**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 June 30, 2004**

 

**Commission File Number 0-14602**

 

| **CYANOTECH CORPORATION**                                           |
|---------------------------------------------------------------------|
| (Exact name of registrant as specified in  its charter)             |
|                                                                |
| **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 July 31, 2004:

 

| **Title of Class**              | ** ** | **Shares Outstanding** |
|---------------------------------|------------|------------------------|
| Common stock -  $.005 par value |       | 20,748,990             |

 

 

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CYANOTECH CORPORATION

FORM 10-Q

 

INDEX

 
| PART I.  FINANCIAL INFORMATION |                                                                                                               |
|-------------------------------------|--------------------------------------------------------------------------------------------------------------------|
|                                |                                                                                                               |   |
| Item 1.                             | Financial Statements                                                                                               |   |
|                                |                                                                                                               |   |
|                                | Consolidated Balance  Sheets (unaudited)  As of June 30, 2004 and March 31, 2004                         |   |
|                                |                                                                                                               |   |
|                                | Consolidated Statements of Operations  (unaudited)  For the three month periods ended  June 30, 2004 and 2003 |   |
|                                |                                                                                                               |   |
|                                | Consolidated Statements of Cash Flows  (unaudited)  For the three month periods ended  June 30, 2004 and 2003 |   |
|                                |                                                                                                               |   |
|                                | 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)

 
| ** **                                                                                                                                                             | ** ** | **June 30,  2004** | ** ** | **March 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| ASSETS                                                                                                                                                                 |       |                    |       |                     |       |
| Current assets:                                                                                                                                                        |       |                    |       |                     |       |
| Cash and cash equivalents                                                                                                                                              |       | $                       | 2,441      |                     | $          | 2,531 |   |
| Accounts receivable, net                                                                                                                                               |       | 1,945                   |       | 2,211                    |       |
| Refundable income taxes                                                                                                                                                |       | 11                      |       | 11                       |       |
| Inventories (see Note 2)                                                                                                                                               |       | 1,307                   |       | 1,099                    |       |
| Prepaid expenses and other                                                                                                                                             |       | 200                     |       | 55                       |       |
| Total current assets                                                                                                                                                   |       | 5,904                   |       | 5,907                    |       |
|                                                                                                                                                                   |       |                    |       |                     |       |
| Equipment and leasehold improvements, net  (see Note 3)                                                                                                                |       | 11,748                  |       | 11,844                   |       |
| Other assets                                                                                                                                                           |       | 588                     |       | 606                      |       |
| Total assets                                                                                                                                                           |       | $                       | 18,240     |                     | $          | 18,357 |   |
|                                                                                                                                                                   |       |                    |       |                     |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                              |       |                    |       |                     |       |
| Current liabilities:                                                                                                                                                   |       |                    |       |                     |       |
| Current maturities of long-term debt                                                                                                                                   |       | $                       | 346        |                     | $          | 346 |   |
| Accounts payable                                                                                                                                                       |       | 716                     |       | 874                      |       |
| Accrued expenses                                                                                                                                                       |       | 568                     |       | 604                      |       |
| Total current liabilities                                                                                                                                              |       | 1,630                   |       | 1,824                    |       |
|                                                                                                                                                                   |       |                    |       |                     |       |
| Long-term debt, excluding current  maturities                                                                                                                          |       | 2,009                   |       | 2,093                    |       |
| Total liabilities                                                                                                                                                      |       | 3,639                   |       | 3,917                    |       |
|                                                                                                                                                                   |       |                    |       |                     |       |
| Stockholders’ equity:                                                                                                                                             |       |                    |       |                     |       |
| Common stock of $0.005 par value, shares  authorized 25,000,000; shares issued and outstanding 20,748,990 at  June 30, 2004 and 20,714,246 at March 31, 2004 |       | 104                     |       | 104                      |       |
| Additional paid-in capital                                                                                                                                             |       | 27,175                  |       | 27,141                   |       |
| Accumulated other comprehensive income -  foreign currency translation adjustments                                                                                     |       | 44                      |       | 30                       |       |
| Accumulated deficit                                                                                                                                                    |       | (12,722                 | )          | (12,835                  | )          |
| Total stockholders’ equity                                                                                                                                        |       | 14,601                  |       | 14,440                   |       |
|                                                                                                                                                                   |       |                    |       |                     |       |
| Total liabilities and stockholders’ equity                                                                                                                        |       | $                       | 18,240     |                     | $          | 18,357 |   |

