**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**QuarterlyReport Under Section 13 or 15(d)of the Securities Exchange Act of 1934**

 

**For Quarterly Period Ended December 31,2003**

 

**Commission File Number 0-14602**

 

**CYANOTECH CORPORATION**

(Exact name of registrant as specified in itscharter)

 

| **NEVADA**                                                          |   | **91-1206026**                        |
|---------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction  of incorporation or organization      |   | (IRS Employer  Identification Number) |
|                                                                |   |                                  |
| **73-4460 Queen Kaahumanu Hwy. #102,  Kailua-Kona, HI  96740** |
| (Address of principal executive offices)                            |
|                                                                |   |                                  |
| **(808) 326-1353**                                                  |
| (Registrant’s telephone number)                                |

 

Check whether the registrant (1) filed all reports required to be filedby Section 13 or 15(d) of the Exchange Act during the past 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.

Yes  ý          No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).Yes  o          No  ý

 

Number of common shares outstanding as of January 31, 2004:

 

| **Title of  Class**             |   | **Shares  Outstanding** |   |
|---------------------------------|--------|-------------------------|--------|
| Common stock -  $.005 par value |   | 20,255,777              |   |

 

 

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CYANOTECH CORPORATION

FORM 10-Q

 

INDEX

 
| PART I.  FINANCIAL INFORMATION |                                                                                                                            |
|------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------|
|                                     |                                                                                                                            |   |
| Item 1.                                  | Financial Statements                                                                                                            |   |
|                                     |                                                                                                                            |   |
|                                     | Consolidated Balance Sheets  (unaudited)  As of December 31, 2003 and March 31, 2003                                  |   |
|                                     |                                                                                                                            |   |
|                                     | Consolidated Statements of Operations  (unaudited)  For the three and nine month periods ended  December 31, 2003 and 2002 |   |
|                                     |                                                                                                                            |   |
|                                     | Consolidated Statements of Cash Flows  (unaudited)  For the nine month periods ended  December 31, 2003 and 2002           |   |
|                                     |                                                                                                                            |   |
|                                     | Notes to Consolidated Financial Statements  (unaudited)                                                                         |   |
|                                     |                                                                                                                            |   |
| Item  2.                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                     |   |
|                                     |                                                                                                                            |   |
| Item  3.                                 | Quantitative  and Qualitative Disclosures About Market Risk                                                                     |   |
|                                     |                                                                                                                            |   |
| Item  4.                                 | Controls  and Procedures                                                                                                        |   |
|                                     |                                                                                                                            |   |
| PART  II.  OTHER INFORMATION   |                                                                                                                            |
|                                     |                                                                                                                            |   |
| Item  1.                                 | Legal  Proceedings                                                                                                              |   |
|                                     |                                                                                                                            |   |
| Item  6.                                 | Exhibits  and Reports on Form 8-K                                                                                               |   |
|                                     |                                                                                                                            |   |
| SIGNATURES                               |                                                                                                                            |

 

2

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PART 1.  FINANCIAL INFORMATION

Item 1.  Financial Statements

 

CYANOTECH CORPORATION

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands except per shareamounts)

(Unaudited)

 
|                                                                                                                                                                       |   | **December 31,2003** |   | **March 31,2003** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------|--------|------------------------|--------|
|                                                                                                                                                                       |   |                      |   |                   |   |
| ASSETS                                                                                                                                                                     |   |                      |   |                   |   |
| Current assets:                                                                                                                                                            |   |                      |   |                   |   |
| Cash and cash equivalents                                                                                                                                                  |   | $                         | 1,517  |                   | $      | 579 |   |
| Accounts receivable, net                                                                                                                                                   |   | 1,862                     |   | 1,839                  |   |
| Refundable income taxes                                                                                                                                                    |   | 3                         |   | 9                      |   |
| Inventories (see Note 2)                                                                                                                                                   |   | 1,449                     |   | 1,400                  |   |
| Prepaid expenses                                                                                                                                                           |   | 85                        |   | 40                     |   |
| Total current assets                                                                                                                                                       |   | 4,916                     |   | 3,867                  |   |
|                                                                                                                                                                       |   |                      |   |                   |   |
| Equipment and leasehold improvements, net  (see Note 3)                                                                                                                    |   | 11,951                    |   | 12,777                 |   |
| Other assets                                                                                                                                                               |   | 618                       |   | 838                    |   |
| Total assets                                                                                                                                                               |   | $                         | 17,485 |                   | $      | 17,482 |   |
|                                                                                                                                                                       |   |                      |   |                   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                  |   |                      |   |                   |   |
| Current liabilities:                                                                                                                                                       |   |                      |   |                   |   |
| Current maturities of long-term debt                                                                                                                                       |   | $                         | 323    |                   | $      | 323 |   |
| Accounts payable                                                                                                                                                           |   | 880                       |   | 803                    |   |
| Accrued expenses                                                                                                                                                           |   | 572                       |   | 389                    |   |
| Total current liabilities                                                                                                                                                  |   | 1,775                     |   | 1,515                  |   |
|                                                                                                                                                                       |   |                      |   |                   |   |
| Long-term debt, excluding current  maturities (see Note 4)                                                                                                                 |   | 2,200                     |   | 3,694                  |   |
| Total liabilities                                                                                                                                                          |   | 3,975                     |   | 5,209                  |   |
|                                                                                                                                                                       |   |                      |   |                   |   |
| Stockholders’ equity:                                                                                                                                                 |   |                      |   |                   |   |
| Common Stock of $0.005 par value, shares  authorized 25,000,000; shares issued and outstanding 20,242,277 at  December 31, 2003 and 18,316,701 at March 31, 2003 |   | 101                       |   | 92                     |   |
| Additional paid-in capital                                                                                                                                                 |   | 26,660                    |   | 25,418                 |   |
| Accumulated other comprehensive income (loss) -  foreign currency translation adjustments                                                                                  |   | 25                        |   | (3                     | )      |
| Accumulated deficit                                                                                                                                                        |   | (13,276                   | )      | (13,234                | )      |
| Total stockholders’ equity                                                                                                                                            |   | 13,510                    |   | 12,273                 |   |
|                                                                                                                                                                       |   |                      |   |                   |   |
| Total liabilities and stockholders’ equity                                                                                                                            |   | $                         | 17,485 |                   | $      | 17,482 |   |

 

See accompanying Notes to ConsolidatedFinancial Statements.

