as  of March 31, 1998 and 1997 are as
          follows:
<TABLE>
<CAPTION>
          <S>                                                                                              <C>        <C>

                                                                                                              1998        1997
          ====================================================================================================================
          Deferred tax assets:
          Net operating loss carryforwards                                                                 $   441    $     99
          Tax credit carryforwards                                                                             255         301
          Other                                                                                                156         145
          --------------------------------------------------------------------------------------------------------------------
              Gross deferred tax assets                                                                        852         545
          Less valuation allowance                                                                            (404)       (134)
          --------------------------------------------------------------------------------------------------------------------
              Net deferred tax assets                                                                          448         411
          Deferred tax liability -- equipment and leasehold improvements, principally due to differences
             in depreciation and amortization                                                                 (448)        (38)
          --------------------------------------------------------------------------------------------------------------------
              Net deferred tax asset                                                                       $    --    $    373
          ====================================================================================================================
</TABLE>

          The  valuation  allowance for deferred tax assets as of April 1, 1997,
          1996  and  1995  was  $134,  $1,675  and  $2,751,  respectively.   The
          valuation allowance increased by $270  during the year ended March 31,
          1998  and  decreased  by  $1,541  and  $1,076  during  the years ended
          March 31, 1997 and 1996, respectively.  In assessing the realizability
          of deferred tax assets, management considers whether it is more likely
          than not that some portion or all of the deferred  tax assets will not
          be  realized.  The  ultimate  realization  of  deferred  tax assets is
          dependent  upon  the  generation  of  future taxable income during the
          periods in which those  temporary   differences   become   deductible.
          Management   considers   the   scheduled   reversal  of  deferred  tax
          liabilities,  projected  future  taxable  income,   and  tax  planning
          strategies in making this assessment.
               Based upon the level of historical taxable income and projections
          for future taxable income over the periods which the net deferred  tax
          assets are deductible,  management believes it is more likely than not
          the   Company   will   realize   the   benefits  of  these  deductible
          differences,  net  of  the  existing  valuation allowance at March 31,
          1998.  The  amount  of  the deferred tax asset considered  realizable,
          however, could  be  reduced  in the near term if  estimates  of future
          taxable income during the carryforward period are reduced.
               At March 31, 1998, the Company has  tax net  operating  tax  loss
          carryforwards  available  to offset  future  federal and state taxable
          income and tax credit carryforwards available to offset future federal
          income taxes as follows:
<TABLE>
<CAPTION>
          <S>                                                      <C>               <C>                 <C>

                                                                                                        Research and
                                                                Net operating         Investment     experimentation
          Expires March 31,                                            losses        tax credits         tax credits
          ==========================================================================================================
          1999                                                     $       --         $       --         $         3
          2000                                                             --                 --                  14
          2001                                                             --                 14                  15
          2002                                                             --                 --                  22
          2003                                                             --                 --                  15
          2004                                                             --                 --                  52
          2005                                                             --                 --                   5
          2006                                                            400                 --                  --
          2011                                                             --                 --                  23
          2012                                                             44                 --                   9
          2013                                                            854                 --                  --
          ----------------------------------------------------------------------------------------------------------
                                                                   $    1,298         $       14         $       158
          ==========================================================================================================
</TABLE>
          In addition,  at March 31, 1998,  the Company has  alternative minimum
          tax  credit carryforwards of approximately  $83 which are available to
          reduce future federal regular  income taxes over an indefinite period.
               Investment  tax  credits will  be  recorded as a reduction of the
          provision for federal income taxes in the year realized.

                                       22
<PAGE>
Note 12   Fair Value of Financial Instruments

          SFAS Statement No.  107,  "Disclosures  about  Fair Value of Financial
          Instruments," defines the fair value of a financial instrument  as the
          amount  at  which  the  instrument  could  be  exchanged  in a current
          transaction between willing parties.
               The  following  methods and assumptions were used to estimate the
          fair value of each class of financial instruments as of March 31, 1998
          and 1997:

                    Cash and Cash Equivalents
          The carrying amounts approximate fair value  because of the short-term
          nature of these instruments.

                    Investment Securities
          The fair  value of  investment  securities  is based on quoted  market
          prices  at  the  reporting  date.  The  carrying  value  of investment
          securities approximates fair value.

                    Note Payable
          The carrying value of the note payable approximates fair value as  the
          interest rate of the note approximates the  rate currently  offered to
          the Company for similar debt instruments of a comparable maturity.

                    Long-Term Debt
          The carrying amounts approximate fair  value  because  the instruments
          reprice at market rates on a quarterly basis.