 

See accompanying Notes to ConsolidatedFinancial Statements.

 

3

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CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per shareamounts)

(Unaudited)

 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                        | ** ** | ** **                           | ** ** | ** ** | ** ** |
| NET SALES                         |       | $                                    | 2,707      |   | $ | 2,428 |   |
| COST OF PRODUCT SALES             |       | 1,820                                |       | 1,724 |   |
| Gross Profit                      |       | 887                                  |       | 704 |   |
|                              |       |                                 |       |   |   |
| OPERATING EXPENSES:               |       |                                 |       |   |   |
| Research and development          |       | 65                                   |       | 38 |   |
| General and administrative        |       | 367                                  |       | 407 |   |
| Sales and marketing               |       | 294                                  |       | 309 |   |
| Total operating expenses          |       | 726                                  |       | 754 |   |
|                              |       |                                 |       |   |   |
| Income (loss) from operations     |       | 161                                  |       | (50 | ) |
|                              |       |                                 |       |   |   |
| OTHER INCOME (EXPENSE):           |       |                                 |       |   |   |
| Interest income                   |       | 8                                    |       | 8 |   |
| Interest expense                  |       | (39                                  | )          | (88 | ) |
| Other expense, net                |       | (2                                   | )          | (29 | ) |
| Total other expense, net          |       | (33                                  | )          | (109 | ) |
|                              |       |                                 |       |   |   |
| Income (loss) before income taxes |       | 128                                  |       | (159 | ) |
|                              |       |                                 |       |   |   |
| INCOME TAX EXPENSE (BENEFIT)      |       | 15                                   |       | (18 | ) |
|                              |       |                                 |       |   |   |
| NET INCOME (LOSS)                 |       | $                                    | 113        |   | $ | (141 | ) |
|                              |       |                                 |       |   |   |
| NET INCOME (LOSS) PER SHARE:      |       |                                 |       |   |   |
| Basic                             |       | $                                    | 0.01       |   | $ | (0.01 | ) |
| Diluted                           |       | $                                    | 0.01       |   | $ | (0.01 | ) |
|                              |       |                                 |       |   |   |
| SHARES USED IN CALCULATION OF     |       |                                 |       |   |   |
| NET INCOME (LOSS) PER SHARE:      |       |                                 |       |   |   |
| Basic                             |       | 20,736                               |       | 18,317 |   |
| Diluted                           |       | 20,992                               |       | 18,317 |   |
|                              |       |                                 |       |   |   |
| COMPREHENSIVE INCOME (LOSS):      |       |                                 |       |   |   |
| Net income (loss)                 |       | $                                    | 113        |   | $ | (141 | ) |
| Other comprehensive income (loss) |       | 14                                   |       | (5 | ) |
|                              |       | $                                    | 127        |   | $ | (146 | ) |

 

See accompanying Notes to ConsolidatedFinancial Statements.