 

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CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per shareamounts)

(Unaudited)

 
|                                                        |   | **Three Months Ended  December 31,** |   | **Nine Months Ended  December 31,** |   |
|-------------------------------------------------------------|--------|-------------------------------------------|--------|------------------------------------------|--------|
|                                                        |   | **2003**                                  |   | **2002**                                 |   | **2003** |   | **2002** |   |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| NET SALES                                                   |   | $                                         | 3,024  |                                     | $      | 2,474 |   | $ | 8,292 |   | $ | 6,524 |   |
| COST OF  PRODUCT SALES                                      |   | 1,840                                     |   | 1,763                                    |   | 5,543 |   | 4,460 |   |
| Gross  profit                                               |   | 1,184                                     |   | 711                                      |   | 2,749 |   | 2,064 |   |
| OPERATING  EXPENSES:                                        |   |                                      |   |                                     |   |   |   |   |   |
| Research  and development                                   |   | 53                                        |   | 38                                       |   | 117 |   | 184 |   |
| Sales and  marketing                                        |   | 298                                       |   | 354                                      |   | 961 |   | 1,377 |   |
| General  and administrative                                 |   | 541                                       |   | 434                                      |   | 1,397 |   | 1,491 |   |
| Total  operating expenses                                   |   | 892                                       |   | 826                                      |   | 2,475 |   | 3,052 |   |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| Income  (loss) from operations                              |   | 292                                       |   | (115                                     | )      | 274 |   | (988 | ) |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| OTHER INCOME (EXPENSE):                                     |   |                                      |   |                                     |   |   |   |   |   |
| Interest  income                                            |   | 1                                         |   | 6                                        |   | 13 |   | 23 |   |
| Interest expense                                            |   | (84                                       | )      | (92                                      | )      | (250 | ) | (339 | ) |
| Other  income (expense), net                                |   | 14                                        |   | 21                                       |   | 17 |   | (201 | ) |
| Total  other expense                                        |   | (69                                       | )      | (65                                      | )      | (220 | ) | (517 | ) |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| Income (loss) before income taxes                           |   | 223                                       |   | (180                                     | )      | 54 |   | (1,505 | ) |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| INCOME TAX  PROVISION                                       |   | 114                                       |   | —                                   |   | 96 |   | — |   |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| NET INCOME  (LOSS)                                          |   | $                                         | 109    |                                     | $      | (180 | ) | $ | (42 | ) | $ | (1,505 | ) |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| NET INCOME  (LOSS) PER SHARE                                |   |                                      |   |                                     |   |   |   |   |   |
| Basic                                                       |   | $                                         | 0.01   |                                     | $      | (0.01 | ) | $ | (0.00 | ) | $ | (0.09 | ) |
| Diluted                                                     |   | $                                         | 0.01   |                                     | $      | (0.01 | ) | $ | (0.00 | ) | $ | (0.09 | ) |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| SHARES USED IN CALCULATION OF NET INCOME (LOSS) PER  SHARE: |   |                                      |   |                                     |   |   |   |   |   |
| Basic                                                       |   | 18,777                                    |   | 18,284                                   |   | 18,471 |   | 17,703 |   |
| Diluted                                                     |   | 18,934                                    |   | 18,284                                   |   | 18,471 |   | 17,703 |   |
|                                                        |   |                                      |   |                                     |   |   |   |   |   |
| COMPREHENSIVE  INCOME (LOSS):                               |   |                                      |   |                                     |   |   |   |   |   |
| Net income (loss)                                           |   | $                                         | 109    |                                     | $      | (180 | ) | $ | (42 | ) | $ | (1,505 | ) |
| Other  comprehensive income                                 |   | 9                                         |   | 8                                        |   | 28 |   | 10 |   |
|                                                        |   | $                                         | 118    |                                     | $      | (172 | ) | $ | (14 | ) | $ | (1,495 | ) |

 

See accompanying Notes to ConsolidatedFinancial Statements.

 

4

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CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 
|                                                                                                 |   | **Nine Months Ended  December 31,** |   |
|------------------------------------------------------------------------------------------------------|--------|------------------------------------------|--------|
|                                                                                                 |   | **2003**                                 |   | **2002** |   |
|                                                                                                 |   |                                     |   |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                |   |                                     |   |   |   |
| Net loss                                                                                             |   | $                                        | (42    | ) | $ | (1,505 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |   |                                     |   |   |   |
| Depreciation  and amortization                                                                       |   | 1,013                                    |   | 987 |   |
| Allowance  for doubtful accounts                                                                     |   | 105                                      |   | 70 |   |
| Debt issue  costs amortization                                                                       |   | 55                                       |   | 121 |   |
| Cumulative  foreign exchange translation gains                                                       |   | 0                                        |   | — |   |
| Warrants  issued in connection with extension of debentures                                          |   | —                                   |   | 223 |   |
| Stock  issued in exchange for services                                                               |   | —                                   |   | 5 |   |
| Net  (increase) decrease in:                                                                         |   |                                     |   |   |   |
| Accounts receivable                                                                                  |   | (128                                     | )      | (361 | ) |
| Refundable income taxes                                                                              |   | 6                                        |   | — |   |
| Inventories                                                                                          |   | (49                                      | )      | (350 | ) |
| Prepaid expenses and other assets                                                                    |   | (104                                     | )      | 28 |   |
| Net  increase (decrease) in:                                                                         |   |                                     |   |   |   |
| Accounts payable                                                                                     |   | 77                                       |   | (29 | ) |
| Accrued  expenses                                                                                    |   | 183                                      |   | 244 |   |
| Net cash  provided by (used in) operating activities                                                 |   | 1,116                                    |   | (567 | ) |
|                                                                                                 |   |                                     |   |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                                               |   |                                     |   |   |   |
| Investment  in equipment and leasehold improvements                                                  |   | (185                                     | )      | (217 | ) |
|                                                                                                 |   |                                     |   |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                                               |   |                                     |   |   |   |
| Release of restricted cash deposit                                                                   |   | 250                                      |   | — |   |
| Proceeds  from issuance of common stock and exercise of stock options                                |   | 1                                        |   | 630 |   |
| Proceeds from issuance of convertible  debentures                                                    |   | —                                   |   | 1,250 |   |
| Principal payments on long-term debt                                                                 |   | (244                                     | )      | (225 | ) |
| Debt issue costs                                                                                     |   | —                                   |   | (59 | ) |
| Repayment of convertible debentures                                                                  |   | —                                   |   | (1,238 | ) |
| Net cash provided by financing activities                                                            |   | 7                                        |   | 358 |   |
|                                                                                                 |   |                                     |   |   |   |
| Net increase (decrease) in cash and cash equivalents                                                 |   | 938                                      |   | (426 | ) |
|                                                                                                 |   |                                     |   |   |   |
| Cash and cash equivalents at beginning of period                                                     |   | 579                                      |   | 1,051 |   |
|                                                                                                 |   |                                     |   |   |   |
| Cash and cash equivalents at end of period                                                           |   | $                                        | 1,517  |   | $ | 625 |   |
|                                                                                                 |   |                                     |   |   |   |
| Supplemental disclosure of non-cash financing  activities:                                           |   |                                     |   |   |   |
| Conversion of long-term debt to common  stock                                                        |   | $                                        | 1,250  |   | $ | — |   |

 

See accompanying Notes to ConsolidatedFinancial Statements.