Note 13   Profit Sharing Plan

          The  Company sponsors a 401(k) profit sharing  plan for all associates
          not  covered  under  a  separate management incentive plan.  Under the
          401(k) profit sharing plan, 5% of pre-tax profits are allocated  based
          on gross wages to  non-management associates  on  a  quarterly  basis.
          Fifty percent of each associate's  profit sharing bonus is distributed
          in cash on an after-tax basis, with  the remainder deposited  in  each
          associate's  401(k) account on a pre-tax basis with a six year vesting
          schedule, based on years of service with the Company.  All  associates
          may make voluntary  pre-tax  contributions  to  their 401(k) accounts.
          Compensation  expense relative to this plan  amounted to nil, $219 and
          $132 for the years ended March 31, 1998, 1997 and 1996, respectively.


Note 14   Commitments and Contingencies

          As of March 31, 1998,  the  Company  has  agreed  with  a construction
          contractor  to  resume  work  on  an  expansion  project  on or before
          January 1, 1999 in a  reasonable  and  customary manner in  accordance
          with the terms of the contract and at a  minimum billable rate of $150
          per  month.  The  remaining  balance  on  the construction contract is
          approximately $1.9 million.  If  work  does not  resume  on or  before
          January  1,  1999,  the contract  will  be  considered  to  have  been
          terminated  by  Cyanotech  and  each party will retain all rights with
          respect to  the   termination  of  the  contract.   Assertion  by  the
          contractor  of its  termination  rights  could have a material adverse
          effect on the Company's financial  condition, results of operations or
          liquidity.  Total costs  incurred as of March 31, 1998 with respect to
          this  expansion  project  approximate  $2,643.  Management  expects to
          resume work on the project on or before January 1, 1999.
               The Company is involved in various claims arising in the ordinary
          course  of  business.  In  the  opinion  of  management,  the ultimate
          disposition of these matters will not have a material  adverse  effect
          on   the   Company's   consolidated  financial  position,  results  of
          operations or liquidity.

                                       23
<PAGE>
                          INDEPENDENT AUDITORS' REPORT


The Board of Directors Cyanotech Corporation:

          We  have  audited  the  accompanying  consolidated  balance  sheets of
          Cyanotech Corporation and subsidiaries as of March 31, 1998 and  1997,
          and the related consolidated statements  of operations,  stockholders'
          equity  and cash flows for each of  the years in the three-year period
          ended March 31, 1998.  These consolidated financial statements are the
          responsibility of  the Company's management.  Our responsibility is to
          express an opinion on these consolidated financial statements based on
          our audits.

               We  conducted  our  audits  in accordance with generally accepted
          auditing  standards.  Those standards require that we plan and perform
          the audit to obtain  reasonable  assurance about whether the financial
          statements  are  free  of  material  misstatement.  An  audit includes
          examining,  on a test basis,  evidence   supporting  the  amounts  and
          disclosures  in   the  financial  statements.  An audit also  includes
          assessing  the  accounting  principles used and significant  estimates
          made by management,  as  well  as  evaluating  the  overall  financial
          statement  presentation.    We  believe  that  our  audits  provide  a
          reasonable basis for our opinion.

               In  our  opinion, the consolidated financial  statements referred
          to above present  fairly,  in all material  respects,  the   financial
          position of Cyanotech  Corporation   and  subsidiaries as of March 31,
          1998  and  1997,  and  the  results of their operations and their cash
          flows  for each of the years in the three-year  period ended March 31,
          1998 in conformity with generally accepted accounting principles.


                                                       KPMG Peat Marwick LLP


          Honolulu, Hawaii
          April 27, 1998
                                       
<TABLE>
<CAPTION>

                       SELECTED QUARTERLY FINANCIAL DATA
          <S>                                          <C>            <C>            <C>            <C>            <C>

                                                           First         Second          Third         Fourth         Total
          ($ in thousands, except share data)            Quarter        Quarter        Quarter        Quarter          Year
          =================================================================================================================
          1998
          Net sales                                    $   1,774      $   2,053      $   1,564      $   2,236      $  7,627
          Gross profit                                       872            885            542            838         3,137
          Net income (loss)                                  125            (54)          (286)           (85)         (300)
          Net income (loss) per common share
              Basic                                         0.00          (0.01)         (0.03)         (0.01)        (0.05)
              Diluted                                       0.00          (0.01)         (0.03)         (0.01)        (0.05)

          1997
          Net sales                                    $   2,455      $   2,812      $   2,782      $   3,350      $ 11,399
          Gross profit                                     1,470          1,740          1,731          1,868         6,809
          Net income                                         845          1,104            956          1,254         4,159
          Net income per common share
               Basic                                        0.06           0.08           0.07           0.09          0.31
               Diluted                                      0.05           0.07           0.06           0.08          0.25
</TABLE>

                                       24
<PAGE>
OFFICERS                                          
                                                  
Gerald R. Cysewski, Ph.D                          
President, Chief Executive Officer                
and Chairman of the Board                         
                                                  
Glenn D. Jensen                 
Vice President - Operations                       

Kelly J. Moorhead                                 
Vice President -
Sales and Marketing                               
President, Nutrex, Inc.                          