 

4

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CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 
| ** **                                                                           | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                                                                           | ** ** | ** **                           | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                |       |                                 |       |   |   |
| Net income (loss)                                                                    |       | $                                    | 113        |   | $ | (141 | ) |
| Adjustment to reconcile net income (loss)  to cash provided by operating activities: |       |                                 |       |   |   |
| Depreciation and amortization                                                        |       | 331                                  |       | 335 |   |
| Amortization of debt issue costs and other  assets                                   |       | 7                                    |       | 17 |   |
| Net (increase) decrease in assets:                                                   |       |                                 |       |   |   |
| Accounts receivable                                                                  |       | 266                                  |       | 293 |   |
| Refundable income taxes                                                              |       | —                               |       | (18 | ) |
| Inventories                                                                          |       | (208                                 | )          | (16 | ) |
| Prepaid expenses and other assets                                                    |       | (120                                 | )          | (168 | ) |
| Net increase (decrease) in liabilities:                                              |       |                                 |       |   |   |
| Accounts payable                                                                     |       | (158                                 | )          | (66 | ) |
| Accrued expenses                                                                     |       | (36                                  | )          | (7 | ) |
| Net cash provided by operating activities                                            |       | 195                                  |       | 229 |   |
|                                                                                 |       |                                 |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                |       |                                 |       |   |   |
| Investment in equipment and leasehold  improvements                                  |       | (235                                 | )          | (47 | ) |
|                                                                                 |       |                                 |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITES:                                                 |       |                                 |       |   |   |
| Proceeds from exercise of stock options and  warrants                                |       | 34                                   |       | — |   |
| Principal payments on long-term debt                                                 |       | (84                                  | )          | (80 | ) |
| Net cash used in financing activities                                                |       | (50                                  | )          | (80 | ) |
|                                                                                 |       |                                 |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                |       | (90                                  | )          | 102 |   |
| Cash and cash equivalents at beginning of  period                                    |       | 2,531                                |       | 579 |   |
|                                                                                 |       |                                 |       |   |   |
| Cash and cash equivalents at end of period                                           |       | $                                    | 2,441      |   | $ | 681 |   |

 

See accompanying Notes to ConsolidatedFinancial Statements.

 

5

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CYANOTECH CORPORATION

FORM 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of June 30, 2004

(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, theydo not include all of the information and footnotes required by generallyaccepted accounting principles for complete financial statements.  These consolidated financial statements andnotes should be read in conjunction with the Company’s consolidated financialstatements contained in the Company’s previously filed report on Form 10-K forthe year ended March 31, 2004.

 

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.  Allsignificant intercompany balances and transactions have been eliminated inconsolidation.  While the financialinformation furnished for the three month period ended June 30, 2004 isunaudited, the statements in this report reflect all material items which, inthe opinion of management, are necessary for a fair presentation of the resultsof operations for the interim periods covered and of the financial condition ofthe Company at the dates of the consolidated balance sheets. The operatingresults for the interim period presented are not necessarily indicative of theresults that may be expected for the year ending March 31, 2005.

 

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 and the disclosure of any contingent assets andliabilities as of the date of the financial statements and the reported amountsof revenues and expenses during the period reported.  Management reviews theses estimates andassumptions periodically and reflects the effect of revisions in the periodthat they are determined to be necessary. Actual results could differ significantly from those estimates andassumptions.

 

2.                                       INVENTORIES

 

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

 
| ** **      | ** ** | **June 30, 2004** | ** ** | **March 31, 2004** | ** ** |
|-----------------|------------|------------------------|------------|-------------------------|------------|
|            |       |                   |       |                    |       |
| Raw materials   |       | $                      | 126        |                    | $          | 191 |   |
| Work in process |       | 246                    |       | 154                     |       |
| Finished goods  |       | 795                    |       | 567                     |       |
| Supplies        |       | 140                    |       | 187                     |       |
|            |       | $                      | 1,307      |                    | $          | 1,099 |   |

 

6

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3.                                       EQUIPMENTAND LEASEHOLD IMPROVEMENTS

 

Equipment and leasehold improvements are stated at cost. Depreciationand amortization are provided using the straight-line method over the estimateduseful lives for equipment and furniture and fixtures, or the shorter of theland lease term or estimated useful lives for leasehold improvements asfollows:

 
| Equipment              |   | 3 to 10 years  |   |
|------------------------|--------|----------------|--------|
| Furniture and fixtures |   | 7 years        |   |
| Leasehold improvements |   | 10 to 22 years |   |