 

5

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CYANOTECH CORPORATION

FORM 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2003

(Unaudited)

 

1.                                       BASIS OFPRESENTATION

 

The accompanying unaudited consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America for interim financial information and with theinstructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by generally accepted accounting principles for complete financialstatements.  These consolidatedfinancial statements and notes should be read in conjunction with the Company’sconsolidated financial statements contained in the Company’s previously filedreport on Form 10-K for the year ended March 31, 2003.

 

The Company consolidates enterprises in which it has a controllingfinancial interest. The accompanying consolidated financial statements includethe accounts of Cyanotech Corporation and its wholly-owned subsidiaries, NutrexHawaii, Inc. and Cyanotech Japan YK. All significant intercompany balances and transactions have beeneliminated in consolidation.  While thefinancial information furnished for the three and nine month periods endedDecember 31, 2003 is unaudited, the statements in this report reflect allmaterial items which, in the opinion of management, are necessary for a fairpresentation of the results of operations for the interim periods covered andof the financial condition of the Company at the dates of the consolidated balancesheets. The operating results for the interim period presented are notnecessarily indicative of the results that may be expected for the year endingMarch 31, 2004.

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, disclosures of contingent assets and liabilities atthe date of the financial statements, and revenues and expenses reported duringthe period.  Actual results may differfrom management’s estimates.

 

2.                                       INVENTORIES

 

Inventories are stated at the lower of cost (which approximatesfirst-in, first-out) or market and consist of the following (dollars inthousands):

 

|            |   | **December 31,  2003** |   | **March 31,  2003** |   |
|-----------------|--------|-----------------------------|--------|--------------------------|--------|
|            |   |                        |   |                     |   |
| Raw materials   |   | $                           | 145    |                     | $      | 161 |   |
| Work in process |   | 199                         |   | 117                      |   |
| Finished goods  |   | 950                         |   | 1,028                    |   |
| Supplies        |   | 155                         |   | 94                       |   |
|            |   | $                           | 1,449  |                     | $      | 1,400 |   |

 

6

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3.                                       EQUIPMENTAND LEASEHOLD IMPROVEMENTS

 

Owned equipment and leasehold improvements are stated at cost.Depreciation and amortization are provided using the straight-line method overthe estimated useful lives for equipment and furniture and fixtures and the shorterof the lease terms or estimated useful lives for leasehold improvements asfollows:

 
| Equipment              |   | 3 to 10 years  |
|------------------------|--------|----------------|
| Leasehold improvements |   | 10 to 23 years |
| Furniture and fixtures |   | 7 years        |

 

Equipment and leasehold improvements consist of the following (dollarsin thousands):

 
|                                            |   | **December 31,  2003** |   | **March 31,  2003** |   |
|-------------------------------------------------|--------|-----------------------------|--------|--------------------------|--------|
|                                            |   |                        |   |                     |   |
| Equipment                                       |   | $                           | 9,705  |                     | $      | 9,631 |   |
| Leasehold improvements                          |   | 14,326                      |   | 14,173                   |   |
| Furniture and fixtures                          |   | 83                          |   | 83                       |   |
|                                            |   | 24,114                      |   | 23,887                   |   |
| Less accumulated  depreciation and amortization |   | (12,352                     | )      | (11,341                  | )      |
| Construction in-progress                        |   | 189                         |   | 231                      |   |
| Equipment and leasehold improvements, net       |   | $                           | 11,951 |                     | $      | 12,777 |   |

 

4.                                       LONG-TERMDEBT

 

On December 10, 2003, the holder of the Company’s ConvertibleDebentures (the “Debentures”) due September 30, 2005 voluntarily convertedthe entire principal amount of the Debentures, amounting to $1,250,000, into1,923,076 shares of Common Stock pursuant to the terms of the Debentures.   Long-term debt at December 31, 2003consists of the following:

 
|                                          |   | **December 31,  2003** |   | **March 31,  2003** |   |
|-----------------------------------------------|--------|-----------------------------|--------|--------------------------|--------|
|                                          |   |                        |   |                     |   |
| Term loan                                     |   | $                           | 2,523  |                     | $      | 2,767 |   |
| Convertible subordinated debentures           |   | —                      |   | 1,250                    |   |
| Total long-term debt                          |   | 2,523                       |   | 4,017                    |   |
| Less current maturities                       |   | (323                        | )      | (323                     | )      |
| Long-term debt, excluding current  maturities |   | $                           | 2,200  |                     | $      | 3,694 |   |

 

On July 30, 2003, the Company received $250,000 of cash previouslyheld as a restricted deposit in connection with the Company’s term loanagreement.   A remaining $250,000restricted cash deposit continues to be held in an interest-bearing restrictedcash account per the terms of the term loan and is included in Other Assets onthe consolidated balance sheet at December 31, 2003.  A warrant to purchase 20,000 shares of theCompany’s common stock was issued in conjunction with this term loan.  The warrant expires in April 2011 andhas an exercise price of $2.55 per share. The warrant may only be exercised after the Company has repaid the termloan in full.

 

7

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5.                                       EARNINGSPER SHARE

 

Basic earnings per share is computed on the basis of the weightedaverage number of common shares outstanding. Diluted earnings per share is computed on the basis of the weightedaverage number of common shares outstanding plus the potentially dilutiveeffect of outstanding stock options and warrants using the “treasury stock”method and convertible securities using the “if-converted” method.

 

Reconciliations between the numerator and the denominator of the basicand diluted earnings per share computations for the three months endedDecember 31, 2003 are as follows (there were no reconciling items for thenine months ended December 31, 2003 and the three and nine months endedDecember 31, 2002):

 
|                                                                    |   | **Three  Months Ended December 31, 2003** |   |
|-------------------------------------------------------------------------|--------|------------------------------------------------|--------|
|                                                                    |   | **Net Income**                                 |   | **Shares** |   | **Per Share  Amount** |   |
|                                                                    |   | **(In  thousands)  (Numerator)**               |   | **(In  thousands)  (Denominator)** |   |   |   |
|                                                                    |   |                                           |   |   |   |   |   |
| Basic earnings per share                                                |   | $                                              | 109    |   | 18,777 |   | $ | 0.01 |   |
| Effect of dilutive securities – Common stock options  and warrants |   | —                                         |   | 157 |   |   |   |
| Diluted earnings per share                                              |   | $                                              | 109    |   | 18,934 |   | $ | 0.01 |   |

 

The following securities were excluded from the calculation of dilutedearnings per share because their effect was antidilutive (commons stock sharesin thousands):

 
|                                          |   | **Three Months Ended  December  31,** |   | **Nine Months Ended  December 31,** |   |
|-----------------------------------------------|--------|--------------------------------------------|--------|------------------------------------------|--------|
|                                          |   | **2003**                                   |   | **2002**                                 |   | **2003** |   | **2002** |   |
| Debentures,  prior to conversion (see Note 4) |   | 1,923                                      |   | 1,923                                    |   | 1,923 |   | 1,923 |   |
| Stock  options and warrants                   |   | 990                                        |   | 1,354                                    |   | 1,298 |   | 1,354 |   |

 