Ronald P. Scott
Executive Vice President -                        
Finance & Administration                          
Treasurer and Secretary                           
                                                  

BOARD OF DIRECTORS
                                                  
Julian C. Baker 2                                                               
Gerald R. Cysewski, Ph.D                           
Eva R. Reichl 1,2                                  
Ronald P. Scott                                   
John T. Ushijima  1,2                             
Paul C. Yuen, Ph.D 1

1 Member of the Audit Committee                   
2 Member of the Compensation and                   
  Stock Option Committee
<PAGE>
CORPORATE INFORMATION

Corporate Headquarters
Cyanotech Corporation
73-4460 Queen Kaahumanu Hwy.
Suite 102
Keahole Point
Kailua-Kona, HI 96740
Tel (808) 326-1353
Fax (808) 329-3597

Wholly-Owned Subsidiaries
Nutrex, Inc.
Cyanoech International FSC, Inc.

Transfer Agent and Registrar
ChaseMellon Shareholder Services, L.L.C.
Shareholder Relations
85 Challenger Road
Ridgefield Park, NJ 07660
(800) 522-6645

Independent Accountants
KPMG Peat Marwick LLP
Honolulu, HI 96812-4150

Legal Counsel
Goodsill Anderson Quinn & Stifel
Honolulu, HI 96801-3196

Form 10-K
A copy of Cyanotech's annual report to the Securities
and Exchange Commission on Form 10-K is available
without charge upon written request to:
     Secretary, Cyanotech Corporation
     73-4460 Queen Kaahumanu Hwy.
     Suite 102
     Kailua-Kona, HI 96740

Notice of Annual Meeting
The 1998 annual meeting of stockholders will be held 
on Thursday, September 17, 1998, at 7:00 p.m. at
Ala Moana Hotel
410 Atkinson Dr.,
Honolulu, Hawaii 96814

Additional Information:
As a service to our stockholders and prospective
investors, copies of Cyanotech news releases and
financial statements issued in the last 12 months are
available 24 hours a day, seven days a week on the
Internet's  World Wide Web at http://
www.cyanotech.com

<PAGE>

Market for Common Equity and Related 
Stockholder Matters
Cyanotech's  Common  Stock is traded on the  Nasdaq  National  Market  under the
symbol "CYAN." The following table sets forth the high and low selling prices as
reported by the Nasdaq Stock Market for the periods indicated.

Three Months Ended        High      Low
=======================================

1998
June 30, 1997           $ 7.13   $ 4.75
September 30, 1997      $ 6.38   $ 4.25
December 31, 1997       $ 5.75   $ 2.44
March 31, 1998          $ 4.06   $ 2.50

1997
June 30, 1996           $ 9.88   $ 6.25
September 30, 1996      $ 8.88   $ 5.31
December 31, 1996       $ 7.38   $ 5.88
March 31, 1997          $ 8.13   $ 2.50

Cyanotech  has never  declared of paid cash  dividends on its Common  Stock.  We
currently  intend to retain all of our  earnings  for use in the business and do
not anticipate  paying any cash dividends on Series C Preferred  Stock or Common
Stock in the foreseeable future.
   The  approximate  number of record holders of outstanding  Common Stock as of
June 17, 1998 was 1,393.

Forward-Looking Information
Certain statements herein set forth  management's  intentions,  plans,  beliefs,
expectations  or  predictions of the future based on current facts and analyses.
Actual  results  may differ  materially  due to a variety  of factors  including
reduced  product  demand,  price  competition,  government  action,  and weather
conditions.  Additional  information  on factors that may affect the Company and
cause  actual  results  to  differ  from  current  expectations  can be found in
Cyanotech's filings with the SEC.
<PAGE>
--------------------------------------------
CYANOTECH CORPORATION

Hawaii Ocean and Science Technology Park
73-4460 Queen Kaahumanu Highway
Suite 102
Kailua-Kona, Hawaii 96740