 

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

 
| ** **                                      | ** ** | **June 30, 2004** | ** ** | **March 31, 2004** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
|                                            |       |                   |       |                    |       |
| Equipment                                       |       | $                      | 9,756      |                    | $          | 9,753 |   |
| Leasehold improvements                          |       | 14,360                 |       | 14,326                  |       |
| Furniture and fixtures                          |       | 83                     |       | 83                      |       |
|                                            |       | 24,199                 |       | 24,162                  |       |
| Less  accumulated depreciation and amortization |       | (13,017                | )          | (12,687                 | )          |
| Construction in-progress                        |       | 566                    |       | 369                     |       |
| Equipment and leasehold improvements, net       |       | $                      | 11,748     |                    | $          | 11,844 |   |

 

4.                                       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 endedJune 30, 2004 are as follows (there were no reconciling items for thethree months ended June 30, 2003):

 
| ** **                                                              | ** ** | **Three Months Ended June 30, 2004** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                              | ** ** | **Net Income  (Numerator)**               | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
| ** **                                                              | ** ** | **(in thousands)**                        | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
|                                                                    |       |                                      |       |   |   |   |   |
| Basic earnings per share                                                |       | $                                         | 113        |   | 20,736 |   | $ | 0.01 |   |
| Effect of dilutive securities – Common  stock options and warrants |       | —                                    |       | 256 |   |   |   |
| Diluted earnings per share                                              |       | $                                         | 113        |   | 20,992 |   | $ | 0.01 |   |

 

7

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

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                             | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Stock options and warrants                             |       | 192                                   |       | 1,267 |   |
| Debentures, prior to conversion in  December 2003 |       | —                                |       | 1,923 |   |

 

5.                                       STOCK-BASEDCOMPENSATION

 

As allowed by Statement of Financial Accounting Standards (“SFAS”) No.123, *Accounting for Stock-BasedCompensation,*the Company has elected to continue to apply theintrinsic value-based method of accounting for employee based stock options andadopted only the disclosure requirements of SFAS No. 123.  The following table illustrates the effect onnet income (loss) and net income (loss) per common share if the Company hadapplied the fair-value method under SFAS No. 123 to its employee stock options:

 
| ** **                                                                                          | ** ** | **Three Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                          | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Net income (loss), as reported                                                                      |       | $                                     | 113        |   | $ | (141 | ) |
| Deduct stock-based employee compensation  expense determined under fair-value method for all awards |       | (19                                   | )          | (21 | ) |
| Pro forma net income (loss)                                                                         |       | $                                     | 94         |   | $ | (162 | ) |
|                                                                                                |       |                                  |       |   |   |
| Basic net income (loss) per common share:                                                           |       |                                  |       |   |   |
| As reported                                                                                         |       | $                                     | 0.01       |   | $ | (0.01 | ) |
| Pro forma                                                                                           |       | $                                     | 0.00       |   | $ | (0.01 | ) |
|                                                                                                |       |                                  |       |   |   |
| Diluted net income (loss) per common share:                                                         |       |                                  |       |   |   |
| As reported                                                                                         |       | $                                     | 0.01       |   | $ | (0.01 | ) |
| Pro forma                                                                                           |       | $                                     | 0.00       |   | $ | (0.01 | ) |

 

8

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**CYANOTECH CORPORATION**

 

**Item 2.****           Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*This report on Form 10-Q contains forward-looking statements regardingthe future performance of Cyanotech and future events that involve risks anduncertainties that could cause actual results to differ materially from thestatements contained herein. This document, and the other documents that theCompany files from time to time with the Securities and Exchange Commission,such as its reports on Form 10-K, Form 10-Q, Form 8-K, and its proxy materials,contain additional important factors that could cause actual results to differfrom the Company’s current expectations and the forward-looking statementscontained herein.*

 

## **Overview**

 