6.                                       STOCK-BASEDCOMPENSATION

 

The Company has adopted the disclosure-only provisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 123 “Accounting for Stock-BasedCompensation” and applied the provisions of Accounting Principle Board OpinionNo. 25 in accounting for stock-based compensation.   Had compensation cost for stock options granted been determinedbased on the fair value method for measuring stock-based compensation, netincome (loss) would have been as follows:

 
|                                                                           |   | **Three Months Ended  December  31,** |   | **Nine Months Ended  December 31,** |   |
|--------------------------------------------------------------------------------|--------|--------------------------------------------|--------|------------------------------------------|--------|
|                                                                           |   | **2003**                                   |   | **2002**                                 |   | **2003** |   | **2002** |   |
|                                                                           |   |                                       |   |                                     |   |   |   |   |   |
| Net income (loss), as reported                                                 |   | $                                          | 109    |                                     | $      | (180 | ) | $ | (42 | ) | $ | (1,505 | ) |
| Less  stock-based employee compensation determined under the fair value method |   | (21                                        | )      | (20                                      | )      | (65 | ) | (61 | ) |
| Pro-forma  net income (loss)                                                   |   | $                                          | 88     |                                     | $      | (200 | ) | $ | (107 | ) | $ | (1,566 | ) |

 

8

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Based on the pro-forma net income (loss), thebasic and diluted netincome (loss) per share would have been as follows:

 
|                                 |   | **Three Months Ended  December  31,** |   | **Nine Months Ended  December 31,** |   |
|--------------------------------------|--------|--------------------------------------------|--------|------------------------------------------|--------|
|                                 |   | **2003**                                   |   | **2002**                                 |   | **2003** |   | **2002** |   |
|                                 |   |                                       |   |                                     |   |   |   |   |   |
| Basic net income (loss) per share:   |   |                                       |   |                                     |   |   |   |   |   |
| As  reported                         |   | $                                          | 0.01   |                                     | $      | (0.01 | ) | $ | (0.00 | ) | $ | (0.09 | ) |
| Pro-forma                            |   | $                                          | 0.00   |                                     | $      | (0.01 | ) | $ | (0.01 | ) | $ | (0.09 | ) |
|                                 |   |                                       |   |                                     |   |   |   |   |   |
| Diluted net income (loss) per share: |   |                                       |   |                                     |   |   |   |   |   |
| As  reported                         |   | $                                          | 0.01   |                                     | $      | (0.01 | ) | $ | (0.00 | ) | $ | (0.09 | ) |
| Pro-forma                            |   | $                                          | 0.00   |                                     | $      | (0.01 | ) | $ | (0.01 | ) | $ | (0.09 | ) |

 

7.                                       RECENTACCOUNTING PRONOUNCEMENTS

 

*Accounting for Certain Financial Instrumentswith Characteristics of Both Liabilities and Equity* InMay 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 150“Accounting for Certain Financial Instruments with Characteristics of BothLiabilities and Equity.”  SFAS No. 150requires issuers to classify as liabilities (or assets in some circumstance)three classes of freestanding financial instruments that embody obligations forthe issuer.  Generally, SFAS No. 150 iseffective for financial instruments entered into or modified after May 31, 2003and is otherwise effective at the beginning of the first interim periodbeginning after June 15, 2003.  InNovember 2003, the effective date for certain mandatorily redeemablenon-controlling interests has been deferred indefinitely.  The adoption of SFAS No. 150 did not have amaterial effect on the Company’s financial condition, results of operations orliquidity.

 

8.                                       GOING CONCERN

 

The Company’s consolidated financial statements have been prepared on agoing concern basis, which assumes continuity of operations and realization ofassets and liquidation of liabilities in the ordinary course of business.  For the nine months ended December 31,2003, the Company incurred a net loss of $42,000.   During the years ended March 31, 2003, 2002 and 2001, theCompany incurred losses of $1,775,000, $2,589,000 and $1,067,000,respectively.  The Company’s workingcapital at December 31, 2003 was $3,141,000 with cash and cash equivalentsamounting to $1,517,000.  Net cash andcash equivalents provided by operating activities for the nine months endedDecember 31, 2003 was $1,116,000.  For the years ended March 31, 2003 and 2002, net cash and cashequivalents used in operating activities amounted to $502,000 and $567,000,respectively.

 

The Company’s continuation as a going concern is dependent upon itsability to generate sufficient cash flow to meet its obligations on a timelybasis, to comply with the terms of its financing agreements, to obtainadditional financing or refinancing as may be required, to sustainprofitability, or a combination thereof. While the Company generated cash and cash equivalents from operatingactivities for the nine months ended December 31, 2003, there can be noassurance that future efforts will continue to be successful or that theCompany will have sufficient cash resources to support its future operations.  The accompanying unaudited consolidatedfinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.

 

9

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**CYANOTECH CORPORATION**

 

**Item2****.****           Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

*This report on Form 10-Q containsforward-looking statements regarding the future performance of Cyanotech andfuture events that involve risks and uncertainties that could cause actualresults to differ materially from the statements contained herein. Thisdocument, and the other documents that the Company files from time to time withthe Securities and Exchange Commission, such as its reports on Form 10-K, Form10-Q, Form 8-K, and its proxy materials, contain additional important factorsthat could cause actual results to differ from the Company’s currentexpectations and the forward-looking statements contained herein.*

 

**Overview**

 

The Company returned to profitability for thethree months ended December 31, 2003 reporting net income of $109,000 or$0.01 per diluted share and reduced the net loss on a year-to-date basis to$42,000 or $(0.00) per diluted share.  The Company believes that the following selectedconsolidated statements of operations data were key contributors to theCompany’s performance for the periods indicated:

 
|                                        |   | **Three  Months Ended  December 31,** |   | **Nine  Months Ended  December 31,** |   |
|---------------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
|                                        |   | **2003**                                   |   | **2002**                                  |   | **2003** |   | **2002** |   |
|                                        |   |                                       |   |                                      |   |   |   |   |   |
| Net sales                                   |   | $                                          | 3,024  |                                      | $      | 2,474 |   | $ | 8,292 |   | $ | 6,524 |   |
|                                        |   |                                       |   |                                      |   |   |   |   |   |
| Gross profit as a percentage of sales       |   | 39.1                                       | %      | 28.7                                      | %      | 33.2 | % | 31.6 | % |
|                                        |   |                                       |   |                                      |   |   |   |   |   |
| Operating expenses as a percentage of sales |   | 29.4                                       | %      | 33.4                                      | %      | 29.8 | % | 46.8 | % |
|                                             |        |                                            |        |                                           |        |  |  |  |  |  |  |  |  |

 

The sales increases for both current year periods resulted fromincreased bulk sales of the Company’s natural astaxanthin products whichcontinue to experience strong demand from both the aquaculture market(NatuRose®) and human nutritional supplement market (BioAstin®).   The natural astaxanthin market isrelatively young and thus the Company is currently able to generate highermargins for these products compared to its Spirulina products, which compete ina mature market (for a more comprehensive description of the Company’s productsand markets for such products, see Part I. Item 1. Business of the Company’sAnnual Report to Stockholders on Form 10-K for the fiscal year endedMarch 31, 2003 which is hereby incorporated by reference).  As the supply from other producers ofnatural and synthetic astaxanthin increases in the market, these margins mayerode due to the increased competition. The Company is working with industry-leading manufacturers in humannutrition and cosmetics to integrate BioAstin into their products.  Likewise, NatuRose has become the naturalalternative to synthetic astaxanthin in the aquaculture market, especially inJapan where the Company has established its subsidiary, Cyanotech Japan YK.

 

For the three months ended December 31, 2003, the increased levelof sales was accompanied by an increase in gross profit margin resulting fromimproved production efficiency. Improvements in cultivation and processing are aimed at ongoingreduction of production costs while concurrently allowing the Company tomaintain its ability to cultivate and manufacture its products at levelssufficient to serve its customers.  TheCompany is in the process of reallocating its cultivation in an effort toincrease production of natural astaxanthin while concurrently optimizing itsSpirulina production to improve yield and quality.

 

10

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Operating expenses, as apercentage of net sales, decreased for both three and nine month periods as theresult of the Company’s focus on controlling discretionary spending.  The Company is continuing its focus on matchingoperating expense as determined by changing market conditions and saleslevels.

 

The Company generated cash and cash equivalents from operations of$1,116,000 for the nine months ended December 31, 2003.   The sales in the period generated increasedcash receipts partially offset by higher purchases of raw materials andsupplies used in cultivation and production.

 

**Results of Operations**

 

The following table sets forth certain consolidated statements ofoperations data as a percentage of net sales for the periods indicated:

 
|                               |   | **Three  Months Ended  December 31,** |   | **Nine  Months Ended  December 31,** |   |
|------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
|                               |   | **2003**                                   |   | **2002**                                  |   | **2003** |   | **2002** |   |
| Net sales                          |   | 100.0                                      | %      | 100.0                                     | %      | 100.0 | % | 100.0 | % |
| Cost of product sales              |   | 60.9                                       |   | 71.3                                      |   | 66.8 |   | 68.4 |   |
| Gross profit                       |   | 39.1                                       |   | 28.7                                      |   | 33.2 |   | 31.6 |   |
|                               |   |                                       |   |                                      |   |   |   |   |   |
| Operating expenses:                |   |                                       |   |                                      |   |   |   |   |   |
| Research and development           |   | 1.7                                        |   | 1.5                                       |   | 1.4 |   | 2.8 |   |
| Sales and marketing                |   | 9.8                                        |   | 14.3                                      |   | 11.6 |   | 21.1 |   |
| General and administrative         |   | 17.9                                       |   | 17.6                                      |   | 16.9 |   | 22.9 |   |
| Total operating expenses           |   | 29.4                                       |   | 33.4                                      |   | 29.9 |   | 46.8 |   |
|                               |   |                                       |   |                                      |   |   |   |   |   |
| Income (loss) from operations      |   | 9.7                                        |   | (4.7                                      | )      | 3.3 |   | (15.2 | ) |
|                               |   |                                       |   |                                      |   |   |   |   |   |
| Other income (expense):            |   |                                       |   |                                      |   |   |   |   |   |
| Interest income                    |   | 0.0                                        |   | 0.2                                       |   | 0.2 |   | 0.4 |   |
| Interest expense                   |   | (2.8                                       | )      | (3.7                                      | )      | (3.0 | ) | (5.2 | ) |
| Other income (expense), net        |   | 0.5                                        |   | 0.9                                       |   | 0.2 |   | (3.1 | ) |
| Total other expense                |   | (2.3                                       | )      | (2.6                                      | )      | (2.6 | ) | (7.9 | ) |
|                               |   |                                       |   |                                      |   |   |   |   |   |
| Income (loss) before  income taxes |   | 7.4                                        |   | (7.3                                      | )      | 0.7 |   | (23.1 | ) |
| Income tax provision               |   | 3.8                                        |   | —                                    |   | 1.2 |   | — |   |
| Net income (loss)                  |   | 3.6                                        | %      | (7.3                                      | )%     | (0.5 | )% | (23.1 | )% |

 

*Third Quarter of Fiscal 2004 Compared toThird Quarter of Fiscal 2003*

 

Net sales for the three months ended December 31, 2003 increased22% to $3,024,000 from the comparable period a year ago.   The increase resulted from continued strongsales of the Company’s bulk astaxanthin products, BioAstinâ andNatuRoseâ, which nearly doubled in sales from thesame period a year ago while all other products remained comparable to prioryear results.  International salesincreased 9% for the three months ended December 31, 2003 compared to theprior year period resulting from increased sales in Japan offset in part bylower sales in Europe.   As a percentageof total sales, international sales were 55% for the three months endedDecember 31, 2003 compared to 57% a year ago.  Two distributors of natural products, one based in Europe and onebased in the United States, accounted for 16% and 14%, respectively, of netsales for the three months ended December 31, 2003.  For the comparable period a year ago, onlythe European distributor accounted for more than 10% of net sales at 12% .

 

11

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Gross profit represents net sales less the cost of product sales, whichincludes the cost of materials, manufacturing overhead costs, direct labor costand depreciation and amortization.  Gross profit for the three months ended December 31, 2003 was$1,184,000, an increase of 67% from the $711,000 recorded in the comparableperiod a year ago.  The increase ingross profit is primarily attributable to increased sales of naturalastaxanthin products with higher profit margin and operating at more optimalproduction levels.

 

Operating expenses for the quarter ended December 31, 2003 were$892,000, an increase of 8% from the comparable prior year period.  Such increase in the current year period wasprimarily due to increases in bad debt reserves, increased royalty expense onhigher sales and the costs incurred in connection with appealing the proposeddelisting of the Company’s Common Stock (the Company’s Common Stocksubsequently regained compliance with the per share minimum bid pricerequirements and continues to be listed on the NASDAQ SmallCap Market).  The overall increase in expenditures waspartially offset by reduced advertising for packaged consumer products in thecurrent quarter.  As a percentage of netsales, research and development expenses for the quarter remained at 2%, salesand marketing expenses decreased to 10% from 14%, and general andadministrative expenses remained at 18%, compared to the comparable prior yearperiod.  The Company is committed toongoing cost containment aimed at controlling its level of operating expensesbut may increase such discretionary spending in future periods as dictated bythe needs of the business.

 

For the three months ended December 31,2003, an income tax provision of $114,000 was recorded for its operations inJapan.

 

*Nine Months Ended December 31, 2003Compared to Nine Months Ended December 31, 2002*

 

Net sales for the nine months ended December 31, 2003 were$8,292,000, a 27% increase from the comparable prior year period.   Significant increases in sales of theCompany’s bulk astaxanthin products were offset slightly by reduced sales ofspirulina and packaged consumer products.   International sales represented 57% and 58% of net sales for the ninemonth periods ended December 31, 2003 and 2002, respectively.   For the nine months ended December 31,2003 and 2002, sales to one European distributor of natural products accountedfor 12% and 16% of net sales, respectively.