A comparison of selectedconsolidated statements of operations data as reported herein and in theCompany’s previously filed report on Form 10-K for the year ended March 31,2004 follows for the periods indicated (dollars in thousands):

 
| ** **                     | ** ** | **Three Months Ended  June 30, 2004** | ** ** | **Prior Year  Comparable Quarter  Three Months Ended  June 30, 2003** | ** ** | **Prior  Consecutive Quarter  Three Months Ended  March 31, 2004** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **$**                                      | ** ** | **$**                                                                      | ** ** | **Change**                                                              | ** ** | **$** | ** ** | **Change** | ** ** |
|                           |       |                                       |       |                                                                       |       |                                                                    |       |   |   |   |   |
| Net sales:                     |       |                                       |       |                                                                       |       |                                                                    |       |   |   |   |   |
| Spirulina  products            |       | $                                          | 1,379      |                                                                       | $          | 1,429                                                                   |       | (3 | )% | $ | 2,077 |   | (34 | )% |
| Natural astaxanthin products   |       | 1,303                                      |       | 928                                                                        |       | 40                                                                      | %          | 1,189 |   | 10 | % |
| Other products                 |       | 25                                         |       | 71                                                                         |       | (65                                                                     | )%         | 24 |   | 4 | % |
|                           |       | $                                          | 2,707      |                                                                       | $          | 2,428                                                                   |       | 11 | % | $ | 3,290 |   | (18 | )% |
|                           |       |                                       |       |                                                                       |       |                                                                    |       |   |   |   |   |
| Gross profit                   |       | $                                          | 887        |                                                                       | $          | 704                                                                     |       | 26 | % | $ | 1,191 |   | (26 | )% |
|                           |       |                                       |       |                                                                       |       |                                                                    |       |   |   |   |   |
| Income  (loss) from operations |       | $                                          | 161        |                                                                       | $          | (50                                                                     | )          | 422 | % | $ | 455 |   | (65 | )% |
|                           |       |                                       |       |                                                                       |       |                                                                    |       |   |   |   |   |
| Net income (loss)              |       | $                                          | 113        |                                                                       | $          | (141                                                                    | )          | 180 | % | $ | 441 |   | (74 | )% |

 

For the first quarter of fiscal2005, the Company’s results improved from the first quarter of fiscal 2004;however, on a consecutive quarter basis, results declined from the three monthsended March 31, 2004.   For the threemonths ended June 30, 2004, we were unable to fulfill all of our customers’orders for certain Spirulina products thus resulting in a decline in currentquarter revenues from the revenue levels reported in the fourth quarter offiscal 2004.   The shortage of certainSpirulina products was caused by unseasonably rainy weather during the quartercausing a nutrient imbalance in our cultivation ponds.   Efficient cultivation of microalgae requiresconsistent light, warm temperature, low rainfall and proper chemical balance ina very nutrient-rich environment.   Ifthe chemical balance of a pond changes, the cellular composition and hence thequality of the Spirulina can be affected.

 

Historically, our facility at Keahole Point usually experiences wetweather during December through February.  This year the rainy season continued into June with precipitationmeasurements recorded at the

 

9

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nearby airport by the National Oceanic and Atmospheric Administrationat 383% of our normal levels for the April to June period.   Although action to remedy the unanticipatedsituation was timely, the amount and duration of the precipitation and shippingdelays of ordered nutrients from our suppliers in California hampered ourability to remedy the problem.   Ourponds are now stabilizing at the proper chemical balance.  The quantity of the first quarter’sproduction of Spirulina was consistent with past levels but the quality of suchproduction was affected.   This resultedin a portion of the current quarter’s Spirulina production being of a lesserquality grade not suitable for use in certain Spirulina products because of ourinternal quality standards and specifications.  Thus we were unable to produce enough of those Spirulina products tofill some customers’ orders.