 

Gross profit increased 33% to $2,749,000 for the nine months endedDecember 31, 2003, from $2,064,000 for the comparable period a yearago.  As a percentage of sales, thegross profit margin was comparable to the prior year period.   During the current year, the significant improvementin the third quarter gross profit margin offset a first quarter contractextraction facility problem that resulted in higher production costs.

 

Operating expenses were $2,475,000 during the nine months endedDecember 31, 2003, a decrease of $577,000, or 19% from the comparableperiod of fiscal 2003.  The Companyreduced spending in the current year period for discretionary contractualservices and packaged consumer products advertising.  All categories of operation expenses showed reduced spending ascompared to the prior year period: research and development expenses decreased$67,000 or 36%, sales and marketing expenses decreased $416,000 or 30% andgeneral and administrative expenses decreased $94,000 or 6%.

 

Net other expense amounted to $220,000, a decrease of $297,000, or 57%from the comparable period a year ago. The decrease is primarily attributable to $235,000 of prior year costsrelating to the May 2002 extension of the maturity date of the subordinatedconvertible debentures issued in 2000.  Other factors in the current year period decrease were lower interestexpense and gains arising from exchange rate fluctuations on transactions ofthe Company’s Japan subsidiary, which are denominated in Yen.

 

12

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A provision for income taxes of $96,000 was recorded in the nine monthsended December 31, 2003 for taxes relating to its operations in Japanpartially offset by a state tax refund.

 

*Variability of Results*

 

The Company has experienced significant quarterly fluctuations inoperating results and anticipates that these fluctuations may continue infuture periods. Future operating results may fluctuate as a result of changesin sales levels to our largest customers, new product introductions, productiondifficulties, weather patterns, the mix between sales of bulk products andpackaged consumer products, start-up costs associated with new facilities,expansion into new markets, sales promotions, competition, increased energycosts, foreign exchange fluctuations, the announcement or introduction of newproducts by competitors, changes in our customer mix, overall trends in themarket for our  products, governmentregulations and other factors beyond our control.  While a significant portion of our expense levels are relativelyfixed and the timing of increases in expense levels is based in large part onforecasts of future sales, if net sales are below expectations in any givenperiod, the adverse impact on results of operations may be magnified by ourinability to adjust spending quickly enough to compensate for the salesshortfall. We may also choose to reduce prices or increase spending in responseto market conditions, which may have a material adverse effect on financialcondition and results of operations.

 

**Liquidity and Capital Resources**

 

Working capital for the nine months ended December 31, 2003increased by $789,000 to $3,141,000 from $2,352,000 at March 31, 2003primarily due to an increase in cash and cash equivalents.  For the nine months ended December 31,2003, cash and cash equivalents increased by $938,000 to $1,517,000 due to cashflows provided from operating activities and the release of restricted funds bythe Company’s long-term debt holder partially offset by principal payments onlong-term debt, investments in equipment and leasehold improvements and arefundable deposit amounting to $88,000 which was required by the State ofHawaii in connection with an obligatory native wildlife conservation plan.  The primary reason for the increase in cashflows from operating activities was the substantial reduction in net lossesincurred by the Company.

 

Cash used in investing activities (for capital expenditures) decreased14% to $185,000 for the nine months ended December 31, 2003 from $217,000in the comparable prior year period due to the Company’s ongoing costcontainment program.  Investmentactivities may increase in future periods due to the Company’s plans toreallocate cultivation ponds and process equipment to increase production ofits natural astaxanthin products.  It isexpected that capital spending during the fourth quarter of fiscal 2004 willapproximate the level incurred during the quarter ended December 31, 2003.

 

Cash from financing activities amounted to $7,000 for the nine monthsended December 31, 2003, a decrease from $358,000 for the comparable prioryear period.  The decrease was primarilydue to $630,000 provided in the prior year period from the completion of aprivate placement of the Company’s Common Stock in May and October 2002,offset by the release, in July 2003, of $250,000 of restricted cashdeposits by the Company’s long-term debt holder.

 

*Term Loan Agreement*

 

The Company has a Term Loan Agreement (“Term Loan”) with a lenderproviding up to $3.5 million in credit facilities, secured by substantially allthe assets of the Company.  The TermLoan has a maturity date of May 1, 2010 and is payable in 120 equal monthlyprincipal and interest payments of approximately $48,000, commencingJune 1, 2000.  The interest rateunder this Term Loan, in the absence of a default under the agreement, is theprime rate, as defined, in effect as of the close of business on the first dayof each 

 

13

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calendar quarter, plus 1% (at December 31, 2003, the prime ratewas 4.0%).  At December 31, 2003,the Company was in compliance with all restrictive covenants of the TermLoan.  In connection with the Term Loanthe Company is prohibited from declaring any common stock dividends without thelender’s prior written consent.

 

On July 29, 2003, the Company received approval from the lenderfor the release of $250,000 of cash previously held as a restricted deposit inconnection with the Term Loan.   The useof these released funds is unrestricted and is being used by the Company forworking capital purposes.  A remaining$250,000 restricted cash deposit continues to be held in an interest-bearingrestricted cash account per the terms of the Term Loan and is included in OtherAssets on the consolidated balance sheet at December 31, 2003.   A warrant to purchase 20,000 shares of theCompany’s common stock was issued in conjunction with this Term Loan.  The warrant expires in April 2011 andhas an exercise price of $2.55 per share. The warrant may only be exercised after the Company has repaid the TermLoan in full.

 

*Conversion of Convertible Debentures dueSeptember 30, 2005*

 

In October 2002, the Company issued in aprivate placement (a) $1,250,000 principal amount of 10% ConvertibleSubordinated Debentures (the “Debentures”) originally due September 30,2004, convertible into shares of the Company’s Common Stock at a price of $0.65per share and (b) 750,000 shares of Common Stock with proceeds to the Companyof $300,000.  Proceeds from the Debentureswere used to retire convertible debentures of $1,238,000 due to mature onOctober 31, 2002.   The remainingnet proceeds from the issuance of Common Stock were used for working capitalpurposes.  Subsequent to thistransaction, the investor was elected to the Company’s Board of Directors.  In September 2003, the Company reachedan agreement with the holder of the Debentures to extend the maturity date byone year to September 30, 2005. The Company incurred no additional expenses associated with this extension.

 

On December 10, 2003, the holder of the Debentures voluntarilyconverted the entire principal amount of the Debentures into 1,923,076 sharesof Common Stock pursuant to the terms of the Debentures.