 

Spirulina that does not meet our highest quality standards is sold to alimited number of manufacturers, such as animal feed formulators.   The value of this Spriulina in this marketis less than the selling price for our standard Spirulina products, and in somecases, its production cost will exceed market value.   When cost exceeds market value, inaccordance with our accounting policy regarding inventory valuation, we statethe inventory at the lower market value.  This results in higher cost of sales and lower gross profit margins asexperienced in the current quarter from the fourth quarter of fiscal 2004.   Our gross profit margin percentage was 33%for the three months ended June 30, 2004 compared to 36% for the threemonths ended March 31, 2004.

 

Compared to the prior consecutive quarter ended March 31, 2004,both income from operations and net income decreased during the current quarterdue to lower sales and gross profit margins.  Current quarter’s operating expenses and total other expense, net werecomparable to the fourth quarter of fiscal 2004.

 

**Results of Operations**

 

*First Quarter of Fiscal 2005 Compared to First Quarter of Fiscal 2004*

 

Net sales for the three months ended June 30, 2004 increased 11%to $2,707,000 from the comparable period a year ago.   The increase resulted primarily fromincreased volume in sales.  International sales were 46% of total sales for the current year’s firstquarter compared to 56% a year ago. Historically, our major customers (sales exceeding 10% of total sales)were two distributors, one based in Europe and one in the United States.   For the three months ended June 30,2004, the United States distributor accounted for 11% of sales.   The European distributor placed an order atthe end of the first quarter of this year, to be shipped in the second quarter;therefore, our first quarters’ sales were less than 10% for this customer.   For the comparable period a year ago, salesto the European distributor amounted to 16% of total sales.

 

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.  Grossprofit for the three months ended June 30, 2004 was $887,000, an increaseof 26% from the $704,000 recorded in the comparable period a year ago.  The increase in gross profit is primarilyattributable to increased volume in sales in the current year and thenon-recurrence of prior year costs associated with a contractual extractionfacility problem.  Partially offsettingthese items in the current year quarter were costs associated with Spirulinapond instability resulting from inclement weather.

 

Operating expenses for the quarter ended June 30, 2004 were$726,000, a 4% decrease from the comparable prior year period.  Research and development expenses increaseddue primarily to the participation in a customer sponsored clinical study, butsales and marketing expenses decreased 5% primarily due to reduced spendingassociated in the Company’s packaged product business.   General and administrative expensesdecreased 10% primarily due to the cessation of certain royalty payments in thethird quarter of fiscal 2004.

 

10

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As a percentage of net sales, research and development expenses for thecurrent quarter remained at 2%, sales and marketing expenses decreased to 11%from 13%, and general and administrative expenses decreased to 14% from 17%,compared to the comparable prior year period. The Company is committed to ongoing discretionary cost containment butmay invest in focused expenditures in future periods as dictated by the needsof the business.

 

Total other expense, net improved 70% for thethree months ended June 30, 2004 from the comparable period a year agoprimarily due to lower interest expense in the current period as a result ofthe conversion of the outstanding debentures in December 2003.

 

For the three months ended June 30, 2004, an income tax provisionof $15,000 was recorded for our operations in Japan.   For the three months ended June 30,2003, a benefit for estimated state income tax refunds of $18,000 was recorded.

 

*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, government regulations and other factors beyond ourcontrol.  A significant portion of ourexpense levels are relatively fixed and the timing of increases in expenselevels is based in large part on forecasts of future sales.   Therefore, if net sales are belowexpectations in any given period, the adverse impact on results of operationsmay be magnified by our inability to adjust spending quickly enough tocompensate for the sales shortfall. We may also choose to reduce prices orincrease spending in response to market conditions, which may have a materialadverse effect on financial condition and results of operations.

 

**Liquidity and Capital Resources**

 

Working capital for the three months ended June 30, 2004 increasedby $191,000 to $4,274,000 from $4,083,000 at March 31, 2004.   The increase to working capital wasprimarily from higher inventory balances and prepaid assets, and a decrease inaccounts payable.   The working capitalincrease was partially offset by decreases in our cash and cash equivalents andaccounts receivable balances.  For thethree months ended June 30, 2004, cash and cash equivalents decreased by$90,000 to $2,441,000.   The Companygenerated cash from operations of $195,000 in the current quarter.