 

The Company’s contractual obligations due in by period as ofDecember 31, 2003 are as follows (in thousands):

 
|             |   | **Less than  1 Year** |   | **1 – 3  Years** |   | **4 – 5  Years** |   | **After  5 Years** |   | **Total** |   |
|------------------|--------|-----------------------|--------|-----------------------|--------|-----------------------|--------|--------------------|--------|-----------|--------|
| Long-term debt   |   | $                     | 323    |                  | $      | 667                   |   | $                  | 816    |      | $      | 717 |   | $ | 2,523 |   |
| Operating leases |   | 243                   |   | 466                   |   | 352                   |   | 2,368              |   | 3,429     |   |
| Total            |   | $                     | 566    |                  | $      | 1,133                 |   | $                  | 1,168  |      | $      | 3,085 |   | $ | 5,952 |   |

 

**Going Concern**

 

The Company’s consolidated financial statements have been prepared on agoing concern basis, which assumes continuity of operations and realization ofassets and liquidation of liabilities in the ordinary course of business.  For the nine months ended December 31,2003, the Company incurred a net loss of $42,000.   During the years ended March 31, 2003, 2002 and 2001, theCompany incurred losses of $1,775,000, $2,589,000 and $1,067,000, respectively.  The Company’s working capital atDecember 31, 2003 was $3,141,000 with cash and cash equivalents amountingto $1,517,000.  Net cash and cashequivalents provided by operating activities for the nine months endedDecember 31, 2003 was $1,116,000.  For the years ended March 31, 2003 and 2002, net cash and cashequivalents used in operating activities amounted to $502,000 and $567,000,respectively.

 

14

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The Company’s continuation as a going concern is dependent upon itsability to generate sufficient cash flow to meet its obligations on a timelybasis, to comply with the terms of its financing agreements, to obtainadditional financing or refinancing as may be required, to sustainprofitability, or a combination thereof. Although the Company generated cash and cash equivalents from operatingactivities for the nine months ended December 31, 2003, there can be noassurance that future efforts will continue to be successful or that theCompany will have sufficient cash resources to support its futureoperations.  The accompanying unauditedconsolidated financial statements do not include any adjustments that mightresult from the outcome of this uncertainty.

 

**Critical Accounting Policies**

 

Our unaudited financial statements and accompanying notes are preparedin accordance with accounting principles generally accepted in the UnitedStates of America for interim financial information and with the instructionsto Form 10-Q and Regulation S-X. Preparing financial statements requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenueand expenses.  These estimates andassumptions are affected by management’s application of accountingpolicies.  The Company has identifiedcertain policies that require the application of significant judgment bymanagement.  Our most criticalaccounting policies are those related to inventory valuation, revenuerecognition, equipment and leasehold improvements, income taxes and impairmentof long-lived assets.  These criticalaccounting policies are stated in the notes to consolidated financialstatements in the Company’s previously filed report on Form 10-K for the fiscalyear ended March 31, 2003.  Thisdiscussion and analysis should be read in conjunction with such notes and ourconsolidated financial statements and related notes included elsewhere in thisreport.

 

**Other Material Events**

 

*Common Stock Listing*

 

On June 18, 2003, the Company receivednotification from NASDAQ that it had been granted an additional 90 days untilSeptember 10, 2003 to meet compliance for continued listing on theSmallCap Market.   On September 15,2003, the Company requested a hearing with the NASDAQ Listing QualificationsPanel (the “Panel”) which was subsequently heard on October 16, 2003.   On November 14, 2003, the Companyannounced that in response to the appeal, the Company was given untilNovember 20, 2003 to demonstrate a closing bid price of at least $1.00 pershare for a minimum of ten consecutive trading days.

 

In a letter dated November 26, 2003, thePanel determined that the Company had evidenced compliance with allrequirements necessary for continued listing on the SmallCap Market, stating -“As of the close of business on November 25, 2003, the Companydemonstrated a closing bid price of at least $1.00 per share for 13 consecutivetrading days.   Accordingly, the Paneldetermined to continue the listing of the Company’s securities on the NASDAQ SmallCapMarket.”

 

*Conversion of Debentures*

 

On December 10,2003, the holder of the $1,250,000 principal amount Debenture voluntarilyconverted the debt to 1,923,076 shares of the Company’s common stock pursuantto the terms of the Debentures.

 

15

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*Recent Accounting Pronouncements*

 

In May 2003, the FASB issued SFAS No. 150 “Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities andEquity.”  SFAS No. 150 requires issuersto classify as liabilities (or assets in some circumstance) three classes offreestanding financial instruments that embody obligations for the issuer.  Generally, SFAS No. 150 is effective forfinancial instruments entered into or modified after May 31, 2003 and isotherwise effective at the beginning of the first interim period beginningafter June 15, 2003.  InNovember 2003, the effective date for certain mandatorily redeemablenon-controlling interests has been deferred indefinitely.  The adoption of SFAS No. 150 did not have amaterial effect on the Company’s financial condition, results of operations orliquidity.

 

**Outlook**

 

*This outlook section contains a numberof forward-looking statements, all of which are based on current expectations.Actual results may differ materially. See also the discussion of going concernuncertainty included elsewhere in Item 2.*

 

To successfully produce and market high-value natural products frommicroalgae has been and continues to be our strategy.  Our current line of product offerings include Certified Organicand Naturally Cultivated Spirulina Pacificaâin powder, flake and tablet form, NatuRoseânatural astaxanthin powder for the animal nutrition market, BioAstinânatural astaxanthin in lipid extract, softgel caplet and micro-encapsulatedbeadlet form for the human nutrition and cosmetic industries andPhycobiliproteins for use in medical diagnostics.  Information about our Company and our products can be viewed atwww.cyanotech.com, www.nutrex-hawaii.com or www.phycobiliprotein.com.  Consumer products can be purchased online atwww.nutrex-hawaii.com.

 

Net sales for the third quarter of 2004 were $3,024,000, a 6% increaseabove the $2,840,000 reported for the second quarter ended September 30,2003.   Third quarter sales increased inall of the Company’s bulk products, however, this was partially offset by theexpected decline in packaged product sales due to the seasonal holiday downturnin demand from our distributors.

 

Our natural astaxanthin products continued to experience strong demandin both the human nutrition and animal nutrition markets.  Our efforts in the human application marketwith BioAstin are promising and we are continuing our work withindustry-leading cosmetic manufacturers, pharmaceutical companies that offerbranded nutraceuticals, direct marketing organizations and natural foodsupplement manufacturers to integrate BioAstin into their products.

 

Likewise, NatuRose has become the natural alternative to syntheticastaxanthin in the aquaculture market, especially in Japan.  Recent news articles highlight the problemswith farmed fish, such as salmon, which are not raised on a natural diet butare fed synthetic astaxanthin in order to make farmed raised salmon appear liketheir wild counterparts.   Wild salmon arenaturally pink or orange in color due to natural astaxanthin, a carotenoid thatnot only adds color, but also possesses natural antioxidant and anti-agingproperties.   The appeal of our product,NatuRose, is that it is derived from a natural source and produces resultscomparable, or in some cases superior, to petro-chemical based syntheticastaxanthin.   Consistent with lastfiscal year, we expect some seasonal impact to our NatuRose sales for theaquaculture market in the last quarter of fiscal 2004.