 

Cash used in investing activities (for capital expenditures) was$235,000 for the three months ended June 30, 2004 from $47,000 in thecomparable prior year period.   Theseinvestments were for our natural astaxanthin production expansion which isexpected to continue into the third quarter of this fiscal year at a totalbudgeted cost of approximately $750,000.

 

Cash used in financing activities represented principal payments on theCompany long-term debt of $84,000 and $80,000 for the three months endedJune 30, 2004 and 2003, respectively.  In addition, the Company received cash proceeds of $34,000 from theexercise of stock options and warrants during the first quarter of fiscal 2005.

 

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The Company’s contractual obligations and commitments (consisting of aterm loan and operating leases) are disclosed in the Company’s previously filedreport on Form 10-K for the fiscal year ended March 31, 2004 in thefollowing sections: Item. 7 Management’s Discussion and Analysis of FinancialCondition and Results of Operations – Liquidity and Capital Resources, and Item8. Financial Statements and Supplementary Data – Notes 5 and 6 of Notes to ConsolidatedFinancial Statements.   There have beenno significant changes in contractual obligations and commitments fromMarch 31, 2004 to June 30, 2004, other than those reported elsewherein this Form 10-Q.

 

## **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 critical accountingpolicies are those related to inventory valuation, revenue recognition,equipment and leasehold improvements, income taxes and impairment of long-livedassets.  These critical accountingpolicies are stated in the notes to consolidated financial statements in theCompany’s previously filed report on Form 10-K for the fiscal year endedMarch 31, 2004.  This discussion andanalysis should be read in conjunction with such notes and our consolidatedfinancial statements and related notes included elsewhere in this report.

 

## **Outlook**

 

*This outlook section contains a number of forward-lookingstatements, all of which are based on current expectations.  Actual results may differ materially.   See first paragraph of this Item 2.*

 

Cyanotech Corporation’s ongoing strategy to be a world-leader in theproduction and marketing of high-value natural products from microalgaecontinues to be the focus of our company. Our current product offerings include Certified Organic and NaturallyCultivated Spirulina Pacifica® in powder, flake and tablet form, NatuRose®natural astaxanthin powder for the animal nutrition market, BioAstin® naturalastaxanthin antioxidant 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 ourproducts can be viewed at www.cyanotech.com, www.nutrex-hawaii.com or www.phycobiliprotein.com .  Consumer productscan also be purchased online at www.nutrex-hawaii.com .

 

We began fiscal 2005 with net sales of $2,707,000 for the quarter endedJune 30, 2004, compared to $2,428,000 and $3,290,000 reported for thefirst quarter and fourth quarter of the prior year, respectively.  Although our total net sales declined fromthe fourth quarter of the prior year, sales of our natural astaxanthin productsgrew 10% above the prior consecutive quarter level and 40% above the priorcomparable quarter level.   However,sales of our Spirulina products did not show increased sales this quarter as aresult of inclement weather production issues previously described.

 

Sales of our natural astaxanthin products, BioAstin and NatuRose,continued to increase steadily during the first quarter and are in line withour projections for fiscal 2005.  OurNatuRose product has widespread acceptance in Japan for aquaculture use as thenatural alternative to synthetic pigments. As in such use, we

 

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expect to see increased competition from other manufacturers of similarnatural pigments.  We are, however,confident of our ability to market NatuRose successfully and believe we havecustomers who are committed to this product. We are also diversifying our customer base for NatuRose in otherinternational aquaculture markets. Concurrently, sales of BioAstin, our natural astaxanthin product for thehuman nutrition and cosmetics markets continue to remain strong.  Here again, we are diversifying our customerbase and are experiencing increased acceptance of BioAstin as an efficientantioxidant for multiple applications in nutraceutical formulations.