 

16

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This quarter’s increased level of sales was accompanied by an increasein gross profit margin resulting from improved production efficiency.  Reducing our cost of production whileconcurrently allowing us to maintain our ability to cultivate and manufactureour high quality products at levels sufficient to serve our customers is theaim of our effort.   We are in theprocess of allocating more ponds to astaxanthin to increase production volumeswhile concurrently optimizing our Spirulina production by improving yield andquality.  However, there can be noassurance that such efforts will provide continuing improvement in gross profitmargin.  This effort may result inhigher investment in capital equipment in future periods.

 

Our Company is firmly committed to its ongoing cost containment effortaimed at controlling our level of operating expenses.  While operating expenses increased slightly during the thirdquarter as a result of higher general and administrative costs, we were stillable to keep our operating expense to a level consistent with the priorsequential quarter.   Such efforts haveresulted in Cyanotech’s return to profitability, reporting net income of$109,000 for the quarter ended December 31, 2003.   This improvement is due to the hard work ofevery employee in our Company and we are pleased with the results.

 

We enter the final quarter of fiscal 2004 with a much improvedfinancial condition.  OurDecember 31, 2003 consolidated balance sheet reflects the improvement inoperations with higher cash balances and working capital and lower long-termdebt, (as the result of voluntary conversion of the debentures — see Note 4 ofNotes to Consolidated Financial Statements). In addition to reducing overall debt and increasing the Company’s netequity, this conversion will decrease future quarterly interest expense byapproximately $31,000.

 

The Company’s future results of operations and the otherforward-looking statements contained in this Outlook, in particular thestatements regarding revenues, gross margin, research and development, andcapital spending, involve a number of risks and uncertainties. In addition tothe factors discussed above that could cause actual results to differmaterially are the following:  businessconditions and growth in the natural products industry and in the generaleconomy; changes in customer order patterns, outcome of the clinical trials forBioAstinâ, and changes in demandfor natural products in general; changes in weather conditions; competitivefactors, such as competing Spirulina and astaxanthin producers increasing theirproduction capacity and their impact on world market prices for Spirulina andastaxanthin; government actions; shortage of manufacturing capacity; and otherfactors beyond our control.  Riskfactors are discussed in detail in exhibit 99.1, hereto included in thisreport.

 

Cyanotech believes that it has the product offerings, facilities,personnel, and competitive and financial resources for improved results, butfuture revenues, costs, margins and profits are all influenced by a number offactors, as discussed above, all of which are inherently difficult to forecast.

 

17

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**Item 3.****           Quantitativeand Qualitative Disclosures About Market Risk**

 

We have not entered into any transactions using derivative financialinstruments or derivative commodity instruments and believe that our exposureto market risk associated with other financial instruments is not material.

 

**Item 4. ****Controls and Procedures**

 

Inaccordance with Item 307 of Regulation S-K promulgated by the Securities andExchange Commission, the Chairman of the Board, President and Chief ExecutiveOfficer (“CEO”) and the Chief Financial Officer (“CFO”) of the Company (the“Certifying Officers”) have conducted an evaluation of the Company’s disclosurecontrols and procedures as of December 31, 2003.  As defined under Sections 13a-15(e) and 15d-15(e) of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”), the term“disclosure controls and procedures” refers to controls and other procedures ofan issuer that are designed to ensure that information required to be disclosedby the issuer in the reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported, within the time periods specifiedin the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed byan issuer in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the issuer’s management, including itsprincipal executive officer or officers and principal financial officer orofficers, or persons performing similar functions, as appropriate to allowtimely decisions regarding required disclosure.

 

Basedon that evaluation, the CEO and CFO have concluded that the Company’sdisclosure controls and procedures are effective to provide reasonableassurance that material information relating to the Company is made known tomanagement, including the CEO and CFO, during the period when this report wasbeing prepared.  Subsequent to the dateof their evaluation, there were no significant changes in the Company’sinternal controls or in other factors that could significantly affect thedisclosure controls, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

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| **PART II.** |   | **OTHER INFORMATION**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|--------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| Item 1.      |   | Legal Proceedings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|         |   | None                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| Item 6.      |   | Exhibits and Reports on Form 8-K                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|         |   | a)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | The following exhibits are furnished with this report: |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |   |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 31.1 | Certification by the Chief Executive Officer pursuant to Rule  13a-14(a)/15d-14(a) of the Exchange Act |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |   |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 31.2 | Certification by the Chief Financial Officer pursuant to Rule  13a-14(a)/15d-14(a) of the Exchange Act |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |   |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 32.1 | Certification by the Chief Executive Officer pursuant to 18 U. S. C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |   |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 32.2 | Certification by the Chief Financial Officer pursuant to 18 U. S. C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |   |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 99.1 | Risk Factors |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |   |
|         |   | b)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | Reports on Form 8-K |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|         |   |      On November 14, 2003, the Company  filed a report on Form 8-K in conjunction with a press release announcing  that the Nasdaq Listing Qualifications Panel had made a decision that in  order for the Company’s shares to remain listed on the Nasdaq SmallCap  Market, the Company’s common stock must demonstrate a closing bid price of at  least $1.00 per share for a minimum of ten consecutive trading days on or  before November 20, 2003. |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|         |   |      On December 1, 2003, the Company  filed a report on Form 8-K in conjunction with a press release announcing  that Cyanotech had received notification that the Nasdaq Listing  Qualifications Panel had determined to continue the listing of the Company’s  securities on the Nasdaq Small Cap Market.                                                                                                                                                       |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|         |   |      On December 11, 2003, the Company  filed a report on Form 8-K in conjunction with a press release announcing  that the holder of a $1,250,000 principal amount convertible debenture had  voluntarily converted the debt to 1,923,076 shares of the Company’s common  stock.                                                                                                                                                                                  |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|         |   |      On February 2, 2004, the Company  filed a report on Form 8-K in conjunction with the Company’s press release  announcing the financial results of the Quarter ended December 31, 2003.                                                                                                                                                                                                                                                                   |

 

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**SIGNATURES**

 

In accordance with the requirements of the Securities Exchange Act of1934, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

 
|                         | CYANOTECH CORPORATION (Registrant) |
|------------------------------|------------------------------------|
|                         |
|                         |
| February  13, 2003 |                               | By: |  /s/ | Gerald R. Cysewski |   |
| (Date)                       |                               |   |   | Gerald R. Cysewski |
|                         |                               |   |   | Chairman of the Board, |
|                         |                               |   |   | President and Chief Executive Officer |
|                         |                               |   |   |   |
|                         |                               |   |   |   |
|                         |                               | By: | /s/ | Jeffrey H. Sakamoto |   |
|                         |                               |   |   | Jeffrey H. Sakamoto |
|                         |                               |   |   | Vice President – Finance & Administration |
|                         |                               |   |   | (Principal Financial and Accounting Officer) |
|                              |                                    |  |  |  |  |  |  |  |

 

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