 

During the first quarter we continued to increase our productioncapacity for our natural astaxanthin products. This project, which is comprised of the conversion of cultivation pondsand selected improvements in processing equipment, is on schedule andbeing funded entirely by cash flow generated from operations.  We expect all phases of this project to becompleted by December 31, 2004, the end of our third fiscal quarter.

 

Our Spirulina products are a significant component of our businessrepresenting 51% of net sales for the current quarter and 59% and 63% of netsales for the first and fourth quarters of the prior year, respectively.   Although we were unable to satisfy all ofour customers orders this quarter, we continued to see a significant demand forour Spirulina products.   Our backlog ofSpirulina orders as of June 30, 2004, increased over 300% from theMarch 31, 2004 balance.   We may notbe able to fill all such orders in the current quarter.   Although we have balanced the chemicalcomposition of our cultivation ponds after the heavy rains of the recent past,our cost of goods sold for Spirulina products will probably remain even withprofit margins of our prior quarter.  This is due to the first quarter residual carrying cost impacts in ourexisting finished goods inventories.

 

The Company’s future results of operations and the otherforward-looking statements contained in this Outlook, in particular thestatements regarding revenues, gross margin and capital spending involve anumber of risks and uncertainties.  Inaddition to the factors discussed above that could cause actual results todiffer materially are the following: business conditions and growth in the natural products industry and inthe general economy; changes in customer order patterns; changes in demand fornatural products in general; changes in weather conditions; competitivefactors, such as competing spirulina and astaxanthin producers increasing theirproduction capacity and the resulting impact, if any, on world market pricesfor these products; government actions; shortage of manufacturing capacity; andother factors 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, but futurerevenues, costs, margins and profits are all influenced by a number of factors,as discussed above, all of which are inherently difficult to forecast.

 

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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.

 

**Item4.  Controls and Procedures**

 

Underthe supervision and with the participation of management, including thePresident and Chief Executive Officer (“CEO”) and the Chief Financial Officer(“CFO”) of the Company (the “Certifying Officers”), we have evaluated theeffectiveness of the Company’s disclosure controls and procedures as of the endof the period covered by this report in accordance with Item 307 of RegulationS-K promulgated by the Securities and Exchange Commission.  As defined under Rules 13a-15(e) or 15d-15(e)issued under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), the term “disclosure controls and procedures” refers to controls andother procedures of an issuer that are designed to ensure that informationrequired to be disclosed by the issuer in the reports that it files or submitsunder the Exchange Act is recorded, processed, summarized and reported, withinthe time periods specified in the Commission’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by an issuer in the reports that it files or submitsunder the Exchange Act is accumulated and communicated to the issuer’smanagement, including its principal executive officer or officers and principalfinancial officer or officers, or persons performing similar functions, asappropriate to allow timely decisions regarding required disclosure.

 

Basedon that evaluation, the CEO and CFO have concluded that the Company’sdisclosure controls and procedures are effective.   There were no changes in our internalcontrols over financial reporting during the quarter ended June 30, 2004that have materially affected, or are reasonably likely to materially affect,our internal controls over financial reporting.

 

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PART II.                                                 OTHER INFORMATION

 

Item 1.                                                             LegalProceedings

 

None

 

Item 6.                                                             Exhibitsand 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                                    |
|   |                                                   |   |
|   | (1)                                                    | A report on Form 8-K dated April 1, 2004 included Item 5. Other  Events and Regulation FD Disclosure and Item 7. Financial Statements, Pro  Forma Financial Information and Exhibits in conjunction with the Company’s  press release announcing the resignation of Ronald P. Scott from the  Company’s Board of Directors. |
|   |                                                   |   |
|   | (2)                                                    | A report on Form 8-K dated May 11, 2004 included Item 12. Results of  Operations and Financial Condition in conjunction with the Company’s press  release announcing the financial results for the Quarter ended March 31,  2004. |

 

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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) |
|----------------------|------------------------------------|
|                 |                               |   |
|                 |                               |   |
| August 13, 2004 |                               |   | 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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